A Eurodollar is any US Dollar that is in a time deposit account outside the United States. Since it is outside the jurisdiction of the Federal Reserve, it is free of that entities regulation.
The term originally applied to only those banks in Europe that were holding USD. However, after grappling with the term "Asiadollar", the idea was scrapped. Now it applied to any USD outside the US domestic banking system.
Hence it has nothing to do with the EURO, the currency for the European Union.
The Euro prefix, in financial terminology, means currency or securities that are held offshore. It is possible. for example, to have a Euroeuro which is a EURO that is deposited in a non-European Union bank.
We also see this tied to bonds. There are Eurobonds and Euroeurobonds.
History of the Eurodollar
The Eurodollar dates back to the end of World War II. After the devastation to Europe, the United States passed the Marshall Plan. This was done to help rebuilt the continent which was leveled due to years of bombing by both sides.
Between 1948 and 1951, European nations received $13 billion from the United States in aid. This was a lot of money that ended up being shipped across the ocean. Obviously, this banknotes ended up being deposited in European banks.
Today, many American banks have offshore branches which they can accept Eurodollar payments. These are usually housed in the Caribbean. Foreign arms of US banks are considered not part of the domestic system, hence are treated similar to non-US banks.
All Eurodollar deposits are exempt from FDIC insurance. This means they tend to payer a higher interest rate.
How Rates Are Determined
Eurodollars that are deposited have different interest rates. If they are submitted overnight to a week, they follow the Fed Funds Rate. For longer dated maturities, they use LIBOR.
Most transactions are overnight and rather large. It is not uncommon for deposits to top $500 million. These are started with the money being sent via Fedwire or CHIPS system.
Deposits in Eurodollars amount to hundreds of billions per day.
Like much of the monetary system, there are very few physical US dollars tied to the Eurodollar. All of this is now ledger based, meaning banks account for the transactions themselves. This ties to the balance sheet which enables the banks to expand, or forces them to contract, their Eurodollar operations.
Eurodollar Futures Contracts
All future contracts for the Eurodollar are traded on the Chicago Mercantile Exchange (CME). These are financial contracts based upon the deposits. Actually, the contracts are derivatives based upon the interest rate paid on the deposits. The price movement is based upon LIBOR. They are cash settled contracts.
Basically, Eurodollar futures contracts are a way for companies to lock in a rate today for money they plan to borrow in the future. This is a way to hedge against rate increases.
As with US Treasuries and the 10-Years bond, there is a standard with LIBOR that everyone watches. This it the 3-mmonth. All Eurodollar future contracts are based upon the USD LIBOR interest rate expected at settlement date.
The face value is $1 million. Through leverage, this can be traded for lesser amounts.
Use By US Banking
Until 2011, United States banks could not pay interest on corporate checking accounts. To get around this, the banks would move the money into an overnight investment option. This would allow for the customer to earn some interest on the money.
This is known as a sweep.
It typically involved moving the deposit into money market mutual funds.