California community bank’s bet on crypto pays off

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Silvergate Capital has carved out a niche for cryptocurrency exchanges at a time when digital assets may seem like a risky business for some traditional banks. For now, the bet seems to be paying off.

The $ 12 billion asset bank in La Jolla, Calif., Provides an alternative payment rail to facilitate transactions between institutional investors and crypto exchanges such as Coinbase, Kraken, Gemini and Bitstamp. Silvergate also allows stablecoin issuers to mint their digital currency.

While regulators and even some banks remain skeptical about the security and commercial potential of crypto, Silvergate is perfecting a specialty that other banks have tried to emulate. Stock exchanges and institutional investor firms use the bank’s Silvergate Exchange Network, which allows bitcoin buying and selling at night and on weekends when normal payment rails like the automated clearinghouse and FedWire are disabled.

Silvergate Bank CEO Alan Lane said he converted to the power of cryptocurrencies to disrupt the financial system in a good way.

I’ve been drinking the Kool-Aid when it comes to bitcoin and decentralization and all that, Lane said in an interview. I believe it is a better financial future for our children and grandchildren. … I want to leave them not only a healthy planet, but also a healthy financial system. And I think bitcoin can help with that.

Silvergate’s strong second quarter performance, growing customer base, and selection to issue Diem with the digital currency originally known as Facebooks Libra are signs that community banks are pivoting to cryptocurrency is working.

In the second quarter, the total volume of dollar transfers on the Silvergate Exchange Network increased 44% from the previous quarter to $ 240 billion. This is an increase of 968% from the second quarter of last year.

Silvergates’ digital currency customers grew to 1,224 in the second quarter from 1,104 in the first quarter and 881 in June 2020. Digital currency customer deposits increased by $ 4.3 billion to 11. $ 1 billion as of June 30, 2021, compared to $ 6.8 billion. March 31, 2021. All assets and deposits have experienced strong growth over the past year, largely due to bitcoin related activity.

Analysts said Silvergates’ strong second quarter performance, coupled with the decline in bitcoin’s value, showed the resilience of its business model.

I absolutely believe he is a forerunner and an industry leader in what he is looking for, said Michael Del Grosso, research analyst at Compass Point Research & Trading in Miami.

A few new entrants have tried to follow the lead of what Silvergate has built, including Signature Bank with its Signet blockchain-based digital payment platform, and BankProv with ProvXchange, which allows customers to exchange money. between them in real time without the delays of traditional payment rails.

“But for now, at least in terms of what they’re building for digital currency-focused hedge funds, for exchanges, for stablecoins providers, in terms of the network, Silvergate is the Visa of the space. , said Del Grosso.

Despite the good quarter, the number of facilitated crypto transactions on the bank’s network actually decreased by 17% compared to the first quarter to 137,947. This is still an increase of 242% compared to 40,286 transactions processed in the second quarter of 2020.

Lane says the drop in transactions was caused by the drop in the price of bitcoin in the second half of the quarter, particularly in June. Many institutional clients have sold their positions and switched to cash or moved dollars through the system, he said.

They traded fewer daily, but those trades were larger in dollars, Lane said.

Origins of the ILC

Silvergate Bank opened in 1988 as a state-chartered industrial loan company, supported by the Federal Deposit Insurance Corp.

Lane joined the bank in December 2008, during the financial crisis and just before the first block of bitcoin was mined in January 2009. The bank had $ 280 million in assets and 40 employees.

Prior to joining Silvergate, Lane was President and COO of Southwest Community Bank in San Diego. Prior to that, he was CEO of the Business Bank of California.

I was drawn to Silvergate because of its size, but mostly because it was clean, Lane said. She had no credit quality issues and strong capital ratios for a small bank. So it was a potential platform that we could build on.

Bank branches collected high-rate CDs and money market accounts and made residential and commercial real estate loans.

I was looking for a bank that was already operational but could be shaped and changed, Lane said.

Within three months of joining the bank, Lane converted the Silvergates ILC charter to a commercial bank charter and began hiring staff.

A market that “never sleeps”

In 2013, Lane saw the growing popularity of cryptocurrency and realized that there was an opportunity to create a network that would reduce friction and counterparty risk in cryptocurrency transactions.

The ‘aha’ moment for us several years ago was that there was this friction that existed between the traditional banking system and the digital currency system, as traditional banks only operate 40 hours a week, Monday through Friday. , Lane said. And they depend on the Federal Reserve or Swift payment system in Europe. Yet digital currency markets are traded 24/7, they just never sleep.

The proprietary Silvergate Exchange Network enables institutional investors to buy and sell crypto assets by facilitating transactions between the investor and the crypto exchange. Using SEN, investors and exchanges can transfer US dollars between their accounts in near real time, 24 hours a day, seven days a week. Silvergate maintains a ledger in which these transactions take place.

Today, literally anyone who is anyone in crypto is on the Silvergate Exchange Network, said Joe Vafi, fintech analyst at Canaccord. All the major exchanges, all the institutions, the companies which launch themselves there, are connected via Silvergate.

SEN transactions are free. The bank charges fees for using ACH, wire transfers, and currency exchange. Stablecoin issuers are charged a monthly subscription fee.

“We assume that these are transfers on our platform, basically going from one customer’s account at Silvergate to another customer’s account at Silvergate, and they’re free for us,” said Lane. “And so we pass this zero cost on to our customers.

Silvergate also makes money through a loan product called SEN Leverage, through which institutional investors can borrow against the bitcoin they own.

You can think of it as a margin loan, Lane said. If customers promise us their bitcoin for a loan, we’ll lend them dollars to buy more bitcoin.

Lane recognizes that there is a risk because bitcoin is volatile. However, the bank recorded no losses and no forced liquidations on these loans, which it started offering in January 2020.

He attributes the low loan losses to the low loan-to-value ratio of these loans. The bank monitors loans 24/7, he said.

If someone has $ 1,000 worth of bitcoin, we might only lend them $ 650, Lane said. Thus, the price of bitcoin could drop 35% before a refund or liquidation is necessary. Yet we have a trigger that says if it hits 80% then we’re going to liquidate. So we have built-in protections.

A third way Silvergate makes money is by offering custody of digital assets. Most of the time, customers ask Silvergate to keep their bitcoin because they want to borrow against it.

The bank still has a branch and carries out some traditional banking activities.

This whole digital currency initiative has really overshadowed what we were doing before, Lane said.

Focus on crypto brings new risks

There are unusual risks associated with Silvergate’s unusual business model.

One is the possibility of a mass exodus of crypto institutions, noted Del Grosso.

Silvergate bet the farm, so to speak, on those types of customers, he said. Having said that, I think it’s a strategy that has power.

There is also a regulatory risk. Treasury Secretary Janet Yellen, Federal Reserve Board Chairman Jerome Powell and some members of Congress have all raised the idea of ​​new regulation and supervision of cryptocurrency. President Biden’s financial markets task force plans to issue recommendations for new cryptocurrency regulations.

What I hope is that members of Congress will do the hard work to really understand what bitcoin is and what some of the other use cases are, Lane said.

There is this narrative that it is only used by bad actors, but that is clearly not the case, he said.

Look ahead

Silvergates’ future company plans to start issuing Diem, the digital currency Facebook initially attempted to launch as Libra, by the end of the year.

The fact that Silvergate was chosen to issue Diem shows that all the big players in this industry see Silvergate as a key resource for different parts of their business to cross the finish line, improve it, make it more profitable , to make it more efficient, said Vafi.

With the weight of Facebook and others behind him, Diem could accelerate the growth of Silvergates.

It could also make Silvergate the target of a potential buyer, Del Grosso said.

It would make a lot of sense for a big bank to come and buy Silvergate if it wanted to break into the crypto space and wasn’t already there, Del Grosso said.

Lane recognizes this threat.

If we didn’t see that at least as a possibility, we’d be pretty naïve, he said. The two banks where he previously worked were both sold to bigger banks.

We’re definitely not building Silvergate to sell it to the next bank, he added.

If a large bank or other company made an offer, it would be a strategic and financial decision. Are they potentially offering us more than what we think we can do if we remain independent? It’s the litmus test, Lane said.

For now, Lane would prefer Silvergate to remain independent.

What bitcoin could do for future generations, he said, is to create a much fairer financial system for everyone and not just for the benefit of a few, ”he said.

“A decentralized bitcoin-based financial system could offer a more equitable distribution of wealth and an opportunity for everyone to participate.

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