Euro-currencies

Reality is always more complicated than theory, especially in banking. Currencies can actually be created and exist outside of their domestic zones or home jurisdictions. Examples are ‘Euro-currencies,’ e.g., Eurodollar, Euro-euro, Euro-sterling. The Euro-prefix originated from Europe the region, and should not be confused with:

the Euro currency (€) itself, or

the terminology used in the foreign exchange (FX) trading, e.g., ‘Euro/dollar’ which refers to the exchange rate between euros and dollars.

In this context, the prefix ‘Euro’ indicates that the currency exists outside of its home zone. It was first used when the first USD loan was created outside of the USA, in Europe. So, Euro-dollar, Euro-sterling, and Euro-euro mean, respectively, a US dollar that exists outside the USA, a British pound that exists outside the UK, and a Euro that exists outside the Eurozone.

How are Euro-currencies created? When a bank writes a loan in the

currency outside its domestic currency zone (e.g., a British bank issuing a loan in USD), it creates money that exists outside its currency zone (i.e., USD deposits existing outside the USA). This is allowed and is normal business practice, fairly common in fact, but complicates the financial world, especially when countries are trying to count how much of their own currency exists in the world. So it is not the case that all currency is directly controlled by its respective central bank.

At this stage, it is worth busting a common myth. It is commonly believed that banks take money from one customer and lend it to another. This is a sloppy way of thinking about banking and leads to incorrect conclusions. Banks create money, in the form of deposits, when they write loans.

These new deposits are new money, sometimes called ‘fountain pen money’ because bankers used to approve loans by signing a document with a fountain pen. If you take out an unsecured loan from a bank, the bank adds deposits to your account (increasing their total liabilities) and adds a loan to their balance sheet (increasing their total assets). New money has been created; it hasn’t been ‘borrowed’ from another depositor. The Bank of England explains this in a research piece entitled ‘Money creation in the modern economy’65.

Foreign Exchange

Now that we’ve dealt with single currency payments (that is, the movement across borders of value denominated in a single currency), what about foreign exchange? What about Alice wanting to send GBP from her sterling account for it to arrive as USD in Bob’s US dollar account?

Money doesn’t simply ‘become’ other money, just because of ‘banks’. Pounds sterling cannot become US dollars any more than a pint of milk can become a litre of beer, or a lump of silver can become a lump of gold. 1 pound is not 1.2 dollars. 1 pound is not even ‘the same as’ 1.2 dollars.

Sterling is a completely different asset from US dollars, and assets and currencies cannot, and do not, magically morph from one type to another. You always need a third party who is prepared to accept one currency and give you the other.

In a payment involving two currencies, someone somewhere is acting as a third party willing to accept some of your currency in return for some of the other currency. When Alice pays GBP to end up as USD in Bob’s account, the role of exchanger may be fulfilled by Alice’s bank, who will deduct GBP from Alice’s account, and credit USD to Bob’s bank, or by Bob’s bank, who will accept GBP from Alice’s bank, and credit USD into Bob’s account. Or Alice could use a specific third party, an MTO such as Transferwise. Transferwise, and other similar MTOs, have local currency accounts in banks in many countries, and they will receive GBP from Alice into their GBP account in London, and they will instruct their USD bank in New York to send some USD from their USD account to Bob’s account. Transferwise has therefore changed the balance of currencies it holds by holding more GBP and less USD. This in turn changes its risk arising from foreign exchange fluctuations—that is, movements in the value of those currencies relative to each other. To maintain its original risk profile, Transferwise will then hope that someone will want to send money the other way, helping to square up its books, or it may try to sell those extra GBP to another agent for USD.