March 8, 2023
Silvergate’s Silver Lining
In the wake of Silvergate’s liquidation, we believe strong and thoughtful risk management along with clear regulatory guidance will lead to a robust and efficient digital asset banking system.
While multinational banks have generally stayed away from providing banking services to digital asset companies due to regulatory uncertainties, smaller banks have wasted no time in stepping into this opportunity. There are a few U.S. banks that do work with digital asset companies, such as Signature Bank, Blue Ridge Bank, Customers Bank, New York Community, U.S. Bancorp, and, until recently, Silvergate Bank.
Officially, U.S. regulators do not prohibit banks from serving digital asset companies. In February, the Board of Governors of the Federal Reserve System (the Fed), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) jointly stated that “banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.”[1] Indeed, operating as a digital asset banking institution presents its own set of risks and uncertainties that require additional risk management practices to prevent a bank failure.
At Samara Alpha, we believe that strong and thoughtful risk management combined with clear regulatory guidance will lead to a robust and efficient digital asset banking system. In the wake of Silvergate’s announcement of its liquidation, we review how we got here and highlight the lessons learned.
Silvergate Bank
Silvergate (NYSE: SI) began as a traditional bank, converting from an industrial bank to a commercial bank in 2009. It is a member of the Federal Reserve System with access to Fedwire, a settlement funds transfer system operated by the Fed. In 2013, Silvergate pioneered acceptance of the digital asset sector in banking by providing depository and payment services. Today, the company is almost entirely focused on the digital asset market. Unlike other banks, Silvergate does not pay interest on its digital asset deposits and has the lowest cost of funds amongst its peers. More than 97% of its total deposits are non-interest bearing and are from digital asset customers. There are two main drivers of Silvergate’s core deposit business: Silvergate Exchange Network and SEN Leverage.
Silvergate Exchange Network
At the heart of Silvergate's business model is the Silvergate Exchange Network (SEN), launched in 2017. SEN is Silvergate’s proprietary real-time payments platform that facilitates the transfer of U.S. dollars between digital asset customers free of charge (Exhibit 1). SEN customers need to hold their deposits within SEN to transfer money within that ecosystem. At its peak, Silvergate had more than $17 billion in deposits across 1,700 customers, including digital asset exchanges, over-the-counter trading desks, institutional investors, stablecoin issuers, and others operating in the digital asset industry.
Exhibit 1: Silvergate Exchange Network
Source: Silvergate Capital Investor Presentation Second Quarter 2020
Silvergate had created a frictionless, highly efficient closed loop whereby institutional investors can plug into all major crypto exchanges and brokers, including Coinbase, FTX, Genesis, and Gemini to name a few. SEN offers its institutional clients three key competitive advantages: (1) around the clock trading capabilities, 24/7/365; (2) reduced counterparty risk since users on SEN have passed Silvergate’s Know-Your-Customer and Anti-Money-Laundering due diligence; and (3) access to credit via SEN Leverage, extending U.S. dollar loans collateralized by bitcoin.
SEN Leverage
In early 2020, Silvergate started offering bitcoin-collateralized loans to its customers through a program called SEN Leverage. As of 4Q22, SEN Leverage held approximately $1.1 billion in loan balances. The loans generally have an initial loan-to-value (LTV) of 50-75%, depending on loan purpose and credit quality of the borrower. Silvergate monitors the collateral value daily throughout the life of the loan. If the LTV reaches 75-80%, Silvergate calls the borrower for additional funds to get the LTV back down to the initial LTV. It liquidates the bitcoin collateral if the borrower fails to meet the collateral margin call.
Bank Runs and Losses
The key revenue driver for Silvergate is the reinvestment of SEN interest-free deposits into interest-bearing fixed income securities. Under a stable deposit environment, and as interest rates rise, Silvergate’s net interest margin should improve significantly. But the reality was not rosy for Silvergate.
At the time of the FTX collapse, Silvergate had approximately $1 billion in FTX deposits. The collapse triggered a “crisis of confidence” for the digital asset industry and an avalanche of deposit outflows for Silvergate. Its digital asset customer deposits declined from $11.9 billion in 3Q22 to $3.8 billion in 4Q22. As a depository institution, Silvergate is obligated to honor customer withdrawals at any time without prior notice, which means, in theory, nearly all of its deposits can evaporate in days. Structurally, this leaves Silvergate with a significant duration mismatch between its assets in securities and liabilities in on-demand deposits.
Given the Fed’s hawkish position and determination in combating high inflation, bond yields rose significantly during 2021. Silvergate’s fixed income securities in both available-for-sale and held-to-maturity had experienced considerable mark-to-market losses and impairments, respectively. As of 3Q22, its balance sheet showed approximately $11.4 billion of municipal bonds, mortgage-backed securities, agency corporate, and Treasury securities. By 4Q22, only $5.7 billion was held in securities, yielding 2.61% per annum (Exhibit 2). Silvergate funded deposit outflows with securities sales, crystalizing $885 million of losses in 4Q22. Unfortunately, Silvergate did not anticipate the magnitude and speed of deposit withdrawal and failed to hedge its interest rate exposure accordingly.
Exhibit 2: Securities Composition
Source: Silvergate Capital 4Q22 Earnings Presentation
Additionally, Silvergate borrowed $4.3 billion from the Federal Home Loan Bank (FHLB) of San Francisco, a government-chartered institution providing short-term secured loans to banks with residential lending business.
On March 1st, Silvergate warned in an NT 10-K filing that it might not be able to stay in business due to its depositors’ rush to move their money elsewhere, a bank run. It was disclosed that the company had to sell additional securities beyond what was anticipated to repay its outstanding advances from the FHLB. Further, the company noted that additional securities losses “could result in the Company and the Bank being less than well-capitalized."[2] A bank is said to be well-capitalized if its leverage ratio is above 5% and adequately-capitalized if its leverage ratio is greater than 4%. A bank run would cause Silvergate’s leverage ratio to fall from the 5.36% as of 4Q22 to 4-5%.
On March 3rd, Silvergate “made a risk-based decision to discontinue the Silvergate Exchange Network (SEN).” [3] Its biggest customers had left the platform and the SEN leverage program was set to wind down. Silvergate was clearly experiencing structural problems with its “digital-assets only” business model.
On March 8th, Silvergate followed with the announcement that it will be winding down operations and liquidating the bank. “In light of recent industry and regulatory developments, Silvergate believes that an orderly wind down of bank operations and a voluntary liquidation of the bank is the best path forward,” the company said in a statement.[4] While not altogether unanticipated, Silvergate’s liquidation will likely have implications on the market and the ongoing discussion around regulation within the digital asset industry.
Regulating Digital Asset Banking
The aforementioned Fed, FDIC, and OCC February 2023 joint statement foreshadowed the Silvergate crisis by highlighting two liquidity risks: (1) deposits from crypto-asset related customers could be subject to large and substantial inflows and outflows; and (2) deposits that banks receive from stablecoin-related reserves could be volatile.
Digital asset companies have historically found it difficult to use traditional banks as those banks perceive them to be too risky. The elevated regulatory concerns around the risks of serving the digital assets industry are to be expected after the FTX collapse and the resulting crisis-of-confidence environment. We expect the continuous dialogue between regulatory authorities to be the catalyst that helps provide greater regulatory clarity to the digital asset ecosystem.
The regulatory guidance is that banks holding digital currency deposits will likely need to maintain these deposits in High-Quality Liquid Assets rather than less liquid loans and held-to-maturity securities. They also suggested that banks serving the digital asset industry need to: understand the drivers of deposit behavior and its susceptibility to volatility; limit potential concentration and correlation risk; perform liquidity stress testing; and engage in ongoing monitoring and assessment of deposit outflows.
The Silver Lining
As of the publishing of this paper, other than Silvergate’s drastic drop in share price following its announcement, the Silvergate crisis has not led to systemic risk events in the market. After the closing of SEN, deposit balances were either absorbed by other digital asset banks or flowed into stablecoin issuers, such as USD Circle. In fact, market participants have been diversifying away from Silvergate since the Luna/Terra collapse in May 2022.
The current Silvergate crisis reiterates the importance of regulation and prudent risk management. From this latest failure in the crypto-economy, there will undoubtedly be regulatory scrutiny and review, likely with new regulatory guidance further defining the nascent industry. The silver lining here is that much needed clear regulatory guidance and actionable recommendations will lead to a more robust banking system for digital currency. We at Samara Alpha support a healthy and fair capital market for digital assets; and Banking is the bedrock on- and off-ramp for a blockchain economy. The current crisis offers an opportunity to rebuild rather than to abandon.
[1] “Joint Statement on Liquidity Risks to Banking Organizations Resulting from Crypto-Asset Market Vulnerabilities”, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, February 23, 2023.
[2] Silvergate NT 10-K Filing, March 1, 2023.
[3] “Silvergate suspends crypto payments network; shares fall after-hours.” Reuters, March 4, 2023.
[4] “Silvergate Capital Corporation Announces Intent to Wind Down Operations and Voluntarily Liquidate Silvergate Bank,” March 8, 2023.