What’s going on with Silvergate?

Summary

Silvergate Capital is a US bank that has carved out a niche in the cryptocurrency industry by providing services to exchanges and traders. The bank operates the Silvergate Exchange Network (SEN), a digital currency infrastructure that allows for the efficient movement of US dollars between SEN participants. The SEN platform is used to facilitate instant dollar transfers between exchanges, and traders pay no interest on their deposits.

However, the collapse of crypto prices and FTX led to a mass wave of withdrawals, which reduced the bank's non-interest-bearing deposits from $12bn to just $3.9bn. Silvergate was forced to borrow $4.3bn from the Federal Home Loan Bank of San Francisco to pay out the withdrawals. Now Silvergate is facing a potential bankruptcy case if they can sort their business out.

Introduction

The world of cryptocurrencies has been rocked by yet another wave of panic, as one of the leading crypto-friendly banks, Silvergate, faces the threat of bankruptcy. The news has sent shockwaves through the industry, with major clients such as Kraken, Circle, and Paxos cutting ties with the bank and abandoning its network. The situation has raised concerns about the stability and future of the crypto ecosystem, and many are now wondering what this means for the future of digital currencies. In this article, we’ll explain exactly what Silvergate does, how they got into this mess and what to expect going forward

Banking in crypto

Crypto trades globally, 24 hours a day, seven days a week. But if you want to buy crypto with dollars, you need to use the U.S. dollar financial system. You may have to send a bank transfer, but the banks are not open 24/7, and some of them might raise annoying questions if you try to transfer money from your bank account to buy crypto.

There are solutions. One solution is to deposit your dollars at a "trustworthy" crypto exchange, then use the dollars in your exchange account to buy and sell crypto. There are problems with this solution. The issue is that sometimes trustworthy crypto exchanges aren't; they lose or steal your dollars. But another issue is that depositing your dollars at the exchange needs to be deposited somewhere. It needs to keep customer dollars at some crypto-friendly bank that will give them back on demand.

Another solution is stablecoins: Instead of keeping your dollars at a bank, you turn them into crypto dollars by buying stablecoins that are always meant to be worth a dollar. Instead of buying and selling crypto with dollars, you buy them and sell crypto with dollar-denominated stablecoins. And the stablecoin issuer needs to put the money somewhere, so again, there is a need for a crypto-friendly bank.

So it would help if you had a crypto-friendly bank. For big U.S. crypto exchanges and traders, that bank is Silvergate Capital Corp. It is so crypto-friendly that it accepts deposits from crypto exchanges and traders and built its payments network for crypto settlement. Here's how Silvergate describes its Silvergate Exchange Network (SEN):

A crypto-friendly infrastructure

SEN is a digital currency infrastructure solution that allows for the efficient movement of U.S. dollars between SEN participants 24/7/365. It enables participants to transfer U.S. dollars from their SEN account to the Bank account of another SEN participant with a counterparty relationship and view received funds transfers. SEN transfers are virtually instantaneous, unlike wire transfers and ACH transactions. SEN has a cloud-based API and online banking tools for customers to control their fiat currency, transact through the SEN, and automate their interactions with the technology platform.

It's a way to send dollars at a bank that feels welcoming to crypto investors: It's 24/7, it has a cloud-based API, and crypto exchanges are on it.

And so Silvergate attracted a lot of crypto deposits. Suppose you are a crypto exchange or a crypto trading firm. In that case, you will find it attractive to keep your money at Silvergate because:

1. They like crypto.
2. They let you send money 24/7.
3. They are an actual bank, regulated by U.S. banking regulators, with public audited financial statements and capital regulation to keep them from losing your money, which is definitely not true for many crypto exchanges and stablecoin issuers.

Silvergate’s Business Model

This suggests a straightforward business model for Silvergate:

1. Take lots of deposits from crypto exchanges and investors, who need a friendly bank, and pay them no interest.
2. Invest the deposits in very safe assets, U.S. Treasuries and reserves at the Fed because you have cheap deposit funding and don't need to take many risks to earn a decent return.

The apparent risk for Silvergate to take on the asset side of its balance sheet would be to succumb to the temptation of lending against crypto:

• Its customers have a lot of Bitcoin.
• They might want to borrow dollars.
• They'll pay high-interest rates.
• Silvergate has a lot of dollars.

Does Silvergate do this? Yes, They do:

The SEN Leverage product enables digital currency customers to borrow U.S. dollars directly from the Bank to provide liquidity to support bitcoin trading activity using bitcoin as the collateral for these loans, which we refer to as SEN Leverage direct lending. In the SEN Leverage direct lending structure, a digital currency service provider, acting as a custodian, holds the borrower's bitcoin. The bank uses the SEN to fund the loan directly to the borrower's account at the exchange. In addition, the Bank also provides loans collateralized by bitcoin to digital currency industry companies for corporate treasury and other business purposes, which we refer to as SEN Leverage indirect lending. In the indirect lending structure, the lender uses bitcoin to collateralize its loan with the Bank, and the funding of the loan and liquidation of the collateral may or may not occur via the SEN.

The Losses

In Silvergate's recent filing, where they delayed filing their annual report they announced that they had some problems.

1. Silvergate had tons of deposits from crypto firms: $13.2 billion at the end of September, most of them not paying interest.
2. Then crypto melted down, and crypto investors took their money back from exchanges, which in turn took it back from Silvergate. By the end of December, non-interest-bearing deposits were down from $12 billion to just $3.9 billion.
3. Silvergate needed to come up with about $8 billion of cash to pay out these withdrawals.

It got some of the cash by borrowing $4.3 billion from the Federal Home Loan Bank(FHLB) of San Francisco. This government-chartered institution is basically in the business of giving short-term secured loans to banks that suddenly need cash. In late 2022 and early 2023, that described crypto banks, and it became controversial that they were borrowing from the FHLBs.

It got the rest of the money by selling a bunch of its bond portfolio: At the end of September, it had $11.4 billion of bonds, $8.3 billion of them. At the end of December, it had just $5.7 billion of bonds, all of them available-for-sale. It had sold the rest.

To accommodate sustained lower deposit levels and to maintain a highly liquid balance sheet, Silvergate sold $5.2 billion of debt securities for cash proceeds during the fourth quarter of 2022. The sale resulted in a loss on the sale of securities of $751.4 million during the fourth quarter of 2022.

Another thing it means is that Silvergate had to recognize losses on the bonds it kept because it had been accounting for some of them as hold-to-maturity. The Bitcoin loans held up fine, but that's not the point. The result is that Silvergate had a net loss of $1.05 billion in the fourth quarter.

Balance Sheet Problems

Silvergate's balance sheet as of Sept. 30, 2022, shows about $11.4 billion of "securities," meaning bonds: muni bonds, mortgage-backed securities, agency and Treasury securities. Meanwhile, there was about $1.4 billion of "loans," meaning the $300 million of Bitcoin loans plus some real-estate lending.

In the Q4 FTX collapsed, causing billions of dollars to be redeemed at Silverbank. On top of that. US authorities have been racing to sever ties between banks and risky crypto ventures, worried the financial system could someday suffer severe losses. They may have been too late. In the starkest warning yet by a US bank catering to the sector, Silvergate Capital Corp. said Wednesday it needs more time to assess the extent of damage to its finances stemming from last year's crypto rout. The shares plunged about 30% in premarket trading on Thursday.

The firm, which already reported a $1 billion loss for the fourth quarter, said that figure could climb higher. The company is still tallying the cost of rapidly selling assets to repay advances from the Federal Home Loan Bank System. It may also need to mark down the value of some remaining holdings.

Assets

Silvergate's assets are very safe, despite those Bitcoin loans: They consist primarily of highly-rated bonds likely to be paid back in full. As of September, Silvergate had:

• $15.5 billion of assets;
• $14.1 billion of liabilities;
• $1.3 billion of shareholders' equity (about 8.6% of assets);
• a regulatory leverage ratio of 10.7%;
• a total risk-based capital ratio of 45.5% because many of its assets had zero risk weights.

That capital ratio of 45.5% looks very safe. The leverage ratio of 10.7% looks fine. But then Silvergate lost a ton of deposits, had to sell assets, and had a billion-dollar net loss. That left it with

• $11.4 billion of assets;
• $10.8 billion of liabilities;
• $571.8 million of shareholders' equity (about 5.0% of assets);
• a regulatory leverage ratio of about 5.1%;
• a total risk-based capital ratio of 57%.

That capital ratio of 57% looks very safe. The leverage ratio of 5.1% looks a whisper higher than the 5% regulatory requirement to be "well capitalized."

Final Motion

Silvergate Bank has sold more investment securities than expected to repay a loan, resulting in additional losses that negatively impact its regulatory capital ratios. The bank is evaluating the impact of these events on its ability to continue as a going concern and is reevaluating its businesses and strategies.

Following the news, investors and business partners are leaving the bank. Crypto firms, including Kraken, Circle, and Paxos, have stopped accepting or initiating payments through Silvergate. This exodus threatens the bank's key source of deposits and a platform for crypto participants to transfer money among each other. This has forced crypto firms to look for an alternative for money transfers. At this time no solution has been found.

But Silvergate is having a real run on the bank. It has lost money, not by making dumb Bitcoin loans but by doing the normal banking business, borrowing short (taking deposits from crypto firms) to lend long (buying Treasuries and munis). Silvergate's assets are standard boring stuff. If its depositors had kept their money at Silvergate, its bonds would have matured with plenty of money to pay them back. Instead, the depositors demanded their money back all at once. Silvergate had to dump its long-term assets at significant losses to repay them.

This counts as contagion from the crypto crash to the natural financial system: A regulated US bank is worried about its ability to continue. It is undoubtedly the sort of contagion that regulators will want to discourage, and now they have clear evidence that it's real.