Bloomberg: What is the reason for Silvergate's collapse?

Original author: Matt Levine, Bloomberg

Original title: Silvergate Had a Crypto Bank Run

Original compilation: Leo, BlockBeats

Recently, Silvergate Bank's holding company, Silvergate Capital Corporation, announced that it would delay the submission of its annual 10-K report for the fiscal year 2022. Silvergate stated, "The company is currently analyzing certain regulatory inquiries and investigations related to the company." Subsequently, numerous crypto companies and trading platforms, including Coinbase, Circle, Tether, and Galaxy Digital, distanced themselves from Silvergate; meanwhile, in the capital markets, Silvergate's stock plummeted last night. Bloomberg crypto reporter Matt Levine wrote an article analyzing the reasons behind Silvergate's "bank run":

Silvergate's Close Ties to Crypto

The basic way to buy cryptocurrency is through dollars; you sell cryptocurrency using dollars, but are there other channels? The main point is that if you are bullish on BTC, you will spend some dollars to buy a portion of BTC, and as it rises (or falls), you will sell it for dollars.

If you are very fond of cryptocurrency, or if you are an institutional crypto trader, you may find yourself feeling quite helpless regarding the flow of dollars. Cryptocurrency trading globally is 24/7, and you can automatically send crypto assets using smart contracts; sending crypto assets is usually a permissionless and lightly regulated activity. However, if you want to buy cryptocurrency with dollars, you need to use the dollar financial system, which may make crypto natives uncomfortable. You might need to transfer through a bank, but banks do not operate around the clock, and if you try to transfer funds through a bank account to buy cryptocurrency, some banks may ask you annoying questions.

Solutions do exist. One solution is to deposit your dollars into a trusted large crypto exchange and then use the dollars in your exchange account to buy and sell cryptocurrency. The exchange holds a large amount of dollars and crypto for its customers. When you buy cryptocurrency, the exchange deducts some dollars from your account and adds some crypto to your account; when selling, the opposite occurs. This solution has problems, the biggest being that sometimes large, trusted crypto exchanges are not so trustworthy; they may lose or steal your assets. Another issue is that when you deposit dollars into the exchange, the exchange needs to store those assets somewhere, and it has to keep customers' dollars in some crypto-friendly banks to return them when needed.

Another solution is stablecoins: you do not need to deposit dollars in a bank, but instead convert them into cryptocurrency by purchasing dollar-pegged stablecoins, which usually value at 1 dollar, allowing you to buy and sell cryptocurrency with dollar-valued stablecoins. However, in this case, you also have to trust the stablecoin issuer, which is not a stable-friendly approach (for example, there are risks associated with stability), and the stablecoin issuer needs to keep the money somewhere, thus again requiring a crypto-friendly bank.

Another solution is bank fraud; do not do this.

In summary, the industry needs a crypto-friendly bank, and for large U.S. crypto exchanges and traders, this bank is often Silvergate Capital Corp.'s Silvergate Bank—a bank very friendly to crypto, accepting deposits from crypto exchanges and traders and establishing its own crypto settlement payment network for cryptocurrency settlements. Through the "payment network," if both you and I have accounts at Silvergate, and I want to buy some BTC from you with dollars, we can complete the dollar portion of the transaction through Silvergate's payment network by deducting dollars from my account and adding them to yours. Here is Silvergate's description of its exchange network, SEN (Silvergate Exchange Network):

We designed SEN as a network for cryptocurrency trading platforms and investors, enabling dollars to flow efficiently among SEN participants 24/7. In this regard, SEN can be considered the first crypto infrastructure solution.

The core function of SEN is to allow participants to transfer dollars from their SEN accounts to another participant's SEN account and to view the funds transferred from their SEN trading counterparties. SEN establishes counterparty relationships between parties involved in cryptocurrency trading to facilitate dollar transfers associated with such transactions.

Compared to traditional bank electronic funds transfers (such as wire transfers and ACH transactions), SEN transfers occur almost instantaneously, while the former may take hours to days. Our proprietary cloud-based API, combined with our online banking tools, allows customers to effectively control their fiat currency, trade via SEN, and automatically interact with our technology platform.

This method of transferring dollars through bank transfers is very popular among crypto investors: it is 24/7, cloud-based API, and under the umbrella of crypto exchanges, etc.

Silvergate's Business Model

Thus, Silvergate's characteristics attract a large amount of crypto assets. If you are a crypto exchange or trading company, you will find it very appealing to deposit money in Silvergate because they are friendly to you, like cryptocurrency, which many other banks are not; they can wire money to your crypto counterpart at 2 a.m. on a Saturday, which many other banks cannot do; they are a real bank, regulated by U.S. banking regulators, with publicly audited financial statements and capital regulation to prevent your funds from being lost, which is certainly not the case for many crypto exchanges and stablecoin issuers.

This presents Silvergate with a very simple "narrow banking" business model:

• Attracting a large amount of deposits from crypto exchanges and investors who genuinely need a friendly bank and do not pay interest.

• Investing those deposits in very safe assets, U.S. Treasuries and Federal Reserve reserves, because you have cheap deposit funding and can earn substantial returns without taking on much risk.

In reality, everyone takes a bit more risk than this. From the asset side of the balance sheet, the obvious risk Silvergate has to bear is the temptation to lend against crypto collateral: its clients (crypto traders and exchanges) hold large amounts of BTC, and they may want to borrow dollars at high interest rates. Silvergate has a large amount of dollars (from its clients), which is a natural fit. Is Silvergate doing this?

Our SEN leverage product allows our crypto clients to borrow dollars directly from the bank to provide liquidity, supporting BTC trading activities using BTC as collateral for these loans, which we call SEN leverage direct lending. In the SEN leverage direct lending structure, crypto service providers hold the borrower's BTC as custodians, and the bank uses SEN to deposit the loan directly into the borrower's account on the trading platform; additionally, the bank also provides BTC-collateralized loans to crypto industry companies for corporate funding and other business needs, which we call SEN leverage indirect lending. In the indirect lending structure, lenders use BTC to collateralize loans to the bank, and loan financing and collateral liquidation may occur through SEN or may not.

As of the end of 2022, the total amount committed to SEN leverage was $1.1 billion, of which about $300 million appears to have been drawn. Silvergate stated in January: "All of our SEN leverage loans continue to perform as expected, with no losses or forced liquidations."

For Silvergate, a more mundane risk is the old interest rate risk. Silvergate can purchase other relatively safe assets, such as Treasury bills, U.S. agency securities, mortgage-backed securities, and municipal bonds, to earn higher yields instead of keeping customers' money in the Federal Reserve or Treasury bills maturing within a month. This seems to be the main risk of Silvergate's existence. As of September 30, 2022, the company's balance sheet showed about $11.4 billion in "securities," i.e., bonds: municipal bonds, mortgage-backed securities, agency and Treasury bonds. Meanwhile, there were about $1.4 billion in "loans," which included $300 million in BTC loans plus some real estate loans.

The Crypto Woes Faced by Silvergate

Some bad things happened in the fourth quarter of 2022, as Bloomberg's Max Reyes reported:

For months, U.S. authorities have been tightening the links between banks and high-risk crypto firms, fearing that the financial system could one day suffer severe losses. They were late to the game.

Silvergate Capital Corp. stated on Wednesday that it needed more time to assess the extent of the damage caused by last year's crypto winter to its finances, including whether it could continue to survive. On Thursday, the stock plummeted about 30% in pre-market trading.

Silvergate reported a fourth-quarter loss of $1 billion and indicated that this figure could be higher. The company is still calculating the costs of rapidly selling assets to repay advances from the Federal Home Loan Bank system, and it may also need to write down the value of some remaining assets.

Based in La Jolla, California, Silvergate wrote in a regulatory filing that this could lead to "capital insufficiency." "The company is assessing the impact of these subsequent events on its ability to continue as a going concern."

This comes from the filing, and the issues are:

• Silvergate holds a large amount of crypto deposits: as of the end of September, there were $13.2 billion in deposits, most of which were non-interest-bearing deposits.

• Then, the crypto crash occurred, and cryptocurrency investors withdrew their money from exchanges, which in turn withdrew money from Silvergate. By the end of December, non-interest-bearing deposits had dropped from $12 billion to $3.9 billion.

• Silvergate needed to come up with about $8 billion in cash to cover these withdrawals.

Silvergate obtained part of the cash by borrowing $4.3 billion from the Federal Home Loan Bank of San Francisco, a government-chartered institution primarily engaged in providing short-term secured loans to banks in need of cash. In late 2022 and early 2023, the banks borrowing from the FHLB were primarily crypto banks, and their borrowing raised controversy.

Silvergate obtained the remaining funds by selling a series of bond portfolios: at the end of September, it had $11.4 billion in bonds, of which $8.3 billion were "available for sale" (an accounting term meaning Silvergate must mark them to fair value on its books), and the other bonds were "held to maturity" (meaning Silvergate can mark them at cost without worrying about changes in market value). By the end of December, the company had only $5.7 billion in bonds, all available for sale; the rest had been sold.

This raised issues because the value of these bonds was below what Silvergate had paid for them, primarily due to the significant rise in interest rates in 2022, meaning Silvergate incurred losses on the sales:

To adapt to persistently low deposit levels and maintain a highly liquid balance sheet, Silvergate sold $5.2 billion in bonds for cash proceeds in the fourth quarter of 2022, which also led to a securities sale loss of $751.4 million in the fourth quarter of 2022.

This means Silvergate had to recognize losses on the bonds it held because it had been treating some of those bonds as held to maturity (no need to recognize losses), and now the company had to account for them as available-for-sale assets: "Additionally, the company recorded an impairment charge of $134.5 million, expecting to sell $1.7 billion in securities in the first quarter of 2023 to reduce borrowings."

BTC loans remained healthy, but that was not the point. The result was a net loss of $1.05 billion for Silvergate in the fourth quarter.

A core feature of bank regulation is capital requirements. If you are a bank, you deposit $100 and issue $100 in loans, and if one of those loans defaults, you can only recover $98, then you do not have enough money to repay all depositors, which is very bad. What regulators do is require a bank that issues $100 in loans to fund those loans with no more than $92 in deposits, and the other $8 must come from the bank's shareholders. Then if some loans default and the bank can only recover $98, it can repay all $92 in deposits, and only the shareholders lose money.

Capital requirements are mostly "risk-based": for every $100 of "risk-weighted assets," about $8 of capital must be held, with different assets having different risk weights. A bank that provides a large number of reasonable mortgages and commercial loans may need $8 of capital for every $100 in loans, while a bank holding a large amount of BTC may need $100 of capital for every $100 of assets. Very safe assets—such as U.S. Treasuries—have a risk weight of zero: they are very safe, and regulators are not concerned about you losing money on Treasuries.

However, this rule has a support called the "leverage ratio." Essentially, regardless of the risk weights of these assets, a bank must have at least $5 of capital for every $100 of assets to be considered "well-capitalized." If you are a small bank with only $95 of deposits in U.S. Treasuries, you still need to put in your own $5.

Silvergate's Asset Situation

With BTC loans, Silvergate's assets are still very safe: they are primarily composed of highly rated bonds that are likely to be fully repaid. As of September, Silvergate's situation was:

$15.5 billion in assets;

$14.1 billion in liabilities;

$1.3 billion in shareholder equity (about 8.6% of assets);

Regulatory leverage ratio of 10.7%;

Total risk capital ratio of 45.5%, as a large portion of its assets have a risk weight of zero.

A 45.5% capital ratio looks very safe, and a 10.7% leverage ratio looks decent. But then, Silvergate lost a large amount of deposits and had to sell assets, resulting in a net loss of $1 billion. What remains is:

$11.4 billion in assets;

$10.8 billion in liabilities;

$571.8 million in shareholder equity (about 5.0% of assets);

Regulatory leverage ratio of about 5.1%;

Total risk capital ratio of 57%.

A 57% capital ratio looks very safe. A 5.1% leverage ratio seems slightly above the regulatory requirement of "well-capitalized" at 5%, but if Silvergate were to incur an additional loss of $19 million, this number would fall below 5%.

From Silvergate's filings yesterday:

After December 31, 2022, several events occurred that would negatively impact the timing of the previously reported earnings and the unaudited results, including the sale of additional investment securities beyond previous expectations and those disclosed in the earnings release, primarily to fully repay the company's outstanding advances from the Federal Home Loan Bank of San Francisco. The company sold additional debt securities in January and February 2023, which are expected to be recorded as temporary impairments in the securities portfolio outside of other losses. These additional losses will negatively impact Silvergate Bank's regulatory capital ratios and may lead to capital insufficiency for the company and the bank. Additionally, the company is assessing the impact of these subsequent events on its ability to continue as a going concern within twelve months of the release of its financial statements. Given the current business and regulatory challenges, the company is currently reevaluating its business and strategy.

Silvergate had to sell more bonds to repay the Federal Home Loan Bank loans, thus incurring more losses, so these are closely related, but its current leverage ratio seems to be below 5%, thus "well-capitalized." Technically, it is not yet "the end of the world"; if this number is above 4%, Silvergate will still be "well-capitalized," but that is not good; it points in the wrong direction.

If you have a bank, you do not want to head in the wrong direction.

Investors and business partners are withdrawing, with stock prices dropping by as much as 55%, while Coinbase Global Inc., Galaxy Digital Holdings Ltd., Paxos Trust Co., and other crypto companies have decided to stop accepting or initiating payments through Silvergate, and the outflow of funds may threaten the bank's primary source of deposits and the platform for inter-transfers among crypto participants.

Coinbase stated on social media: "In light of recent developments, and out of an abundance of caution, Coinbase will no longer accept or initiate payments to Silvergate, and Coinbase will facilitate cash transactions for institutional clients with other banking partners."

Over the past year, we have talked a lot about the topic of bank collapses related to crypto. Typically, when a crypto-related bank fails, executives will say it is a "bank run": it has valuable assets, but customers suddenly want their money back, so it has to sell those assets, and thus they lose value, so it does not have enough money to repay all customers. I have always been skeptical of these claims because, overall, these valuable assets are like "magic beans" invented by the crypto-related banks themselves. The assets of crypto-related banks—such as Terra, FTX, Celsius, etc.—are mostly based on confidence in the shadow banking system itself, and when that confidence disappears, those assets vanish as well.

The Spread from Traditional Finance to Crypto

At the same time, in the regulated U.S. banking sector, the idea of a "run" is somewhat odd. Bank runs happen in the movie "It’s a Wonderful Life," but in the real world of large U.S. banks, this particular situation—where you hear some bad news about your deposit bank, you rush to withdraw your funds, and the bank has to sell assets to obtain cash, ultimately becoming insolvent—is quite strange. In modern U.S. banking, there is deposit insurance to reassure small depositors. There are some programs—the Federal Home Loan Bank, the Federal Reserve discount window—designed to ensure that solvent banks can obtain cash to pay depositors. There are also capital and prudential regulations aimed at ensuring bank solvency.

But Silvergate is experiencing a real run! It has incurred losses, not because of making foolish BTC loans—BTC loans are fine—but because of normal banking operations, borrowing short and lending long (absorbing deposits from crypto companies, purchasing U.S. Treasuries and municipal bonds). Silvergate's assets are normal assets; if depositors leave their money in Silvergate, its bonds will mature, providing enough cash to repay. Instead, depositors suddenly demanded their money back, and Silvergate had to sell its long-term assets at significant losses to repay.

Today's story is that Silvergate's customers are withdrawing funds because they are worried about Silvergate, "in light of recent developments, out of caution," which is typical bank run behavior, but that is not why they withdrew their funds at the end of 2022 (when the trouble began). They withdrew their money because cryptocurrency had collapsed: Silvergate's crypto exchange clients faced customer withdrawals, so they took money out of Silvergate. The problem lies with the customers—the crypto exchanges—not Silvergate.

Just last week, U.S. regulators warned banks:

The Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (collectively referred to as the agencies) issued a statement regarding the liquidity risks posed by certain funding sources of crypto asset-related entities and some effective practices for managing such risks:

Crypto asset-related entities provide deposits for the benefit of customers (ultimate clients) of crypto asset-related entities. The stability of such deposits may be driven by the behavior of ultimate clients or dynamics in the crypto asset industry, not solely by the crypto asset-related entities themselves, which are the direct counterparties of banks. The stability of deposits may be affected by factors such as periods of stress, market volatility, and vulnerabilities related to the crypto asset sector, which may or may not be unique to crypto asset-related entities. When ultimate clients react to market events, media reports, and uncertainties related to the crypto asset industry, such deposits are susceptible to large and rapid inflows and outflows. This uncertainty and the resulting volatility of deposits may be exacerbated by inaccurate or misleading statements by crypto asset-related entities regarding deposit insurance, which can confuse ultimate clients.

As if they knew it would be this way, regulators did not explicitly state, "Therefore, do not let banks engage in crypto trading"; in fact, they did the opposite: "Where permitted by law or regulation, neither prohibiting nor discouraging banking organizations from providing banking services to any specific class or type of customer."

I believe this is the spread from the crypto collapse to the real financial system: a regulated U.S. bank is worried about "its ability to continue as a going concern," and it is selling U.S. Treasuries, municipal bonds, and mortgage-backed securities to repay debts. This is a small-scale spread: that bank is equivalent to a crypto bank (I do not think), for example, because Silvergate had to sell billions of dollars in bonds, your mortgage rates will rise significantly. But this is certainly the kind of spread that regulators want to prevent, and now they have clear evidence that the spread is real.