EUROCURRENCY LOANS AND EUROMARKETS

Eurocurrency market

Definition and background• The Eurocurrency market consists of banks

(called Eurobanks) that accept deposits and make loans in foreign currencies. A Eurocurrency is a freely convertible currency deposited in a bank located in a country which is not the native country of the currency. The deposit can be placed in a foreign bank or in the foreign branch of a domestic US bank.

• [Note of caution! The prefix Euro has little or nothing to do with the newly emerging currency in Europe.]

• Eurocurrency is any deposit of a currency in a country other than that of the currency’s origin. For example, a deposit of $US in a bank in France is a deposit of Euro-dollars. The entire market for loans and deposits in Eurocurrency is the Eurocurrency Market. The Eurocurrency Market does not have buyers and sellers, it has lenders and borrowers. Note that the prefix “Euro” is historical in nature, referring to the fact that the market was initially centred in Europe. Today, however, a deposit of $US in a Japanese bank is still referred to as Eurocurrency.

Eurocurrency market

• From relatively humble beginnings, the Eurocurrency deposits have developed into a market measured in the trillions of dollars (as of 1989 the total value of eurocurrency deposits globally was over $5 trillion US). The Eurocurrency market was created to avoid capital controls imposed by governments. It grew in response to further capital controls, especially by the U.S. government (for example the Interest Equalization Tax of 1963 applied to interest earned from $US loans to foreign firms (since repealed), and Regulation Q (also since repealed) which put a limit on the rate that could be paid by American banks on deposits).

Eurocurrency market

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THE EUROMARKETSTHE EUROMARKETS

THE EUROMARKETS THE EUROMARKETS

- the most important international - the most important international financial markets today.financial markets today.

The Eurocurrency MarketThe Eurocurrency Market

- Composed of eurobanks who - Composed of eurobanks who accept/maintain deposits of foreign accept/maintain deposits of foreign currencycurrency

-Dominant currency: US$-Dominant currency: US$

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THE EUROMARKETSTHE EUROMARKETS

Growth of Eurodollar Market caused by Growth of Eurodollar Market caused by restrictive US government policies, restrictive US government policies, especiallyespecially

• Reserve requirements on depositsReserve requirements on deposits

• Special charges and taxesSpecial charges and taxes

• Required concessionary loan ratesRequired concessionary loan rates

• Interest rate ceilingsInterest rate ceilings

• Rules which restrict bank competition.Rules which restrict bank competition.

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THE EUROMARKETSTHE EUROMARKETSEurodollar Creation involvesEurodollar Creation involves• A chain of depositsA chain of deposits• Changing control/usage of depositChanging control/usage of depositEurocurrency loansEurocurrency loans• Use London Interbank Offer Rate: LIBOR as Use London Interbank Offer Rate: LIBOR as

basic ratebasic rate• Six month rolloversSix month rollovers• Risk indicator: size of margin between cost Risk indicator: size of margin between cost

and rate and rate charged.charged.

• Generally, Eurobanks are able to pay higher rates on deposits and charge lower rates on loans than purely domestic banks. They are able to do this because they can often avoid government regulations such as reserve requirements and the need to pay deposit insurance. This lowers the cost of operations for Eurobanks and these lower costs can be passed through to the clients. As well, eurocurrency loans are generally very large and the customers are well known firms. This means that the banks are not subject to as much default risk and can charge lower margins on the large loans

THE EUROMARKETSTHE EUROMARKETS

BENEFITS

Thriving on government regulationBy using Euromarkets, banks and financiers

are able to circumvent / avoid certain regulatory costs and restrictions. Some examples are:

• Reserve requirements• Requirement to pay FDIC fees• Rules or regulations that restrict

competition among banks

Illustration I• German firm sells medical equipment to institutional buyer

in the US. It receives a US$ check drawn on Citicorp, NY. Initially this check is deposited in a checking account for dollar working capital use. But to earn a higher return (or rate of interest) on the $ 1 million the German firm decides to place the funds in a time deposit with a bank in London, UK.

• One million Eurodollars have thus been created by substituting a dollar account in a London bank for the dollar account held in NY. Notice that no US $ left NY but ownership of the US deposit has moved from a foreign corporation to a foreign bank. The London bank would not like to leave the funds idle in NY account. If a government or commercial borrower is unavailable, the London bank will place the $ 1 million in the London interbank market. The interest rate at which such interbank loans are made is called the London interbank offer rate (LIBOR).

CONTD..

• This example demonstrates that the Eurocurrency market is a chain of deposits and a chain of borrowers and lenders. The majority of Eurocurrency transactions involve transferring control of deposits from one Eurobank to another Eurobank. Loans to non-Eurobank borrowers account for less than half of all Eurocurrency loans.

• The Eurocurrency market operates like any other financial market, but for the absence of government regulations on loans that can be made and interest rates that can be charged.

• There are several eurocurrency centres around the world where eurobanks conduct most of their business. The largest are: London, the Cayman Islands, Bahrain, Singapore and some “International Banking Facilities” that have been set up in the U.S.

• Approximately 80% of the eurocurrency market involves banks lending to, and depositing with, other banks. This is done on a Bid-Ask basis with the bid being the rate offered on deposits and the ask the rate charged on loans.

• A main characteristic of eurocurrency loans is that they are usually floating rate (this also referred to as rollover pricing or as cost-plus pricing) and are typically set as a percentage over LIBOR.

CONTD..

Eurocurrency loans

• Eurocurrency loans are made on a floating – rate basis.

• Interest rates on loans to governments, corporations and nonprime banks are set at a fixed margin above LIBOR for a given period and currency.

Example• If the margin is 75 basis points (b.p.) and the current

LIBOR is 6%, the borrower is charged 6.75% for the relevant period. LIBOR is the underlying variable rate of interest, usually set for a 6 month period.

• The margin or spread between the lending bank’s cost of funds and the interest charged by the borrower is based on the borrower’s perceived creditworthiness / riskiness. The spreads can range from 15 b.p. to more than 300 b.p., the median of the range varying from 100 to 200 b.p.

Eurocurrency loans

EUROCURRENCY LOAN SYNDICATION

• The maturity of the Eurocurrency loan can range from 3 to 10 years. Eurocurrency loans are made by bank syndicates. The bank originating the loan becomes the lead bank managing the syndicate, inviting one or two other banks to be co-managers of the loan. The borrower is charged a one-time syndication fee ranging from 0.25 % to 2 % of the loan value according to the size and type of the Eurocurrency loan.

• The drawdown [period over which the borrower may use the loan] of the loan and the repayment period vary in accordance with the borrower’s needs. A commitment fee of about 0.5 % per annum is paid on the unused balance, and prepayments in advance of the agreed upon schedule are permitted but are sometimes subject to a penalty fee.

Multicurrency loans

• Though most Eurocurrency loans are Eurodollar loans, these often come with a multicurrency clause. This clause gives the borrower the right (subject to availability) to switch from one currency to another on any rollover (or reset) date. This option allows the borrower to match currencies with cash inflows and outflows (which is an effective way of managing exposure to currency risk, and thus an effective risk-management technique). The option also allows borrowers to take advantage of its own expectations regarding currency changes and search for funds with the lowest effective cost.

EUROBONDS

• There exists a well developed domestic market for bonds (Canadian firms issuing bonds denominated in Canadian dollars and selling them in Canada). However, there also exists an international bond market. The international bond market is really a set of loosely connected individual markets around the world. There are many different bond markets in many countries, taken together as a whole they constitute the international bond market.

• The international bond market can be broken down into two parts:

1) Foreign Bonds2) Eurobonds

Foreign Bonds

• Foreign bonds are simply bonds issued in a bond market by a foreign company. For example, a Japanese firm issuing a U.S. dollar denominated bond in the U.S. is issuing a foreign bond.

• Because foreign bonds are simply a part of the domestic bond market, the only real difference is their treatment under the law. In many countries, foreign bonds are subject to different tax treatment, registration requirements et cetera.

• The most important foreign bond markets are located in Zurich, New York, Tokyo, Frankfurt, London and Amsterdam.

• The reasons that a company may go to another country to issue bonds include the simple fact that there may not be enough demand in the domestic market. Going to a foreign market opens up a whole new set of potential investors to the firm. For instance, a German pharmaceutical firm may wish to borrow DM 500 million. However, its investment bank tells it that there is only demand for DM 250 million of its bonds. In order to float the rest it would have to offer a much higher yield. But, for some reason there is demand in the US for the debt of pharmaceutical firms, and that demand is not being met by US companies. The German firm could then float an issue in Germany (in DM) and also float an issue in the US (in $US) in order to sell all of the bonds it wants. Of course, the firm may choose to swap its new $US debt for DM debt at the same time.

Foreign Bonds

• Note that issuing a bond in Zurich (for instance) does not mean that the firm is necessarily borrowing from Swiss lenders. Generally, a foreign firm issues a Swiss Franc denominated bond in Zurich and most of the buyers of that bond will also be foreign. Basically, the Sfr is simply a unit of account for the transaction between the buyer and the lender.

• A taxonomy has arisen for foreign bonds. Foreign bonds issued in the U.S. are termed Yankee bonds, in Japan they are called Samurai bonds, in England Bulldog bonds and in the Netherlands Rembrandt bonds

Foreign Bonds

Eurobonds

• Eurobonds are bonds denominated in one currency but issued in a country that is not the home of that currency. For example, a bond denominated in $Can but issued in London is a Eurobond. Similarly, a Sfr denominated bond issued in Germany is a Eurobond.

• Most countries have very few regulations governing the issuance of Eurobonds (since they are not denominated in that country’s currency, the government does not care all that much about them). While some countries have tried to control issues of bonds denominated in their currency even if issued in a foreign country, this is very hard to do for obvious reasons. One thing that this means is that interest paid on Eurobonds is usually free of all withholding taxes.

• A withholding tax is when the government takes a portion of each interest payment before the lender gets it. The borrower (the firm issuing the bond) withholds a part of the interest and gives it to the government. With a withholding tax, the firm issuing the bonds would have to pay a higher rate of interest in order to compensate lenders. In the eurobond market, therefore, firms can often pay a lower rate by avoiding the tax.

• Most eurobonds are bearer bonds. The owner of the bond is not registered with the firm that initially issued the bond. Actually having physical possession of the bond is evidence of ownership. This makes eurobonds attractive to investors who wish to remain anonymous (to avoid taxes or for other reasons).

Eurobonds