1994-06-11 - Re: Regulatory Arbitrage

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From: rah@shipwright.com (Robert Hettinga)
To: hughes@ah.com (Eric Hughes)
Message Hash: 397e1f69dbe27c556f99e64d9bc96dc1bdf9803ba7e6f9603dcf14c601277050
Message ID: <199406110237.WAA15282@zork.tiac.net>
Reply To: N/A
UTC Datetime: 1994-06-11 02:38:37 UTC
Raw Date: Fri, 10 Jun 94 19:38:37 PDT

Raw message

From: rah@shipwright.com (Robert Hettinga)
Date: Fri, 10 Jun 94 19:38:37 PDT
To: hughes@ah.com (Eric Hughes)
Subject: Re: Regulatory Arbitrage
Message-ID: <199406110237.WAA15282@zork.tiac.net>
MIME-Version: 1.0
Content-Type: text/plain

>   Eurodollars were invented
>   to get around American tax and currency regulations, and those of other
>   countries.
>Eurocurrency and eurobond markets started about thirty years ago, as
>the Bretton Woods monetary agreement was breaking down, which
>officially happened in 1973.  So for a good clear twenty years there's
>been this mediated market which uses regulatory arbitrage to provide
>it's services.  It's been there _longer_than_modern_cryptography_.

I went to University of Chicago for a while.  I went back to school to
learn things they didn't teach a Philosophy major at the University of
Missouri in the late '70s, like math.  One of my cronies from Chicago, a
finance type named Mark McCarren, was lurking over my shoulder this
afternoon while I was showing him the Wonders of Cyberspace (TM).  He saw
this post and muttered, "it started with the Soviets in the 50's..."  So, I
weaseled the story out of him, and then he produces this dusty old textbook
to back it up...

Loosely Plagiarized from Modern International Economics, (1983)
by Wilfred Ethier
ISBN 0-393-952-50-9
Pages: 419-423

The eurocurrency market developed for three reasons (all forms of
regulatory arbitrage):

1. Geopolitics:  In the 50's,  the Soviet Union got dollars in trade with
the US and others, and wanted to keep them out of US banks.  It seems that
US had frozen Chinese assets during the Korean war, and for some reason,
the USSR didn't want the same thing to happen to *their* stash....  It
turns out the cable address of Parisian bank where this particular money
was stashed was "EUROBANK".  Hence the origin of the term "eurodollars".

2. National controls.  From 1963 to 1974, US exchange controls limited the
ability foreigners to borrow dollars in US.  If they wanted to borrow lots
of dollars, they had to do it in foreign countries.

3.  A country doesn't regulate other countries' currencies within it's own
borders.  Nations don't regulate foreign currencies in their own banks
because that money doesn't affect their own domestic monetary policy.
(Except in high-inflation economies, like Israel in the late 80's, where
governments "dollarize" savings accounts to increase domestic savings.
There's a thread going on now about this about this in sci.econ, if
anyone's interested.)

As regards Bretton Woods, it's not clear whether the Bretton Woods collapse
had much to do with the popularity of the eurocurrency markets.  Remember
from previous discussions here, Bretton Woods broke down because the
"dollar as good as gold" policy of the post war economic order eventually
caused a massive US  trade deficit with the rest of the world.  We talked
before about De Gaulle cashing in dollars for gold, and various presidents
decoupling the dollar from gold and floating the dollar, etc.  Coupled with
the above structural reasons, the popularity of eurocurencies in late 70's
seems to have  came a lot from the oil shocks, which caused a), inflation
and higher interest rates, and b), lots of Arab oil money, which had to be
put somewhere.  Since US banking regulation Q put a ceiling on the interest
rates US banks could pay depositors, most of that money stayed out of the
US.  (Even though Muslim law forbids interest ;-))

Think of the eurocurrency markets in terms of the old "bowling-ball on a
waterbed" analogy of gravity.  Regulation increases the mass of the bowling
ball and its escape velocity, or the depth of the hole the bowling ball
sits in.  In other words, the more regulation there is out there, the more
the money runs down the hill to the euromarket.  Assuming a frictionless
waterbed, of course;-).  Nassau, Panama, the Caymans, Luxembourg, Bahrain,
Zurich, Paris, Amsterdam, Hong Kong, Singapore are all down at the bottom
of the monetary gravity well.  The most important is London.  But we knew
this already, from a list of spiffy places to put your money published here
a few weeks ago.

A more concrete example of Regulatory Arbitrage, using a pretty sensible
regulation, domestic monetary policy (reason 3, above), is this one:

Fredonian Bank A has a 25% reserve requirement in it's own currency, call
them "tokens", mandated by the government's own monetary policy board, "the
Fred".  Thus, Bank A can lend 75%.  They have a 100 "token" liability on a
75 "token" asset.  If the interest rate paid on deposits is 5%, break even
point is 5/75 = 6.25% .  But the 1.25% doesn't cover its operating costs.
It's just its cost of capital to loan out.  If assume a 1.75% operating
margin, and you get an 8% loan rate.

With eurodollars, there's no reserve requirement, and the Bank can pay more
on deposits and charge less on loans.  Thus, it can pay the old deposit
rate plus a little more, say 5.5%, and it can loan money at 7.5% for the
same operating costs, because that 1.25% caused by the reserve requirement

By the way, I lent McCarren my copy of Schneier in exchange.  I think he
got the better end of the deal, but that's a cost of e$vangelizing <hyuk!>
to the financial community...


Robert Hettinga  (rah@shipwright.com) "There is no difference between someone
Shipwright Development Corporation     who eats too little and sees Heaven and
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