How Soros Broke the Pound

George Soros is a genius. But he is not a genius for searching and finding the trades. He is not sitting around and doing calculations or running analyses with fancy algorithms.

Instead, he is amazing at risk management. He knows precisely when to 'go for the jugular' and bet really big.

It's a really instinctual type thing, he can gauge the psychology of the market really well and understand when bubbles are about to pop.

The other great thing about Soros is that he has a remarkably open mind. There is a story about how Soros went and played tennis with someone, at the time, he had a big trade betting on one direction of the market. The person he played tennis with was vehemently against that position and expressed his concern.

The next day the market turned opposite to Soros' trade and his tennis partner called, to see if he was doing okay, thinking that Soros must have lost a lot of money that day. But, he was greeted with a happy George Soros who reported that after the tennis match he totally changed the direction of his trade.

It is pretty rare to find people, especially in financial markets, who can quickly change directions and basically admit that they were originally wrong. Trading is a business that is dominated by people with huge egos, but you will notice that most of the best traders are ones that will switch direction without hesitation.

The Bank of England tried to keep the value of the pound high enough to stay within the 'allowed band' of the ERM by buying up the excess pounds (and the bullish side of Soros' short contracts) on the open market, using their foreign currency reserves. If the bank had allowed the pound to fall instead of trying to prop it up though, Soros wouldn't have had a buyer. Moreover, if Soros had lost his nerve or his solvency selling shorts before the BoE ran out of reserves, the pound would have stayed high and he would have lost his shirt fulfilling the contracts.

Once Soros sold his contracts, he stood to lose if the value of the pound stayed high. The Bank of England could keep it high even after their attempts to buy up pounds had failed, by drastically raising interest rates and keeping them high. That would have thrown the British economy into a recession so Soros was betting that the BoE wouldn't go through with it.

In the end, the BoE didn't have the nerve to jack interest rates, so they let the value of the pound fall out of the ERM-allowed band, and Soros was able to fulfill his contracts with cheap pounds and pocket the difference.

Usually when you peg an exchange rate, you want economies that are similar and will be going in similar directions. This is pretty rate to pull off, essentially you are dictating your monetary policy to another nation's central bank.

The exchange rate mechanism kept the pound artificially high by forcing the Bank of England to intervene whenever there was selling pressure. That way the pound would not devalue below the 1:2.95 level. Similarly, raising interest rates would have been a non-starter too because it might lead to the pound exceeding the 1:2.95 level.

With Soros selling at such a great magnitude, Billions versus hundreds of millions, he was able to force England to stop using the mechanism and let the pound float to a lower price which more accurately reflected its true value.

Basically, he took 10 billion British Pounds and exchanged them for other currencies (Deutsche Marks mainly if I remember correctly). Since the pound was already less desirable due to lower interest rates it triggered a snowball effect and many people followed suit.

The Pound left the ERM, and plummeted in value since everybody was selling at that stage.

With the pound on the cheap, Soros then bought the bound back with his Deutsche Marks, except that this time around he got a lot more then the 10 billion which he sold as the Pound was cheaper to buy.

The currencies you mentioned all have floating exchange rates, the central banks aren't fighting any sort of battle to support them. The exchange rate isn't really a policy goal of "modern" central banks anymore, they adjust interest rates with a target level of inflation and economic growth, not a target exchange rate. Achieving inflation & growth goals actually precludes the use of monetary policy to maintain a specific exchange rate. Look up the IS/LM model, while not perfect it gives you a good framework to think about monetary policy and macro economics.