The Evolution of Short-Term Funding: Who's Borrowing and Lending in Eurodollar and Selected Deposit Markets?
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The financial world relies on complex mechanisms to facilitate the movement of money. One crucial aspect is the short-term lending market, where banks and institutions borrow and lend overnight funds to meet their immediate needs. While the Federal Funds market, where banks lend directly through the Federal Reserve, is well-known, two other significant markets exist: Eurodollars and selected deposits.
According to a research blog article published by economists at the New York Fed, these markets play a crucial role in the financial landscape.
Understanding Eurodollars and Selected Deposits
Eurodollars are U.S. dollar deposits held outside of the United States, typically in offshore branches of banks. Selected deposits, on the other hand, are also unsecured U.S. dollar deposits, but they are held within the U.S. Both instruments serve as short-term, overnight funding sources for banks, but the regulatory treatment of each has varied over time.
Historically, both Eurodollars and selected deposits were exempt from reserve requirements, alongside Fed Funds. However, selected deposits became exempt only in 2020, when the Federal Reserve eliminated all reserve requirements for certain deposits, including selected deposits. This shift in regulation, combined with the removal of restrictions on paying interest on demand deposits in 2011, has influenced the dynamics of these markets.
A Shift Towards Selected Deposits
Between 2019 and 2024, the volume of overnight Eurodollar and selected deposit transactions has averaged $150 billion per day, surpassing the $80 billion of the overnight Fed Funds market. This surge in activity has been driven by a notable shift towards selected deposits, which now account for 85% of the combined volume, compared to 50% in 2019.
Several factors have contributed to this shift. One key factor is the Dodd-Frank Wall Street Reform and Consumer Protection Act, which encouraged banks to simplify their structures and eliminate offshore branches, impacting the use of Eurodollars. The subsequent elimination of reserve requirements for selected deposits in 2020 further accelerated their growth.
Who's Borrowing?
The primary borrowers in both Eurodollar and selected deposit markets are U.S. branches and agencies of foreign banks (FBO branches). These branches account for more than 90% of total daily volume, highlighting their reliance on these markets for short-term funding. This reliance stems from their inability to accept retail deposits, unlike domestic banks, making them more dependent on wholesale funding sources like Eurodollars and selected deposits.
Who's Lending?
The main lenders in these markets are non-depository institutions, including financial institutions involved in activities like brokerage, underwriting, credit origination, and insurance. These institutions account for roughly 80% of the lending volume, providing a broader range of lenders compared to the Fed Funds market.
This difference highlights the distinct features of the Eurodollar and selected deposit markets. In contrast to Fed Funds, where Federal Home Loan Banks (FHLBs) dominate lending, these markets offer a more diverse group of lenders to meet the diverse needs of borrowers.
The Competitive Advantage of Fed Funds
Despite the growth of Eurodollar and selected deposit markets, Fed Funds continue to attract borrowers due to a regulatory advantage. Banks benefit from favorable treatment in their Liquidity Coverage Ratio (LCR) calculations when borrowing from FHLBs, making Fed Funds potentially more attractive. This advantage is reflected in the higher rates that banks typically pay to borrow Fed Funds compared to Eurodollars or selected deposits.
In Conclusion
The Eurodollar and selected deposit markets have evolved significantly since the Great Financial Crisis. Regulatory changes, along with shifts in the U.S. banking system, have narrowed the differences between these markets. While Eurodollars once dominated short-term funding, selected deposits have surged in recent years, offering a more flexible and attractive option for banks.