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THE EURODOLLAR SYSTEM
Part 1: Origins & Mechanics
► Part 2: Crisis Patterns (1997-2020) (You are here)
Part 3: Current Vulnerabilities
Part 4: Alternatives & Endgame
INTRODUCTION: THE PATTERN THAT REPEATS
In Part 1, we revealed how the Eurodollar system was architected: Cold War asset protection, regulatory arbitrage, Bank of England support, and the collapse of Bretton Woods created a $65+ trillion offshore dollar-funding machine operating without a lender of last resort.
Now we document what happens when that architecture fails—and why it keeps failing the same way, despite "reforms" and "solutions" after each crisis.
The devastating pattern:
- Crisis every 3-5 years (1997, 2008, 2011, 2019, 2020)
- Same cascade mechanism: synthetic dollar unwinding → asset fire sales → contagion
- Same Fed response: emergency swap lines providing "unlimited" liquidity
- Same outcome: architecture preserved, fragility persists
This is not bad luck. This is architectural inevitability. The system was designed to fail catastrophically under stress, and each "solution" merely delays the next failure without addressing root causes.
Over five crises spanning 23 years, we see the same story repeated. The names change. The triggers vary. The underlying architecture—and its failure modes—remain constant.
THE RECURRING CASCADE: A UNIVERSAL PATTERN
Before examining each crisis individually, we must understand the universal cascade pattern that repeats across all Eurodollar crises:
The Eurodollar Crisis Cascade (Universal Template)
Stage 1: The Trigger (Varies by Crisis)
- Dollar strength (makes dollar debts more expensive in local currency)
- Risk-off event (investors flee to safety, withdraw from risky markets)
- Monetary policy divergence (Fed tightens while others stay loose)
- Credit event (default, bankruptcy, sovereign downgrade)
Stage 2: FX Swap Basis Widening
- Demand for synthetic dollars (via FX swaps) increases sharply
- Cross-currency basis deviates from covered interest parity
- Synthetic dollar borrowing becomes dramatically more expensive
- Arbitrageurs cannot eliminate basis due to balance sheet constraints
Stage 3: Dealer Retreat and Market Segmentation
- Banks reduce FX swap market-making (to preserve capital, manage risk)
- Bid-ask spreads widen; liquidity deteriorates
- Market segments become isolated (money can't flow where needed)
- Entities unable to roll dollar funding face immediate crisis
Stage 4: Asset Fire Sales
- Entities needing dollars begin selling dollar-denominated assets
- Treasuries, corporate bonds, mortgage-backed securities dumped
- Asset prices fall, triggering mark-to-market losses for other holders
- Forced selling accelerates price declines (downward spiral)
Stage 5: Contagion to US Markets
- Asset sales hit US markets directly
- Treasury yields spike (prices fall), credit spreads widen
- US financial conditions tighten despite domestic Fed accommodation
- Threat of systemic collapse if dollar funding freezes completely
Stage 6: Fed Intervention or Systemic Collapse
- Fed activates swap lines to provide dollars to foreign central banks
- Foreign central banks lend dollars to their domestic banks
- Dollar funding stress eases, FX basis narrows, asset fire sales stop
- Crisis "resolved" without addressing architectural fragility
CRISIS #1: THE 1997 ASIAN FINANCIAL CRISIS — THE TEMPLATE
The 1997 Asian Financial Crisis was the first modern Eurodollar crisis—the template that all subsequent crises would follow. It revealed the fragility of dollar-pegged currencies, the dangers of short-term dollar borrowing, and the cascade mechanism that would repeat for decades.
The Setup: Dollar Borrowing in Emerging Asia
Throughout the 1990s, Asian "Tiger" economies experienced rapid growth. Thailand, Indonesia, Malaysia, South Korea, and the Philippines attracted massive foreign investment:
- Currency pegs to the dollar: Fixed exchange rates provided apparent stability
- High domestic interest rates: Attracted capital inflows seeking yield
- Rapid credit expansion: Banks and corporations borrowed heavily in dollars
- Real estate and stock bubbles: Capital inflows fueled asset price inflation
Scale: Thailand's external debt reached ~50% of GDP by 1996. Indonesia, South Korea, and Malaysia also accumulated substantial dollar debts. Much of this borrowing was short-term, requiring continuous rollover.
The Trigger: Thailand's Baht Peg Breaks
Early 1997: Thai current account deficit reaches 8% of GDP. Foreign reserves begin declining as investors withdraw capital.
May 1997: Speculators attack the baht, betting the peg is unsustainable. Thailand's central bank defends the currency, burning through reserves.
July 2, 1997: The Crisis Begins — Thailand abandons the dollar peg, allowing the baht to float. The currency immediately collapses, losing 20% in days.
What this meant for dollar borrowers: A Thai company that borrowed $100 million when the baht was 25 to the dollar now owed the equivalent of 125 million baht (at 31 to the dollar) — a 24% increase in local currency terms, overnight. Many borrowers became insolvent instantly.
The Cascade
Stage 2-3: Regional Contagion (July-October 1997)
- Philippines (July 11): Peso weakens dramatically as investors flee
- Malaysia (July 14): Ringgit depreciates despite central bank intervention
- Indonesia (August): Rupiah begins weakening; crisis accelerates through fall
- Hong Kong (October 23): Speculative attack on HK dollar peg; interest rates spike to 300% to defend currency
- South Korea (November): Won collapses; largest IMF bailout in history ($57 billion) announced December
Stage 4: Asset Fire Sales
Asian entities holding dollar-denominated assets began selling to raise cash:
- US Treasury holdings sold (though central banks tried to avoid this)
- Equity holdings liquidated
- Real estate assets dumped at distressed prices
- Stock markets plunged 50-75% across the region
Stage 5: Global Contagion
- October 27, 1997: Dow Jones plunges 554 points (7.2%) — largest single-day point loss to that date
- Global risk-off: Investors fled emerging markets worldwide
- Russia (1998): Crisis spreads; Russia defaults on debt
- Long-Term Capital Management (September 1998): Major hedge fund collapse nearly triggers US financial system failure
The Response: IMF Packages (Not Fed Swap Lines—Yet)
The 1997 crisis predated the modern Fed swap line architecture. Instead, the response came through IMF bailout packages:
| Country | IMF Package | Conditions |
|---|---|---|
| Thailand | $17 billion (August 1997) | Budget cuts, interest rate increases, bank closures |
| Indonesia | $40 billion (November 1997) | Fiscal austerity, financial sector reform |
| South Korea | $57 billion (December 1997) | Corporate restructuring, labor market reforms |
The Fed's role: Limited. The Fed provided a bridge loan to Thailand in early stages and coordinated with other G7 central banks, but did not deploy swap lines. The Federal Reserve Bank of New York hosted a meeting on December 24, 1997, encouraging banks to extend Korean debt maturities to avoid disorderly default—essentially organizing a private sector "bailout."
The Aftermath: Lessons (Not) Learned
Economic Impact:
- ~$120 billion in IMF/multilateral/bilateral support
- Regional GDP contractions of 12-43% (Indonesia worst)
- Currency depreciations of 35-83% against dollar
- Millions unemployed; social and political upheaval (Indonesia's Suharto fell)
The "Reforms":
- Asian countries built massive foreign exchange reserves (self-insurance)
- Chiang Mai Initiative (2000): Bilateral currency swaps between ASEAN+3
- Reduced dollar peg dependence (more flexible exchange rates)
- Financial sector reforms (better regulation, capital requirements)
What Was NOT Reformed:
- The global Eurodollar architecture itself (still no lender of last resort)
- Short-term dollar funding dependence (continued growing globally)
- FX swap markets (synthetic dollar creation expanded post-crisis)
- US monetary policy's global spillover effects (no coordination mechanism)
CRISIS #2: THE 2007-2009 GLOBAL FINANCIAL CRISIS — THE BIG ONE
If 1997 was the template, 2008 was the full-scale demonstration of Eurodollar fragility—and the crisis that forced the Federal Reserve to become the de facto lender of last resort to the world.
The Setup: European Banks' Dollar Addiction
In the years leading to 2008, European banks massively expanded their dollar-denominated activities:
- US mortgage-backed securities: European banks were major buyers of US subprime MBS
- Dollar-denominated loans: European banks lent dollars globally
- Investment banking activities: Dollar-denominated trading, derivatives, structured products
- Funded via Eurodollar markets: Borrowed dollars short-term in Eurodollar and FX swap markets
Why this was fragile: European banks couldn't borrow from the Fed (only US banks can access Fed facilities directly). They depended entirely on continuous access to wholesale Eurodollar funding. If that funding dried up, they would face immediate dollar liquidity crisis—despite being solvent in euro terms.
The Trigger: Subprime Collapse and BNP Paribas
August 9, 2007: The First Domino — BNP Paribas announces it cannot value mortgage-backed securities in three of its funds and suspends redemptions. This was the moment the subprime crisis became a global Eurodollar crisis.
What BNP's announcement meant: If BNP—one of Europe's largest banks—couldn't value MBS, no one could. This created immediate fear about which banks held toxic assets and how much they were really worth. Counterparty risk exploded.
August-September 2007: European banks face "slow dollar run" as US money market funds begin withdrawing short-term funding. USD LIBOR (London Interbank Offered Rate) spikes above Fed policy rates—evidence of dollar funding stress offshore.
The Cascade: Fed Swap Lines Deployed
Stage 2-3: Dollar Funding Stress Accelerates (Fall 2007-Spring 2008)
December 6, 2007: Fed announces first currency swap line with European Central Bank ($20 billion)
December 11, 2007: Swap line with Swiss National Bank (CHF 4 billion)
Fed's rationale: European banks scrambling for dollars were driving up US fed funds rate early in the day (London trading hours), interfering with Fed's ability to control domestic interest rates. FOMC transcripts show Chairman Bernanke worried: "There is a shortage of dollars there early in the day, which often leads the funds rate to open high. It creates problems for our monetary policy implementation."
March-September 2008: Dollar funding stress continues. Fed repeatedly increases swap line sizes. Crisis simmers without exploding.
September 15, 2008: Lehman Brothers Collapses — The trigger that turns simmer into explosion.
Stage 4-5: The Cascade Goes Critical (September-October 2008)
Lehman was a major counterparty in FX swaps and Eurodollar markets. Its bankruptcy froze markets as participants scrambled to unwind positions and assess exposure. Counterparty risk reached panic levels—banks refused to lend to each other at any price.
September 2008 consequences:
- USD LIBOR-OIS spread (measure of interbank stress) exploded to 364 basis points (normal: 10-20bp)
- FX swap basis blew out: EUR/USD basis reached -200bp+ (synthetic dollars dramatically more expensive)
- Money market funds began "breaking the buck" (Reserve Primary Fund)
- Commercial paper market froze (corporations couldn't roll short-term debt)
- Asset fire sales intensified (MBS, corporate bonds, even Treasuries sold for cash)
The Response: Unlimited Fed Swap Lines
September 18, 2008: Fed expands swap lines to Bank of Japan, Bank of England, Bank of Canada
September 24, 2008: Further expansion to Australia, Denmark, Norway, Sweden
September 29, 2008: Swap line sizes increased dramatically
October 13, 2008: THE DECISIVE MOMENT — Fed announces UNLIMITED dollar swap lines with ECB, SNB, Bank of Japan, Bank of England
"The Federal Open Market Committee has authorized further expansion of its liquidity facilities to help improve liquidity conditions in global financial markets. All central banks will continue to work together closely and are prepared to take whatever measures are necessary to provide sufficient liquidity in short-term funding markets."
October 28-29, 2008: Swap lines extended to New Zealand, Brazil, Mexico, South Korea, Singapore
| Date | Outstanding Swap Line Draws |
|---|---|
| September 2008 | $288 billion |
| October 2008 | $534 billion |
| December 17, 2008 (Peak) | $583 billion |
For context: $583 billion represented approximately 25% of the Fed's total balance sheet at the time—a quarter of Fed assets were swap lines to foreign central banks.
Primary users:
- European Central Bank: $300+ billion (peak)
- Bank of Japan: Substantial draws
- Bank of England, Swiss National Bank: Major users
The ECB then lent these dollars to European banks facing dollar funding crises—primarily through weekly dollar tenders where banks bid for dollar liquidity against euro-denominated collateral.
The Aftermath: Standing Swap Lines Made Permanent
Economic Impact:
- Global GDP contracted ~2% (2009)
- Unemployment surged worldwide
- $10+ trillion in household wealth destroyed (US alone)
- Governments spent trillions on bailouts and stimulus
- Sovereign debt crises emerged (especially Europe)
The "Solution":
- May 2010: Fed reestablishes swap lines during European debt crisis
- October 31, 2013: Fed makes swap lines with five major central banks PERMANENT (standing arrangements)
- ECB, Bank of Japan, Bank of England, Swiss National Bank, Bank of Canada: unlimited access whenever needed
What This Means:
The Fed effectively became the lender of last resort to the global Eurodollar system. Not through formal treaty or legislation, but through repeated emergency interventions that created expectations of future support. The "temporary" crisis response became permanent architecture.
[The complete Part 2 would continue with Crisis #3 (2011 European Debt Crisis), Crisis #4 (2019 Repo Crisis), and Crisis #5 (2020 COVID Panic), following the same analytical structure. Each demonstrates the same cascade pattern, same Fed response, and same preservation of architectural fragility. Would you like me to continue building out the remaining three crises?]
The final three crises (2011, 2019, 2020) and the devastating conclusion: why the pattern cannot break without fundamental reform
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