"All pegs are stories," concludes Patrick McKenzie --formerly of Stripe -- as he discussed stablecoins a while back (https://bam.kalzumeus.com/archive/stablecoin-mechanisms-and-use-cases/) "A peg is a story about why two things which are not the same are, in fact, similar enough to be treated interchangeably."

In monetary history, a "peg" -- aka fixed exchange rates -- always involves an asset that the pegger controls, i.e. can print more of (like TerraUST for the Luna foundation people or the British pound for the Bank of England) and a target asset that the pegger doesn't control. The simplest way to uphold a peg is to transparently hold (and back) every unit of the asset you control by a unit of the asset you don't control. Think money market funds, the USDC or GeminiUSD stablecoins, or the many successful currency boards around the world (e.g., Hong Kong, Bulgaria).

Most don't do that, prefering to achieve some monetary magic.

A pegger can always deal with upward market pressure on the asset they control by printing more. Denmark’s Nationalbank has successfully pegged its currency, DKK, to the euro at 7.46 (with a 2.25% band around it) for years. A few years ago, the DKK breached that level and traded above the official peg on and off for about two years, and there was lots of chatter around markets that something was happening to the peg (=euro break-up risk). But since the market pressure was in the “wrong” direction there was never any issue forcing the hands of Denmark’s monetary central planners. Foreigners wanted to hold more DKK (potentially as a hedge against problems with the ECB or the eurozone), which the Nationalbank could and did supply in whichever quantities markets demanded. Money printing go brrr....

The headache-inducing problem for peggers happens when market pressure goes in the other direction: when the world wants to ditch the asset the pegger has issued them and wants more of the asset the pegger doesn’t control. This is when the pegger must back its pegging words with real actions by selling real assets on the open market.

The Danish central bank doesn’t control the euro and cannot issue more of it, so it is limited to selling the euros it has on its balance sheet (or, in a pickle, can acquire from the ECB, which does control the euro). For this, the Nationalbank carries FX reserves equal to about 20% of Danish GDP or one-third of outstanding Danish kroner — which, if required, it could sell into the market (purchase DKK) and thus bring about the desired exchange rate between DKK and EUR. It’s not fully backed... but with enough of the non-controlled asset to credibly defend the peg.

This was the trouble that the Bank of England ran into in September 1992, as its bank officials struggle to uphold the pound peg.

In the mid-1900s, economists, politicians and monetary theorists were enamored with the idea of “fixed” monetary relations -- “fixed” because fixing implies a fixer, a glorious Atlas carrying the monetary Earth on his shoulders. There was no such character in this lost monetary world — not the 19th-century romanticized era of global trade and internationalization that it looked back on — but it was the experience of international merchants and policymakers at the time that currencies seemed to be fixed, pegged, tied, or connected to one another at a certain rate.

It might be that consumers and businesses don’t like it when currencies fluctuate in value according to fickle demand. They wanted to control — fix, or in other words “peg” — them. Regulators concluded: We must pin down the filthy speculators and their errant capital flows. We had the Bretton Woods agreement in operation from the late-1950s to 1968, where international currencies were “managed” by politicians and economic experts. After the gold pool broke in 1968 , the Nixon shock 1971 temporarily (read: permanently) unshackled the dollar from the cushy constraints of gold, and the inflation that accompanied that decade, European politicians began once more to sketch on a way to tie down their currencies.

The outcome, the ERM, was the forefather to the euro and required participants to steer their currencies toward a benchmark rate; if the market wandered too far off the rate set by bureaucrats, central bankers were expected to bring it back by selling foreign reserves on the open market or issuing more of its domestic currencies to bring it back down.

Britain had joined the arrangement in 1990, as a result of its ever-fickle relationship with the European integration project — sometimes in, sometimes out. In 1992, following years of high interest rates, depressed property prices, and a recession, market participants had snuffed out a weakness in the officially pegged British pound. Like every other peg, the Britain’s attempt at joining the ERM with other European countries was a story told by suit-and-tie government officials: We say the pound is worth 2.95 Deutschmark. Pointing to a vast warehouse of foreign asset, the officials said that they stood ready to sell these assets to prove it, or print more pound if the DM/GBP went above that rate.

As long as the pile of assets held by the pointy hats with overblown credentials at the Bank was big enough, the rest of the world’s financial markets said “fine, whatever.” We’ll treat the pound as worth 2.95 Deutschmark, markets said; if it ever deviates above or below that rate, we’ll even help you by front-running whatever trade we expect you to make in order pocket the arbitrage difference.

It’s a Jedi mind-trick, wrote Claire Jones and Joseph Cotterill in the Financial Times suitably about an altogether different reserve problem (Russia, 2022: https://www.ft.com/content/526ea75b-5b45-48d8-936d-dcc3cec102d8): If markets know you’ve got a load of [reserves], they’re less likely to challenge you to use them.”

Thus, when there’s enough credibility the Bank of England doesn’t have to do anything but credibly state what the market rate shall be for it to be so. It’s very cheap to operate monetary policy by magic. If the stuff held by the men in pointy hats and overblown credentials happens not to be big enough, the rest of the world’s financial markets say “ehh, no? Let’s see how serious you are.”

In September 1992, market participants — including, most famously, Hungarian billionaire George Soros — borrowed tens of billions’ worth of pounds and sold them for Deutschmark, with the explicit intention of breaking that peg. The suit-and-tie people’s silly words were not credible and Soros meant to show that. In the “trade of the century,” Soros and other currency speculators did exactly that. They bet that the politicians and the central banks couldn't maintain artificially high exchange rates for political integration reasons

The speculators sold pounds and pushed GBP outside of its allowed span, which resulted in the Bank of England selling from its foreign exchange reserve to protect the peg, i.e., they were buying GBP (the asset they controlled) with foreign reserves (the assets they didn’t control). Over a span of a few weeks, the Bank shoveled billions after billions to keep the peg at the stated price — until they finally gave in on September 16. At around noon of that fateful day, the Bank raised its interest rate by 200 basis points, but the avalanche of pound shorting would not stop. The U.K. government suspended the peg and left the ERM. When monetary policy action reeks of desperation, the magic credibility that upheld it vanishes faster than monetary wizards can say “Wingardium Levoisa.”

The British pound quickly dropped in value, Soros pocketed a nice round £1 billion profit, and monetary central planners were taught a painful lesson in trying to peg a currency (the total loss to the Bank amounted to something like £3.3 billion).

Alchemic monetary policy failed and controlling a currency’s value turned out to be a lot more expensive than to cheaply state the rate at which the market ought to value it. A peg under threat forces the pegging institution to put its money where its mouth is, actively upholding the peg with real assets rather than the soft, fake-y assets of merely speaking the words. Credibility is everything.

Not the only reason basically no major country runs fixed exchange rates today, but quite a large one. The arbitrage/speculative attack risk with open capital markets makes fixed rates pretty undesirable.

Anyway, nice little tidbit from the history of money.

That's today's little money lesson. Peace, J