The Breakdown - The Real Reasons Silvergate Collapsed

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDest. What's going on, guys? It is Thursday, March 9th, and today we are discussing the real reasons that Silvergate Bank collapsed. Before we get into that, if you were enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers. Discord. You can find a link in the show notes or go to bit.L.L.Y slash breakdown pod. All right, guys, well, it has happened. As of last night, Silvergate Bank, one of the pioneers in giving crypto companies banking access, is officially winding down. Today, we're going to deep

Starting point is 00:00:51 dive on the closure and how we got here because I think the how is incredibly important. I think that there are three possible interpretations of this whole affair. The first, let's call crypto risk. The idea that this was some inevitable byproduct of bankers getting involved with the overly risky crypto sector. This you might sum up as the Elizabeth Warren position. The second possible interpretation is that Silvergate's failure wasn't strictly a byproduct of crypto risk, but had to do with specific risks that Silvergate took in its business, in other words, specific business decisions they made. The third, possible interpretation, is that this was a coordinated hit led by a combination of short sellers and antagonistic politicians out for blood in the wake of the collapse of FTX.

Starting point is 00:01:32 So keep those three possibilities in mind as we dig into the story. On Wednesday, Today, Silvergate Bank announced that it would, quote, voluntarily liquidate its assets and wind down operations. A press statement explained, quote, 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 bank's wind down and liquidation plan includes full repayment of all deposits. The company is also considering how best to resolve claims and preserve the residual value of its assets, including its proprietary technology and tax assets, end quote.

Starting point is 00:02:03 outside legal, financial and project management advice firms have been appointed to assist with the winding down process. Now, Silvergate has looked shaky since announcing last Wednesday that it would be delaying the filing of its 10K annual report. The delay notification stated that Silvergate needed more time to assess how regulatory investigations and losses associated with last November's $8 billion bank run had affected its earnings. The filing suggested that the situation of the bank could be died, explaining that these events had led management to evaluate the bank's, quote, ability to continue as a going concern. In the fallout from last week's announcement, Silvergate rapidly shed its crypto customers as one-by-one major crypto firms announced that they had cut ties with the distressed bank over the course of the following day. Silvergate's stock tumbled, collapsing by more than 60% to an all-time low, after having already drawn down by more than 90% in the previous 12 months. In the wake of all that, Silvergate announced

Starting point is 00:02:53 that they were closing their Silvergate Exchange network or Sen, which was a near instant settlement network between customers that held accounts with Silvergate and was used extensively by crypto exchanges and trading firms to rapidly settle transactions. at any time, including nights and weekends. So all of this gets us to this week and Silvergate looking extremely beleaguered and on the outs. But let's go back to try to understand how we got here. The troubles really began for Silvergate in November as FTX was collapsing. Silvergate was a major banking partner for FTX holding around $1 billion in deposits for the exchange, but claiming not to have any investment or loan exposure. Coming into Q4 of last year, Silvergate had a little over $12 billion

Starting point is 00:03:30 in deposits. And as the industry got nervous about the fallout of F-TX, the bank was required to service over $8 billion in withdrawals during a bank run that rivaled classic runs of the 1930s for its speed and size. Once the dust settled, Silvergate had managed to service all customer withdrawals, but had taken major losses in the process. According to its financial reports, Silvergate saw a billion dollar loss from selling its reserve assets prior to maturity. Now, it's important to note here that the $8 billion in withdrawals during Q4 wasn't about concerns over Silvergate specifically. Most of the deposits held with Silvergate were from crypto trading firms and exchanges on behalf of their customer base. When exchange customers

Starting point is 00:04:06 demanded withdrawals and trading firms pulled their money out of the crypto ecosystem, this depleted the assets held with Silvergate, meaning that the run on crypto exchanges was also a proxy run on the bank. When its Q4 financials were reported, Silvergate disclosed that during the bank run, it had taken approximately $4.3 billion in loans from the federal home loan bank of San Francisco. This would become a huge source of political consternation, so it's worth digging into a little bit more. The FHLB system is a great Depression-era institution that provides a range of liquidity assistance programs to banks that deal in mortgage products. The FHLB doesn't typically act as an emergency liquidity provider, with that role usually being played by the Fed. However, it doesn't appear

Starting point is 00:04:45 that Silvergate did anything particularly out of line in approaching it for loans. Unsurprisingly, then, these loans were highly controversial, with lawmakers' concern that the FDIC could end up backstopping the loans if Silvergate failed to repay. This rhetoric continued despite the fact that the FHLB only makes fully collateralized loans, is entirely funded by the private banks in its network, and is never recorded a loss on loan funds. In other words, the idea that taxpayers were giving Silvergate a bailout just wasn't true. Now, during last week's discussion around what went wrong at Silvergate, many commentators speculated that the bank might have taken on significant duration risk in their reserves. When a bank takes deposits, they don't pile up

Starting point is 00:05:23 dollar bills in a vault. They use the deposits to purchase debt securities issued by governments and other institutions, then hold those as a reserve. Francis Coppola dug into Silvergate's financials for Q3 last year and found that Silvergate held a mix of U.S. treasuries, mortgage-backed securities, and municipal bonds. In other words, nothing considered risky, really, and mostly maturing within one year. Now, there might be some duration risk in holding one-year bonds, especially against crypto-firm deposits, but it's still well within regulatory requirements. Ceteris Paribus, a crypto researcher at Delphi says, willing to change my mind on this if more info comes to light, but so far it seems like the only

Starting point is 00:05:57 mistake Silvergate made was taking too much duration risk. I'm sure there are hundreds of other banks that would be in the exact same situation. But since Silvergate's clientele is all crypto and crypto people are always concerned about bank runs, because we have exchanges go through them constantly, Silvergate gets an actual run on it while other banks just hold these at cost on balance sheet. And indeed, this is something that came up to the extent that people were critiquing Silvergate's specific business decisions. It wasn't that they were doing something wrong or out of sync with what other banks were doing. It's just that maybe given their deposit situation, given how much of it came from crypto, they might have wanted to think about it differently.

Starting point is 00:06:30 Professor Austin Campbell writes, the only part of this tale that is shocking to me is that they did it. Silvergate is the ideal bank to do nothing other than own T-bills and just rake in profits, giving that they were paying 0% on deposits. In that world, why take the duration risk? Now, the final issues appear to have come from Silvergate being forced to liquidate all these assets to service withdrawals. When the interest rates on bonds rise in the open market, this is reflected in a decrease in the price that bonds trade at. This means that during last year's rapid interest rate rises, bank reserve assets would have been dramatically marked down. Banks generally planned to hold reserve assets to maturity, so fluctuations in price don't matter. They get paid out

Starting point is 00:07:04 at par and reinvested. However, if a bank is forced to liquidate their reserves, and to do so in the context of rising interest rates, they have to do it in a way that makes them realize a loss in market price. So if Silvergate was able to handle this $8 billion bank run, what was it that forced them to liquidate the rest of their reserves. Well, after the fact, it has become clear that the FHLB either recalled their loans to Silvergate at the end of December or refused to roll them over. American banker reports that over the past two months, January and February, Silvergate had repaid the $4.3 billion loan in full. It's not clear why the loans were recalled. But many think the most logical conclusion is that Silvergate no longer satisfied capital requirements to be a

Starting point is 00:07:42 suitable borrower. The capital rules for FHLB loans have already been noted by the American Bankers Association as causing liquidity problems at smaller banks. during periods when interest rates rise. It's also possible that political pressure caused the FHLB board to back away from supporting Silvergate, and that's something we'll get to in just a minute. Whatever the case, this action appears to be highly unusual, to go from having provided a lifeline to Silvergate during a time of acute stress,

Starting point is 00:08:05 to then recalling the loans over a short time frame just a few months later. Join CoinDesk's Consensus 2023, the most important conversation in crypto and Web 3, happening April 26 through 28th in Austin, Texas. is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders, founders, brand leaders, entrepreneurs, and more. Use code breakdown to get 15% off your paths. Visit consensus.coindex.com or check the link in the show notes.

Starting point is 00:08:47 Indeed, economist Francis Coppola, who's no big supporter of Silvergate or fan of crypto, went so far as to call the action draconian. And in fact, it seems that removing access to FHLB loans at Silvergate's time of need was what did them in. To put it another way, removing access to a government institution designed to assist with the financial stability of banks on short notice, unsurprisingly blew up a precarious bank. So let's talk then about the political dimension of this. Where the Silvergate story gets really messy is in considering the anti-cryptopolitical pressure placed on the bank. In December, a group of four U.S. senators, including Elizabeth Warren and John Kennedy, wrote to Silvergate

Starting point is 00:09:22 demanding answers about what the bank knew about FDX misdirecting customer deposits into Alameda research accounts also held with Silvergate. In their response, Silvergate said they were not allowed to disclose confidential supervisory information under the threat of criminal penalties. Warren and her band of senators pressed the issue again, writing in late January, claiming that Silvergate's excuse was not good enough. Unsurprisingly then yesterday, Senator Warren tweeted smugly, as the bank of choice for crypto, Silvergate Bank's failure is disappointing but predictable. I warned if Silvergate's risky, if not a legal activity, and identified severe due diligence failures. Now customers must be made whole, and regulators should step up against

Starting point is 00:09:55 crypto risk. Senate Banking Committee Chairman Sherrod Brown took the opportunity to foreshadow even greater restrictions for banks that dare to service crypto firms. As the impact of FTCS's collapse continues to ripple outward, today we are seeing what can happen when a bank is over-reliant on a risky volatile sector like cryptocurrencies. I've been concerned that when banks get involved with crypto, it spreads risk across the financial system, and it will be taxpayers and consumers who pay the price. That's why I'm continuing to work with my colleagues and Congress and financial regulators to establish strong safeguards for our financial system from the risks of crypto. Now, it is worth noting at this point that despite all these comments,

Starting point is 00:10:29 not a single dollar of taxpayer money has been used to address the collapse of Silvergate so far. The FHLB loan was repaid in full. No customers have reported being unable to withdraw their deposits, and Silvergate have committed to returning all deposits in full. The most that can really be said about Silvergate being a burden on government resources is that they will likely need to collaborate with the FDIC to shut down in an orderly manner, but that's a role that the regulator is explicitly tasked with performing. Now, of course, there are other questions that surround Silvergate. As someone who was deeply personally affected by the fraud perpetrated at FTX,

Starting point is 00:11:01 I want senators and everyone else asking questions about what Silvergate knew when. I think that allegations around anti-money laundering concerns need to be played out in full. But I also think it's important that there is a thing called due process in this country, where when you face those sort of allegations, you are investigated, thoroughly and by the appropriate authorities. That's quite different than having your business detonated by senators who are looking to score media points and perpetuate their broader narrative. Ram Alawalia, the CEO of Lumidia wealth, pointed out the issue with Senator Warren injecting herself into the regulatory process. He wrote, Silvergate, the first crypto bank, faced a bankron that led to its downfall.

Starting point is 00:11:37 Despite facing allegations around AML, it was not these issues that ultimately caused the demise of Silvergate. The responsibility for bank supervision lies with the executive branch, but this process was cut short. A senator's letter, amplified by social media, undermined public trust in Silvergate, ultimately leading to a crisis of confidence. It is important to uphold the principle of due process. Silvergate was denied due process. The senator's allegations should not be used to justify the destruction of a Federal Reserve banking member in a 120-character Twitter thread.

Starting point is 00:12:06 Masari founder Ryan Selkis wrote yesterday, It's market manipulation when you're a hedge fund working with short sellers to defame and destroy a company. It's not market manipulation when you're a sitting senator doing that. ZeroX makes he writes, Reminder that Elizabeth Warren politicized the FDIC and FHLB and lobbied to remove Silvergate's access to FHLB loans. This required them to sell their securities portfolio at a loss and triggered a bank run,

Starting point is 00:12:29 undermine the financial stability purpose of FHLB and set a dangerous precedent. In another tweet, he put it in clearer terms. Rugging FHLB access caused a bank run. This playbook can now be used to target banks servicing sectors and regions you care about in a different administration. So let's bring this back to our original question. Was the collapse of Silvergate, one, the inevitable byproduct of crypto-riskiness? Two, the byproduct of specific decisions that Silvergate made.

Starting point is 00:12:55 Or three, the byproduct of a bank run caused by bloodthirsty senators. Well, on Crypto Riskius, I think we have to shift our framework a little bit. If the question is, are there things that make the crypto industry susceptible to bank runs? The answer is yes. Because people interface with so much of crypto through centralized exchanges, those institutions become nexus for problems when the industry goes through turmoil. However, it's worth noting that you'll see that I specifically said centralized exchanges and what I really mean is custodial exchanges. In other words, it's not the non-custodial

Starting point is 00:13:22 self-hosted wallet side of crypto, the core of crypto, in fact, that has these bankrun concerns. It's the centralized institutions that many use to interface with it. Second, even when it comes to these custodial exchanges, if we take, for example, the case of FTX, there were theoretically safeguards in place, namely the contractual promise that all customer assets were held in reserve. That turned out to be a lie. In fact, it was the rotten lie at the the core of Sam's rotten empire. But to be clear, that was fraud. Fraud that Sam is soon to be on trial for and faces up to 165 years in prison for committing. And the point of all of this is that this isn't a problem of quote-unquote crypto. It's a question of what rules and regulations there should be

Starting point is 00:14:02 around safeguarding customer assets when they're on custodial platforms. In no world is that a crypto-only problem, but for what it's worth, it is a discussion that we should be having about what the right rules for crypto are here. Coinbase CEO Brian Armstrong said on odd lots the other day, I do think there's a moment in the wake of FTX where, you know, reasonably so, bank regulators are asking tough questions and they're basically coming in and saying, what are the liquidity risks if you're going to take crypto deposits? Is it okay to be making loans against those deposits, or are they too risky? And I think those are totally fair questions to ask.

Starting point is 00:14:33 Now, the irony is that alternative approaches to this are exactly like what someone like Caitlin Long and her bank custodia have been proposing. Custodia is literally proposing to be a full reserve bank, but have been denied access to the Fed system because their connection to crypto makes their business model, quote-unquote, too exotic. And this also sort of gets us to our second possible explanation, that this was the byproduct of specific decisions Silvergate made. It was in the sense that there was some amount of duration and especially interest rate risk on the asset side of their balance sheet. I'm genuinely sympathetic

Starting point is 00:15:02 to the argument that given how much of Silvergate's business was tied up in crypto, it might have made sense to take a totally different approach to managing their balance sheet and erring on the side of extreme caution. But I also think it's pretty hard to look at what they were investing in and say that it's some sort of Celsius-style gambling apparatus. It was pretty in line with other fractional reserve banks. So yes, part of Silvergate's downfall was caused by the decisions that they made, but it's also worth noting that those decisions were firmly in line with the type of decisions well-functioning banks make day in and day out. Still, there is a different part of crypto-riskiness in the case of Silvergate that we need to address, and that's concentration risk. Part of why Silvergate

Starting point is 00:15:38 was so susceptible to this bank run was that such a huge part of their deposit base was in crypto. But it's hard to look at that and not see it as a combination of, one, a normal capitalist process, and two, a massive market dislocation caused by unrelenting political pressure against illegal and legitimate industry. Here's how Austin Campbell described Silvergate getting into the crypto business. For those who don't know, Silvergate was one of the banks that was an early supporter of the crypto industry. And by a supporter, I mean merely a bank that did not aggressively turn away crypto clients

Starting point is 00:16:05 and was instead willing to at least consider working with them. Considering that most of the banking industry has reacted to crypto about the same way someone would react to a person running up and sh-hking on their porch, this was actually quite remarkable and forward-thinking on the part of Silvergate. End quote. Now, when Silvergate started working with crypto companies when others wouldn't, other crypto companies naturally came flooding in, making the business extremely successful but also highly concentrated. And that concentrated part is the market dislocation. If other banks had been willing to take on crypto companies, fully legal and legitimate companies, the normal forces of competition might have made it such that

Starting point is 00:16:37 instead of a small handful of banks with huge concentrations of their deposits from a single industry. You might have had a dozen or two dozen banks with a much more reasonable percentage of their deposits coming from the crypto space, which would have meant that each one of them was in turn less subject to the concentration risk that made such a huge portion of Silvergate's deposits flow out all at once. Now, for the sake of completeness, we can't say this for sure as it's obviously a counterfactual. It is possible that something like Silvergate's real-time settlement network, Sen, might have created such strong network effects that still a huge part of the industry would have banked with them, and they'd be in this situation anyway. But it's pretty

Starting point is 00:17:10 undeniable to me that only having a few banks willing to bank crypto led to part of the problems here. And so it's worth asking why only a few banks were willing to bank crypto. And that, my friends, brings us back to the third possible explanation, that Silvergate was killed by overzealous politicians. On the one hand, it's clear that politics weren't the only thing at play. There was a genuine proxy bank run following FDX. There's just no denying that. What's more, even if Silvergate's asset purchases were totally in line with a conventional bank, I think they can be critiqued for not recognizing that when 90% of your deposits are from crypto companies, you shouldn't count yourself and operate as a conventional bank. And yet, there's sort of no denying that the unbelievable

Starting point is 00:17:48 political pressure put on Silvergate by senators, combined, I will note, with an aggressive media campaign from short sellers, pushed them over the edge from weathering a really difficult storm to actually just being dead. And to the extent we discovered that the FHLB decided to call their loan in such a draconian manner, as Francis Coppola put it, because of political pressure. It seems fairly clear that Silvergate's blood is at least partially on those politicians' hands. But then again, this is sort of exactly what that particular set of politicians want. Scott Melko writes, Silvergate's collapse is exactly the ammo the government needs to try to cut the crypto industry off from the banking system. And that, my friends, is where we are. It is a bloody, brutal mess and one

Starting point is 00:18:27 that we are going to be cleaning up from for some time. I think for now, one of the most important things is to not allow easy narratives of this just being some inevitable byproduct of crypto take hold. So the battle continues. As always, I appreciate you guys listening. And until tomorrow, be safe and take care of each other. Peace.

The Breakdown - The Real Reasons Silvergate Collapsed

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