The Breakdown - What the Silvergate Death Spiral Means for the Crypto Industry

Episode Date: March 3, 2023

  In today's episode, NLW discusses Silvergate Bank's painful collapse. In order to understand the industry's banking resources, he examines where the bank came from, why it became important to the industry and how it faltered. Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW   - “The Breakdown” is written, produced and narrated by Nathaniel Whittemore aka NLW, with editing by Michele Musso and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Foothill Blvd” by Sam Barsh. Image credit: Henrik5000 / Getty Images, modified by CoinDesk.  Join the discussion at discord.gg/VrKRrfKCz8.   Join the most important conversation in crypto and Web3 at Consensus 2023, happening April 26-28 in Austin, Texas. Come and immerse yourself in all that Web3, crypto, blockchain and the metaverse have to offer. Use code BREAKDOWN to get 15% off your pass. Visit consensus.coindesk.com.  

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 CoinDess. What's going on, guys? It is Thursday, March 2nd, and today we are talking about the causes and consequences of the Silvergate Death Spiral. Before we get into that, however, if you are 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. Well, guys, in many ways, the last year has been us waking up each day and asking what part of the sky is falling. In that period, rapidly decreasing prices led to protocol failures, led to credit crunches, led to credit crises, led to institutional failures, led to further credit issues, led to more institutional failures, and so on. Since FTCS failed, one of the key questions has been what other dominoes would follow.

Genesis and DCG have been a key part of that question. Genesis halted withdrawals the week after FTX declared bankruptcy, and parent company DCS, has basically been negotiating with creditors ever since. Now, that story isn't fully done, with a big $575 million dollar DCG loan payment to Genesis technically coming due in May. However, the other big institution that has been under the spotlight is publicly traded bank Silvergate. And today, Silvergate is absolutely the main character.

Yesterday, they delayed their annual report, triggering a big sell-off in aftermarket trading. J.P. Morgan and others cut their rating of the stock. And then this morning, Coinbase jumped off to sinking ship, announcing that they were moving their business to signature. As I write this, Silvergate's stock is down 50% since yesterday, hitting its lowest level since its 2019 IPO. And the bank is quite literally now saying that it's examining its own viability. So today we're going to dig into not only why Silvergate is crashing, but how it got to this point and what its death spiral means for the industry. Let's start at the beginning. Silvergate Bank is a medium-sized crypto-friendly bank based

in California. For most of its 30-year history, Silvergate was a tiny community bank focused on financing smaller real estate deals. It had only three branches and less than $1 billion in bank assets. In 2016, under the leadership of CEO Alan Lane, the bank pivoted to providing banking services to crypto firms. Ben Reynolds, Silvergate's president, who was hired to oversee this change in business strategy said, we needed deposits, and Alan started seeing that companies like Coinbase were getting kicked out of banks. So the idea was, if we can bank Coinbase, we can find deposits. Allen went to the Federal Reserve and said, we want to provide basic banking services to Bitcoin

companies, and they said okay. Over the next six years, Silvergate downsized its existing business banking and real estate teams to lean heavily into crypto. In 2016, the bank had only 20 crypto clients, including Paxos and Bitfury, but this number grew to over 1,000. This rapid expansion and dealing with the early crypto industry came with a large increase in compliance risk and overhead. According to anonymous sources speaking with Financial Times, Silvergate had to hire twice as many compliance staff as comparable banks of its size. Waiting times for compliance checks on new customers ballooned out to six months. One of FTE's sources said, quote, when they got into it, crypto was this little new thing,

and I think they didn't realize it would take off as fast as it did. So then they put all their chips in that direction, it ran away from them. It got very big, very quickly. Now, part of the reason that Silvergate were able to achieve such a prominent position in the crypto ecosystem was the launch of their Silvergate Exchange Network, or Sen, in 2017. Sen enabled crypto firms to immediately transfer U.S. dollars to other account holders at Silvergate 24 hours a day every day of the year. Funds would be cleared near instantly and could be used immediately. While this feature might not have an obvious use case for the average retail trader,

for large crypto funds, this opened up the possibility of conducting arbitrage trades across exchanges at a much faster speed, while also allowing funds held on exchanges to be topped up after hours or on weekends. In short, it was a feature that kind of matched the way that crypto actually traded versus the way the traditional markets traded. Sen saw a huge amount of success, with Silvergate claiming in late 2019 that more than 75% of the total addressable digital asset market held accounts with the bank.

Volumes, as you would expect, exploded in 2021, with Sen clearing more than $150 billion in each quarter that year, coming close to clearing $250 billion in Q2 at the height of the bull run. The volume in Q1 of that year represented an 84% increase from levels at the end of 2020. The growing use of Sen was a paradox. shift for the industry. Exchanges had gone from having difficulty obtaining any banking services

whatsoever to having an instant settlement network available for off-chain funds. In a testimonial that has since been scrubbed from Silvergate's promotional material, Sam Bankman-Fried of FTX said, quote, Life as a crypto firm can be divided up into before Silvergate and after Silvergate. It's hard to overstate how much it revolutionized banking for blockchain companies. Now, it doesn't take a risk management specialist to understand that if a huge part of your business is the crypto industry, then upheavals in that industry could be particularly painful for your business. The recent run of problems at Silvergate indeed started in November following the collapse of FTX. At the time, FTX and associated crypto lending firm BlockFi represented around 10% of Silvergate's

deposits. According to bankruptcy filings, FTX held around 20 different accounts under a range of different company names. What followed was a savage bank run. Concerned about Silvergate's solvency, customers from throughout the crypto industry scrambled to withdraw deposits. When the dust settled, Silvergate had seen an $8.1 billion drawdown in deposits around 70% of the bank's deposit base. Silvergate's reserves were mostly comprised of so-called safe assets, like U.S. government and municipal bonds. Even so, the bank recorded $718 million in losses as they liquidated their reserves, showing a total loss of more than $1 billion in Q4 of last year. Shortly afterwards, details surfaced that Silvergate had tapped into emergency

liquidity via a loan for $4.3 billion from the Federal Home Loan Bank of San Francisco. These sort of loans are relatively standard in the banking industry to prevent the fire sale of safe assets, but the reputational damage was massive. This move was easily portrayed as Silvergate using government-backed money to service withdrawals during the bank run. This is even though the FHLB system is entirely privately funded and has never actually needed to be backed up by government funds in its 90-year history. The issue now appears to be that although Silvergate survived the bank,

bank run, its deposits have not returned. Customers appear to be less than enthusiastic about taking risk with Silvergate. Block Tower CIO, Airy David Paul, said, Everyone was scared. Everyone was primed to fear counterparty risk. It didn't surprise me that you have that massive flight of capital out of Silvergate. Everybody like myself is feeling extra conservative in how we think about risks. Now, continuing to understand what's been going on at Silvergate, although much of the outward criticism has been focused on their handling of the bank run,

more recent concerns about their internal processes and compliance have surfaced. Veteran shortseller Mark Cohodas was loud and early in his airing of a shortcase for Silvergate back in November. He suggested that the banks lax procedures had left them unaware of money laundering and bank fraud conducted by their clients at best, or complicity in the activity at worst. Throughout the last month, Cahotas and other shortsellers have written to notify Silvergate's auditors and accountants of the issues as they see them. On February 6th, shortseller James Gibson wrote to Silvergate's auditor, we write to alert you to the risks that customers of Silvergate have used the entity to engage in substantial money laundering and that management of Silvergate has misrepresented its business operations,

potentially in violation of law and auditing standards. End quote. In the aftermath of the FTX collapse, speculation began to surface that customers had been directed to deposit funds intended for the exchange into bank accounts operated by Alameda Research. Allegations surrounding this conduct were later leveled by the Justice Department, with the recent additional allegation that FTX had opened an account in the name of North Dimension, which was held out to be an electronics company with no connection to FDX or Alameda. The DOJ did not mention the bank which operated these accounts by name. However, Bloomberg

reporting this week cited an anonymous source who said that the bank was Silvergate, while the FTX bankruptcy case listed two accounts held in the name of North Dimension at Silvergate. On top of that, last month, Reuters reported that officers at the International Binance Exchange had accessed bank accounts held at Silvergate by Binance U.S. The reporting stated that former Binance U.S. CEO, Catherine Coley, had questioned the bank account activity and could not get a straight answer. Shortly afterwards, she resigned and has not been publicly heard from since. In total, around $400 million was moved from Binance U.S.

account to a trading firm called Merritt Peak in the first quarter of 2021. In June that year, Silvergate cut off Binance International as a customer, which meant the exchange could no longer perform U.S. dollar wire transfers. When a bipartisan group of senators wrote to demand answers from Silvergate in December, they said, quote, Your bank's involvement in the transfer of FTX customer funds to Alameda reveals what appears to be an egregious failure of your bank's responsibility to monitor for and report suspicious financial activity carried out by its clients.

Now, for their part, Silvergate has maintained innocent surrounding this activity. In response to the letter from U.S. lawmakers, Silvergate said, Like many others, Silvergate was the victim of FTC's in Alameda researches apparent misuse of customer assets and other lapses of judgment, and we believe our full cooperation will help set the record straight about our role in the digital asset ecosystem. So that's where things were coming into this week. But then it got even worse for the already beleaguered bank. Join CoinDesk's Consensus 2023, the most important conversation in crypto and Web 3, happening April 26 through 28th in Austin, Texas. Consensus 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, and more. Use code breakdown to get 15% off your paths. Visit consensus.coindex.com or check the link in the show notes. Former FTX registered broker-dealer Ledger X announced that it would no longer be accepting deposits via send. Then on Wednesday, Silvergate lodged notification with the SEC that it's

annual report, known as a 10K, would be delayed. The report was due that day, but Silvergate had said it would need more than an additional two weeks to complete its report. The filing said that Silvergate needed more time to perform analysis, evaluate internal controls, and review adjustments. Its independent accountants and auditors are requesting more information. Most concerningly, the filing said, quote, the company is currently analyzing certain regulatory and other inquiries and investigations that are pending with respect to the company. Anonymously sourced reporting over the last few months have stated that the bank is facing investigations from the Justice Department and assorted bank regulators. While a bipartisan group of senators have also written to the bank twice,

demanding details on the bank's compliance procedures regarding accounts held by the FTX group companies. 10K filings are required to outline all material risks the company currently faces or may face in the future. And the notification of delay in filings gives a brief overview of the risks that Silvergate are currently analyzing, including general concerns about the viability of crypto-focused banking given the high-profile bankruptcies throughout the sector, ability to comply with the heightened regulatory scrutiny of banking institutions that provide products and services to the digital asset industry, safety and soundness concerns expressed by the federal banking agencies regarding banks that have a concentrated customer base of crypto firms.

It also explained that the bank had needed to sell additional reserve securities at a loss throughout the last two months, in part to repay an emergency loan taken from the Federal Home Loan Bank of San Francisco late last year. It stated that, quote, these additional losses will negatively impact the regulatory capital ratios of the company and could result in the bank being less than well capitalized. The list of risks culminates in a statement that sent shockwaves through the industry. Quote, the company is evaluating the impact that these subsequent events have on its ability to continue as an ongoing concern.

So what's clear from all of these statements is that Silvergate is considering not just reevaluating its crypto banking business model, but considering whether it's time to shudder entirely. Now, as I mentioned right at the top, the analysts weren't keen on all of this. J.P. Morgan announced that it was downgrading the stock from neutral to underweight and withdrew a $14 price target. Canacore Genuity downgraded the stock from buy to hold and cut its price target from $25 to $9. Still, the even bigger deal was Coinbase vacating its banking relationship with Silvergate. At 8.23 a.m. Eastern time today, they tweeted,

Coinbase all client funds continue to be safe, accessible, and available. In light of recent developments and out of an abundance of caution, Coinbase is no longer accepting or initiating payments to or from Silvergate. Coinbase will be facilitating institutional client cash transactions with our other banking partners and have taken proactive action to ensure that clients experience no impact from this change. Coinbase has de minimis corporate exposure to Silvergate. After that news, Silvergate stock fell to as low as $6.80, its lowest point since its IPO. Todd Baker, a senior fellow at Columbia University's Richmond Center for Business Law and Public Policy said,

it confirms the fears that many regulators have had. If this bank fails, it's going to be held up as an example of why bank. should be extremely conservative in dealing with crypto companies. So, what are we supposed to make of all of this? Well, one position that needs to be represented is that this isn't just a question of crypto failing, but about specific decisions that Silvergate made. Max Boonin, a former Goldman Sachs officer, says,

it seems the losses are so fucking stupid. They bought long-term fixed income, financed by short-term deposits. The deposit base shrinks because much of it is crypto, and then they have to sell their bonds to meet redemptions. Bonds are down across the board due to higher interest rates, so they realize huge losses. This classic screw-up has much to do with the Trad V fiction that bond prices are stable

and little to do with crypto. There also remained questions about what Silvergate knew about Alameda and FTX, which is a set of questions that I expect to be investigated pretty in depth. But still, the most important thing right now is not so much what happens to Silvergate, but what it means for crypto, and friends, it is not good. Adam Cochran writes, Silvergate's death spiral is going to be rough for crypto. I don't think retail investors realize how much marketmaker money moved around quickly via Sen, and how many crypto-execkel exchanges were or are banking with them. Stock almost down to its all-time lows after hours. Who do you think buys the assets and who buys the debt? Whoever buys the debt can decide if they

call the sailor loans. So what Adam is referring to right there is the fact that in late 2020, Silvergate launched a business lending platform catered specifically to crypto firms. The product called Send Leverage was relatively unique in the U.S. banking sector, with Silvergate being the only bank offering U.S. dollar loans collateralized by Bitcoin. Silvergate saw reasonably strong demand for Bitcoin-backed loans initially, growing their Bitcoin-backed loan book to $571 million by the end of 2021. In March of last year, Michael Saylor's Micro Strategy announced that it had taken a $205 million loan from Silvergate, backed by around 20,000 Bitcoin on a three-year term.

At the time, the Bitcoin collateral was worth around $820 million, but its value is now slashed in half. Micro Strategies loan helped boost the outstanding Bitcoin-backed loanbook to more than $1 billion in Q1 of 2022. Now, coming back to Adams' comments, Brad Michelson formerly of Yatoro wrote, All major exchanges have been working on transition plans away from Silvergate for months, not far away from hearing some make statements about it. Adam responded to that, sure, but there isn't a replacement send network, and it's not going to be major banks, so it's still a pain point.

As if to put a fine point on all of this, even as it was happening, Cracken announced yesterday that it was pulling back from signature, the exact bank that Coinbase left Silvergate for. From Bloomberg, quote, non-corporate clients won't be able to make dollar deposits or withdrawals using signature, according to an email reviewed by Bloomberg that was sent to customers on Wednesday. The deposits will be phased out on March 15th, while the withdrawals will end March 31st. End quote.

This, of course, comes in response to news from Signature in early February that it wouldn't support any of its crypto exchange customers buying and selling in increments of less than $100,000, which itself followed a December announcement from Signature that they would be significantly reducing their exposure to crypto. So let me try to sum up the real situation that faces the industry. And let's do it in historical terms. First was the period during which U.S. banks didn't want to deal with crypto. Then a few stepped up and decided they were willing to take on those risks.

Those firms reaped the rewards on the way up, based both on number go up, but also, and even more importantly, the fact that they were the only game in town. Is it any wonder that so much business raced in given that there were so few banks who were willing to work with crypto companies? Now, in that context, decisions were then made or not made about risk management, and I do think that it's reasonable and important to dissect those specific decisions. However, what comes after is what always comes after. The number started going down, and there were consequences. In addition to natural market pressures, intense political scrutiny has increased the cost of doing business

with crypto. And in that light, existing partners are either, one, failing, in part due to their own decisions, and in part due to markets recognizing that increased political risk, or two, they are generally decreasing their exposure to the industry, which means that we have come all the way back around to where we started, with U.S. banks not wanting to deal with crypto. This is the most painful round trip of the crypto cycle. This is Operation Chokepoint 2.0 aided and abetted by decisions made by the crypto industry over the last few years. And this is the very, very dangerous scenario we now find ourselves in today. Anyways, guys, I hope that helps you understand what's going on with Silvergate and why it matters.

always I appreciate you listening. Until tomorrow, be safe and take care of each other. Peace.