WEBVTT - The Hidden History of Eurodollars, Part 1: Cold War Origins 0:00:02.720 --> 0:00:12.320 Bloomberg Audio Studios, podcasts, radio news. 0:00:11.600 --> 0:00:13.600 Joe, Joe, what's the noise? 0:00:14.760 --> 0:00:15.440 Where's this going? 0:00:15.560 --> 0:00:17.079 Tracy, I'm setting the scene? 0:00:18.280 --> 0:00:18.840 What was that? 0:00:19.640 --> 0:00:20.600 All right, let's just start. 0:00:20.680 --> 0:00:23.680 I'm Joe Wisenthal and I'm Tracy Alloway and this is 0:00:23.760 --> 0:00:26.560 a very special edition of the All Thoughts podcast. 0:00:27.000 --> 0:00:27.360 Tracy. 0:00:27.480 --> 0:00:29.680 So, one thing I've been really fascinated by, and I 0:00:29.800 --> 0:00:32.480 mentioned it on some episodes lately, I've been really getting 0:00:32.520 --> 0:00:35.519 into Cold War history actually, and I guess I don't know, 0:00:35.560 --> 0:00:37.720 probably because I'm a middle aged man and that's a 0:00:37.800 --> 0:00:41.479 middle aged man hobby. You start reading about twentieth century history, 0:00:41.800 --> 0:00:45.839 but particularly Soviet and Chinese history. And one thing I've learned, 0:00:46.159 --> 0:00:48.480 and this did actually come up on an old episode, 0:00:48.680 --> 0:00:51.840 there's some interesting financial linkages in the past that people 0:00:51.960 --> 0:00:54.320 might not have expected at all, and I feel like 0:00:54.320 --> 0:00:55.640 more people should be talking about this. 0:00:55.960 --> 0:00:59.280 I agree. And also, if you like Cold War history, Joe, 0:00:59.320 --> 0:01:01.920 you are going to love what we are about to do, 0:01:02.000 --> 0:01:04.640 because there is a big connection between the history of 0:01:04.680 --> 0:01:08.640 the Cold War and the development of the modern financial system, 0:01:08.959 --> 0:01:12.720 and that connection is euro dollars. And of course, just 0:01:12.800 --> 0:01:16.520 to be clear, this is not the euro dollar exchange rate. 0:01:17.240 --> 0:01:21.319 I will fully admit that it took me ten years, 0:01:21.560 --> 0:01:24.840 like ten years, maybe less, maybe five, No, it probably 0:01:24.959 --> 0:01:27.160 was closer to ten. That euro dollar did not mean 0:01:27.600 --> 0:01:30.119 the euro the EU R USD exchange rate. 0:01:30.240 --> 0:01:33.000 It can be admittedly confusing, So why don't we just 0:01:33.080 --> 0:01:38.400 define it right away? So euro dollars are dollar denominated 0:01:38.440 --> 0:01:42.959 bank deposits held at foreign banks or overseas branches of 0:01:43.160 --> 0:01:45.960 US banks. And you can think of them as basically 0:01:46.000 --> 0:01:50.360 offshore dollars that sit outside the US banking system and 0:01:50.520 --> 0:01:53.720 kind of away from the Federal Reserve. They're basically a 0:01:53.880 --> 0:01:57.240 very special form of money. You could call them shadow money. 0:01:57.400 --> 0:02:00.000 And it's totally gigantic. So it's almost ten trillion dollar 0:02:00.560 --> 0:02:03.080 And I just find it so interesting, right because when 0:02:03.120 --> 0:02:06.920 I think of dollars, they're either coming from you know, 0:02:06.960 --> 0:02:11.560 the government spends dollars into existence or US bank credit. 0:02:11.760 --> 0:02:15.800 US banks licensed to de facto create dollars or deposits 0:02:15.840 --> 0:02:16.200 it will. 0:02:16.800 --> 0:02:18.079 And yet euro. 0:02:17.960 --> 0:02:20.079 Dollars are kind of this weird thing, I guess, because 0:02:20.080 --> 0:02:21.080 they're not that. 0:02:21.560 --> 0:02:25.400 Yeah, they're not either of those. And euro dollars didn't 0:02:25.440 --> 0:02:29.000 just spring up fully formed out of thin air. They 0:02:29.000 --> 0:02:32.280 were the result of a series of decisions, all aimed 0:02:32.320 --> 0:02:35.880 at solving particular problems. And that's what we're going to 0:02:35.960 --> 0:02:40.000 hear about today. So the origins of the euro dollar market, 0:02:40.240 --> 0:02:44.160 and this story has a lot in it. There's political intrigue, 0:02:44.600 --> 0:02:48.720 rivalry between the East and West, big existential questions about 0:02:48.720 --> 0:02:51.480 the role of the US dollar itself in the global 0:02:51.520 --> 0:02:56.359 financial system. Just a lot of fascinating history to satisfy 0:02:56.520 --> 0:02:58.880 your new middle aged man fans. 0:02:59.160 --> 0:03:03.320 Thank you. And we literally literally have the perfect guests 0:03:03.360 --> 0:03:04.480 to tell this story. 0:03:04.440 --> 0:03:07.000 While we're trapped in this bunker or vault. 0:03:07.480 --> 0:03:10.440 Yeah, you might recognize our storytellers. We're going to be 0:03:10.480 --> 0:03:13.400 speaking once again with Levmnand and Josh Younger. 0:03:13.520 --> 0:03:16.680 I'm levmanand I'm a law professor at Columbia Law School, 0:03:16.680 --> 0:03:19.040 where I study money and banking and the history of 0:03:19.120 --> 0:03:19.800 central banking. 0:03:20.440 --> 0:03:22.440 I'm Josh Younger. I'm a policy advisor at the Federal 0:03:22.440 --> 0:03:25.200 Reserve Bank of New York and the views I am 0:03:25.240 --> 0:03:27.560 going to express are my own and not necessarily those 0:03:27.600 --> 0:03:29.080 of the Federal Reserve Bank of New York or the 0:03:29.080 --> 0:03:30.079 Federal Reserve System. 0:03:30.400 --> 0:03:33.120 They have been digging deep into archives and are ready 0:03:33.160 --> 0:03:35.240 to tell us the story of the hidden History of 0:03:35.240 --> 0:03:37.880 Your Dollars in this very special series. There's going to 0:03:37.920 --> 0:03:39.560 be three episodes with Levin. 0:03:39.360 --> 0:03:42.880 Josh and because it's so good, they tell the story 0:03:43.040 --> 0:03:45.800 so well, Joe and I aren't going to say anything 0:03:45.800 --> 0:03:47.240 at all. We're just going to listen in. 0:03:47.440 --> 0:03:49.720 I love this. We should do all of our episodes 0:03:49.760 --> 0:03:50.640 like that, where we just get to. 0:03:50.600 --> 0:03:52.720 There, just cut ourselves out, all right, let's do it. 0:04:27.760 --> 0:04:31.120 So euro dollars are among the most important financial instruments 0:04:31.240 --> 0:04:34.400 in the world, really the backbone of the global dollar system. 0:04:34.880 --> 0:04:38.440 But they come from a very humble beginnings, very idiosyncratic start, 0:04:38.480 --> 0:04:41.240 and really it all started in Yugoslavia. And I mean 0:04:41.240 --> 0:04:43.560 that quite literally. This is like the original sin that 0:04:43.720 --> 0:04:47.000 leads to the development of euro dollars, and it starts 0:04:47.120 --> 0:04:50.719 especially when Marshal Tita takes over in Yugoslavia. So in 0:04:50.800 --> 0:04:54.520 nineteen forty five and November there's a communist revolution and 0:04:54.560 --> 0:04:56.279 the US is miffed in a bunch of ways, but 0:04:56.320 --> 0:04:59.400 one of them is that the old government owes them money, 0:05:00.040 --> 0:05:01.360 and so the question is how are they going to 0:05:01.440 --> 0:05:04.760 get it? And a few months later, Tito asked for 0:05:04.839 --> 0:05:07.520 his gold back because the Yugoslav government had seventy million 0:05:07.560 --> 0:05:10.520 dollars worth of gold in New York, and the Secretary 0:05:10.520 --> 0:05:13.600 of State, George Marshall, of the Marshall Plan, he realizes 0:05:13.600 --> 0:05:16.120 he's got a bargaining ship, which is the gold. It's 0:05:16.120 --> 0:05:18.280 in New York, and they don't get it back until 0:05:18.279 --> 0:05:21.000 they settle their claims. Now, even people within the State 0:05:21.040 --> 0:05:24.480 Department were kind of skeptical of this. The Yugoslavian government 0:05:24.480 --> 0:05:26.560 is obviously furious, and so the Russians, who at this point, 0:05:26.600 --> 0:05:28.599 you know, Tito and Stallin have a falling out eventually 0:05:29.040 --> 0:05:30.720 a few years later, but at this point they're quite 0:05:30.760 --> 0:05:34.600 closely aligned, and so the Russians are furious. The Yugoslavian 0:05:34.600 --> 0:05:38.080 government is furious. The State Department internally has some turmoil 0:05:38.080 --> 0:05:40.599 over this, and they take it to the UN, which 0:05:40.600 --> 0:05:44.120 has just been constituted, and the UN says pass they 0:05:44.160 --> 0:05:47.359 won't consider the claim, and so the Russians get the 0:05:47.440 --> 0:05:50.040 sense that the US is willing to use gold as 0:05:50.040 --> 0:05:53.080 a bargaining ship. They'd previously actually been building up dollar 0:05:53.120 --> 0:05:55.360 balances in New York. This is kind of a misnomer 0:05:55.400 --> 0:05:57.040 about the post war period. There's this sense that the 0:05:57.120 --> 0:06:00.839 Russians are extracting all their resources from but they're actually 0:06:00.839 --> 0:06:03.480 building up reserves of dollars because the thought is, we're 0:06:03.480 --> 0:06:05.200 probably going to need to trade with these people. We 0:06:05.240 --> 0:06:07.280 have a trading company based in the US, and they 0:06:07.279 --> 0:06:11.080 need resources, and so they're building up foreign currency deposits 0:06:11.120 --> 0:06:14.479 and gold. But in nineteen forty seven they realize it's 0:06:14.520 --> 0:06:16.320 not going to go well potentially, and they. 0:06:16.240 --> 0:06:17.000 Pull all the gold out. 0:06:17.000 --> 0:06:18.920 They actually just called banks in New York and they say, 0:06:18.920 --> 0:06:22.920 we want to go back, a massive reversal of the policy. 0:06:23.080 --> 0:06:25.520 And the questions where's it going to go? And so 0:06:25.640 --> 0:06:29.039 they need dollars because the US dollar is the currency 0:06:29.040 --> 0:06:30.800 of foreign exchange. If they want to trade with the West, 0:06:30.839 --> 0:06:33.360 they have to trade in dollars. They need gold because 0:06:33.520 --> 0:06:36.080 gold is the basis for the monetary system. And so 0:06:36.880 --> 0:06:38.880 the question is where can they put gold and dollars 0:06:39.400 --> 0:06:42.479 in a safe place that's still on the right side 0:06:42.480 --> 0:06:44.679 of what was then already known as the Iron Curtain. 0:06:45.279 --> 0:06:47.760 And so it turns out Paris is the ticket. They've 0:06:47.800 --> 0:06:50.280 actually been secretly stockpiloting cash and gold in Paris. They 0:06:50.279 --> 0:06:52.320 put it in briefcases. They would fly people to Paris 0:06:52.760 --> 0:06:54.640 and put it in the consulate offices. They would just 0:06:54.680 --> 0:06:58.040 build up piles of cash and gold. And in particular 0:06:58.480 --> 0:07:01.640 there's a bank b SENT that I won't try to 0:07:01.680 --> 0:07:04.200 do it in French and BCN is owned by or 0:07:04.279 --> 0:07:07.440 run by a notorious communist synthesizer who has a very 0:07:07.440 --> 0:07:09.520 good relationship with the Palaparo. And so there's a friendly 0:07:09.560 --> 0:07:13.440 bank and so they take on deposit the Soviet money 0:07:13.600 --> 0:07:16.960 and Bsen's moniker and the telex system that they used 0:07:16.960 --> 0:07:21.400 to communicate was Eurobank, and so euro dollars were initially 0:07:21.680 --> 0:07:25.400 in the late forties just deposits issued by Eurobank BCN 0:07:25.880 --> 0:07:28.400 generally for the Soviet, so they're also for the Chinese. 0:07:28.760 --> 0:07:31.280 And slowly this starts to percolate. There's another communist O 0:07:31.280 --> 0:07:34.120 one bank in London, there's one in Brussels which DCIA 0:07:34.200 --> 0:07:36.360 just describes as run by someone with few scruples, I 0:07:36.360 --> 0:07:38.200 think was the way they put it. And so there's 0:07:38.240 --> 0:07:41.080 some friendlies across Europe are willing to take their money, 0:07:41.520 --> 0:07:45.240 and the euro dollar market begins this way, which is 0:07:45.280 --> 0:07:48.480 preempt to sanctions evasion, basically that we might be sanctioned. 0:07:49.200 --> 0:07:51.240 It happened to Tito, it might happen to us, and 0:07:51.280 --> 0:07:53.400 so we need a safe place to go, and the 0:07:53.440 --> 0:07:56.160 European regulations allowed for this, and they need dollars again 0:07:56.280 --> 0:07:59.880 because they trade with the West, and so the first 0:08:00.080 --> 0:08:02.360 severe dollars is for that, and also to replace the 0:08:02.360 --> 0:08:05.120 salaries of striking French coal miners. See an Their potential 0:08:05.160 --> 0:08:07.000 place to do this is the record's not super clear. 0:08:07.440 --> 0:08:09.280 I think it's worth pausing here for a second to 0:08:09.360 --> 0:08:13.600 ask why wouldn't the Soviets have just been in France 0:08:13.640 --> 0:08:17.520 all along? Why were they in New York initially? Why 0:08:17.600 --> 0:08:20.720 had another people thought of this? And I think the 0:08:20.800 --> 0:08:28.080 answer is the dollar liabilities of communist sympathizing French bank 0:08:28.520 --> 0:08:32.840 are not the same thing as the dollar liabilities of 0:08:32.880 --> 0:08:36.000 a bank headquartered in New York. And I think it's 0:08:36.160 --> 0:08:38.959 helpful to think about why we even hold the dollar 0:08:39.040 --> 0:08:43.400 liabilities of a bank headquartered in New York, Like even today, 0:08:43.720 --> 0:08:46.400 when you log onto your bank account and you see 0:08:46.480 --> 0:08:50.120 a balance five thousand dollars, ten thousand dollars, the bank 0:08:50.160 --> 0:08:54.280 doesn't hold US government dollars to back that, and yet 0:08:54.520 --> 0:08:58.520 we are very comfortable treating those as equivalent. We aren't 0:08:58.640 --> 0:09:01.440 concerned that those those dollars are not the same thing. 0:09:02.120 --> 0:09:05.240 And why is that? There's a number of factors that 0:09:05.320 --> 0:09:08.400 go into it. Of course, since nineteen thirties, we've had 0:09:08.600 --> 0:09:10.959 deposit insurance up to a two hundred and fifty thousand 0:09:10.960 --> 0:09:15.960 dollars balance. Of course, businesses routinely hold larger balances and 0:09:16.000 --> 0:09:19.880 they are comfortable treating them as equivalent. Well, there's the 0:09:19.920 --> 0:09:22.200 implicit backing of the United States that comes from the 0:09:22.200 --> 0:09:25.000 fact that your bank was actually chartered by the US government, 0:09:25.040 --> 0:09:27.280 it's supervised by the US government. There's a sense that 0:09:27.280 --> 0:09:29.960 it's backed by the US government. And then there's the 0:09:30.080 --> 0:09:34.160 actual institutional apparatus of the Federal Reserve, which has a 0:09:34.200 --> 0:09:37.920 facility the discount window. And if you do go to 0:09:37.960 --> 0:09:40.840 your bank and say I actually want to turn this 0:09:41.040 --> 0:09:44.800 balance into government cash, the bank can go to the 0:09:44.800 --> 0:09:47.600 Federal Reserve and get that cash. The FED can print 0:09:47.640 --> 0:09:50.080 it for the bank and hand it over. And so 0:09:50.120 --> 0:09:54.800 there's this whole apparatus that facilitates you treating your balance 0:09:54.840 --> 0:09:58.080 at a US bank as equivalent to government cash. Those 0:09:58.120 --> 0:10:01.800 are trading at par This bank over in France that's 0:10:01.840 --> 0:10:05.040 now issuing these dollar liabilities that the Soviets are holding. 0:10:05.400 --> 0:10:08.880 Why should we think that that should maintain par equivalents 0:10:08.880 --> 0:10:12.319 to US government dollars, that bank's not FDIC insured, that 0:10:12.360 --> 0:10:14.640 bank's not chartered by the US government, that bank's not 0:10:14.720 --> 0:10:17.319 supervised by the US government, and that bank can't call 0:10:17.400 --> 0:10:20.280 up the FED when the Soviets are drawing down their balance, 0:10:20.720 --> 0:10:22.800 and the FED won't print money and hand it over. 0:10:23.040 --> 0:10:25.840 And so this move by the Soviets, they're taking on 0:10:25.920 --> 0:10:27.800 a lot of risk to get out of the US, 0:10:28.280 --> 0:10:30.520 and they're doing it because they're worried about the risk 0:10:30.600 --> 0:10:33.360 on the other side, the Yugoslavia risk, the risk that 0:10:33.920 --> 0:10:37.679 the US will actually freeze their balances, and so they 0:10:37.720 --> 0:10:41.360 have much higher risk tolerance, and they are willing to 0:10:41.400 --> 0:10:44.760 go out and try something different, which is whole dollar 0:10:44.800 --> 0:10:45.760 balances offshore. 0:10:46.120 --> 0:10:47.880 And it's the risk for the bank taking it as well, 0:10:47.880 --> 0:10:49.640 because the question for Beesson and others is what are 0:10:49.640 --> 0:10:51.760 you going to do with this money. So there's actually 0:10:51.800 --> 0:10:54.400 an antecedent to the eurodona market from the twenties when 0:10:54.400 --> 0:10:56.559 the dollar is actually the global reserve currency in the twenties, 0:10:56.600 --> 0:10:59.480 and then it lost that status in the thirties. But 0:11:00.000 --> 0:11:02.760 at that time dollar acceptances, which is a form of 0:11:02.760 --> 0:11:06.360 trade finance, were larger than ones drawn on London, and 0:11:06.400 --> 0:11:08.640 the dollar was the currents eve international trade and in 0:11:08.640 --> 0:11:11.400 particular the reserve currency of the world. It was the largest, 0:11:11.440 --> 0:11:13.720 was much bigger than Stirling, at least for a few years. 0:11:14.400 --> 0:11:17.160 And as a consequence of that, some of the Austrian 0:11:17.160 --> 0:11:20.160 banks in particularly started issuing dollar deposits. There's one in 0:11:20.200 --> 0:11:23.080 particular in Austria that did a pretty brisk business in this, 0:11:23.120 --> 0:11:24.880 and they were doing inter bank deposits. They were doing 0:11:25.200 --> 0:11:27.880 private deposits like non bank deposits. It looked a lot 0:11:27.920 --> 0:11:31.160 like the euro dollar market. The difference is they were 0:11:31.200 --> 0:11:33.600 basically holding it in cash on the other side, so 0:11:33.640 --> 0:11:37.200 it was more of a correspondent custody type arrangement. And 0:11:37.240 --> 0:11:39.560 so the question for a bank taking deposits is not 0:11:40.200 --> 0:11:43.200 are you comfortable issuing deposits? Of course they're comfortable issuing deposits. 0:11:43.240 --> 0:11:44.720 What are you going to do with the money? And 0:11:44.760 --> 0:11:47.920 so what can a communist own bank in Paris in 0:11:48.000 --> 0:11:50.840 nineteen forty eight do with the money? And at the 0:11:50.880 --> 0:11:53.440 time there was still some trade between the East and 0:11:53.480 --> 0:11:56.560 the West cross Iron Curtain. Now the Soviets don't like 0:11:56.600 --> 0:11:58.360 this in general because they have this policy of self 0:11:58.360 --> 0:12:00.920 reliance for obviously, since they don't want to rely in 0:12:00.920 --> 0:12:03.160 the West for anything, and we actually don't know how 0:12:03.240 --> 0:12:04.959 much of their trade this was because you'd be sent 0:12:05.000 --> 0:12:07.000 to the goolog for talking about economic data, So no 0:12:07.080 --> 0:12:10.320 talking about payrolls Joe in Soviet Russia in the forties, 0:12:10.320 --> 0:12:12.880 at least starting in the forties. But the key was 0:12:13.320 --> 0:12:15.800 there was enough to make a business out of it, 0:12:16.040 --> 0:12:19.400 and it was in dollars. So using these dollar deposits 0:12:19.440 --> 0:12:22.040 to finance East West cross Iron Curtain trade was profitable 0:12:22.040 --> 0:12:23.640 in two respects. One is you just making more money 0:12:23.640 --> 0:12:25.679 on loans and you make on cash. The others you 0:12:25.679 --> 0:12:27.160 don't have to hedge it because you have a dollar 0:12:27.200 --> 0:12:30.280 asset a dollar loan to facilitate trade, and a dollar 0:12:30.320 --> 0:12:33.480 liability a dollar deposit, so you're not taking foreign exchange risk. 0:12:34.080 --> 0:12:36.000 And so that turns out to be an okay business. 0:12:36.000 --> 0:12:38.240 Like there's not enough of that to make for a 0:12:38.320 --> 0:12:40.880 large market, but it grows. You know, it's two hundred 0:12:40.880 --> 0:12:43.960 million dollars in the early fifties and so like this 0:12:44.000 --> 0:12:47.240 is the seed that's planted, and it basically sets a precedent, 0:12:47.240 --> 0:12:49.440 which is banks are willing to do this. But the 0:12:49.520 --> 0:12:51.920 question is how do you make this a bigger business? 0:12:52.000 --> 0:12:55.040 What are the business opportunities to do it, and that's 0:12:55.120 --> 0:12:58.400 where the early fifties are a critical period because after 0:12:58.440 --> 0:13:00.960 the war, most foreign exchange markets are you're straight up closed. 0:13:01.160 --> 0:13:03.680 The British in particular are like heavily controlling their currency. 0:13:04.240 --> 0:13:05.880 London's the obvious place to do this kind of business. 0:13:05.920 --> 0:13:06.320 It's still a. 0:13:06.320 --> 0:13:08.720 Center for international trade, but they can't hedge, so if 0:13:08.760 --> 0:13:12.440 they issue dollar deposits, they're just holding dollars. And unless 0:13:12.440 --> 0:13:14.640 they have a dollar loan to make, on the other hand, 0:13:14.640 --> 0:13:17.280 which they didn't necessarily have at the time, you're just 0:13:17.320 --> 0:13:20.679 warehousing the risk that the dollar depreciates or appreciates relative 0:13:20.720 --> 0:13:22.840 to sterling, which is ultimately what you pay employees in 0:13:22.880 --> 0:13:26.160 that's your sterling funder, meaning like you are a British business, 0:13:26.640 --> 0:13:29.360 you care mostly about Stirling. Then in nineteen fifty two, 0:13:29.760 --> 0:13:32.840 as things are starting to improve, the Marshall Plan is 0:13:32.880 --> 0:13:35.600 mostly done, the dollar gap has been mostly filled. We'll 0:13:35.600 --> 0:13:38.520 talk about that a little little bit, and things are normalizing, 0:13:38.520 --> 0:13:41.920 so the British feel comfortable partially liberalizing their foreign exchange 0:13:41.960 --> 0:13:44.720 markets now, not all at once. The spot meaning today 0:13:44.760 --> 0:13:47.280 you want to exchange sterling for dollars, the rate at 0:13:47.320 --> 0:13:49.240 which you can do. That is still heavily controlled by 0:13:49.280 --> 0:13:52.280 the Bank of England. It's in a range that's widened, 0:13:52.320 --> 0:13:55.720 but it's still pretty narrow. But in particular they've liberalized 0:13:55.760 --> 0:13:58.520 the foreign exchange futures market or forward market. So what 0:13:58.600 --> 0:14:00.520 is a foreign exchange forward. A foreign exchange forward is 0:14:00.840 --> 0:14:02.840 I'm going to give you dollars for sterling, not today, 0:14:03.160 --> 0:14:05.720 maybe tomorrow, maybe in a month, maybe in a year. 0:14:05.800 --> 0:14:08.480 This is a very very large market today. It's a 0:14:08.520 --> 0:14:11.520 critical piece of hedging equipment for a bank because you 0:14:11.559 --> 0:14:14.920 can use those forwards. If you've borrowed dollars and lent 0:14:15.000 --> 0:14:17.120 them out for say a year, you don't want to 0:14:17.120 --> 0:14:19.640 hedge your dollar risk today. You want to hedge it 0:14:19.680 --> 0:14:21.400 for the return of those dollars in a year. You 0:14:21.440 --> 0:14:23.120 want a coverage for the full term of the loan. 0:14:23.640 --> 0:14:25.600 So the forwards market is critical to this, and so 0:14:26.200 --> 0:14:29.320 the Bank of England says, now you can trade forwards 0:14:29.920 --> 0:14:32.680 on dollar, sterling and other major currencies, but in particular 0:14:32.720 --> 0:14:36.640 dollars sterling, and we won't control that rate. So now 0:14:36.640 --> 0:14:39.760 there's a hedging instrument. And now banks in London can 0:14:39.800 --> 0:14:41.240 look around and say what can I do with this? 0:14:41.280 --> 0:14:43.840 Because there's clearly interest as a precedent for dollar deposits, 0:14:44.360 --> 0:14:45.960 and then the question is what can I do with it? 0:14:46.040 --> 0:14:47.320 And so they. 0:14:47.120 --> 0:14:49.360 Figure out so it still happens today, which is there's 0:14:49.360 --> 0:14:52.240 a shortage of dollars in the UK. That means if 0:14:52.240 --> 0:14:55.320 they were to borrow dollars and functionally lend them out 0:14:55.480 --> 0:14:59.440 through the FX markets, they can construct arbitrage type arrangements. 0:14:59.480 --> 0:15:02.200 And by arbitra, I mean I borrow a dollar, I 0:15:02.280 --> 0:15:05.240 hedge that dollar, I use the sterling proceeds of the 0:15:05.280 --> 0:15:08.520 hedge to buy an on shore sterling asset, and I 0:15:08.560 --> 0:15:11.480 collapse the whole thing when everything matures. So this is 0:15:11.520 --> 0:15:14.520 just cross border interest rate arbitrage. Today we'd call it 0:15:14.520 --> 0:15:17.640 a cross currency basis, but it is not perfectly efficient, 0:15:17.960 --> 0:15:20.640 meaning if there's more demand for dollars or more demand 0:15:20.640 --> 0:15:23.640 for sterling, the pricing can get out of whack relative 0:15:23.720 --> 0:15:25.280 to the relative. 0:15:24.840 --> 0:15:26.320 Interest rates on those two instruments. 0:15:26.880 --> 0:15:30.200 And so the banks in London and particular Midland Bank 0:15:30.760 --> 0:15:34.880 realizes that if they issue Euro dollars, use the dollars 0:15:34.920 --> 0:15:37.760 they borrow through year dollar issuance to buy sterling assets 0:15:37.760 --> 0:15:56.200 and hedge that package, they can make arbitrage profits and 0:15:56.240 --> 0:15:59.080 so the first use case of your dollars is sanctions evasion. 0:15:59.520 --> 0:16:02.960 The second use is to facilitate cross iron curtain trade, 0:16:03.000 --> 0:16:05.560 although that's a pretty small business. And so the third 0:16:05.600 --> 0:16:09.680 and much larger business is cross border interest rate arbitrage. 0:16:09.680 --> 0:16:12.480 And that sounds really technical, but what it's really doing 0:16:12.560 --> 0:16:16.200 is using foreign exchange markets and derivative markets to source 0:16:16.280 --> 0:16:20.440 dollars that the UK particular needs in this post war environment. 0:16:20.640 --> 0:16:24.000 So imagine a euro dollar bank. A eurobank takes in 0:16:24.000 --> 0:16:25.880 a euro a dollar deposit, which means it gets a 0:16:25.920 --> 0:16:28.320 dollar in cash. Let's think of a physical bill. That's 0:16:28.360 --> 0:16:33.040 an asset. It issues a euro dollar liability, and then 0:16:33.120 --> 0:16:34.920 what is it going to do next, because it needs 0:16:34.920 --> 0:16:36.600 to do some sort of investing. And what it does 0:16:37.040 --> 0:16:41.080 is it exchanges that dollar asset for a sterling cache 0:16:41.600 --> 0:16:44.440 and it invests that sterling cash in some short term 0:16:44.760 --> 0:16:47.960 sterling investment that's short bills or something like that. And 0:16:48.760 --> 0:16:50.360 after it does that, it says, I want to hedge 0:16:50.360 --> 0:16:52.160 my foreign exchange risk because now I have a dollar 0:16:52.200 --> 0:16:55.400 liability and a sterling asset, So I'm going to use 0:16:55.480 --> 0:16:59.480 the foreign exchange forward market to agree to sell that 0:16:59.520 --> 0:17:02.000 sterling back for dollars at some point in the future 0:17:02.000 --> 0:17:04.520 at a fixed price that we agree on today. So 0:17:04.600 --> 0:17:07.240 that's the bank's position. Who's on the other side of 0:17:07.280 --> 0:17:11.920 that trade. Let's say a corporation, a manufacturing entity. They 0:17:11.920 --> 0:17:17.280 make radios, and that radio production process requires inputs. Those 0:17:17.320 --> 0:17:20.680 inputs are imported, and so that radio production company needs 0:17:20.760 --> 0:17:23.600 dollars with which to buy the raw materials that it 0:17:23.680 --> 0:17:27.040 uses to make the radio that it then sells four 0:17:27.119 --> 0:17:30.439 dollars in foreign markets, and so they get those dollars 0:17:30.480 --> 0:17:32.679 from the Eurobank in exchange with the sterling they have 0:17:32.760 --> 0:17:35.920 on hand. They go buy all the parts, but they 0:17:36.280 --> 0:17:38.200 want to make sure that they know how much they're 0:17:38.200 --> 0:17:40.480 going to receive in local currency at the end of 0:17:40.480 --> 0:17:43.199 the production process when they sell that radio broad They 0:17:43.240 --> 0:17:44.960 don't want the value of the dollar to go down, 0:17:45.840 --> 0:17:48.800 so they sell those dollars forward in exchange for sterling, 0:17:49.040 --> 0:17:51.280 and so they ventured into a derivative agreement, which is 0:17:51.280 --> 0:17:53.679 the opposite of the one that the Eurobank has or 0:17:53.680 --> 0:17:57.119 the eurobanking system. And so then they put together the radio, 0:17:57.240 --> 0:18:00.480 they sell it abroad, they receive dollar proceeds, turn those 0:18:00.480 --> 0:18:02.600 into sterling, which is what they pay their employees in 0:18:02.680 --> 0:18:05.720 that's what they pay for their land and equipment in 0:18:06.320 --> 0:18:08.440 and that exchange rate was the one they agreed upon 0:18:08.480 --> 0:18:10.960 in advance through the foreign Exchange forward contract. And so 0:18:11.800 --> 0:18:15.040 basically what's happening is the eurobanks are pulling in dollars 0:18:15.040 --> 0:18:18.680 from abroad, distributing them through the foreign exchange market that's 0:18:18.720 --> 0:18:21.959 trading on shore to those that need dollars today, and 0:18:22.000 --> 0:18:25.080 then providing hedges to those that will receive dollars in 0:18:25.119 --> 0:18:28.119 the future, and in the case of the Eurobank, the 0:18:28.160 --> 0:18:30.960 dollars they'll owe in the future potentially to the euro 0:18:31.000 --> 0:18:32.119 dollar deposit holder. 0:18:32.760 --> 0:18:36.320 Think about this from the perspective of the city of 0:18:36.359 --> 0:18:40.199 London coming out of the war and those bankers and 0:18:40.240 --> 0:18:42.840 the world that they grew up in, which is a 0:18:42.880 --> 0:18:45.560 world that we've completely forgotten, but was the world of 0:18:45.680 --> 0:18:49.640 sterling dominance before the First World War and the role 0:18:49.720 --> 0:18:54.720 that the Empire played in financing global trade. What we're 0:18:54.720 --> 0:18:59.880 looking at in the fifties is a group of London 0:19:00.080 --> 0:19:05.760 based financial institutions trying to figure out a way to 0:19:05.800 --> 0:19:12.480 continue their dominance in global economy that runs on dollars 0:19:12.520 --> 0:19:16.040 now and not on starling. And so the euro dollars 0:19:16.080 --> 0:19:18.520 are sort of worth the risk to the City of 0:19:18.560 --> 0:19:22.919 London and to some extent to UK financial regulators like 0:19:22.960 --> 0:19:26.439 the Bank of England, because they need to fix their 0:19:26.520 --> 0:19:29.199 business model for a dollar world, and they want to 0:19:29.240 --> 0:19:32.439 get in on the dollar world. Dealing in dollars is 0:19:32.440 --> 0:19:34.679 going to be a necessary part of that, and so 0:19:34.840 --> 0:19:38.520 the UK is adapting here by turning to dollars and 0:19:38.560 --> 0:19:42.440 embracing dollar liabilities for its own institutions. 0:19:43.119 --> 0:19:45.200 And in the UK this was a particular problem because 0:19:45.200 --> 0:19:48.199 they imported so much of what they used to produce 0:19:48.240 --> 0:19:52.520 products that were manufactured to sell finish goods abroad, and 0:19:52.560 --> 0:19:55.760 so there's a great newsreel from the late forties for 0:19:55.800 --> 0:19:58.080 the British populations and you have to go without today 0:19:58.600 --> 0:20:02.160 for high quality, clean manufactured goods so that we can 0:20:02.160 --> 0:20:04.280 export as much as possible and source the dollars. But 0:20:04.320 --> 0:20:06.160 another way to do it is to get euro dollars. 0:20:06.920 --> 0:20:10.880 The Smith household is very dissatisfied. Dad wants a new wallace, 0:20:11.400 --> 0:20:15.840 mother wants a sewing machine, and Betty wants glamorous beauty preparations. 0:20:16.600 --> 0:20:19.320 But these are needed for export because we must build 0:20:19.400 --> 0:20:23.280 up overseas markets. We sell these goods overseas for foreign 0:20:23.359 --> 0:20:27.520 currency to buy the food and raw materials we need 0:20:27.560 --> 0:20:32.239 to live and work. These things would soon vanish if 0:20:32.280 --> 0:20:35.879 we couldn't pay for them. We must sell the things 0:20:35.880 --> 0:20:39.840 we'd like to buy the things. 0:20:39.520 --> 0:20:45.360 We need, and so this cross border interest rate arbitrage 0:20:45.480 --> 0:20:49.760 is really just a way markets distribute the currency according 0:20:49.760 --> 0:20:53.000 to who needs it and provide the hedges that facilitate 0:20:53.080 --> 0:20:56.160 the functioning of British corporations as well. It's what we'd 0:20:56.160 --> 0:20:58.040