At a Glance
- Eurodollar futures are a critical cog in the global finance system. Indeed, some market participants and economists consider it the most important market in the world.
- 35th anniversary of the most actively traded futures contract in the world
This is the first in a series of stories on products critical to futures markets that have defined their progress over 150 years.
The Eurodollar futures complex has achieved unparalleled success since its launch in December 1981. It is one of the most actively traded futures products in the world.
While the average investor may know little about the Eurodollar market, by some accounts, the underlying market is a critical component in how banks fund and manage their liability structures.
The Eurodollar futures market is “one of the largest liquidity pools on God’s green earth,” says Fred Sturm, executive director of financial research and product development at CME Group.
Action in the Eurodollar market can offer insight into global capital flows, credit demand and interest rate expectations. If money is an engine that makes the world go round, Eurodollar futures prices could be a considered a barometer of “the cost of money,” Sturm says.
Why does this matter to anyone outside the world of bank funding? It all comes down to money flows.
Corporations, governments, individuals rely on borrowing, says Agha Mirza, global head of interest rate products at CME Group. “There is a significant amount of borrowing and lending in the system. It is an integral part of the economic engine. Eurodollar futures have been the flagship for interest rate hedging for decades. Now they are stronger than ever,” Mirza says.
Active users of Eurodollar futures include asset managers, corporate treasurers, hedge funds, mortgage companies and proprietary trading companies, as they manage short-term interest rate exposures. “Eurodollar futures have become the de facto measure of generic U.S. dollar-denominated unsecured funding cost,” Sturm says.
Here’s an example. A corporation arranges a commercial bank loan at the London Interbank Offered Rate (LIBOR) plus some additional premium based on the credit-worthiness of the company. The corporation faces the risk of rising interest rates and can hedge that exposure by selling Eurodollar futures.
The final settlement price of an expiring Eurodollar futures contract is determined by reference to three-month LIBOR on the last trading day. Thus, movements in the Eurodollar futures market provide clues as to where the smart money players think LIBOR will be in the future.
A Market Still At Its Prime
Eurodollar futures rack up the highest average daily volume of any contract traded at the CME, with the largest open interest. At the end of November , total open interest, or contracts outstanding, represented a $12.84 trillion notional value.
Eurodollar futures are used as a hedging tool for interest rate swaps, loans and mortgages. The four attributes that make the Eurodollar futures market stand out are its 1) liquidity, 2) diversity of market participants 3) diversity of applications and 4) capital efficiency relative to alternatives such as interest rate swaps, Mirza says.
A Eurodollar Is Not a Currency
Despite its name, a Eurodollar has no relation to the euro currency or the European Union. A Eurodollar refers to a U.S. dollar-denominated bank deposit booked outside of the United Sates, anywhere from London to Rio de Janeiro to Tokyo.
Eurodollar futures are based on the rate on 3-month term Eurodollar time deposits.
Historically, the Eurodollar market evolved internationally as a result of political tensions in the 1950’s and 1960’s. At that time, the Soviet Union and associated Eastern bloc satellites, along with the People’s Republic of China, feared that the United States could freeze their accounts due to Cold War tensions and confiscate dollar balances held at New York City banks.
The Birth of Cash Settlement
By 1980, trading volume at the Chicago Mercantile Exchange surged in gold, foreign currencies and T-bill futures, overtaking its agricultural products for the first time in exchange history.
CME Chairman Emeritus Leo Melamed initially pinpointed another huge global market – the short-term interest rate on dollars traded throughout the world — and that became the basis for the Eurodollar futures contract.
Fred Arditti, former CME Chief Economist, played a key role in developing and defining the Eurodollar futures market. A potentially serious challenge to adoption of the Eurodollar futures contract was the concept of cash settlement. At that time in the United States, most futures contracts expired by physical delivery. Futures contracts that expired by cash settlement were rare. Other money market interest rate futures products popular at the time, such T-Bill futures or futures on bank CDs , could be physically delivered. “Arditti and his staff really had to go out of their way to show how cash settlement would work,” Sturm says.
Arditti traveled to London to meet with major global banks prior to the approval by the CFTC of the CME’s proposed Eurodollar contract. Upon his return, Arditti drafted the contract specifications that turned cash settlement from a theory into reality.
While Eurodollar futures are now traded electronically, in the trading floor’s heyday, roughly 1,500 traders and clerks flocked to the Eurodollar futures pit each day, bracing for an active day of buying and selling. Brokers, local traders, clerks and runners donned colorful trading jackets and filled the trading pit, which stood nearly as big as a football field.
Current State of the Market
For evidence of its robustness, consider how the Eurodollar futures complex weathered the static near-zero interest rate environment that has persisted since the 2008 financial crisis. Because contract months extend out to 10 years, trading volume was able to shift out to distant dates, where Eurodollar futures users found the interest rate risks that mattered to them.
In 2008, over 55 percent of Eurodollar futures volume took place in the nearby four quarterly contract months. By 2014, their share of volume had dropped to less than 25 percent as trading volume migrated to longer-dated contracts, Sturm says. “The action moved farther out on the curve because that’s where people had differences of opinion that made for a trade.”
Now, in 2016, the volume in the four nearby contract has rebounded back to the 40 percent area.
One of the most valuable characteristics of the Eurodollar futures market is its ample, consistent and nearly round-the-clock liquidity, Mirza says. A wide variety of measures — including size of market, bid/offer spreads, trading volumes and open interest — attest that Eurodollar futures market liquidity is near record highs, he says. “It has been a flagship for decades and now is stronger than ever.”
As the calendar flips to the 35th birthday for the venerable Eurodollar futures, Sturm notes that the contract “possesses more flexibility than Fred Arditti could have imagined. Here it is in 2016, bigger than ever. It is a remarkable story.”