Here’s hedge fudge manager/university professor Patrick Boyle goes into detail of just how it went down.
“Silvergate’s importance in the recent crypto boom is possibly best described by a now-deleted testimonial from the bank’s website: ‘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.’ The testimonial was written by a millennial who still lives in his parents’ basement playing video games and has had some recent run-ins with the law. His name is Sam Bankman Fried.”
“If we go back ten years, Silvergate was a small San Diego based real estate lender that transformed itself into the go-to bank for the crypto industry.”
“Silvergate invited in crypto entrepreneurs and asked them what problems they were trying to solve and how the bank could be helpful. After this, the bank transformed itself and grew rapidly. It went public in late 2019 at a share price of $13, and a year later the stock price had risen by 1,580% as it became a key interchange point between dollars and cryptocurrencies.”
“Major Silverlake clients included Paxos, bitFlyer, Kraken and also innovators in atonal rock music – Mars Junction…” [This is an inside joke. Mars Junction is the band of Cameron & Tyler Winklevoss, AKA the WInklevoss Twins of Facebook investing controversy] “…who also had some involvement in the Crypto industry. FTX and Alameda were also big customers.”
“The bank’s growth mirrored the growth of the crypto industry, and it declined alongside that industry too, announcing in a regulatory disclosure earlier this week that it plans to wind down operations in the face of ‘turmoil in digital currency markets.'”
Last week Silvergate had announced that they would be unable to file an annual report with the SEC on time due to a weakening in their capital position. They announced that they might be forced to close at that time, blaming growing problems, in part on pending investigations into their operations. The filing confirmed that Silvergate is being investigated by the US Department of Justice.”
“Customers rushed over the last few months to pull money out of Silvergate. In January they reported that customers had withdrawn more than $8 billion, forcing them to sell held-to-maturity assets to fund the run, accruing losses on the sale of those securities of $718 million dollars.”
Why was Silvergate so important in the world of crypto? Well, people who trade cryptocurrencies often want to use dollars to buy crypto, or they want to sell crypto and receive dollars and the dollar side of those transactions is where things get bogged down. If you are transferring large sums of money to buy crypto, you need to deal with the US banking system, who might ask you a lot of questions relating to anti money laundering regulations. Crypto people hate questions like this. Similarly, if you just sold some crypto and want to deposit the dollars you received, most banks will have a long list of questions about the source of your funds, and there is a really good chance that they will simply refuse to do the transaction. It is going to be a struggle for a US regulated financial institution to show their regulator that they have done enough due diligence to be sure that your funds are not the proceeds of crime. And the last thing a bank needs is to be accused of money laundering; they would rather just simply not deal with suspicious transactions.
“For this reason, stablecoins like Tether and Terra exist – or existed.” If you weren’t paying attention, the value of theoretically stable Terra crashed hard last year.
“If you can convert your dollars into crypto once, you can then buy stablecoins that are supposed to always be worth a dollar, and then instead of buying and selling crypto, with actual dollars you buy and sell crypto with dollar-denominated stablecoins, your money can stay ‘on chain.’ The problem with that, is that you have to trust the stablecoin issuers, and they, for some reason, don’t always seem trustworthy. They won’t really tell you where the money is.”
“They’ll sometimes announce that they are going to be audited by a top 12 auditor (I’m not really sure what a top 12 auditor is – but when you hear that – you know you are getting number 12 on the list), and you start to wonder if Friehling & Horowitz made that list.” Friehling & Horowitz were Bernie Madoff’s auditors.
“If you have deposited your dollars with a crypto exchange or a stablecoin provider, they still need to deposit them somewhere. They need a bank too. Now (of course), another way of dealing with this banking issue, might be to lie to your bank about what your account is being used for (SBF and the team at FTX did that), but the technical term for ‘lying to your bank’ is Bank Fraud (as Sam Bankman-Fried just found out) – and you can get in trouble for that.”
“There was significant demand for a “crypto friendly bank” and Silvergate was willing to fill that role, when no other bank was willing to take that risk. Silvergate weren’t just crypto friendly either, they built their own payments network called the Silvergate Exchange Network to (according to their marketing documents) enable the efficient movement of U.S. dollars between participants 24 hours a day, 7 days a week, 365 days a year.”
“As you might imagine, Silvergate (being the only bank that would deal with them) attracted a lot of big crypto customers, as these customers were able to open up accounts without lying too much.”
“Silvergate dealt with most of the big players in the industry and they were an actual US regulated bank with excruciatingly detailed audited financial statements and capital regulation. This meant that your money was safe at Silvergate, unlike at the other venues we just went over.”
“The beauty of dealing with these crypto customers, crypto exchanges, [was] that because you don’t have any real competition in this space, you don’t really have to pay them any interest on their deposits. You could take the billions of dollars they deposit with you, put it all in treasuries, and you get to keep all of the interest. You’ll probably have to spend some of the profits on lawyers to keep the regulators at bay, but overall you might have a profitable business. But that’s boring right? And no one gets involved in crypto for a boring life…”
“They had a product called SEN Leverage direct lending, where they would lend people money collateralized with bitcoin. Exchanges could also borrow dollars collateralized with bitcoin for corporate treasury and other business purposes. In January, they announced that total SEN Leverage commitments were $1.1 billion dollars and that all of their SEN Leverage loans ‘continued to perform as expected, with no losses or forced liquidations.’ So, as crazy as that business might sound, it was not really the source of their problems.”
“As of September, 2022 their balance sheet showed about $11.4 billion of ‘securities,’ meaning bonds: Treasury securities, mortgage-backed securities, agency bonds and so on and $1.4 billion of ‘loans,’ meaning the Bitcoin loans and some other real-estate lending. They had $13.2 billion worth of deposits at the end of September, most of them being from crypto companies – so non-interest paying deposits, the best kind.”
“The problem for Silvergate was that when FTX was exposed as being insolvent, crypto investors were considerably less willing to leave their cash on exchanges.”
“They asked for their money back from the exchanges, meaning that the crypto companies had to ask for their money back from Silvergate, so Silvergate was faced with a good old fashioned bank run – driven not by a loss of faith in Silvergate, but by a loss of faith in crypto exchanges. By the end of December, noninterest bearing deposits at Silvergate fell from $13.2 billion dollars to just $3.9 billion dollars.” Yowzers! It’s hard to expect any bank to survive an outflow of 2/3rds of their deposits in such a short period of time.”
“There is a good chance that if you had an account at a crypto exchange, that exchange banked with Silvergate, and if you closed your account and cashed out, the cash came from a deposit at Silvergate.”
“There were other FTX related problems too. When prosecutors started looking into the collapse of FTX, their attention was drawn to their banker – Silvergate, for hosting accounts connected to Sam Bankman-Fried. Now, a big problem for Silvergate, was that – with their money all tied up in bonds or lent out, Silvergate had to come up with around 9 billion dollars to pay out these withdrawals.”
“Their accounts show that by the end of December they had sold half of their bonds and had controversially borrowed $4.3 billion from the Federal Home Loan Bank of San Francisco, a government institution that is in place to give short-term secured loans to banks that have a short-term liquidity problem.” That, and the FTX connection, attracted the attention of Washington D.C.
In September Silvergate had shown 3.1 billion dollars’ worth of bonds as being “held to maturity” and 8.3 billion dollars’ worth of bonds as being available for sale. The difference between these two classifications (from an accounting perspective) is that the available for sale bonds have to be marked to market – or held on the books at their fair market value, while the “held to maturity” bonds could be marked at their cost price. By the end of December there were no “held to maturity” bonds left on the balance sheet, meaning that they had either been sold, or reclassified as available for sale. One way or another, interest rates had gone up a lot in 2022, and these bonds were worth a lot less than they were being carried on the balance sheet at.
So they might have skated by if rising interest rates hadn’t wrecked their mark-to market.
The sale resulted in a loss of $751.4 million during the fourth quarter of 2022 and in addition, the company recorded a $134.5 million dollar impairment charge related to an estimated $1.7 billion dollars of securities it “expects to sell in the first quarter of 2023 to reduce borrowings.” This is because reclassifying some of the bonds to “available for sale” meant that they now had to be marked to market and that the loss had to be recognized under GAAP accounting rules. Silvergate also had to write down a $196 million dollar investment in “certain developed technology assets related to running a block-chain-based payment network” that it had bought in January 2022. So, all in, there was a net loss of over a billion dollars in the fourth quarter of 2022.
“Bank capital requirements are ‘risk-based’ and need to be kept above 4% to be ‘adequately capitalized’ and above 5% to be considered ‘well capitalized.’ Different types of assets have different risk weights, and this is done to keep deposits safe.”
“A bank that makes a lot of mortgage and business loans might have a capital requirement of around 8%, and assets like bitcoin have a 100% capital requirement, meaning that a bank would need to have $100 of capital for every $100 of bitcoin on its books.”
“In September Silvergate was fine, as despite the Bitcoin loans, most of their money was in high quality bonds that had zero risk weights. But when their deposits went out the door and they had to sell assets and realize a billion-dollar net loss, they were left in a situation where an additional $19 million-dollar loss would but their capital below 5% and they would no longer be considered well capitalized.”
“Last week Silvergate announced that they had sold additional debt securities in January and February to repay the company’s outstanding advances from the Federal Home Loan Bank of San Francisco and that they ‘expect to record further losses related to the other-than-temporary impairment on the securities portfolio.’ These additional losses they said would ‘negatively impact the regulatory capital ratios of the company and could result in the bank being less than well-capitalized.” And that’s when Brunhilda strode on stage to give her farewell.
“This announcement caused the stock price to half that day and according to Bloomberg caused Coinbase, Galaxy, Paxos and other crypto firms to announce that they would stop accepting or initiating payments through Silvergate. These customers leaving were the final nail in the coffin, as they reduced deposits even further.”
“A bank run, on a real bank, caused by crypto related losses and crypto volatility.”
“Matt Levine at Bloomberg argues that one way to think about the rise and fall of Silvergate is that the crypto boom was at its heart a low-interest-rate phenomenon. People started speculating in crypto because interest rates were below the rate of inflation, and so Silvergate was hugely exposed to interest-rate risk simply because of its exposure to its crypto customers.”
“Rising interest rates caused the deposits to evaporate at the same time as the assets backing those deposits fell in value. Levine argues that (with hindsight), Silvergate’s risk management – a year ago – should have been laser-focused on the risk of rising interest rates crushing both its assets and its customers, and it should have hedged that risk one way or another.”
I know all this is long and a bit detailed and technical, but I wanted to point it out as an example of how a cascading chain of events (much like the Piper Alpha disaster) caused a failure, mainly how massive fraud on the basis of one crypto space player and rising interest rates ended up bankrupting a real bank in the real world.