How George Soros Broke the Bank of England

George Soros has been a successful investor. He’s one of those that saw early success in the financial market; having grown his hedge fund, Quantum Fund, to a billion-dollar fund in the 1980s. In 1992, he made history as the man who broke the bank of England when he bet against the success of U.K. involvement in the Bundesbank-backed Exchange Rate Mechanism and won.

This Timeless Strategy is Used By Legendary Traders

German and France initiated the European Monetary System (EMS) in 1979

German and France in 1979, decided to set up the European Monetary System (EMS) so as to reduce inflation, maintain stable exchange rates, and prepare Europe for monetary integration. The Exchange Rate Mechanism (ERM) which was one of the EMS’s main components allowed every currency in the system a central exchange rate against a basket of currencies, the European Currency Unit (ECU), led by the Bundesbank.

In the beginning, the countries involved were: France, Germany, Italy, the Netherlands, Belgium, Denmark, Ireland, and Luxembourg. They were mandated to keep their exchange rates no more than a 2.25 percent fluctuation above or below each bilateral central rate. This system was able to maintain a low-inflationary and stable economy in Europe under the leadership of German Central Bank, the Bundesbank.

The United Kingdom Joined the Exchange Rate Mechanism (ERM) in 1990

In order to take part in the stable and low-inflationary economy in Europe, the U.K. decided to join the Exchange Rate Mechanism (ERM) of the European Monetary System in 1990. The exchange rate was pegged at 2.95 Deutsche marks to a pound allowing only +/– 6 percent fluctuation.

This alliance would keep the pound at the mercy of the Deutsche mark as it would subject the U.K. to the monetary policies enforced by the Bundesbank.

Bundesbank reacted to the inflationary effects of German reunification

The German reunification in 1989 created a need for massive infrastructural development. This led to increased government’s spending and inevitably, high inflation.

In mid-1992, the German central bank had to aggressively increase interest rates to curb the inflation. The interest rate hike expectedly placed upward pressure on the German mark forcing other central banks to raise theirs to maintain the mandatory currency exchange rates.

George Soros bet against the success of U.K. involvement in the ERM

George Soros knew that the United Kingdom could not maintain the pegged exchange rate mandated by the ERM owing to their high unemployment rate and a weak economy. He predicted that the pound would depreciate or the United Kingdom would leave the ERM. So, by the third quarter of 1992 he started shorting the pounds aggressively.

He established enormous short positions in pounds and long positions in the Deutsche marks by borrowing pounds to buy marks and also making use of options and futures. In fact, he leveraged the entire value of his Quantum funds — about $1 billion — to place a $10 billion position.

Other investors would later follow suit and the pound was under serious pressure. The Bank of England initially tried to defend the pounds by buying tens of billions of pounds but was simply overwhelmed by the speculative attacks.

The events of September 16, 1992 — the Black Wednesday

By September 16, 1992, a day that would be popularly known as Black Wednesday, the pressure was becoming unbearable for the Bank of England. There was so much confusion. In an attempt to boost the pound’s appeal, the bank initially announced a 2 percent rise in interest rates — from 10 percent to 12 percent.

A few hours later, it raised the rates again — to 15 percent — but Soros and other speculators could not be swayed, knowing that the odds are high for U.K. to leave ERM and devalue the pounds. Speculators continued shorting pounds in huge volumes, and the Bank of England kept buying them.

Finally, the bank of England caved-in and — at 7:00 p.m. that same day — Chancellor Norman Lamont announced that Britain would leave the ERM and return the interest rate to their initial level of 10 percent. As you would imagine, the pound was on a free fall.

The Quantum Fund made approximately $2 billion profit in one month

George Soros’s Quantum Funds made about $2 billion profit in the following four weeks as the pounds depreciated almost 15 percent against the Deutsche mark and about 25 percent against the dollar. He would be known as the man who broke the Bank of England, for leading the speculative attack on the pounds.

In conclusion, George Soros used his knowledge of the fundamental factors that determine the value of a nation’s currency to his advantage. Knowing that the odds were enormously on his side, he was able to go for the kill and ended up $2 billion richer. In the process, he demonstrated how central banks can be vulnerable to speculative attacks as well as made history as “the man who broke the Bank of England”.