What a breakaway Scotland would mean for sterling

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Scotland has been joined together with England in the United Kingdom since 1707. Nonetheless for some time now many people in Scotland have been arguing that they should become an independent country again, and the province will vote on the issue on September 18th.

Scottish secession would be an enormous change for the U.K., yet it isn't priced into the FX market at all. This graph of polls on the question explains why. The results have been pretty consistent recently: the percent of people who intend to vote "yes" in favor of independence fluctuates around 36 percent, while the "no" vote is around 46 percent. So the "no" vote is in the lead and has been for some time. That's why the market isn't particularly worried about Scotland breaking away. But still, with the undecided vote at around 16 percent, it's possible that Scotland could vote to leave the UK. A lot depends just on who shows up to vote on the day.

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Since a "no" vote is more likely, let's first discuss what that would mean for the pound. On the surface, nothing changes, so it looks like it shouldn't have any impact on the currency. But in fact two things would probably change. First off, unless the "no" vote got overwhelming support, there would still be some doubts. The "yes" camp would probably try to keep the issue alive and schedule another vote in a few years. That's what happened with Quebec, the French-speaking province of Canada. Quebec voted to remain as part of Canada in 1980, but the issue didn't really die until they held another referendum 15 years later and the separatists lost that one too. So there may be some uncertainty about Scotland's place in the UK even after the referendum, which could be a drag on growth, at least in Scotland.

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Moreover, even if they vote "no" and decide to stay in the U.K., the Scottish people are clearly demanding more local control over their lives. They'll probably get it after the election. And if Scotland gets more local control, then the rest of the country will probably get more local control too. This means either way, fundamental changes are likely in the way Britain is managed. That could be good for the country, or it could be bad. We won't know in the short term. But over the longer term, it could make a difference in the productivity of the U.K. economy and therefore the strength of the pound. We won't know which way for many years, though.

A "yes" vote, although unlikely, would clearly be a huge event. A cataclysmic event. What would happen? Nobody knows. Uncertainty would go through the roof. What currency would the new country use? Would they keep the pound, or have their own currency? How much of Britain's debt would they assume? What would happen to the North Sea Oil revenues? Would Scotland join the EU? Would they join the euro? What would be the effect on the UK economy? All of this would take time to settle, and while it dragged on, Britain and the pound would be engulfed in uncertainty. And markets hate uncertainty.

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On top of which, if Scotland votes to leave the UK, it would reshape British politics. One of the two major political parties, the Labour Party, would lose about 16 percent of its representatives, while the other major party, the Conservatives, would lose almost none. So if Scotland leaves, it becomes more likely that the Conservatives will be re-elected at the next election in 2015. And if the Conservatives are in power in 2015, they've pledged to hold a referendum in 2017 on whether to stay in the EU. So if Scotland leaves the U.K., not only does the immediate future of the UK become uncertain, but also its long-term prospects become more uncertain as well, because the chances of the country leaving the EU increase considerably. That would really hit the pound.

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Finally, if Scotland votes to secede from the UK, then we're likely to see more such movements throughout Europe. For example, Catalonia, a region in Spain that has been agitating for independence, would be more likely to hold a referendum on independence. There could be an increase in such movements in Belgium and Italy as well. I think a "yes" vote would have huge implications not only for the pound, but for the euro too.

As I said before, a "yes" vote seems unlikely – at the moment. That's why it isn't priced into the market. For example, a GBP/USD at-the-money call option expiring on 15 Sep was trading recently at 0.755 percent (mid-price) while one expiring two days later (the day before the vote) was about 0.028 percentage point higher at 0.783 percent. An option expiring two days after that – the day after the vote – was 0.809 percent, or 0.027 points higher – the same increment. In other words, options expiring after the vote are priced exactly like options expiring before the vote. But as the 18th century Scottish poet Robert Burns observed, "the best-laid plans o' mice an' men gang aft a-gley." (The best-laid plans of mice and men often go astray.) Even if the odds are heavily against secession, there has to be some chance that the vote goes in favor of it, and that chance is not priced in at all. (To quote a more recent American author, Damon Runyon, "nothing in life is more than three to one.") My concern is that as we get closer to the date of the referendum, the market could begin to price in at least a small possibility of a "yes" vote, and that could put some downward pressure on the pound.

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Either way, the UK will have a general election in 2015 and if the Conservatives win, they have promised to hold a referendum on whether to remain in the EU or to leave. That is likely to be a major political event for the UK as well. But we have a few months to go before it becomes a market theme.