There is a quote commonly attributed to Niccolo Machiavelli that demands that one never waste the opportunities that come from a “good crisis”.
This quote, attributed to Winston Churchill, Saul D Alinsky and most recently Rahm Emanuel, is one that is also very appropriate to the world of forex funding.
After all, when working with mutually exclusive pairs, inevitably a crisis for one is an opportunity for the other, and your goal as a forex trader is to make sure you are on the right side of such a trade.
For an example of what happens when you do, we reach the story of “The Man Who Broke The Bank of England”, the audacious history-altering currency short he oversaw, and the rippling consequences and huge opportunities that it allowed.
Prelude To Black Wednesday
This famous trade was undertaken by the Quantum Group of Funds, a collection of hedge funds and asset management companies owned by speculator and multi-billionaire George Soros.
Born in Hungary and a survivor of the Siege of Budapest, Mr Soros became an investor that specialised in European stocks in 1956, working for various funds and finally setting up his own company, Soros Fund Management, in 1970, which would eventually become the most successful hedge fund in history.
By the 1980s, spurred on somewhat by an $800m loss on the Japanese stock market due to the effects of Blue Tuesday on 20th October 1987, the Quantum Group would move into foreign exchange, quickly finding a new target in the United Kingdom.
Outside of Japan, Blue Tuesday was known as Black Monday and coincided with a massive stock market crash that wiped $1.71tn off of the World’s economy.
Stung like almost everyone else, the United Kingdom opted, not without controversy, to join up with the European Exchange Rate Mechanism in 1990, a currency-linking system designed to avoid considerable market fluctuations.
Initially entered at a rate of DM 2.95 to £1, the rule of the ERM was that the pound’s value could not fluctuate by more than six per cent relative to the Deutschmark which meant in practice that a pound could not end up with an exchange rate lower than DM 2.773.
A combination of factors quickly made this impossibly difficult, with the UK facing 15 per cent interest rates, triple the rate of inflation relative to Germany and lower productivity, suggesting a potential recession on the horizon.
A savings and loan crisis in the United States further hurt the UK, as many exports were pegged to the US dollar rather than the pound, both of which were rapidly falling in value. Germany’s own high-interest rates caused by reunification added greater pressure.
Tension across Europe regarding the Maastricht Treaty put pressure on both the pound and Italian lira, as both were close to the lower end of the ERM, and speculators started to circle when the risk of devaluation loomed.
The Great British Short
Whilst not the only speculator to short the pound, George Soros was one of the earliest to realise that the UK had been brought into the ERM at too high a rate and started to buy DEM/GBP currency pairs in order to take a gigantic short position.
Most forex traders warn against betting everything on a position, especially a short position, but Mr Soros was so confident after trader Stanley Druckenmiller saw the pound’s weakness that he leveraged everything he could in the early part of 1992.
Exactly how big his bet was is unclear, but according to later reports it could have been as high as £6.5bn in both German Deutschmarks and French francs, which was almost as high as the cost of plans to defend the pound.
By September, then-Chancellor of the Exchequer John Major authorised the purchase of millions of pounds on the currency markets to prop up the pound and keep it above that minimum threshold.
On 15th September 1992, the hammer fell. In remarks that Bundesbank President Helmut Schlesinger claimed were off the record and merely a statement of facts, he said that after the Italian lira was devalued that currencies in the ERM would need to be comprehensively realigned.
Statement of fact or otherwise, this led to a surge of sell-offs of the pound by forex traders, at a rate far faster than the Bank of England could buy them.
Two and a half hours into the trading day, at 10:30 am on 16th September 1992, the base interest rate was increased to 12 per cent and later in the day was going to be increased to as high as 15 per cent, although ultimately the UK government decided to leave the ERM after an emergency meeting.
In total, the UK Treasury has estimated that Black Wednesday cost the UK £3.3bn, which is much lower than past estimates that claimed the UK lost as much as £27bn amidst the chaos.
As for Quantum Bank, the withdrawal was a tremendous success and the gambit paid off. Once everything had been settled, Mr Soros made over £1bn on the deal and had emerged from relative obscurity to become a man known for breaking the Bank of England.
The ramifications were tremendous, leading to the establishment of the ERM-2 and the formation of the single Euro currency on the European side, and triggering financial and political upheaval in the UK, with even an eventual stronger economy being blamed on other factors.
It also led to a number of similarly huge short bets placed against a variety of world currencies to try and replicate the success of the Quantum Group, including in 1996 in Finland and in both Thailand and Malaysia in 1997.
However, the Quantum Group themselves, whilst still a huge economic force, never managed to replicate the success or scale of that initial trade.
A similar bet against the Japanese yen in 1994 led to them losing $600m in a single day, and whilst not a forex trade, during the 1998 financial crisis in Russia, the fund lost $2bn.