1992: Bank of England Fails to Support GBP / George Soros made $1 billion overnight

The purpose of this article is to show one of the most famous examples of central bank intervention in an attempt to keep an exchange rate at a fixed level, and subsequent failure to do so. The Bank of England in September 1992 used its reserves to support the British Pound in an effort to stay within the confines of the European Exchange Rate Mechanism, but it ultimately ran out of funds to do so and could not oppose speculators indefinitely.

The European exchange rate mechanism (ERM) was introduced by the European Community in early 1979. It was a major part of the European Monetary System (EMS), which aimed to reduce exchange-rate variability and achieve monetary stability in Europe before the introduction of the Euro as a single common currency.

The ERM was based on fixed currency exchange rates with a small margin of just over 2% allowed for the rates to fluctuate in either direction. Individual currencies were compared against a weighted basket of the other currencies. The ERM did not allow exchange rates to fluctuate outside of these margins and because of this the system was inflexible. If a country wanted to stay in the ERM and stay on course to becoming part of the common European currency, its individual currency had to remain within the inflexible threshholds designated by the ERM.

In order to remain within the limits established for the British pound, the Bank of England was forced to use its reserves to buy the GBP against the German Mark (DEM), the other major currency within the ERM. As rumors circulated that the BoE would not be able to maintain the required level indefinitely, speculation against the GBPDEM increased. In September, the weight of the speculative selling pressure finally overwhelmed the BoE, and GBPDEM fell dramatically overnight and in the next few days.

Most famous among the speculators against the BoE was George Soros, who borrowed massive amounts of British pounds in order to convert them into DM’s. When the exchange rate collapsed, he simply bought back the pound and repaid his borrowed funds for a tremendous profit. Soros, in fact, made a reported $1 billion overnight. Certainly one individual does not have the resources to trade against the BoE, but this is also an excellent example of how a central bank can not trade against the rest of the market indefinitely if the fundamentals are against the bank and there are enough speculators aligned on the opposite side of the trade.

The ERM has, of course, since been replaced by the common Euro currency. At the end of 1998, rates between Eurozone countries were frozen in place, but the failure of the BoE to keep the GBP within its alotted margin has been one of the major milestones preventing the U.K. from adopting the common currency.