Chapter 19. George Soros – the story of one trader

As in any other business, forex trading has its outstanding personalities whose names have gone down in history. In the foreign exchange market, one of the most successful traders in history is considered to be George Soros. George Soros’ career began with the foundation of the Quantum Fund in 1969 on Curacao (an island in the archipelago of the Lesser Antilles in the West Indies). During its existence, the Quantum fund has conducted a large number of successful speculative operations on the Forex currency market. For example, on the spot market in 1996 alone, the Quantum fund earned an income commensurate in size with the annual income of the entire McDonald’s corporation. However, the most successful transaction of George Soros is considered to be a deal on currency speculation with the British pound sterling in 1992, which generated about 2 billion dollars of net profit in a month. Because of this success and the facts behind it, George Soros gained a reputation as the man who “broke the Bank of England”.

 

George Soros owes such successful currency speculation to the situation on the world stage in the early 1990s. In 1979, the European Monetary System (EMU) was established on the initiative of Germany and France. The purpose of the EMU was to maintain the stability of exchange rates of currencies of European countries that are members of the system, as well as to prepare for currency integration. The original members of the EMU were Germany, France, Italy, the Netherlands, Belgium, Denmark, Ireland and Luxembourg. The exchange rate maintenance mechanism, which is the backbone of EMU, was based on the introduction of the European Currency Unit (ECU), which was the prototype of today’s Euro (EUR). Each country in the European Monetary System had a central rate against the ECU and a currency corridor within which the exchange rate was allowed to change. EMU member countries were obliged to maintain the exchange rate of their national currency on these terms by any means or to withdraw from the system. The central rates of the EMU member countries could be adjusted under the terms of the agreement, and this happened nine times between 1979 and 1987.

In 1990, the United Kingdom joined the EMU and the pound sterling (GBP) exchange rate was fixed at 2.95 German marks (DEM) with an allowable exchange rate band of ± 6%. By mid-1992, the exchange rate holding mechanism had succeeded in bringing inflation rates in the European member states of EMU down significantly. However, the artificial maintenance of exchange rates within the currency corridor caused increasing distrust among investors. The situation worsened after the reunification of West and East Germany in 1989. The weakness of the East German economy led to increased government spending, which forced the German Central Bank (Bundesbank) to put more money into circulation. This policy led to inflation, to which the Bundesbank responded by raising the interest rate. The high interest rate attracted foreign investors, which caused an increased demand for the German mark and hence its appreciation. The UK, bound by the EMU agreement, was obliged to maintain the exchange rate of its national currency within the exchange rate corridor set against the German mark. At that time, the UK economy was weakened and unemployment was high. Raising the interest rate following Germany in such conditions could only aggravate the situation. The UK had no other opportunities to strengthen the national currency in the short term. In such conditions George Soros and many other investors bet that Great Britain would not be able to keep the exchange rate of its national currency at the necessary level for a long time, and it would have to either announce its devaluation (depreciation) or give up the mechanism of keeping the exchange rates.

George Soros decided to borrow pounds sterling (GBP), sell them for German marks (DEM), which were invested in German assets. This resulted in the sale of about 10 billion GBP. George Soros was not alone in his reasoning, and many investors followed his example. As a result of such speculation, the UK’s already precarious economic situation was further exacerbated. The central bank of Great Britain in an attempt to correct the situation and raise the exchange rate of the national currency bought at the expense of its reserves about 15 billion pounds sterling. But it did not bring the expected result. Then on September 16, 1992, the day that would later be called “Black Wednesday”, the Central Bank of Great Britain announced an increase in the interest rate from 10% to 12% in an attempt to neutralize the existing agitation. But the expectations of British politicians were not met.

Investors selling sterling were confident that they would make huge profits after the future collapse of its exchange rate. A few hours later, the UK Central Bank promised that the interest rate would be raised to 15%, but traders still continued to sell sterling in large numbers. This continued until 19:00 of the same day, after which Treasurer General Norman Laymont announced that the UK was withdrawing from the exchange rate holding mechanism and the interest rate would be reduced to its previous level of 10%. From that day onwards, the pound sterling began to plummet, falling almost 15% against the German mark and 25% against the US dollar over the next five weeks. This brought huge profits to the Quantum fund – during the month George Soros earned about 2 billion dollars, buying German assets for the already significantly depreciated pound sterling. The fall of the pound sterling exchange rate against the US dollar after the events described above is shown in the figure. As can be seen, the pound sterling fell by about 3,000 points in September 1992 alone!

Падение курса фунта стерлингов (GBP) по отношению к доллару США (USD) на Форекс после событий «черной среды» сентября 1992 г.

Thus George Soros – the man who “broke the Bank of England” – showed how central banks can be vulnerable to currency speculation by large investors in the face of artificially held exchange rates. The use of leverage allowed George Soros to make a huge fortune in just a few weeks, which is what launched his philanthropic endeavors. As we have seen, in order to prevent the negative impact of currency speculation on the country’s economy, central banks create reserves in the form of foreign assets. But, as practice has shown, such reserves can be ineffective if they are opposed by huge capitals of large investors united by a common goal. Today’s forex market is much more liquid than it was in the early 90s. Therefore, no single investor, even one with billions of dollars of capital, is unlikely to be able to single-handedly influence the exchange rate of any currency for a long time. The “Black Wednesday” of September 1992 is far in the past, but historical facts still cannot be neglected, as history has a tendency to repeat itself.
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