Role of the Offshore Deposit Markets

Role of the Offshore Deposit Markets for Euro/Dollars and Other Currencies Forward contracts have existed in commodity markets for hundreds of years.

In the foreign exchange markets, forward contracts have been traded since the nineteenth century, and the concept of interest arbitrage has been understood and described in economic literature for a long time.

But it was the development of the offshore Euro currency deposit markets the markets for offshore deposits in dollars and other major currencies in the 1950s and ‘60s that facilitated and refined the process of interest rate arbitrage in practice and brought it to its present high degree of efficiency, closely linking the foreign exchange market and the money markets of the major nations, and equalizing returns through the two channels.

With large and liquid offshore deposit markets in operation, and with information transfers greatly improved and accelerated, it became much easier and quicker to detect any significant deviations from covered interest rate parity, and to take advantage of any such arbitrage
opportunities.

From the outset, deposits in these offshore markets were generally free of taxes, reserve requirements, and other government restrictions. The offshore deposit markets in London and elsewhere quickly became very convenient for, and closely attached to, the foreign exchange market.
These offshore Euro currency markets for the dollar and other major currencies were, from the outset, handled by the banks’ foreign exchange trading desks, and many of the same business practices were adopted.
These deposits trade over the telephone like foreign exchange, with a bid/offer spread, and they have similar settlement dates and other trading conventions. Many of the same counter parties participate in both markets, and credit risks are similar.
It is thus no surprise that the interest rates in the offshore deposit market in London came to be used for interest parity and arbitrage calculations and operations.
Dealers keep a very close eye on the interest rates in the London market when quoting forward rates for the major currencies in the foreign exchange market. For currencies not traded in the offshore Euro currency deposit markets in London and elsewhere, deposits in domestic money markets may provide a channel for arbitraging the forward exchange rate and interest rate
differentials.