On September 16, 1992, a day that shook the financial world, George Soros made a staggering $1 billion in just a few hours.
This trade, often hailed as a masterstroke in financial history, didn’t just make headlines — it sparked controversy and debate. But were Soros and his team actually responsible for breaking the bank, or is there more to the story? Today, we delve into the intricate details:
- How did Soros and his team make one billion in just a few hours.
- Did they truly manage to ‘break the Bank of England’?
- And what can you learn from this trade to make more money in the markets?
Before we understand the trade, we need to understand the setup. This means understanding the European Monetary System (EMS) and its central component: the Exchange Rate Mechanism or ERM.
The origins of the EMS can be traced back to 1960 when the heads of the member states of the European Economic Community met in The Hague and agreed to move towards the goal of a single European economy.
In 1970, Prime Minister of Luxembourg, Pierre Werner, produced the Werner Report outlining the structure of the European Monetary System (EMS) and moving towards this goal in three stages with the ultimate goal of pegging the currencies to each other to make cross-border transactions easier and ushering in new levels of peace.
In 1972, the European Economic Community currencies were pegged to each other in a scheme called the Snake in the Tunnel, which created a single currency band combining the currencies together, akin to rock climbers hooking together for safety while they move across a rocky terrain.
This slithery ERM did make it easier to transact across borders and paved the way for a single European currency, but it put pressure on each country’s central bank and collapsed a year later.
When there are lots of selling one currency for another, it pushes the sold currency’s price down and increases the purchased currency’s price.
Supply and demand mechanics work for currencies just like they do for goods, but with the ERM, there was a catch.
If a currency’s price moves outside of the agreed-upon bands, central banks would need to keep the currency within the bands by buying when the currency fell too much or selling when it moved above the band.
And this requirement, as we will soon see, sewed seeds of destruction.
But first, a little political drama.
European currency exchange rate stability was one of the most important objectives for policymakers since the Second World War.
This desire led the leaders of Germany and France to successfully champion the European Monetary System on December 5th, 1978. France, Denmark, Belgium, Luxembourg, Ireland, Netherlands, Germany, and Italy’s currencies again formed a snake.
And even though there was no formal anchor, the German central bank and the Deutsche Mark stabilized the so-called snake.
The UK didn’t join the party as Prime Minister Margaret Thatcher feared history might repeat itself, but she caved due to poor economic conditions.
A few months after joining the ERM, she resigned, and Chancellor John Major, who championed the ERM and held positions beneath Margaret, came to power.
It was done.
United Kingdom entered the ERM in October 1990, agreeing to join with a fluctuation band of 6%. At entry, the pound sterling had 15% inflation, three times the rate of Germany, and low labor productivity.
But joining house Slytherin wasn’t a magic bullet.
Over the next two years, the economic climate in the UK went from bad to worse as the economy continued to shrink with an inverted yield curve.
Typically, when an economy is in recession, central banks will cut rates making borrowing easier. The cheaper debt helps fuel growth. But they couldn’t do this since they had to maintain their currency exchange rate.
On the other end of the snake, Germany kept interest rates high to combat inflation, keeping demand for their currency high from currency speculators chasing yield.
And if this wasn’t bad enough, the UK had double deficits. The government was spending more than it was making from taxes. And it was also spending more on trade than it was earning.
All of these factors weakened demand for the pound over time, forcing the UK’s central bank to forego its foreign exchange reserves and buy its currency.
The writing was on the wall setting up one the greatest trades in history.
How Soros and Druckenmiller Made $1 Billion in a Few Hours
Starting in August 1992, Druckenmiller and Soros began building a position. The trade thesis was simple: The Snake in the Tunnel was unsustainable, and the artificial demand from the central banks would eventually break.
They started by shorting the pound and Italian lira. They would borrow these currencies from the banks to buy German marks while paying interest. The idea is that when the ERM broke, the currencies would drop relative to German marks, and they would buy back the currencies at a discount earning the difference minus interest paid as a profit.
But understand that George and Stanley are pushing serious cash around, and slippage can be massive.
To reduce the liquidity risk and leverage the returns, they used the marks to buy German and French bonds while simultaneously purchasing equities in weak currencies and selling short equities in strong currencies.
Let’s break this down.
Bonds in strong currencies move up in a flight to safety, assuming no deleveraging events.
The rationale behind bonds is simple: The underlying currency is strong, and bonds add additional yield on top.
Stocks do the opposite, and this is a little more nuanced.
When a currency falls, stocks in that currency move up. The reason is due to something called purchasing power parity.
If you think about it, it makes no sense for Tesla’s value to drop just because the value of the US dollar plummets. Tesla is priced at what the market thinks it is worth, irrespective of currency.
This isn’t to say a weak currency over time can’t be bad for business – it can. But the opposite is also a hidden gem, finding companies in weak countries where most of their revenue comes from strength, but I digress.
Let’s get back to the bombshell catalyst for this ten-billion-dollar trade.
In early September, the President of the Bundesbank, Helmut Schlesinger, spoke privately in an interview with the Wall Street Journal, where he stated that he believed some currencies might come under pressure.
But what Helmut didn’t know, allegedly, is that he was being recorded, and his story was ready for publication.
But more on that in a second.
On the 13th of September, Germany cut interest rates by 0.25% or 25 basis points, causing the Italian Lira to drop by 7% in response. This massive asymmetric move made the untenable relationship between the German marks and the weaker ERM currencies crystal clear.
On the evening of Tuesday, September 15th, 1992, Helmut’s bombshell interview was published.
This was the catalyst Drunkenmiller and Soros needed.
Bundesbank was basically egging on the speculators to speculate against the weaker currencies, and we took our queue actually from the Bundesbank
— George Soros
When Druckenmiller told Soros he was going to short 100% of the fund in the British Pound against the Deutschmark, George was pissed. He said:
When you have tremendous conviction on a trade, you have to go for the jugular.
— George Soros
George thought the opportunity was a once-in-a-lifetime opportunity and that Drunkemiller should be at 200% of the fund.
If they lose, they will lose very little, but if they win, they stand to win big. A perfect example of an asymmetric bet.
But can’t the Bank of England stop accepting offers to sell pounds preventing its currency from falling and preventing George and Stanley from pocketing billions?
And this is why the naming of the snake is so apt:
The ERM required the Bank of England to accept any offers to sell pounds. So when trading began, sell orders came in like an avalanche.
Chancellor Norman Lamont and Robin Leigh-Pemberton, governor of the Bank of England, smashed the buy button to prevent the collapse.
They began by buying 300 million pounds twice before 8:30 am but to little effect.
Around 10:30 am on September 16th, two hours later, the British government made a fatal mistake. They announced an increase in the base interest rate from 10% to 12% to tempt speculators to buy pounds, and cost the short sellers money.
Their thought process was that the increased interest rates would hurt short sellers borrowing the currency and cause interest from others to reach for higher yields.
As selling continued, they increased base rates from 12 to 15% to curb the selling, but it only fueled the fire.
Their move backfired.
It was clearly seen by the markets for what it was: an act of desperation.
After all, when your economy is in recession, you reduce rates to spur growth – you don’t invite a depression by increasing your rates by 50%.
Traders smelled blood, dumping pounds as fast as they could; but this time, spooked businesses liquidating, too.
By 7:00 pm that evening, Lamont announced Britain would leave the ERM and rates would remain at the new level of 12%; however, on the next day, interest rates were 10%.
What a day.
This September 16th, 1992, is forever known as Black Wednesday.
The currency eventually devalued by around 20%, making short sellers a fortune. Especially for George and Stanley, who had the foresight to see the inevitable and bet big.
And by big, I mean ten billion dollars big on equity of seven billion dollars.
In other words, for every dollar in equity, they borrowed 43c to make a $1.43 position. Now that’s going for the jugular.
Did George Really Break the Bank of England?
But was it really George and Stanely’s bite that defeated the Bank of England?
I’m not so sure.
The daily turnover in exchange markets in the early 1990s was typically over a trillion dollars per day. And while a ten billion dollar bet is a massive amount, a trillion is much more.
The truth is that Stanley and George saw the structural imbalance, and made a killing from it, but they didn’t break the bank.
The truth is that the Snake in the Tunnel bit off more than it could chew, and this indigestion wasn’t a matter of if, but when.
And another thing, it’s conventional wisdom that the devaluation caused a boom, making some call it White Wednesday since it was followed by years of increased growth; however, the economies of similar countries that didn’t devalue also experienced similar growth rates.
So, while conventional wisdom around this historic event is wrong, does it really matter?
What Can You Learn From This Trade to Make More Money in the Markets?
Look for structural imbalances, especially when they’re artificially created from political agendas. And when you have conviction, go for the jugular.
Druckenmiller states that this was the greatest lesson he ever learned from Soros:
What separates average investors from super investors is their ability to make big bets when they think they’re right. This is the greatest lesson I learned from George.
— Stanley Druckenmiller