What is external arbitration
External arbitration is a type of arbitration that multinational banks based in the United States engage in, which takes advantage of differences in interest rates between the United States and other countries. External arbitration occurs when interest rates are lower in the United States than abroad, so banks can borrow in the United States at low rates and then lend that money abroad to a higher rate, pocketing the difference as profit.
DISTRIBUTING external arbitration
External arbitration is a key concept in modern finance. Modern financial theory is based on the idea that pure arbitrage, a system by which an investor or company can take advantage of price differentials to make money without fail, does not actually happen. Academic finance postulates that a real arbitrage opportunity would disappear almost instantly as investors enter this market and compete for these easy profits. But the real world is more complicated than economists’ models, and some arbitrage opportunities arise in real markets, due to imperfect competition. For example, it is not easy for any bank to evolve to the point where it can take advantage of cross-border differences in interest rates, due to imperfect regulation and markets for financial services. This lack of competition allows opportunities for external arbitration to continue.
External arbitration and the Eurodollar market
External arbitration was a phrase coined in the mid-twentieth century, after there was a great demand for foreign savings accounts denominated in US dollars. These savings deposits were called eurodollars, because all foreign accounts denominated in dollars were then located in Europe. Today, however, the Eurodollar can be purchased in many countries around the world outside of Europe. The eurodollar market took off after 1974, when the United States lifted capital controls that hampered cross-border lending. Since then, the Eurodollar market has become an important source of funding and profits for American banks.
Example of external arbitration
Let’s say that a large American bank wants to earn money through external arbitration. Suppose also that the rate in effect for one-year certificates of deposit in the United States is 2%, while certificates of deposit denominated in dollars pay 3% in France. The big American bank could decide to earn money by accepting certificates of deposit in the United States, then by cashing the products to issue loans in France at a higher rate. Internal arbitration is possible when the situation is reversed and interest rates are higher in the United States than abroad.