UPDATE 4-Sterling slumps after lawmakers reject bid to prevent no-deal Brexit

Sterling fell sharply on Tuesday after British lawmakers voted against a bid in parliament to prevent a potentially disorderly no-deal Brexit. With two months left until Britain is due by law to leave the European Union, parliament was trying to find a way forward by voting on different amendments, though none of the first five that were voted on were approved.

Growing expectations that Britain can avoid a no-deal Brexit have fuelled a 3 percent rally in the pound this month against the dollar and the euro. But sterling tumbled after lawmakers voted down a proposal by lawmakers to wrest control of the negotiations from Prime Minister Theresa May if she fails to secure concessions from Brussels.

Sterling fell 0.7 percent to the day's low of $1.3088 . It also dropped to the day's low against the euro, falling 0.8 percent to 87.33 pence. The pound remains well below a 3-1/2 month high of $1.3218 and a spike in volatility in derivatives market reflected nervousness about the likely outcome of the votes.

"The fact we are now staring at the Brexit deadline of March 29 once again as a cliff-edge event has disappointed many in the market who were betting on a sterling recovery," said WorldFirst head of FX strategy Jeremy Cook. "If the Brady amendment goes through now sterling will fall even more," he added.

An amendment selected for a vote, proposed by Conservative lawmaker Graham Brady, calls for the Irish backstop arrangement envisioned by May's Brexit divorce deal to be removed and replaced with "alternative arrangements". The backstop is an insurance policy designed to avoid customs checks between EU-member Ireland and British-ruled Northern Ireland after Brexit. Many in May's party oppose it, fearing it could trap Britain in a permanent customs union.

"The risk that we get a disappointment in tonight's vote is clearly there," Unicredit FX strategist Kathrin Goretzki said, though she noted the vote would not significantly dent optimism that parliament had taken control of the Brexit process to avoid a no-deal scenario. "We don’t expect this to be affected in a negative way in tonight's vote. Any correction will be temporary," she said.

Nervousness was reflected in a rise in implied sterling volatility on options markets, which has fallen steadily since the start of the year. Overnight implied volatility in particular raced to near 23 vol, the highest since Jan. 15, when lawmakers defeated May's Brexit deal. One-month implied vol rose to its highest in a week and a half at 11.2 vol, a day after seeing the biggest one-day rise since November.

(Reporting by Sujata Rao, additional reporting by Virginia Furness; Editing by Janet Lawrence)