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Hanlon's Razor: Never attribute to malice that which can be adequately explained by stupidity.

Thursday, March 26, 2009

Black Wednesday

I ran across a mention of 'Black Wednesday' in a random article I was reading. I'd never heard of it, so I started doing some wiki research. Turns out a man named George Soros affectively did a bank run on the British government.

It's a little confusing and the nitty gritty details aren't available, but here is what I understand so far. In 1990, the British government joined the European Exchange Rate Mechanism. The purpose of the ERM was to pave the way for the Euro at the turn of the millennium. To introduce a new currency they want to stabilize the exchange rate of the Pound to other European currencies, specifically the Deutsche Marks. By joining the ERM, Britain basically said the Pound was worth 2.95 DM. The government pledged to prevent the Pound from moving more than 6%.

Now enters George Soros, who is against a fixed currency and for making personal profit. He and his buddies see an opportunity here that only one of the world's richest men could take advantage. Lucky for him, he is one of those men.

He decides to short the Pound in a big way.

What that means is, he borrowed a huge amount of Pounds from someone. With those Pounds he purchased huge amounts of other currencies. He basically converted 10 billion pounds into Deutsche Marks. On paper, that sounds a bit silly, but in the real world that money has to physically exist in the market. There has to be enough Deutsche Marks and enough people willing for the exchange to occur.

At first it's not that big of a deal, he gets a 2.95 DM for each Pound. Now there is no one else willing to trade him DM for Pound, so he says he'll accept 2.94 DM per Pound - and then 2.9, 2.85 etc. all the way down to 2.778 where the British government says it will never drop below.

In theory it doesn't matter anymore if someone is waiting to exchange DM for Pounds. The government will take that trade all day long. Except the government only has so much DM on hand.

They ran out.

The market now panics and everyone is trying to get rid of their pounds. They don't care what currency they get it in either. The value of the British Pound falls to ridiculous lows and stays there. The government is forced to withdraw from the ERM and the Pound is no longer a 'fixed' currency.

Soros then takes his highly over valued DM and easily pays back his original loan which was in Pounds. This venture reportedly earned him $1.1 billion.


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