Investing Everything In Crypto Led To A Disaster For Silvergate

The final days of Silvergate Capital Corp. were spent under siege.

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Shortsellers flooded the bank, depositors deserted it, and business partners shunned it, as executives of the crypto-focused bank appeared face-to-face with regulators at the head office of the company in La Jolla, California, on Wednesday.

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Officials from the Federal Deposit Insurance Corp. had arrived at the firm's offices in an effort to prevent the US banking system from becoming the country's first casualty of the crypto implosion. One of the options they discussed was finding crypto-investors who could help shore up liquidity during a period of mounting losses for the bank. There were a series of desperate calls put out to potential investors, but none were willing to accept the burden of associating themselves with a bank so deeply entwined in the turmoil of the industry. 

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As survival proved increasingly unlikely and no buyer was in sight, Silvergate announced Wednesday it would be closing its doors after a decade-long crypto dream that made the company a major player during the boom in the industry.

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In the end, the bank was forced to wind down and voluntarily liquidate under the guidance of people familiar with the matter, who spoke on condition of anonymity, as a result of months of turmoil that stemmed from its ties to Sam Bankman-Fried and FTX. Following Silvergate’s collapse into bankruptcy in November and subsequent accusations of fraud, a regulatory crackdown on the crypto industry’s ties with banking was ignited as a result of the collapse.

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Silvergate suffered $1 billion in losses during the fourth quarter, and it is bleeding even more capital this year. As a result, it had to delay its annual report, and this caused some questions about whether it would be able to continue to operate. Silvergate had exposed itself to a risk of an old-world banking type of risk when it had hitched its wagon so firmly to the new world of crypto: When the industry's prospects soured, Silvergate was left with little to fall back on.

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“As much as it is about its exposure to cryptocurrency, Silvergate is having difficulties due to traditional banking risks - lack of diversification, maturity mismatches - as much as it is due to its exposure to traditional banking risks,” said Sheila Bair, headed the FDIC during the Global Financial Crisis.

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Silvergate representative declined to answer any questions.

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Crypto Pursuit

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As of 1988, Silvergate is a company that is primarily engaged in extending loans to industrial clients and also deals with conventional services such as commercial and residential real estate lending. But in 2013, it began to transform itself from a normal community bank into a bank catering to the needs of the digital asset industry. There has been an increase in the amount of institutional crypto players that are willing to deposit money with it, compared to most other traditional financial institutions.

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In 2018, the bank introduced a crypto-payment platform that enabled clients to exchange fiat currency at the same speed that they traded digital assets on systems outside of the bank, such as FTX.

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In a broader sense, the bank's shift away from traditional banking and into a then-niche market reflected a broader trend in the financial industry at the time. There are a number of smaller US banks that are struggling to compete with larger rivals, so they double down in areas traditional finance shuns, hoping that in doing so they will give themselves a fighting chance, but the results have been mixed, to say the least.

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Abbott Cooper, an activist investor who specializes in the banking sector, said that "Any time you do away with a large chunk of your business being defined by relationships on both sides of the balance sheet, you’re going to wind up in trouble.". “Unless you're absolutely, intensely focused on the risks that have been created by this, I'm certain that you'll end up in trouble if you're not paying attention to the risks that have been created by this."

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Balance Sheet

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A key factor in Silvergate's demise was the unique composition of its balance sheet, which played a significant role in its demise. The deposits Silvergate accepted from crypto clients were not subject to interest, so Silvergate had a free pool of money that it was able to invest in investments such as government debt and similarly liquid assets. There were mortgage-backed securities in its portfolio, as well as state and local government bonds that were sold by the government. 

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Foundering tout

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Silvergate's financial situation, although not uncommon for any bank, proved problematic as the Federal Reserve hiked interest rates, eroding the value of a portion of Silvergate's securities as a result. There were many times when Silvergate had to sell securities to pay for the withdrawals that were made as the crypto industry faltered and clients rushed to withdraw money, driving the lender's non-interest-bearing deposits down from $12 billion at the end of September to just $3.9 billion at the end of last year. The bonds, however, were worth less than the company paid for them, which led to it having to sell them at a loss and causing a hole in its earnings of $1 billion late last year as a result.

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During an interview with Trade Algo on March 2 with Todd Baker, a senior fellow at Columbia University's Richman Center for Business, Law, and Public Policy, Baker said that the depositors failed to see that rising interest rates would radically affect the volatility of these deposits. “The other issue that they failed to understand was that when interest rates rose, the value of their securities portfolio would plummet as well.”

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Investigations

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US prosecutors in the Justice Department's fraud unit have been looking into Silvergate's dealings with FTX and its trading firm Alameda Research for a long time.

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As part of the criminal investigation, Silvergate is being examined for accounts it hosted for Bankman-Fried's businesses. Among the questions probed by the SEC concerns what banks and intermediaries were aware of in regard to what US officials have described as years-long schemes aimed at defrauding investors and customers by Bankman-Fried's firms.

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The bank has not been accused of any wrongdoing, and the investigation could end without any charges being brought against the bank.

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It was alleged in court papers that Bankman-Fried engaged in a bank-fraud scheme in February that targeted a company that had been identified by the court documents as "Bank 1" and that this company was based in California, according to the indictment. Trade Algo has been informed by a person familiar with the matter that Bank 1 is Silvergate. 

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In addition to this, a more important question is how one financial institution that has invested so heavily in crypto has not been regulated by its regulators.

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“What happened to Silvergate's regulators?” asks Jerry Comizio, adjunct professor and former Treasury Department official. “Silvergate was missed in a real sense.”