The Euro dollar system is a type of ledger money in the banking sector, operating outside the US and transacting in US dollar denominations. Unlike traditional banking transactions, the Euro dollar system operates through a system of claims on US dollars rather than actual physical currency. This shift away from physical currency has allowed for a qualitative increase in the banking sector as transactions become more efficient and frictionless. As a result of its widespread use, it functions as the real reserve currency, allowing for ease of international transactions by intermediating between different countries, facilitating global commerce. It’s a decentralized system that expands and contracts based on the supply-demand of international private banks and businesses operating globally.

It allows for a level of monetary and credit creation that some advocates find concerning, that too much monetary creation will lead to a bank-centred system where the focus is on creating money for its own sake, leading to risky financial practices like subprime mortgages. The successful operation of the Euro dollar system heavily depends on the banks that operate this currency by ensuring the necessary infrastructure and logistics are in place for the currency to function effectively. This includes maintaining widespread availability and ensuring its predictable operation, which allows for the elasticity required for a Reserve currency to work.

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Throughout history, when there is too much constraint on the money supply, people find ways to work around it. The Euro-dollar system was created to provide an elastic currency, but it has led to a recurring boom-bust cycle due to over-risk taking. In the 1990s, mathematical models that quantified risk convinced people there was no risk in excessive money creation, leading to the 2007 financial crisis. Despite claims that QE solved the crisis, it was actually caused by a global dollar shortage caused by banks realizing the risks of excessive money creation. The shift in risk mentality of banks, due to failures of firms like Bear Stearns and Lehman Brothers, has made them less willing to provide credit to the economy, reducing economic growth and labor force participation. The lack of money in the economy, rather than a lack of demand, is limiting entrepreneurs' ability to hire workers.

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Money supply and QE

Quantitative easing (QE), where the central bank buys long-term securities, is assumed to lower long-term interest rates. However, the FED realizes that it is buying bonds that the market is already buying and not adding an extra buyer to the market, so there is only a slight correlation between QE and interest rates, with the market already lowering interest rates before the central bank starts buying. Central bank takes a safe asset (treasuries or bonds) out of the system and adds an even safer asset (reserves), which is harmful to the collateral system because it causes a collateral shortage. Collateral is used and reused in repo and derivatives transactions, and removing one bond from the collateral stream breaks down funding chains of interbank transactions. The answer to a collateral shortage is not to remove more collaterals from the system and give the system useless bank reserves. The lack of attention to the collateral shortage was one of the factors contributing to the financial crisis in 2007-2008.

The reason interest rates were so low in the 15 years prior to the crisis was not due to QE, but rather a shortage of money and credit. When there is a shortage of money, demand for safe and liquid instruments increases, which drives interest rates down. This is what happened in Japan in the 1990s, the United States during the Great Depression, and Europe as well. The creation of cryptocurrency can be seen as a response to the inelasticity of the Euro-dollar system since the financial crisis of 2007. There was a shift from unconstrained monetary creation to too much constraint, causing a need for a more useful medium of exchange. Cryptocurrency provides a way to store value and create a medium of exchange, as the euro-dollar has been unable to provide the necessary elasticity since 2007.

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Yield curve movements are actually dependent on short term rates

The yield curve shows the relationship between the interest rates and the maturity of fixed income securities, such as government bonds. In 2005, former Federal Reserve Chair, Alan Greenspan, explained to Congress that you can think of the yield curve as a series of one-year forward rates, with the expectation that the Federal Reserve (FED) sets the first forward rate, which then sets the expectations for the rest of the years. However, economists believe that interest rates are not independent and are dependent on the short-term rate, not only set by the FED but also by market participants with different incentives and competing views. The FED has some influence on the short-term rate but not the long-term rate because many other factors play into the setting of the long-term rate, such as expected deflation or the preferences of market participants for safe, liquid instruments. The market sets most interest rates and the FED only manipulates the short-term rate, but if it gets too far out of step with the market's expectations, it can result in inverted yield curves or negative swap spreads.

A repo is short-term borrowing where collateral in the form of bonds is given for cash. The Fed created a repo-like system during WWI to appear to buy bonds from banks and sell back the next day, essentially a collateralized loan. Hedge funds speculate on risky assets with the aim of maximizing profits and prefer to borrow with a safe and liquid asset, such as a Treasury, as collateral. If they don't have a Treasury, they may borrow from dealer banks who rent Treasuries from insurance companies or pension funds. This creates a 4-legged repo transaction where the hedge fund uses borrowed Treasury as collateral. Securities lending, where dealer banks rent Treasuries, became prevalent in the 60s and 70s. The 2008 financial crisis was partly caused by AIG's inability to borrow Treasuries from its insurance company subsidiary, causing a shortage of safe assets and collateral.

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Pandemic dollar Shortage

COVID-19 pandemic created a global dollar shortage, leading to a situation where local banks in different countries were short on dollars. To alleviate this shortage, central banks would sell U.S. Treasuries, which are the reserve assets that can be liquidated. However, this process is not as straightforward as it seems. The Treasuries that are most easily liquidated are the "On the Run" Treasuries, which are the newest Treasuries issued. But if a central bank only has older "Off the Run" Treasuries in its portfolio, it may have a harder time selling them as there is not a deep and liquid market available for them. In this case, a dealer may be able to buy the Off the Run Treasuries, but they would have to fund the transaction in the repo market using the Off the Run Treasuries as collateral. However, if there is a massive dollar shortage and many central banks are trying to sell their Off the Run Treasuries at the same time, the repo market may become illiquid and reject the Treasuries as collateral. This would lead to dealers getting stuck with the Treasuries and having to sell them at reduced prices. The situation in Europe was similar. A company in Europe would contact its local bank for dollars, but the local bank may not have any. In that case, the bank would contact a dealer who has dollars and borrow from the short-term markets to lend to the company. However, if there is a disruption in the short-term markets, the bank may be unable to fund its longer-term asset (the loan to the company) and would have to contact the European Central Bank or the national central bank for assistance. The European Central Bank would then sell some of its Treasuries to provide the necessary dollars.

However, the central banks did not completely solve the problem. The Federal Reserve's announcement of its quantitative easing program (QE) on March 15, 2020, did not immediately solve the liquidity problem. The buying of Treasuries was just an announcement, and the overseas dollar swaps that were supposed to help local banks access US dollar liquidity through their local central banks were not effective until several days later. The announcement of QE did not immediately fix the Treasury market liquidity problem, and the buying of Treasuries did not solve the underlying problem, which was the dollar shortage. The liquidity problem during the financial crisis was not fully resolved until the Federal Reserve or the U.S Treasury issued more Treasury bills. This was a more effective solution as there was also a shortage of collateral. Previously, off-the-run Treasuries were used as collateral in the repo market, but due to their decreasing negotiability, the only usable collateral became on-the-run Treasuries. The shortage of on-the-run Treasuries was alleviated by the U.S Treasury, which started selling more Treasury bills into the market after the CARES Act was passed in March. This increased the supply of on-the-run Treasuries, which helped to make up for the shortfall caused by the unavailability of off-the-run Treasuries in the repo market. When it comes to collateral in the repo market, the repo counterparty only cares about the liquidity characteristics of the collateral they are accepting. In order to participate in the repo market, one needs to have on-the-run Treasuries if off-the-run Treasuries are no longer usable. To secure on-the-run Treasuries, one can look to sources such as the government or securities lending practices by dealers. For example, if JPMorgan has more Treasury bills and is willing to lend them, then a repo transaction can be done.

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Source: https://youtu.be/wRsopaUFjgI - The Offshore Global Dollar System | Jeff Snider

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