CONCEPT PAPER
The Intersection of the Eurocurrency and Cryptocurrency Markets
The Future of International Finance
Executive Summary
The convergence of Eurocurrency and cryptocurrency markets has become a vital topic in the finance world, offering new opportunities for the transition from centralized to decentralized monetary systems in global financial transactions. While both currencies share common characteristics of being non-regulated, stateless, representing potential regulatory and risk control challenges, it is due to their similarities that they could have the most significant impact on the future of finance by offering increasingly flexible and efficient liquidity solutions within global financial transactions. This paper explores the implications of the convergence of the Eurocurrency and cryptocurrency markets by specifically concentrating on developing over-the-counter (OTC) markets for cryptocurrencies and proposes solutions to address some of the key regulatory and risk control challenges. We will also explore the need for industry-wide standardization efforts, embedded supervision, and the development of a peer-to-contract architecture to provide a safer trading environment while continuing to maintain the key benefits of the blockchain system within a decentralized finance (DeFi) setting.
Introduction
The intersection of the Eurocurrency and the cryptocurrency has become an increasingly important topic in the world of finance. Eurocurrency refers to any internationally accepted means of payments deposited outside of its country of origin. Cryptocurrency, on the other hand, is a globally useable currency that operates independently of, and without any reliance on, traditional banking systems. Despite their differences, there are several similarities between the two currencies, including their non-regulated and stateless nature and, more importantly, the opportunities they represent as global monetary systems undergo an unprecedented transition from centralized to decentralized governance models within international financial transactions. While these two currencies have the potential to impact the future of finance significantly, certain challenges and regulatory and risk control considerations represent significant barriers to unlocking such potential future impact. This paper explores the similarities and differences between the Eurocurrency and the cryptocurrency and the potential implications for the future of financial markets.
Eurocurrency and Cryptocurrency
The Eurocurrency and the cryptocurrency share several similarities, making the cryptocurrency a form of Eurocurrency. We will now explore these similarities further:
What is a Eurocurrency?
Eurocurrency refers to foreign currency deposits held in banks located outside the currency’s country of origin. For example, if a US dollar deposit is held in a London-based bank, it is considered a Eurocurrency deposit. The term “Euro” does not only refer to the euro currency or the eurozone, as it existed before the euro was created. It can apply to any foreign currency deposits held in foreign banks outside their home markets.
The Eurocurrency emerged in the 1950s, starting with the Eurodollar, US dollar-denominated deposits held in European banks, especially in London. Several factors drove the emergence of the Eurocurrency, including large quantities of US dollars being held in Europe due to the fixed exchange rate system, economic aid from the US to European countries, and the 1957 sterling crisis, which compelled London-based banks to use dollars for trade.
Today, the Eurocurrency is a prevalent aspect of the global financial system and is used for short-to-medium-term financing by banks, multinational corporations, mutual funds, and hedge funds. It is a key source of global funding due to the ease of convertibility between currencies and the lower regulatory measures applicable to it compared to its domestic market equivalents. The Eurocurrency and Eurobond markets are exempt from domestic interest rate regulations, reserve deposit requirements, and other barriers which typically hinder the free movement of capital. Thus, it is a critical component of international finance and is widely used for international trade and investment.
‘Wrapped’ Nature
A Eurocurrency, such as the Eurodollar, operates outside of the US banking system. It is not recorded in its country of origin’s ledger system but instead is integrated into other proprietary ledger systems and databases managed by European banks and supranational institutions. Therefore, essentially, a Eurocurrency has the same characteristics as “wrapped’ cryptocurrencies, such as wrapped Bitcoin (WBTC) or wrapped fiat currencies called stablecoins (such as USDT and USDC), which allow for greater flexibility and efficiency in global financial transactions, by facilitating DeFi activities through smart-contract-based protocols and settlement enforcement on the blockchain.
As the use of blockchain technology continues to grow, this “wrapped” settlement system has significant implications for the future of finance, especially as the use of blockchain technology continues to grow. As more monetary systems and financial transactions move towards decentralized models, integrating different currencies and assets into other ledgers will become an increasingly important characteristic for any such monetary systems and transactions. The potential benefits of this settlement system, particularly its potential ability to address the inherently high market fragmentation and lack of secondary market liquidity, could help shape the future of international financial markets.
Euromarket and OTC Market
The Euromarket is an offshore marketplace where non-domestic currencies, including the Eurocurrency, are traded. A Eurocurrency, which is circulated outside its home country, is not subject to the regulations of that country. Similarly, a cryptocurrency operates within its blockchain network and is not governed by a specific legal or regulatory jurisdiction. This stateless quality gives any market on which a cryptocurrency is transacted similar characteristics to those of an offshore eurocurrency market.
Over time, the offshore market has become an interbank market that is subject to fewer regulatory measures than its domestic counterparts. European banks and international organizations have historically preferred these markets for their lower regulation and the flexibility and efficiency they offer for currency convertibility, a significant contributor to the overall development of international financial markets. Such transactions are typically conducted on an OTC basis and are often cross-border in nature.
OTC trading enables large-scale and customized transactions to be successfully concluded, but its one-off negotiation process can result in additional trade execution complexities and higher liquidity costs. These include managing settlement and counterparty risks, finding secondary market counterparties, and negotiating legal terms and conditions. These factors have led to the emergence of brokers and central counterparty clearing houses (CCPs), as well as a common standard definition and documentation framework known as the ISDA Master Agreement.
In the context of cryptocurrencies, there is an increasing demand for the development of an OTC market, especially the fixed-income market, due to centralized exchanges and current DeFi protocols’ focus on the short-term money market. The decentralized nature of the OTC market makes it an excellent fit for the yet-to-be-developed, long-term, fixed-income DeFi market.
By utilizing decentralized ledger technology and leveraging the knowledge gained from the Euromarket’s OTC market development, there is limitless potential for further developing a fixed-income OTC cryptocurrency market. Such a blockchain-based OTC market could provide increased flexibility and efficiency, further decentralizing international financial markets and leading to the development of a full-fledged DeFi market protocol and contributing, just as the Eurocurrency, to the development of more scalable, transparent, and efficient global financial markets.
Non-Regulated and Stateless
The Eurocurrency and cryptocurrency are not only subject to lower regulatory measures but are also stateless currencies. As a result, they are not subject to specific traditional banking regulations such as reserve deposits, interest rate restrictions, and withholding taxes. Due to their exemption from such regulatory measures, they offer greater flexibility and efficiency for international financial trades and can be significant contributors, as alternatives to their traditional counterparts, to the further development of global financial markets. However, it is essential to note that while Eurocurrencies may not be regulated within the Euromarket, all financial transactions involving them and cryptocurrencies must adhere to domestic regulations and laws in each jurisdiction within which such transactions occur.
Summary
A cryptocurrency shares enough similarities with a Eurocurrency to be considered a form of it. These similarities have significant implications for the future of finance. While the cryptocurrency’s decentralized nature presents regulatory and risk control challenges, these could be considered and adequately addressed by studying the long history of industry-wide efforts to develop the Eurocurrency’s OTC market.
Overall, the similarities between Eurocurrency and cryptocurrency highlight the potential benefits that could solve the challenges of developing an OTC cryptocurrency market. Therefore, it provides a potential solution for the current DeFi market limitations. It will be interesting to see how the relationship between Eurocurrency and cryptocurrency evolves further and how it impacts the future of finance.
The following section discusses how we can leverage our broad knowledge of the Euromarket to address the challenges of developing OTC, decentralized financial markets for cryptocurrencies.
Philosophy of Market Design
The Need for Standards
Similarly to the Eurocurrency, the cryptocurrency does not have a home country. However, it does have a home jurisdiction, represented by its home blockchain, governed by the decentralized network consensus, and enforced by the deployed code. Due to the unique governance models, advanced technical savviness requirements, and diverse rule enforcement systems, specific considerations are necessary when building financial markets on top of the blockchain system.
The Eurocurrency and Eurobond markets grew as interbank markets without a global regulator. Historically, Eurobanks and international organizations preferred these unregulated markets to seek more flexibility and efficiency. This greatly contributed to the rapid development of international financial markets. Transactions are conducted over-the-counter (OTC) and often involve cross-border transactions. To provide a legal framework for these transactions, standard definitions, and a legal documentation framework were developed, known as the ISDA Master Agreement.
Standardization efforts across the industry and the great flexibility of the Eurocurrency have led to OTC derivatives markets becoming the most important financial markets, with a value of $632 trillion and the bedrock of the entire finance industry. Given these factors, cryptocurrency markets, with their less fragmented nature, higher transparency and efficiency, and lower pricing models, provide a unique opportunity to tap into the scalability of these trillion-dollar markets.
To make the interbank OTC market accessible to all, we must enable retail-sized trades by drastically reducing operating and legal compliance costs while continuing to ensure the same level of embedded security. Decentralized ledger technology, such as smart-contract-based settlement enforcement, can provide such a solution. We believe this is best achieved by designing smart contracts to replicate the Eurocurrency market ecosystem, including clearing counterparties, collateral margin calls, and the EMTN program, widely used among Eurobanks and international organizations to facilitate flexible Eurobond issuances.
Improving Secondary Market Liquidity
OTC trades are typically conducted on a peer-to-peer basis with the primary market. However, this can make it inefficient to bring sufficient liquidity to the secondary market when trying to unwind, cancel, or buyback transactions on a peer-to-peer negotiation basis.
DeFi (Decentralized Finance) introduced the counterparty pool as a solution, turning the peer-to-peer relationship into the peer-to-pool relationship. An open central counterparty pool works like a CCP, separating two counterparties and removing the need to find other counterparties. It has resulted in more liquidity being brought to the secondary market, making it a popular architecture.
However, the peer-to-pool architecture has some disadvantages, such as impermanent loss, external price dependency, and capital inefficiency. Impermanent loss comes from the use of pool price discovery algorithms, which can differ from the price being provided for such assets outside of the pool, depending on the price corrections made by arbitrageurs. The pool’s capital inefficiency is a result of a significant portion of the funds remaining unutilized.
In contrast, the Secured Finance protocol solves these problems using a CCP smart contract with peer-to-contract architecture that provides several benefits over the peer-to-pool model. Firstly, orderbook price discovery is used instead of a pool algorithm to determine the price. This means that the price is universal and not dependent on any arbitrage corrections. Secondly, an immediate novation is effected as part of the execution of a peer-to-peer transaction, ensuring there is no capital inefficiency. Once there is a match of conditions between peers, two back-to-back transactions will be created to isolate counterparty risks. The new relationship is on a peer-to-contract basis and has the same liquidity benefit as the peer-to-pool model but without the disadvantage of impermanent loss, external price dependency, and capital inefficiency.
Therefore, our peer-to-contract architecture provides a superior solution for secondary market liquidity compared to the peer-to-pool architecture used by most other DeFi protocols.
Decentralized Regulation and Embedded Supervision
In the cryptocurrency markets, users are responsible for managing their private keys, which gives them complete control and responsibility over their financial assets, including meeting any Know-Your-Counterparty requirements. While this decentralized and secure environment offers many benefits, it can also pose challenges regarding proper risk control.
To facilitate a safe trading environment and organically grow liquidity, Secured Finance offers standard OTC products, such as loans and derivatives. These “plain vanilla” products are designed to ensure proper risk control and guide users unfamiliar with cryptocurrency finance’s complexities.
However, decentralized financial regulation is needed to ensure investor protection from fraud and manipulation risks. While the blockchain system offers many benefits, such as transparency and data reliability, it can also pose challenges in terms of regulation. This is where embedded supervision comes into play. By embedding regulatory concepts and rules into smart contracts, a framework for decentralized financial regulation can be created to achieve real-time monitoring and automatic reporting.
For instance, Secured Finance’s platform uses a soul-bound token (SBT) that serves as proof-of-humanity, ensuring compliance with on-chain anti-money laundering (AML) activities. This enables us to enforce certain on-chain activities and track transactions transparently and securely. Additionally, our platform utilizes a central clearing counterparty model that eliminates the need for intermediaries and reduces counterparty risk. Furthermore, our model uses a smart-contract to automate trade matching and settlement, ensuring that transactions are executed transparently and efficiently.
Overall, embedded supervision allows for a higher level of decentralized financial regulation that is transparent, secure, and efficient. By utilizing smart contracts to embed regulatory rules, a safe trading environment can be provided while maintaining the benefits of the blockchain system.
Conclusion
The intersection of Eurocurrency and cryptocurrency represents a significant shift in the landscape of international finance. The similarities between the two currencies, including their non-regulated and stateless nature, present an opportunity for cryptocurrency to be considered a form of Eurocurrency. Despite the challenges and regulatory considerations that come with this, the potential benefits of using cryptocurrency as a form of Eurocurrency are significant.
The decentralized nature of cryptocurrency presents both benefits and challenges in terms of regulation and risk control. However, by leveraging blockchain technology, many of these challenges can be addressed, leading to increased flexibility and efficiency in international financial trades. The potential benefits of using cryptocurrency as a form of Eurocurrency, such as increased transparency, security, and accessibility, could help shape the future of international financial markets.
Overall, the intersection of Eurocurrency and cryptocurrency presents an exciting opportunity for the finance industry. As the use of blockchain technology continues to grow, it will be interesting to see how the relationship between Eurocurrency and cryptocurrency evolves and how it impacts the future of finance. By taking into account the lessons learned from the development of the Eurocurrency market, we can work towards unlocking the potential benefits of this intersection and developing a more decentralized and efficient global financial system.
References
Giddy, IH, Dufey, G. and Min, S., 1979. Interest rates in the US and Eurodollar markets. World Economic Archive, 115, pp.51–67.
Frydl, E., 1979. The debate over regulating the Eurocurrency markets. Federal Reserve Bank of New York Quarterly Review, 4(4).
Bryant, R.C., 1984. Eurocurrency banking: alarmist concerns and genuine issues (№400). Brookings Institution. Auer, R., 2022. Embedded Supervision: How to Build Regulation Into Decentralized Finance.
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