Sterling to crash 15% on a Brexit - How much money will you make on a Brexit?

With the forthcoming EU referendum and associated risks to Sterling, with some market players calling for a 15% crash in Sterling, one can't help but recall Black Wednesday, 16 September 1992, when the Conservative government of Britain had no choice but to withdraw the pound from the European Exchange Rate Mechanism (ERM) after it was unable to keep the pound above its agreed lower limit in the ERM - a subsequent cost to Britain of £3.3 billion.

So, why make such a comparison of Britain leaving the EMR to Britain leaving the EU?

While the two are fundamentally different, it is the teachings that history can tell us of which can help Britain not to make the same mistakes. While it seems there will be financial consequences in leaving the EU in the short-term, and the stay camp would argue that there are longer-term negatives risks as well, this time around the BoE might just be in the market buying dollars ahead of the vote and holding plenty of FX reserves in case of a Brexit.

Papers revealed that had the British government maintained $24 billion in foreign currency reserves and should the pound have fallen by the same amount, Britain would have made £2.4 billion of profit on sterling's devaluation rather than losing £3.3 billion.

Lets go back, waaay back....

I'm taking us all the way back to the FX markets in the mid 80's and early 90's, where quite frankly I wish I was in the markets when some of the FX broker veterans that I know today made their multi-millions, making hay while the sun shined, retiring at an early age and living off the fat of their later investments. Then, of course, there are the others that I know and have had the pleasure to work with who were making ridiculous amounts of money as well at the same time, but spent the lot as a young broker, while in hindsight, who will now admit that they should have fixed their roofs while the sun was shining


Source: Free Images

Instead, I was just a young lad, turning-teenager, more into football and roller-discos (not white and pink laces mind you), skating around to Technotronics' "Pump Up The Jam" in a denim jacket, white chinos and flat-top haircut (Will Smith style), doing the village paper round before starting school to collect my weekly allowance, although instead of saving up for fast cars and countryside mansions, I blew my wages on football sticker albums, obsessed with Liverpool and the players such as John Barnes, Rush, Grobbelaar, Walsh, Venison and Beardsley to name a few of the names that I can remember.

These were the last days of the late Margaret Thatcher's prime ministership, of between 1979 to 1990, who pulled Great Britain out of the long winter of discontent through a number of economic initiatives and whose political philosophy and economic policies emphasized deregulation of the financial sector in particular and encouraged you to get out there and make a lot of money. Her legacy? - Well, many would argue, it was Black Wednesday!

She put Britain on the road to Black Wednesday with the decision to take Sterling into the ERM, although she would have argued doing so against her better judgment - which is even worse. She left Downing Street just seven weeks later and Britain slid into recession again with the high exchange rate of the pound locked inside the ERM that meant businesses struggled to sell goods abroad and 1 million people within 18 months were out of work unable to pay their mortgages.

When FX dealers were financial athletes

FX at the time had far less regulation which made for an arcade of gamblers, or financial athletes (besides all that smoking cigarettes in the office) rather than economic scholars. Instead, they started right at the bottom of whatever Bank they worked for and worked their way onto the trading floor, very soon to make more money than the high-street branch managers.

The traders were working on tiny margins on 100's of billions of dollars vs pounds, or marks in to yen, francs in to lira. Some of it was international trade, but most of it was hot money searching for the most profitable home.

The FX arcade

Banks were competing against each other around the world, with traders trying to make money out of money and squeezing every cent they can out of the market. The dealers were connected globally in voice broking systems that eventually turned to a hybrid of direct screen based computerized dealing systems (not much more advanced as the one in the image above).

Dealers were leaving orders overnight with one another, where so long as you were good and a fast thinker, hot on your toes, definitely not dyslexic and very good with making mathematical calculations in your head, running your book from a chalkboard of orders and having a good feeling of where your competitors are positioned, you could really make a lot of money making attractive prices to tempt in the flow of business, only to smash the market the other way to come out, say, half a cent up on the day and taking your commissions day after day to the car dealerships and estate agencies buying your country-side mansion, or instead of those football stickers, buying up shares of your favourite football club, or even becoming a member of the board.

At the time when Britain joined the ERM, Germany was actually facing a recession of their own, which was unthinkable when Britain joined, but inflation was rising due to the cost of unification with East Germany and that was higher than predicted. The Bundesbank council then had to raise interest rates. In theory, Britain should have matched the rate-rises, but if they matched them, this would have hit the housing market in Britain and made things very unstable, economically and politically.

Black Wednesday was brewing


Source: Free Images

So the pound was falling to the bottom limit of the ERM bracket to the DEM as currency dealers got short of the pound and bought the DEM for the higher German interest rates on rumours spreading that the government was about to devalue the currency, locking the pond to the DEM at a lower value and below the lower limit. The government frantically tried to restore confidence by saying they will maintain the pound's parity to the DEM.

The battle ground

Norman Lamont, chancellor of the exchequer at the time in the UK, who was never in favour of ERM policy in the first place, had no choice but to go and try to persuade the Germans to cut their rates. Under pressure, he went to Bath in the UK for the meeting with other European Union members who were also facing a tough time due to the German's high interest rates. There was an air of crisis surrounding this meeting. The assembly rooms was where battle took place and the Germans were under pressure to lower their interest rates. But, the president of the Bundesbank, Helmut Schlesinger, said no after a meeting that created a lot of bad mood and the financial markets took note of the outcome and were expecting a devaluation of the pound. However, instead, John Major, Prime Minister at the time stayed put - he left the pound at the ERM rate and ridiculed others that said other policies would be better for Britain.

Suddenly it emerged that Italy was also headed into crisis - currency dealers jettisoned and sold the Lira and the Bank of Italy poured in money, and by default of the ERM rules, so did the Germans to protect the value of the Lira. However, eventually, the Bundesbank pulled out as it was costing too much. Instead, they offered a deal - that if Italy and other countries were to devalue their currencies, they would decrease interest rates in Germany. Dealers devalued the Lira by 7% and the Germans? Well, the Germans cut their rates by a tiny 0.25%.

The dealers who were long of Lira losing a lot of money for their Banks and clients looked for opportunities to hedge and took the view that the pound will be devalued and started getting short of it. At the same time, investments funds and pensions funds in London holding all of these "safe haven pounds" also took the opinion that the pound would be affected by all of the toxic news in Europe and started to give orders sell as well.

Helmut Schlesinger and the naughty Journalist

But, it wasn't until the president of the Bundesbank, Helmut Schlesinger, that gave an interview to a journalist in Frankfurt that provoked the avalanche of selling when he hinted that the realignment of the Lira wasn't enough and he wanted other currencies to devalue as well. The journalist sent his story across the world even though it was supposed to be off the record. The Bundesbank could not deny the remarks - and Black Wednesday dawned.

Traders got in as early as possible, 6.00am, and the drama began on the rumours of a devaluation. This led to banks, pension and investment funds giving more sell orders to their dealers to get out of the pound and then the speculators came in joining the fray, including Sorors who initially sold GBP5b when the GBP was relatively high with the intention to buy back on a devaluation.

Eddie (BID George) vs (ASK George) Soros 

The BoE, and governor at the time, Eddie George, tried to play Soros off and sustain the value of Sterling by getting on the bid by buying pounds at the official ERM rate. Billions of pounds of public money were thrown in defence of the pound, intervening at a scale that it was quite obvious that they were doing so. However, the intervention wasn't working, and a 2% rise in interest rates were debated by the BoE. They followed through and rates rose to 12%, despite John Major's reluctance in respect to his political stature - However, this was seen as an act of desperation by the speculators and this was an invitation to Soros and speculators to double up and sell as much Sterling as possible.

The end game getting closer?

The BoE had GBP19b in FX reserves to "play with", but GBP2b an hour was being bought as more and more speculators started selling the pound while investors went from selling 5m lots in the pound to 20m, 50m, 100m and the run in sterling just kept on.

The BoE had to throw in the towel before the bank's reserves were completely exhausted and the UK crashed out of the ERM. The game should have been up, but instead they raised rates again, to 15%. A small rally in Sterling of 3/4% was short-lived and the pound was back on the floor again as the market saw it as another sign of weakness and not at all fitting for the state of the UK economy at the time.

GBP15b was spent by that afternoon by the BoE. Rumours then flew around that the Bundesbank would cut rates, but of course they were just rumors. The Bundesbank were not about to give the BoE a free ride.

BoE withdraws from battle and the pound goes in to free-fall

The government made no announcement. The Prime Minister then said they had no choice but to pull out of the ERM, despite the government's credibility would be gravely damaged.

At 4pm, there was no support from the BoE and the dealing rooms went quiet, stunned knowing they had beaten the BoE - They went back to business and slaughtered the pound without there being any support and then the pound just went into free-fall and markets finally closed. However, dealers didn't know that the there had been a momentous decision to leave the ERM.

It wasn't for three and half hours later that anything was announced until the chancellor completed meetings with Britain's partners in the ERM in Brussels:

"Today has been an extremely difficult and turbulent day. Massive speculative flows have continued to disrupt the function of the exchange rate mechanism. As chairman of the council of European Finance ministers, I have called a meeting of the monetary committee in Brussels urgently tonight to consider how stability can be restored to FX markets. In the meantime the government has concluded that Britain's best interests are served by suspending our membership of the exchange rate mechanism" - Norman Lamont's evening announcements. 

And that was "Black Wednesday". Neither the Lamont nor Major resigned, despite losing over three billion pounds of public money on one single day trying to keep the pound inside the ERM.

Soros vs Bundesbank?

While this event was more about currency traders that could see the conflict between the British economy which needed one thing and the German economy that needed another and subsequently reacted, a Brexit and subsequent sell-off in the pound could be on the cards.

However, what concerns me more are the implications for the euro in the longer term. As Brexit fears mount, so to do the fears of France, Greece and other nations also voting to leave the EU and the euro - So perhaps it is the Bundesbank that Soros is now waiting to take on in time ahead, remembering the fortunes to be had? Soros made in the region of $1B on Black Wednesday.

How much will you make on a Brexit?