5 ms·

How Soros Broke the Pound

60 points by cwan 16y ago

rjett 16y ago
Alternate title: "Why Britain Stayed Away from the Euro"
- 1010011010 16y ago
  Other alternate title: "why central banking is dangerous".
  - 1010011010 16y ago
    downvoted? really? Wouldn't a reply have been better?
gfunk911 16y ago
Can somebody explain this to me? I don't get how leaving the exchange rate mechanism made Soros a winner.
- jordanb 16y ago
  Soros sold shorts against the British pound, essentially, betting that it would fall in value. 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.
  - cstross 16y ago
    They did try to jack the interest rates (full disclosure: I'm British and I had a bank account at the time :) -- the base rate rocketed by roughly 1% one day, then 2% the next. Then they chickened out and pulled the eject handle on the ERM, and cut the base rate back to where it had been before Soros' assault. That was the moment when it became obvious that the next government would be a Labour one. (And the reason Labour instantly hived the BoE off as an autonomous entity.)
- jakarta 16y ago
  At the time, Germany and England had economies that were quite different. Germany had to still deal with the effects of their reunification, England had high levels of inflation (much higher than Germany's) and a high deficit. 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.
  - cturner 16y ago
    Does shorting an economy cause inflation? I have this idea that when you short you're increasing the volume of money in the system.
    - jakarta 16y ago
      No, you are just borrowing a lot of the money that already exists and then you are using your large volume and sell order to put downward pressure on the security's price.
- zmmz 16y ago
  http://en.wikipedia.org/wiki/Soros#Currency_speculation http://en.wikipedia.org/wiki/Soros#Currency_speculation 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.
joeycfan 16y ago
This isn't Soro's fault. If the British Govt. hadn't been doing the standard debasing-the-currency, going-into-debt thing, the opportunity would not have arisen.
rameshnid 16y ago
I recommend a book titled "naked economics" for all. It is a great book and a must read for a technologist to see "macro vectors" alongside the "technical vectors" that help for a sounder prediction of the future. http://www.amazon.com/Naked-Economics-Undressing-Dismal-Science/dp/0393049825 http://www.amazon.com/Naked-Economics-Undressing-Dismal-Scie...
bitdiddle 16y ago
I remember these events well and it's interesting to note that Soros and other currency traders also did the same thing in Malaysia during the same time period. This was a lesson not lost on observers like Zhu Rhongi.
- gwern 16y ago
  Indeed. I was reading http://en.wikipedia.org/wiki/Unrestricted_Warfare http://en.wikipedia.org/wiki/Unrestricted_Warfare and was a little surprised to come across Soros's pound raid as a prominent example of what the Chinese authors meant by the concept.
puzzle-out 16y ago
Soros has been betting against the Euro since March, shorting it for US dollars. Again, the central bankers are fighting a losing battle. Sooner or later there will be a similar attack on sterling and eventually the greenback. The transferance of private debt to sovereign states has created a level of currency volatility which is the closest thing to paradise for aggressive currancy trading.
- nradov 16y ago
  How exactly would a speculator "attack" the greenback? The exchange rate may decline relative to other currencies (or precious metals). But the money supply is huge relative to every other currency and our central bank is not trying to actively defend any particular exchange rate. There's not going to be sharp, sudden break like what happened to the pound.
- adamtmca 16y ago
  Attacks like this work when there is a floor or fixed exchange rate that is artificially high, this creates the opportunity to sell high then, if you can break the floor, buy low to fulfill your obligations to deliver the currency. If there is enough downward pressure the central bank will exhaust it's foreign reserves supporting their currency and have to give up on the floor. 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.
parenthesis 16y ago
As an aside, the now UK Prime Minister, David Cameron, was a Special Adviser to the then UK Chancellor when this happened.
- kierank 16y ago
  In the famous Black Wednesday announcement after the pound left the ERM you can see David Cameron behind Norman Lamont.
Jun8 16y ago
The thing is, I read articles like this with interest, but feel like a two-year old. I don't get it. My theory is that intelligence, math ability, etc. has nothing to do with it, your brain has to be wired in a certain way to understand the the varying grotesqueries of financial markets, to paraphrase the Architect.
- jakarta 16y ago
  The two biggest things you can learn from Soros, IMO: 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.
known 16y ago
Lesson learned: Short selling should be regulated.
- adrianscott 16y ago
  I don't understand how your conclusion relates to the data. Can you explain?
  - known 16y ago
    http://en.wikipedia.org/wiki/Uptick_rule http://en.wikipedia.org/wiki/Uptick_rule
    - adrianscott 16y ago
      Why was there any relation to short selling regulation as a lesson learned from the trade in question? Wasn't it more about the policies of the U.K. leading up to the trading opportunity, rather than any abuse of 'short-selling'. (Plus given it was currency markets, rather than stock markets...)

60 points by cwan 16y ago

rjett 16y ago

Alternate title: "Why Britain Stayed Away from the Euro"

1010011010 16y ago
Other alternate title: "why central banking is dangerous".
- 1010011010 16y ago
  downvoted? really? Wouldn't a reply have been better?

gfunk911 16y ago

Can somebody explain this to me? I don't get how leaving the exchange rate mechanism made Soros a winner.

jordanb 16y ago
Soros sold shorts against the British pound, essentially, betting that it would fall in value. 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.
- cstross 16y ago
  They did try to jack the interest rates (full disclosure: I'm British and I had a bank account at the time :) -- the base rate rocketed by roughly 1% one day, then 2% the next. Then they chickened out and pulled the eject handle on the ERM, and cut the base rate back to where it had been before Soros' assault. That was the moment when it became obvious that the next government would be a Labour one. (And the reason Labour instantly hived the BoE off as an autonomous entity.)
jakarta 16y ago
At the time, Germany and England had economies that were quite different. Germany had to still deal with the effects of their reunification, England had high levels of inflation (much higher than Germany's) and a high deficit. 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.
- cturner 16y ago
  Does shorting an economy cause inflation? I have this idea that when you short you're increasing the volume of money in the system.
  - jakarta 16y ago
    No, you are just borrowing a lot of the money that already exists and then you are using your large volume and sell order to put downward pressure on the security's price.
zmmz 16y ago
http://en.wikipedia.org/wiki/Soros#Currency_speculation http://en.wikipedia.org/wiki/Soros#Currency_speculation 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.

joeycfan 16y ago

This isn't Soro's fault. If the British Govt. hadn't been doing the standard debasing-the-currency, going-into-debt thing, the opportunity would not have arisen.

rameshnid 16y ago

I recommend a book titled "naked economics" for all. It is a great book and a must read for a technologist to see "macro vectors" alongside the "technical vectors" that help for a sounder prediction of the future. http://www.amazon.com/Naked-Economics-Undressing-Dismal-Science/dp/0393049825 http://www.amazon.com/Naked-Economics-Undressing-Dismal-Scie...

bitdiddle 16y ago

I remember these events well and it's interesting to note that Soros and other currency traders also did the same thing in Malaysia during the same time period. This was a lesson not lost on observers like Zhu Rhongi.

gwern 16y ago
Indeed. I was reading http://en.wikipedia.org/wiki/Unrestricted_Warfare http://en.wikipedia.org/wiki/Unrestricted_Warfare and was a little surprised to come across Soros's pound raid as a prominent example of what the Chinese authors meant by the concept.

puzzle-out 16y ago

Soros has been betting against the Euro since March, shorting it for US dollars. Again, the central bankers are fighting a losing battle. Sooner or later there will be a similar attack on sterling and eventually the greenback. The transferance of private debt to sovereign states has created a level of currency volatility which is the closest thing to paradise for aggressive currancy trading.

nradov 16y ago
How exactly would a speculator "attack" the greenback? The exchange rate may decline relative to other currencies (or precious metals). But the money supply is huge relative to every other currency and our central bank is not trying to actively defend any particular exchange rate. There's not going to be sharp, sudden break like what happened to the pound.
adamtmca 16y ago
Attacks like this work when there is a floor or fixed exchange rate that is artificially high, this creates the opportunity to sell high then, if you can break the floor, buy low to fulfill your obligations to deliver the currency. If there is enough downward pressure the central bank will exhaust it's foreign reserves supporting their currency and have to give up on the floor. 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.

parenthesis 16y ago

As an aside, the now UK Prime Minister, David Cameron, was a Special Adviser to the then UK Chancellor when this happened.

kierank 16y ago
In the famous Black Wednesday announcement after the pound left the ERM you can see David Cameron behind Norman Lamont.

Jun8 16y ago

The thing is, I read articles like this with interest, but feel like a two-year old. I don't get it. My theory is that intelligence, math ability, etc. has nothing to do with it, your brain has to be wired in a certain way to understand the the varying grotesqueries of financial markets, to paraphrase the Architect.

jakarta 16y ago
The two biggest things you can learn from Soros, IMO: 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.

known 16y ago

Lesson learned: Short selling should be regulated.

adrianscott 16y ago
I don't understand how your conclusion relates to the data. Can you explain?
- known 16y ago
  http://en.wikipedia.org/wiki/Uptick_rule http://en.wikipedia.org/wiki/Uptick_rule
  - adrianscott 16y ago
    Why was there any relation to short selling regulation as a lesson learned from the trade in question? Wasn't it more about the policies of the U.K. leading up to the trading opportunity, rather than any abuse of 'short-selling'. (Plus given it was currency markets, rather than stock markets...)