Layers of Conviction

Soros and Druckenmiller shorting the pound. Reading time: 13 minutes.

"I've learned many things from [George Soros], but perhaps the most significant is that it's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.” -Stanley Druckenmiller

“When I’ve looked at all the investors (that) have very large reputations — Warren Buffett, Carl Icahn, George Soros — they all only have one thing in common. And it’s the exact opposite of what they teach in a business school. It is to make large, concentrated bets where they have a lot of conviction. They’re not buying 35 or 40 names and diversifying. … [In 1992] when I went in to tell Soros that I was going to short 100 per cent of the fund in the British pound against the Deutschmark, he looked at me with great disdain. He thought the story was good enough that I should be doing 200 per cent, because it was sort of a once-in-a-generation opportunity.” -Stanley Druckenmiller, The Hustle

George Soros is famous for “breaking the Bank of England,” for making a cool $1 billion when the pound was devalued in 1992. It’s a famous trade that pitted markets and speculators against the European political establishment. The sheer scale and audacity cemented Soros’s reputation even though Stanley Druckenmiller was the portfolio manager at the time. It’s a case study whose nuances are easy to miss.

There are a couple of obvious issues with taking Druckenmiller’s statement about concentrated bets as advice. There is survivorship bias (though as Gavin Baker pointed out, surviving is kind of the point). And he is Stanley Druckenmiller and you are you (think about your investor Ikigai).

“What is most interesting to me about the breaking of the pound was the combination of Druckenmiller’s gamesmanship – Stan really understands risk/rewards — and George’s ability to size trades. Make no mistake about it, shorting the pound was Druckenmiller’s idea. Soros’s contribution was pushing him to take a gigantic position.” Scott Bessent, Inside the House of Money

Soros and Druckenmiller weren’t the only ones betting against the pound. This was not a case of variant perception. Bank prop trading desks and macro traders like Bruce Kovner and Paul Tudor Jones were betting on the same outcome. But none had the same scale or conviction. When Druckenmiller told The Hustle that Soros “thought the story was good enough,” he didn’t capture the multiple dimensions of conviction that aligned to form the foundation of a generational trade.

What gave Soros the conviction to push Druckenmiller to lever up and bet the farm? Without understanding the conditions of the trade, any lessons are likely to get lost in translation.


It all started with fundamental research

In 1992, Scott Bessent was the head of Soros’s London Office. In Inside the House of Money, he described the lead-up to the pound short: “We’d been thinking about it for a while. We did a lot of bottom-up research. Stan and George believed that if you can find out what’s going on at a micro level, you can figure out the big picture. My very minor contribution to the breaking of the pound was an analysis I had done on the UK housing and property market. In the UK at the time, about 90 per cent of mortgages were linked to the overnight rate. I had been short UK housing stocks for a while.”

The pound was pegged to the German mark as part of the European Exchange Rate Mechanism (ERM), the precursor to the euro. In Germany, the reunification of East and West was leading to inflation and pressure on the Bundesbank to raise rates. Britain’s economy however was in recession and needed lower rates.

From Robert Slater’s biography of Soros: “In 1992 it was becoming increasingly clear that a number of European currencies — not just the pound but the Italian lira as well — were significantly overvalued in relation to stronger ones such as the French franc and the German mark. Because of the British recession, and because there seemed little reason to believe that Britain would be able to keep the pound pegged so high vis-a-vis the mark, speculators began to smell blood.”


Finding asymmetry

In More Money Than God, Sebastian Mallaby recounts how how Robert Johnson, a currency trader Soros was in the process of hiring from Bankers Trust, laid out the risk-reward of shorting the pound:

“Well, sterling is liquid, so you can always exit losing positions. The most you could lose is half a percent or so,” Johnson said.

“What could you gain on the trade?” Druckenmiller asked.

“If this thing busts out, you’d probably make fifteen or twenty percent,” Johnson answered.

“How likely is that to happen?” Druckenmiller pressed.

“On a three-month time frame,” Johnson responded, “about ninety percent.”

“How much would you do in your own fund?” Soros asked, referring to a portfolio that Johnson ran for Bankers Trust.

Johnson indicated that he would leverage himself up to take advantage of this trade. He might do three to five times capital.

“Oh my God,” Druckenmiller said quickly.

The trade came out of a conflict between economics and politics. It pitted the British government and central bank, intent on saving face, against economic reality. It was a Soros special: an unstable equilibrium about to be exposed and toppled by market forces.

According to my theory, every exchange rate regime is flawed. There was a latent flaw in the ERM as well, but it became blatant only as a consequence of the reunification. The flaw was that the Bundesbank played a dual role in the system: It was both the anchor of the ERM and the constitutional protector of the stability of the German currency. … The tremendous injection of capital from West Germany into East Germany set up strong inflationary pressures within the German economy. The Bundesbank was duty-bound—by the constitution, not just by law—to counteract it by pushing up interest rates and it did so with considerable vigor. This was at a time when Europe in general, and Britain in particular, were in the depths of a recession. The high German interest rate policy was totally inappropriate to the conditions that prevailed in England. … Pursuing a resolutely tight monetary policy at a time when the rest of Europe was in recession disqualified the Bundesbank from serving as the anchor of the ERM. That threw the ERM, which had been operating near equilibrium, into dynamic disequilibrium.” From the book Soros on Soros


A behavioral perspective

In addition to the fundamental research performed by his team, Soros had a unique perspective and insight on the key players: the central bankers.

“To make sure the other members of the Common Market accepted the reunification of Germany … Kohl proposed … a strengthening of European institutions. Which set the framework for what eventually became the euro. [This] was the death knell of the Bundesbank, because the Bundesbank was going to be superseded by a European Central Bank. … the Bundesbank was fighting for its institutional survival. In my view, of the three conflicts the third was the least understood and the most decisive.” -Soros on Soros

As pressure on the pound increased, the Bundesbank found itself defending its independence. Britain’s finance minister Norman Lamont practically demanded that the Bundesbank’s president, Helmut Schlesinger, lower interest rates.

“In a pattern that was to repeat itself over the next few days, Lamont’s overreach infuriated Schlesinger. The Bundesbank president felt compelled to correct the impression that he had compromised his institution’s independence. On September 8, after a central bankers’ gathering in Basel, Schlesinger declared publicly that he could make no guarantees about the future course of interest rates.” -More Money Than God

It's important to understand how much access Soros had:

“Not until 1992 was the timing right. I got my first hint [that a breakdown was in the offing] from Bundesbank President Schlesinger in a speech he gave.… He said that he thought investors were making a mistake when they thought of the ECU (European Currency Unit) as a fixed basket of currencies. He was alluding particularly to the Italian lira as a currency that was not too sound. I asked him after the speech whether he liked the ECU as a currency, and he said that he liked it as a concept but he didn’t like the name. He would have preferred it if it were called the mark. I got the message.” -Soros on Soros

Sebastian Mallaby wrote in the footnotes to More Money Than God that this encounter happened at a “prestigious gathering,” likely Schlesinger’s September 8 speech in Basel. Soros called Druckenmiller immediately afterwards to short more lira.

Schlesinger became the linchpin to the trade. His actions catalyzed the pound’s devaluation. Soros was in a position to understand Schlesinger’s incentives, his institutional background. He had direct access, could observe the man’s body language, and ask whatever question he wanted.


Size mattered

A friend of mine likes to say: “there are things the little guys can do that the big guys can’t. But there are also things the big guys can do that the little guys can’t.” I believe this is the final piece of the puzzle. As Druckenmiller and other funds were selling the pound, there was increasingly only one buyer left: the Bank of England.

Let’s return to that fateful moment when Robert Johnson explained the pound short’s asymmetry:

“Well, they only have twenty-two billion pounds’ worth of reserves,” Johnson continued, a sum equivalent to some $44 billion. Quantum could only sell sterling so long as someone was willing to buy it. Given Schlesinger’s comments, there were few private buyers left; the main buyers were the Bank of England and other central banks that were trying to support sterling. Once the Bank of England ran out of reserves, it would be impossible to place further bets against sterling. So $44 billion might be the limit.” -More Money Than God

On the one hand, this presented a liquidity constraint to the trade. They practically couldn’t short more than the Bank of England was able to buy. Druckenmiller mused whether they might “get fifteen of that” to build their position. At the same time, once the Bank of England ran out reserves, the devaluation would be forced. Markets would triumph over politics. Already, the bank had lined up borrowings of $14 billion to bolster its firepower (as much as Druckenmiller alone was looking to sell).

What if, in this particular instance, taking on leverage to short more pounds didn’t increase the risk but instead decreased the risk by changing the odds? Shorting billions of pounds made the devaluation more likely. What if Soros and Druckenmiller had the benefit of a poker stack big enough to bully the other player? And they were not alone: other funds were in the trade and might have found signal value in Soros’s conviction, leading them to boost their own position.

“We realized that we could push the Bank of England against the trading band where they had to buy an unlimited amount of pounds from us. The plan was to trade the fund’s profits and leverage up at the band’s boundary. The fund was up about 12 per cent for the year at the time, so we levered the trade up to the point where if they pushed us back up against the other side of the trading band, we would lose the year’s P&L but not more.” -Inside the House of Money

But not until the final moment did Soros push his disciple to put all the chips on the table.


The levee breaks

“This gets back to the genius we were talking about. I can do all my fancy analysis. I can have the concepts, I can do the economics, and I can even have the timing, but one simple statement like that in terms of size ... We probably got twice the profit I would have had without that snide comment he made about ‘Well, if you love it so much…’” -Stanley Druckenmiller, More Money Than God

Speculators first overwhelmed the Finnish central bank on September 8. On September 11, the Italian lira broke through its permitted band and on the following weekend its devaluation was announced.

On Tuesday, September 15, Schlesinger gave interviews to the Wall Street Journal and German business newspaper Handelsblatt

“According to a news agency report on his remarks, the Bundesbank governor believed that a broad realignment of Europe’s currencies would have been better than a narrow adjustment of the lira. Lamont was stunned. Schlesinger’s remark was tantamount to calling for sterling to devalue.” -More Money Than God

While Schlesinger later disputed the quotes, it was too late. Traders took the cue and aggressively sold the pound.

The report said: "The President of the Bundesbank, Professor Helmut Schlesinger, does not rule out the possibility that, even after the realignment and the cut in German interest rates, one or two currencies could come under pressure before the referendum in France." The Independent

That day, Druckenmiller walked into Soros’s office and told him he wanted to increase the $1.5 billion short position. But he wanted to do so in a steady fashion.

“That doesn’t make sense,” Soros objected.

“What do you mean?” Druckenmiller asked.

Well, Soros responded, if the news story was accurate and there was almost no downside, why just build steadily? Why not jump straight to $15 billion? “Go for the jugular.” -More Money Than God

Druckenmiller started shorting the pound with both hands. The next day, the Bank of England faced a flood of selling. It hiked rates but the pound didn’t budge. The pressure was overwhelming. As its reserves dwindled to no effect, the political commitment to the peg finally broke. In the evening, Britain’s exit from the ERM was announced.


Conclusion

Druckenmiller and Soros ended up shorting $10 billion and made a $1 billion profit on the devaluation alone. This was in addition to profits from shorts of other currencies and bets on equities and bonds that were affected as well. The Quantum fund ended the year up 69 per cent.

Druckenmiller is right that great fortunes are often built on a concentrated bet (be it an investment or building a business). However, one must resist the temptation to treat his experience as an open invitation. His team had started with fundamental research and found a highly asymmetric trade. Soros himself had the most intimate knowledge of the key players and institutions. Lastly, their size allowed them to influence the outcome. These multiple sources of conviction put Soros in a position to push Druckenmiller to lever up and go all-in.

In his speech at the Lost Tree Club, Druckenmiller remembered Soros saying: “Do you know how often something like this comes around? Like [once in] 20 years.” Which reminded me of a comment Soros once made to his friend Byron Wien: "The trouble with you is that you go to work every day and you think that because you go to work every day, you should do something. And you do something every day and you don't realize when it's a special day."

If you want to play the game of highly concentrated bets, you have to be able to recognize when it’s a special day. And you should learn how to build multiple layers of conviction.


Sources

More Money Than God: Sebastian Mallaby’s must-read on the history of hedge funds. Has a great write-up of the trade.

Soros: The Life, Ideas, and Impact of the World's Most Influential Investor by by Robert Slater: a traditional biography and chronology of Soros’s life. More background than trading insights.

Soros on Soros: a conversation with George Soros and peek into his mind.

Inside the House of Money: a collection of interview with global macro traders.