Lots More with Lev Menand on the Eurodollar Market Now

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1:50Joe, three hours of euro dollar market history and we can't get enough. I love that. We've got to do more. I love that. I couldn't even believe that was real. Just sitting, I'm being totally sincere, sitting there in the studio, listening to Lev and Josh talk about the history of Eurodollars, a career highlight, unironically. Definitely a treat. I do feel like there's one thing missing, which is like we kind of have to put everything in modern context. Yes. Right? We didn't really bring it that up to date. We talked a little bit about the Eurodollars role in like the 2008 crisis. There was a mention of it.

2:23But like, let's talk about the current Eurodollar market. Well, can I say something? Yeah. Lev, don't listen to this. Whenever we talk financial market plumbing or things of that nature, this is like really fascinating. Like this is a really interesting topic. And then I was like, how does this matter to anything at all? So I would like to actually talk a little bit more for real about like how does it actually matter? Because I find it very interesting, but I sometimes forget like when and why. Why did we talk about this for three hours? For real, for real. I did a deadlift. I am both the most popular trader and most successful trader at Citadel.

3:05Fed is going viral. Barges. This is an after-school special, except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Black gold. These are the important questions. Is it robots taking over the world? No, I think that, like, in a couple of years, the AI will do a really good job of making the Outlaws podcast. One day that person will have the mandate of heaven. How do I get more popular and successful? We do have the perfect guest. Welcome to Lots More, where we catch up with friends about what's going on right now. Because even when Odd Lots is over, there's always lots more.

3:42And we really do have the perfect guest. Well, Lev Menand is here with us and he's going to provide an update on the market. He is, of course, an associate professor of law at Columbia School. So, Lev, thank you. Thank you for coming on and talking to us even more about Eurodollars. I also think this is a topic that we could just keep doing episodes. No, for sure. Do an all-thought spinoff on Eurodollars. All the good topics are fractal in that you could just go down. This is a core thing I've realized is that actually the good topics, the only limitation on how many episodes you could do is creativity and depth.

4:20But actually, we could just do keep going, right? Yeah. And if anything, it matters more today than it did in 1964 and 1954, which was the periods we were covering. Why? Why does it matter more today? Size and centrality in the U.S. dollar monetary system and in the global financial system. You know, the euro dollar system right now is probably 13 billion, 13 trillion dollars in size, which makes it, you know, more than twice as big as the uninsured deposits in the domestic system and almost as big as the overall deposits in the domestic system. And it's the leading edge of monetary expansion in the U.S.

5:04dollar system takes place offshore, not onshore. And when we were talking about the development of this in the 50s, 60s and 70s, the onshore domestically regulated dollar deposit system was a much bigger percentage of the overall whole. And now we're in a world that looks quite a bit different in terms of the relative importance. And we've been in that world for about 25 or 30 years now. And the 2008 crisis was a crisis of that world. And 2020 was in part a crisis of that world. And so we're now in a financial system where instability in the euro dollar market, that's the main, with the addition of the repo market, That's the main area of instability and concern for our whole system.

5:55You know, in the 20th century, we still had a sort of like, you know, your grandparents banking system. And now it's not. But we have the dollar swap lines, right? Like, isn't that the solution to all of the instability, or at least it has been in the past? The swap lines are both enabling the problem and mitigating the downside consequences. They're enabling the problem because they lead to the ability of euro dollar issuers to draw in euro dollar holders. When you think about what a euro dollar issuer is doing, they're actually selling a product that's their liability. It's a money instrument that people can hold who have demand for cash and cash equivalents in large quantities.

6:44And they are competing with domestic U.S. banks that have a really nice product, the deposit that is up to$250 ,000 per account insured by the FDIC explicitly, and a whole bunch of other money-like products created by other shadow banks. Money market mutual funds create various products. And the swap lines, the existence of the swap lines is what gives people confidence that, you know, this is a pretty robust money type instrument that has backing from the sort of central bank, which is the creator of dollars that makes these money like liabilities money good. And so in order to get such a huge 13 trillion dollars, such a huge market, you need the swap lines there in the first place to give people confidence to hold large quantities of these that they will, in fact, be money good.

7:37But the problem you have is that the extent to which the U.S. government stands behind this$13 trillion money supply, it's ambiguous. It's not explicit. It is like uninsured deposits in the domestic system. It's worse, though, but it's similar to it. And so it's highly runnable and unstable insofar as people aren't sure the extent to which the system will be supported by the Central Bank of the United States when it gets into trouble in various bad states of the world. So in good times, it's fine. But in bad times, people decide, you know what, that competing money instrument created in the domestic U.S.

8:20banking system or those T-bills are just a much better place for us to be. We want out. And I have a historical analogy since we've been doing so much history on this. Think about the U.S. system in the 1920s going to the 1930s. We created the Federal Reserve and the discount window at the Federal Reserve for domestic U.S. banks. It's like a swap line for the banks directly. It's doing what the swap lines are doing with the addition of the foreign central bank. And people thought, oh, we're going to fix bank runs. We've got this infrastructure set up. We created this central bank. It's going to backstop all these deposits.

9:03And we had the worst bank run ever in the 32, 33 period. What happened? What happened was the Fed didn't support all the banks. When push came to shove, the Fed allowed a bank called the Bank of the United States, a Jewish run bank based in New York to fail and created a lot of uncertainty about the extent of its support for state chartered banks that were not members of the Federal Reserve system. And runs just went throughout the system. And over a third of the banking system ultimately collapsed, even though we had this support system. And what you saw in 2008 is a similar problem. people just don't know how much the Fed will be there and to what extent.

9:52And that can cause a systemic catastrophe. And the reason why we got deposit insurance in part in 1933 was the government saying, you know what, we just have to be explicit about the fact that we're backing these money instruments. We can't have this implicit insurance program that is through Fed lending. We got to just be explicit. And that worked really, really well. This is like that. I mean, this is a principle, right, that like big blanket guarantees are cheaper, right, from a dollar basis than sort of backup things that you don't know whether they're going to come. Or you try to go cheap, right, because you're going to let this bank fail and you're going to send a message to the other banks.

10:35Or you say you're going to do whatever it takes and hope that you don't have to. And hope that you don't have to. It's like really the bazookas are ultimately what do it. the beauty of bazookas is because they're so intimidating. You don't have to fire them. Are deposits in the euro dollar market, are the depositors compensated for this ambiguity about runnability? Of course. So how does that look like? How's that? What is that? So as a general matter, the way in which shadow money instruments, non-deposit deposits, deposit alternatives, money instruments, cash equivalents that are competing with just sort of like your checking account at JPMorgan Chase.

11:11They are competing on price. They are paying more interest than obviously your checking account at JPMorgan Chase, where often JPMorgan Chase will just pay you almost zero on that checking account in terms of interest. And so the euro dollar market all developed, you know, 50s and 60s, London banks offering more interest on balances than National City Bank in New York and drawing depositors to their own banks. They could have a deposit account in dollars in London that just paid more interest. And that's the same story you see with the repo market and money market funds. These are ways to get a little bit more yield on your cash instruments.

11:59They're competing on price. And the main customers, historically, were the corporate treasurers who had huge cash balances. And there are lots of different customers now who have cash they want a little bit more yield on. The thing that goes wrong in these markets is they are sacrificing moneyness, safety. They're sacrificing the extent to which it's really a liability of the United States government for some more yield. And when we get to a bad state of the world, that tradeoff starts to look a little bit different. And that's what creates the run dynamic. Suddenly, we're in a bad state of the world.

12:33think August 2008 and you're a repo counterparty of Lehman Brothers. You're parking your extra cash in Lehman Brothers for a little extra yield. And you think, you know what? I'm just going to move my balance to a regular bank account. I'm going to go to JP Morgan and just have a big balance there. Yeah, I'm going to be earning a little less yield on my cash, but I know that it's money good and it's going to be available. And you know what? I just don't need to be a repo counterparty to Lehman Brothers anymore. And that was what brought down Lehman Brothers. It was just an old-fashioned bank run on its repo book.

13:09Yeah, collateral crunch. So one thing that stands out in the series is there are these brief windows where regulators basically consider actually regulating euro dollars. But then what happens is like there's a crisis in energy markets or there's a banking crisis. And so everyone decides now is not the time to start fiddling around with Yes, it's never a good time to regulate. This is my question, like, what would be a good time and what would that regulation actually look like? It's a really deep and difficult question because you guys may have been following the Basel endgame capital requirements project of the last several years of the U.S.

13:51banking regulators and Michael Barr, the vice chair of the Fed for supervision, who's been leading that project, who has recently announced he's going to step down as vice chair for supervision. And part of it is just that it seems unlikely that he's going to be able to get that project over the finish line. And the reason I bring this up is you might think when the banking system is making record profits and the economy is humming along nicely would be a great time to strengthen the regulatory regime. And the Biden administration and its bank regulators have tried to strengthen the domestic onshore deposit, regulatory regime of domestic deposits, and they've been completely stymied.

14:34And so plainly, when things are good, that's not actually a good time because nobody wants to – Everyone looks like it's working, right? Everyone's like, everything is fine. We don't need to make any changes right now. And so the inertia prevents changes. And so actually, practically, it is during crisis. It happened to be the case that the 74 crisis that we talked about, they felt like things were too fragile to do anything. Similarly, in the aftermath of 2008, there was a similar mindset. You might recall there were more significant reforms discussed and at least mooted privately, including with respect to repo and euro dollar liabilities.

15:24And the thought was, we're in a bad recession right now. We should try to get out of that recession and let's not upset the apple cart. And so clearly a certain type of crisis is not enough either. If you just look to history, one thing you do see is if the crisis is really bad, not like 74 or 08, but like 1933, then you get fundamental structural reform. And so if the euro dollar market were to lead to economic fallout on that scale, I feel very comfortable predicting that it would be fundamentally reformed. What would it look like? And I mean, part of the question, and I guess Tracy asked that, but I get like, okay, the timing, one thing, but what would it look like?

16:13And also, what's to stop me ever from being a bank and offshore and offering something that I call a dollar? Yeah, two great questions. So, of course, it could look like a bunch of different things. There's not one answer. There is the cleanest answer, which is an international agreement like Basel, call it Basel IV, that is quite simple. It says each jurisdiction shall ensure that the financial institutions in that jurisdiction only issue short-term money-like liabilities in their own currency. And so if you're a London-based bank regulated by UK financial regulators, you cannot issue a dollar demand deposit type liability unless it's fully reserved on the asset side of the bank with a dollar instrument, either a dollar at a US bank, like a correspondent bank, and that's going to actually tie into the second question, or like a T-bill of a very short maturity.

17:26And so you could still have lots of dollar-based banking globally. You wouldn't be getting rid of global dollar. You would be stabilizing the global dollar by going to full reserve banking for the global dollar. There would be no money creation outside of the U.S. The expansion of the dollar money supply would happen by U.S. domestic banks. But dollars could be held by, say, Japanese banks as long as it was on a one-to-one basis. And I think that would be the optimal answer, and we could talk about why. But you don't have to go all the way to that. You could allow some dollar money creation outside of the U.S., but subject it to some type of U.S.-based oversight and regulation to have congruence between the domestic dollar money creation regulatory scheme and the overseas dollar money creation regulatory scheme.

18:24What makes the current system so unstable and difficult to govern is there is no congruence. And in fact, there can be race to the bottom dynamics. And even worse, right now, there's so much opacity. You know, I said$13 trillion, but we don't really know the figure because there's no systematized reporting. In the US, all of the banks file reports quarterly with their balance sheet information. And we can track the amount of dollar deposits. We actually cannot track the amount of deposit-like liabilities being created offshore because there is no international agreement by which that information is reported to U.S.

19:06authorities. And that would seem to me to be like low-hanging fruit. You don't have to get rid of the ability of banks in Japan and Europe to create dollars. Why don't we just make them tell us how many they're creating and just some information about the assets on the other side of those balance sheets?

19:40Your best bottling plant employs 3 ,300 people. How do you get 3 ,300 people working at peak efficiency? Your best store has reduced waste, water, and energy usage. How do you make every store like your best store? Your best property has every guest raving. How do you make every property like your best property? The answer is Ecolab. Better performance, better outcomes, better impact. Ecolab. Now every location is your best location. For enterprise organizations, managing all your food needs is a tall order. But with Easy Cater, you get a single workplace food vendor with the tools and resources to make it easy, giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform, all while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting.

20:35Easy Cater, your business tool for food. To learn more, visit easycater.com slash podcast. One of the really interesting things here is, as you just mentioned, euro dollars basically mean that banks outside of the U.S. can create dollars, which you would think would impinge on U.S. monetary sovereignty. I mean, it does. But at the same time, the existence of euro dollars combined with the dollar swaps, which, you know, basically make them, as you were saying, a more attractive product to people to use, has solidified the dollar's role in the global financial system. Like it has helped the dollar achieve and maintain reserve status.

21:22So, oh, you're shaking your head. Yeah, I think it's definitely, that's conventional wisdom. Okay, all right. So there's nothing wrong with this. I'm happy to be conventional. But the question I was going to ask is, if you had additional oversight of the market, would that start to dent the dollar's role, given that there are concerns over, you know, the U.S. going too far on sanctions and things like that? I think you're asking a very important question, and I want to try to unpack it a little bit. Because what I was calling conventional wisdom, I think, jumbles up a lot of issues. And it's understandable that they get jumbled up.

22:03But really, to explain what the stakes are of the Basel IV type of response I was just describing, we really have to unjumble them. So first, there's the role of the dollar as a reserve currency. This is really quite distinct from euro dollars, which are the creation of U.S. dollar money offshore by offshore financial institutions. We're going to connect it back a little bit. But the dollar's role as a reserve currency, what that's directly about is the fact that foreign central banks hold treasury securities as their reserve assets. It's not about using the dollar to transact or to finance trade.

22:46although those are also related. It's about the fact that the Chinese, for example, have huge reserves and they have to invest those reserves and they have chosen to invest a very large percentage of them in treasuries. So dollar as reserve currency means foreign central banks hold reserves in treasuries. And they have chosen treasuries for lots of reasons, having very little to do with certainly whether their domestic financial institutions have the ability to create dollar deposit liabilities versus have to hold one-to-one balances with U.S. banks, but also even that has little to do with whether dollars are being used to finance trade or settle international transactions.

23:37If you are a central bank and you have a very, very large amount of reserves, let's say a couple trillion dollars, what assets are you going to put it in? And the choice to invest in treasuries has a lot more to do with U.S. economic hegemony and the sheer enormous quantity of U.S. treasuries than it has to do with what currency is being used to globally trade. So China, for example, has historically held lots of U.S. treasuries. It's really hard to think that it has anything to do with the euro dollar market, which is really not something that is benefiting in any meaningful sense the Chinese.

24:24What does relate to this sort of dollar as a reserve currency for foreign central banks is the liquidity of treasury markets, of course. And one reason why Saudis or the Chinese would want to hold their reserves in treasuries is that they can buy and sell very, very easily with very low cost. That is a shadow banking story, in part, about the creation of the repo market and treasury repo, which is a way to subsidize liquidity in treasury markets. But that's not a euro dollar shadow banking story. that's a repo shadow banking story. Okay. So the first point is, if you change the rules on how banks in Japan and London hold dollar balances, you make them fully reserve, is China going to decide they want to hold euros instead of treasuries?

25:18That's, I find, really, really sort of hard to substantiate. It just doesn't really connect. So does that mean it has nothing to do with it? No. So the global dollar is more than just a reserve currency. It's also a currency of international trade and international finance. And so there's lots of trade between third countries that doesn't involve the United States where they use dollars to transact. That's the means of exchange. And because that's the means of exchange, it's also the lending currency associated with financing that exchange. And so we have this dollar financial system that's quite a bit distinct from dollar as reserve currency.

26:08Chinese central bank wants to hold treasuries, has a bunch of reasons for that. Totally different calculus for why Indian conglomerate wants to sell its products to South American country in dollars. Different calculus. And with that second calculus, the euro dollars fit in a bit more, a bit more, because what's going on there is the Indian company has a bank and the South American company has a bank. And in all likelihood, their primary banks are not U.S. based. and those banks would like to be able to create dollars, lend them in dollars, and not have to look to U.S. banks for that liquidity.

26:53And so what the euro dollar system is really doing is cutting foreign financial institutions into the profits of dollar seniorage. They're giving them a piece of the action, and they're giving them a reason to want to be in the dollar business. And the way the whole thing got going initially was a lot of London banks wanted to get into the dollar business and we let them in basically. And that makes them evangelists for dollar based finance as opposed to constantly trying to say to their clients, you know what, let's do this deal in pounds because we create pounds. And if we had to do this deal in dollars, then we're going to have to go borrow from Citigroup the dollars that we need because we can't just create them ourselves and there's not this whole euro dollar market for us.

27:40We got to go to the domestic U.S. dollar market. And so we would have all these foreign financial institutions trying to suggest other currencies for international trade and financing and not being as gung ho about the dollar, which is not to say that they would necessarily succeed in convincing the vast majority of their clients to change currencies. There's a lot of reasons why. You would just, you know, open up a bank account with a U.S.-based bank, shift your business there. At the same time, the U.S. has gotten very far in embedding and entrenching the dollar by building this coalition of global financial institutions that all are able to profit and benefit off of being in the dollar, as opposed to trying to keep all of those benefits onshore for U.S.-based banks.

28:34So just to further understand this point with a concrete example, one thing that's gotten attention recently is China building out a swap network. And I have seen that couched as China takes on the US dollar and that sort of thing. What do you think they're trying to do in that context? So as it turns out, China's swap lines are just totally different from the Fed's swap lines. And so the Chinese are interested in spreading use of the RMB. They want other countries to use the RMB in trade, especially with China. They would be thrilled if the Indian company wanted to sell to the South American company and denominated an RMB.

29:24Its swap lines, though, are not trying to achieve that in anything like the way that the Fed swap lines are facilitating dollar money creation. The Chinese swap lines are basically a central bank lending program for indebted foreign governments. And so it's like World Bank or IMF loans. And so like a major borrower is Pakistan. Pakistan has had a swap line with the People's Bank of China. Sounds like an outcrop of Belt and Road. It is an outcrop of Belt and Road. It's exactly an outcrop of Belt and Road. And in the U.S., we would just never do that type of lending through our central bank. We did do something like that for Mexico in 1995,$20 billion loan.