how do you break the Pound?
shorting is always difficult to understand. we’ve explained it in the past, but sometimes the best way to simplify things is through an anecdote.
strap yourself into a time machine.
in 1990, with the reunification of Germany, stability and further unification were on the cards for Europe. to help with the unification of the European economies, the United Kingdom decided to get onboard the European Exchange Rate Mechanism (ERM).
the ERM was introduced to reduce exchange rate variability with the various currencies and achieve monetary stability in Europe. the then exchange rate was set as 2.95 Deutschmark, Germany’s currency prior to the Euro, for each British pound (GBP).
as time went by, the exchange rate of the GBP lost its value against the German Mark. it was decided that the UK will have to maintain the exchange rate between the range of 2.78 Deutschmark to 3.13 Deutschmark to stay as a part of the ERM
but by the time the UK joined the ERM, it was in a recession. the GBP was weak and its inflation rate was thrice that of Germany. in order to not let the GBP drop below the agreed upon lower limit, the Bank of England (BoE) would buy GBP from the market.
this attempt to keep the GBP a level above what the market was valuing it against the German Mark presented an opportunity for a few.
American billionaire, investor, and philanthropist George Soros felt the BoE won’t be able to sustain the GBP at these elevated levels for long and decided to short the currency.
Soros and his hedge fund started buying the GBP from British banks with the promise of returning the amount back with interest in a few days. he started buying the German Mark and eventually built a $1.5 billion short position, hoping for the overvalued GBP to depreciate without the support of the BoE.
let’s take a break here. for every large short, there is the need for a trigger. A reason for the direction of travel to change. this trigger was missing in Soros’ play.
but something did come. the President of the Bundesbank, Professor Helmut Schlesinger, who in an interview on September 15, 1992, had said that he “does not rule out the possibility that, even after the realignment and the cut in German interest rates, one or two currencies could come under pressure before the referendum in France.”
“there is no point in being confident and having a small position,” Soros once said. and as he found the trigger he was waiting for, overnight, he increased his short position from $1.5 billion to $10 billion.
then came the day of reckoning.
on September 16, 1992, despite the efforts of the BoE, the GBP fell against other currencies and Soros made a killing as his profits from this single trade stood at over $1 billion.
well, the UK had to withdraw from the ERM. the day had several names in UK’s financial history. Black Wednesday, the day of the withdrawal, to name a few. but in the investment community, it became the day George Soros broke the Bank of England.