Original author: Matt Levine, Bloomberg
Original title: Silvergate Had a Crypto Bank Run
Original translation: Leo, BlockBeats
Recently, Silvergate Capital Corporation, the holding company of crypto-friendly bank Silvergate Bank, announced that it would postpone the submission of its annual 10-K report for fiscal year 2022. Silvergate said, "The company is currently analyzing certain regulatory inquiries and investigations related to the company." Subsequently, many crypto companies and crypto trading platforms in the crypto market, including Coinbase, Circle, Tether, and Galaxy Digital, have distanced themselves from it; and in the capital market, Silvergate's US stocks plummeted last night. Matt Levine, a crypto reporter for Bloomberg, wrote an article about Silvergate's "bank run" and analyzed the reasons:
Silvergate’s Close Ties to Crypto
The basic way to buy crypto is through USD, and you sell crypto using USD, and there are other ways too? But the main thing is that if you are bullish on BTC, you spend some USD to buy a portion of BTC, and as it goes up (or down), you sell it for USD.
If you are very into cryptocurrencies, or if you are an institutional crypto trader, you do this regularly, and you may find yourself frustrated with the flow of dollars. Cryptocurrencies are traded 24/7 around the world, and you can use smart contracts to automatically send crypto assets, which is generally a permissionless and lightly regulated activity. But if you want to buy cryptocurrencies with dollars, you need to use the US dollar financial system, which may make crypto natives uncomfortable. You may need to transfer money through a bank, but banks are not open 24/7, and if you try to buy cryptocurrencies through bank account transfers, some of these banks may ask you questions that are annoying.
Solutions certainly exist, one solution is to deposit your USD into a large, trusted crypto exchange and then use the USD in your exchange account to buy and sell cryptocurrencies, exchanges hold large amounts of USD and cryptocurrencies for their customers. When you buy cryptocurrencies, the exchange deducts some USD from your account and adds some cryptocurrencies to your account; when you sell, it does the opposite. There are problems with this solution, the biggest one being that sometimes large, trusted crypto exchanges aren’t like that and they lose or steal your assets, but another problem is that when you deposit USD into an exchange, the exchange has to keep the assets somewhere, it needs to keep its customers’ USD in some crypto-friendly bank to be returned when needed.
Another solution is stablecoins: you don’t need to deposit dollars in a bank, but convert them into cryptocurrencies by buying stablecoins pegged to the US dollar, which are usually worth $1, and then you can buy and sell cryptocurrencies using stablecoins denominated in US dollars. But when taking this approach, you also have to trust the stablecoin issuer, which is not a stablecoin-friendly approach (for example, there are risks in calculating stability), and the stablecoin issuer needs to put the money somewhere, so here again, a crypto-friendly bank is needed.
Yet another solution is bank fraud, don't do it.
In summary, the industry needs a crypto-friendly bank, and for large U.S. crypto trading platforms and traders, this bank is usually Silvergate Bank, which is controlled by Silvergate Capital Corp. - a very crypto-friendly bank that not only accepts deposits from crypto trading platforms and traders, but also has established its own crypto settlement payment network for cryptocurrency settlement. Through the "payment network", if you and I both have an account at Silvergate, and I want to buy some BTC from you with US dollars, we can complete the US dollar part of the transaction through Silvergate's payment network, deducting US dollars from my account and adding it to your account. The following is Silvergate's description of its exchange network SEN (Silvergate Exchange Network):
We designed SEN as a network for cryptocurrency exchanges and investors, enabling USD to flow efficiently between SEN participants around the clock. In this respect, SEN can be said to be the first crypto infrastructure solution.
The core functionality of SEN is to allow participants to transfer USD from their SEN account to the SEN account of another participant who is their counterparty, and to view the transfer of funds received from their SEN counterparty. The counterparty relationship between the parties to a cryptocurrency transaction is established on SEN to facilitate the transfer of USD associated with such transactions.
SEN transfers occur almost instantly, compared to traditional bank electronic funds transfers such as wire transfers and ACH transactions, which can take hours to days. Our proprietary cloud-based API, combined with our online banking tools, allows customers to efficiently control their fiat currency, transact through SEN, and automatically interact with our technology platform.
This method of transferring dollars via a bank is very popular with crypto investors: it’s 24/7, cloud-based API, and is affiliated with a crypto exchange platform, etc.
Silvergate's business model
Therefore, this feature of Silvergate attracts a lot of crypto assets. If you are a crypto trading platform or a crypto trading company, you will find it attractive to deposit your money with Silvergate because, they are friendly to you and like cryptocurrencies, which is not the case with many other banks; they can transfer funds to your crypto trading counterparties at 2 am on Saturday, which many other banks cannot do; they are a real bank, regulated by US banking regulators, and have public audited financial statements and capital supervision to prevent the loss of your funds, which is definitely not the case for many crypto trading platforms and stablecoin issuers.
This suggests a very simple “narrow bank” business model for Silvergate:
- Attracted a lot of deposits from crypto trading platforms and investors who really needed a friendly bank and didn’t pay interest.
- Invest your deposits in very safe assets, US Treasuries and Federal Reserve reserves, because you have cheap deposit funds and can earn good returns without taking much risk.
In reality, everyone takes a little more risk than that, and the obvious risk that Silvergate takes on from the asset side of the balance sheet is the temptation to lend against crypto: its customers (crypto traders and exchanges) have a lot of BTC, and they might want to borrow USD but have to pay high interest rates, and Silvergate has a lot of USD (from its customers), so it's just a natural fit. Is this what Silvergate does:
Our SEN leveraged product enables our crypto clients to borrow USD directly from the bank to provide liquidity to support BTC trading activities using BTC as collateral for these loans, which we call SEN leveraged direct lending. In the SEN leveraged direct lending structure, the cryptocurrency service provider acts as a custodian to hold the borrower's BTC, and the bank uses SEN to deposit the loan directly into the borrower's account on the trading platform; in addition, the bank also provides BTC-collateralized loans to crypto industry companies for corporate funds and other operations, which we call SEN leveraged indirect lending. In the indirect lending structure, the lender uses BTC to collateralize the loan with the bank, and the loan financing and collateral liquidation may or may not be conducted through SEN.
SEN leveraged commitments totaled $1.1 billion at the end of 2022, of which about $300 million appears to have been drawn. “All of our SEN leveraged loans continue to perform as expected, with no losses or forced liquidations,” Silvergate said in January.
A more boring risk for Silvergate is regular old interest rate risk. Instead of parking its customers’ money at the Fed or in a month-long T-bill, Silvergate could buy other relatively safe assets like Treasuries, U.S. agency securities, mortgage-backed securities, municipal bonds to earn higher yields. This seems to be the main risk for Silvergate. As of September 30, 2022, the company’s balance sheet showed about $11.4 billion in “securities,” meaning bonds: municipal bonds, mortgage-backed securities, agency and Treasury bonds. Meanwhile, there were about $1.4 billion in “loans,” or $300 million in BTC loans plus some real estate loans.
Silvergate’s Crypto Tragedy
Something bad happened in the fourth quarter of 2022, as Max Reyes of Bloomberg reported:
For months, U.S. authorities have been stepping up efforts to cut off ties between banks and risky crypto businesses, fearing that the financial system could one day suffer serious losses. They were slow to react.
Silvergate Capital Corp. said Wednesday it needs more time to assess the extent of damage to its finances from last year’s crypto winter, including whether it can survive. Its shares plunged about 30% in premarket trading Thursday.
Silvergate reported a $1 billion loss in the fourth quarter and has said that number could be higher. The company is still calculating the cost of selling assets quickly to repay advances from the Federal Home Loan Bank System, and it may also need to write down the value of some of its remaining assets.
That could result in “insufficient capital,” La Jolla, California-based Silvergate wrote in a regulatory filing. “The company is evaluating the impact of these subsequent events on its ability to continue as a going concern.”
This is from the documentation, the problem is:
-Silvergate holds a large amount of crypto deposits: $13.2 billion in deposits as of the end of September, most of which are non-interest-bearing deposits.
-Then, the crypto crashed, and cryptocurrency investors got their money back from the exchanges, which in turn got their money back from Silvergate. By the end of December, non-interest-bearing deposits had fallen from $12 billion to $3.9 billion.
-Silvergate will need to come up with about $8 billion in cash to pay those withdrawals.
Silvergate obtained some of its cash by borrowing $4.3 billion from the Federal Home Loan Bank of San Francisco, a government-chartered institution that provides short-term secured loans to banks in desperate need of cash. In late 2022 and early 2023, the FHLB was primarily a source of crypto banks, and their borrowings have been controversial.
Silvergate obtained the remaining funds by selling a range of bond portfolios: at the end of September, it had $11.4 billion in bonds, of which $8.3 billion was "available for sale" (an accounting term that means Silvergate must mark it at fair value on its books), and the rest was "held to maturity" (meaning Silver gate can mark it at cost without worrying about changes in market value). As of the end of December, the company had only $5.7 billion in bonds, all of which were available for sale. The rest were sold.
This raises a problem, because the value of these bonds is less than what Silvergate paid for them, essentially because interest rates rose sharply in 2022, meaning Silvergate lost money on the sale:
In order to adapt to continued low deposit levels and maintain a highly liquid balance sheet, Silvergate sold $5.2 billion of bonds as cash proceeds in the fourth quarter of 2022, which also resulted in a loss of $751.4 million on securities sales in the fourth quarter of 2022.
This means that Silvergate must recognize losses on the bonds it holds because it had been holding some of them as held to maturity (without having to recognize losses), and now the company must account for them as available-for-sale assets: "In addition, the company recorded an impairment charge of $134.5 million and expects to sell $1.7 billion of securities in the first quarter of 2023 to reduce borrowings."
BTC lending remains healthy, but that’s 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 and you take $100 in deposits and you make $100 in loans, and one of the loans defaults and you only get $98 back, then you don't have enough money to pay back all the depositors, which is very bad. What the regulators do is require that a bank that makes $100 in loans must fund those loans with a maximum of $92 in deposits, and the other $8 must come from the bank's shareholders. Then if some of the loans default and the bank only gets $98 back, then it can pay back all the $92 in deposits, and only the shareholders are losing money.
Capital requirements are mostly “risk-based”: you must have about $8 of capital for every $100 of “risk-weighted assets,” with different assets having different risk weights. A bank that makes a lot of reasonable mortgages and business loans might need $8 of capital for every $100 of loans, while a bank that holds a lot of BTC might need $100 of capital for every $100 of assets. Very safe assets — like U.S. Treasuries — have a risk weight of zero: they are so safe that regulators don’t worry about you losing money on them.
However, there is a backstop to this rule, called the “leverage ratio.” Basically, a bank needs to have at least $5 of capital for every $100 of assets to be “well capitalized,” regardless of the risk weighting of those assets. If you’re a small bank with only $95 of deposits in U.S. Treasuries, you’ll need to put in $5 of your own money.
Silvergate's assets
Holding BTC loans, Silvergate’s assets are still very safe: they are mainly composed of highly rated bonds and are likely to be repaid in full. As of September, Silvergate’s situation is:
$15.5 billion in assets;
$14.1 billion in liabilities;
$1.3 billion in stockholders’ equity (about 8.6% of assets);
The regulatory leverage ratio is 10.7%;
The total risk-based capital ratio is 45.5% as a large number of its assets have zero risk weights.
A capital ratio of 45.5% looked very safe, and a leverage ratio of 10.7% looked OK. But then Silvergate lost a lot of deposits and had to sell assets, netting a billion dollars. What's left is:
$11.4 billion in assets;
$10.8 billion in liabilities;
$571.8 million in stockholders’ equity (approximately 5.0% of assets);
The regulatory leverage ratio is about 5.1%;
The total risk-based capital ratio is 57%.
A capital ratio of 57% looks very safe. A leverage ratio of 5.1% seems slightly higher than the regulatory requirement of 5% for “adequate capital,” but if Silvergate only loses an additional $19 million, then that number would be less than 5%.
From yesterday's Silvergate filing:
After December 31, 2022, several circumstances occurred that would have a negative impact on the timing of the reporting and unaudited results previously reported in the earnings release, including the sale of additional investment securities beyond those previously expected and disclosed in the earnings release, primarily to repay in full 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 record losses other than temporary impairments on the securities portfolio. These additional losses will have a negative impact on Silvergate Bank’s regulatory capital ratios and could result in the Company and the Bank becoming undercapitalized. In addition, the Company is evaluating the impact of these subsequent events on its ability to continue as a going concern twelve months after the issuance of its financial statements. The Company is currently re-evaluating its business and strategy in light of the current business and regulatory challenges it faces.
Silvergate had to sell more bonds to pay back the FHLB loans, so it incurred more losses, so these are closely related, but it appears to be under 5% leverage now, so "well capitalized." Technically, it's not the "end of the world," if the number was above 4%, Silvergate would still be "well capitalized," but it's not good, it's pointing in the wrong direction.
If you have a bank, you don't want to go in the wrong direction.
Investors and business partners rushed out, sending shares down as much as 55%, while Coinbase Global Inc., Galaxy Digital Holdings Ltd., Paxos Trust Co. and other crypto firms decided to stop accepting or initiating payments through Silvergate, an outflow that could threaten the bank’s main source of deposits and a platform for crypto players to transfer money to one another.
Coinbase said on social media: "In light of recent developments, out of an abundance of caution, Coinbase will no longer accept or initiate payments to Silvergate. Coinbase will facilitate cash transactions for institutional clients with other banking partners."
We’ve talked a lot about crypto banks collapsing over the past year. Usually, when a crypto bank collapses, executives will say it was a “bank run”: it had valuable assets, but customers wanted their money back all at once, so it had to sell off those assets, so they lost value, so it didn’t have enough money to pay back all its customers. I’ve always been skeptical of these claims because, by and large, these valuable assets are like “magic beans” invented by crypto banks themselves. The assets of crypto banks — like Terra, FTX, Celsius, and so on — are mostly confidence in shadow banking itself, and when that confidence disappears, these assets disappear with it.
The spread of traditional finance to crypto
Meanwhile, in the world of actual regulated U.S. banking, the idea of a “run” is a bit quaint. Bank runs happen in the movie It’s a Wonderful Life, but in the real world of big American banks, this particular situation—you hear some bad news about the bank where you have your money, you rush to withdraw your money, the bank has to sell off assets to get money, and ends up insolvent—is bizarre. In modern American banking, there is deposit insurance to reassure small depositors. There are programs—the Federal Home Loan Bank, the Federal Reserve’s discount window—designed to ensure that solvent banks have access to cash to pay depositors. There is also capital and prudential regulation designed to ensure that banks remain solvent.
But Silvergate is experiencing a real run! It has lost money, not from doing stupid BTC loans - BTC loans are great, but from doing normal banking business, borrowing short and lending long (taking deposits from crypto companies, buying US Treasuries and municipal bonds). Silvergate's assets are normal assets, and if depositors had left their money with Silvergate, its bonds would have matured with enough money to pay them back. Instead, depositors demanded their money back all at once, and Silvergate had to sell off its long-term assets at a huge loss to pay them back.
The story today is that Silvergate customers withdrew their money because they were worried about Silvergate, "out of an abundance of caution in light of recent developments," a classic bank run, but that's not why they withdrew their money in late 2022 (when the trouble began). They withdrew their money because cryptocurrencies had crashed: Silvergate's crypto exchange customers were facing withdrawals from customers, so they took their money out of Silvergate. The customers - the crypto exchanges - were the problem, not Silvergate.
Just last week, US regulators warned banks:
The Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (collectively, the Agencies) issued a statement regarding liquidity risks posed by certain sources of funding for crypto-asset-related entities and certain effective practices for managing such risks:
Deposits provided by crypto-asset-related entities for the benefit of the crypto-asset-related entity’s clients (end-clients). The stability of such deposits may be driven by the behavior of end-clients or crypto-asset industry dynamics, rather than solely by the crypto-asset-related entity itself, which is a direct counterparty to the banking organization. The stability of the deposits may be affected, for example, by periods of stress, market volatility, and related vulnerabilities in the crypto-asset sector, which may or may not be unique to the crypto-asset-related entity. Such deposits are susceptible to large and rapid inflows and outflows as end-clients react to market events, media coverage, and uncertainty related to the crypto-asset industry. Such uncertainty and resulting deposit volatility may be exacerbated by confusion among end-clients about inaccurate or misleading statements by crypto-asset-related entities about deposit insurance.
As if they knew this would happen, the regulators did not explicitly say “So, don’t let banks deal in crypto,” in fact, they said the exact opposite: “Banking institutions are neither prohibited nor prevented from providing banking services to any particular class or type of customer, where permitted by law or regulation.”
I think of this as contagion from the crypto crash into the real financial system: a regulated US bank is worried about "its ability to continue as a going concern" and is selling off Treasuries, municipal bonds, and mortgage-backed securities to pay down its debts. This is a small-scale contagion: that bank is the equivalent of a crypto bank (which I don't think), and, say, your mortgage rate goes up dramatically because Silvergate had to sell a few billion dollars of bonds. But this is certainly the kind of contagion that regulators want to prevent, but now they have clear evidence that contagion is real.