Ouch! The collapse of cryptocurrencies has reached the real financial system

Silvergate, one of the most important banks in the crypto space, is in big trouble. Maybe an existential problem.

Silvergate didn’t start with encryption. It started in real estate. But in January 2014, the bank switched to Bitcoin, a volatile year – Bitcoin started the year at $770 and closed above $300 in December. “Some of the companies that were founded at that time to provide services in this nascent Bitcoin space, many of them were having trouble finding and maintaining bank accounts,” Silvergate CEO Alan Lane said in a June 2022 episode . Odd lots podcast. “So that’s where we really started.”

The bank’s focus was on institutions — other companies, some of which work with consumers. For example, Genesis, DCG’s now-defunct cryptocurrency lending subsidiary, was among Silvergate’s first customers. The bank developed the Silvergate Exchange Network, which was a way for crypto institutions like Coinbase, Gemini and Kraken to trade dollars 24/7. “We have it all,” Lane said in 2022. “All the highlights. Anyone who is serious about regulation.”

Also among Lane’s clients: FTX. Federal prosecutors are now looking into Silvergate’s role in managing Sam Bankman-Fried’s failed banking empire. The most pressing problem is that FTX’s collapse spooked other Silvergate customers, causing the bank to run $8.1 billion: 60 percent of its deposits flew out the door in just one quarter. (“Worse than what the average bank experienced closing in the Great Depression,” The Wall Street Journal helpfully explained.)

In the earnings filing, we found out that Silvergate’s results last quarter were absolute shit, a loss of $1 billion. Then on March 1, Silvergate entered a surprise regulatory filing. He says that, in fact, the quarterly results were Even worseand it is not clear that the bank will be able to continue operating.

In response, CoinbaseGalaxy Digital, Crypto.com, Cycleand Paxos have said they will stop using Silvergate – as have other, less reputable customers. Tether, the controversial stablecoin that has had its own problems with banks, He helpfully appeared to remind us that he wasn’t using Silvergate.

The laundry list of customers helps explain why Silvergate’s woes are terrifying. Very few banks will touch crypto because it’s so risky — and most traditional banks don’t allow crypto customers to trade dollars 24/7. Access to banking that moves at the rate that crypto does is rare, and only one other US bank can do it.

“If Silvergate goes out of business, it will push funds and market makers further offshore,” Ava Labs president John Wu said. Barron’s. The issue is how easy it is to get into real cash, which in finance is called liquidity. Less liquidity makes trading more difficult. There is already a wider gap between the price at which a trade is expected to execute and the actual price at which it executes, Wu said.

So Silvergate’s problems are a problem for the entire crypto industry.

Silvergate’s SEN was a major ramp into and out of the mighty dollar (and the almighty euro) in cryptocurrencies. In 2022, Lane said all “regulated US dollar-backed stablecoin issuers” will bank on Silvergate.

But for the stablecoins issued by Circle, Paxos and Gemini, among others, SEN was important to the creation and burning of their tokens, which were issued when someone deposited a dollar into Silvergate’s bank accounts, Lane said.

Silvergate was a transit point for cryptography. Stablecoins backed by dollars at least theoretically have cash or cash-like assets in reserve somewhere. (The reason why Tether is controversial is that there are questions about the existence and value of this reserve.) Silvergate’s job was to create a token when someone put a dollar in, say, USDC and burn a token when someone took out a dollar. “We’re that critical piece of infrastructure where people, as they come out of the ecosystem and want to go to cash — those dollars go through Silvergate,” Lane said in 2022.

You’ll notice I say “was.” This is because on March 3rd, Silvergate announced that it has suspended SEN, effective immediately.

The dollar side of the transaction meant Silvergate customers had to keep a pile of cash in the bank to pay each other and anyone who wanted to cash out. To make money here, Silvergate could do a few things. The safest thing to do is buy, like, one-month Treasuries at the Fed and call it a day.

Now, when it comes to financing, taking more risk can also mean more profit. So Silvergate appears to have bought bonds. (Lip beloved Matt Levine at Bloomberg has a more in-depth breakdown of how that worked if you want the gory details.) The problem isn’t that the bonds were extremely risky – it’s that FTX triggered a massive dollar outflow and Silvergate suddenly had to come up with a bunch of money. Unfortunately, this meant that it was selling its bonds at a loss in order to pay its obligations. Ironically, the bonds were quite safe—“if his depositors had kept their money in Silvergate, his bonds would have matured with a lot of money to pay back,” notes Levine.

Silvergate has another way of touching stablecoins besides serving as the ramp in and out for their transactions. It bought assets from Facebook’s doomed stablecoin effort Libra, later renamed Diem, in January 2022. At the time, Silvergate said it would begin making Diem available by the end of the year. The goal was a digital payment network.

One of the other services offered by Silvergate was the ability to lend dollars against Bitcoin. Now, Silvergate said in January on its fourth-quarter earnings that “all SEN Leverage loans continued to perform as expected, with no losses or forced liquidations.” Maybe these loans are good! Silvergate doesn’t appear to have done anything extremely dangerous elsewhere.

But if you want to use your Bitcoin to get a dollar loan, I think it just got harder.

Silvergate had a life before crypto: it was a tiny bank focused on real estate deals in southern California. During that time, it never had deposits above $1 billion, according to The Financial Times. And Silvergate needed deposits. When Lane steered the company into crypto, her business soared. By 2021, Silvergate had more than $10 billion. The bank went public in 2019 at $12 per share and peaked at over $200 per share in 2021. (Shares closed at $5.77 per share on March 3.)

Real estate became less and less of a focus because crypto was a rocket for the bank. However, this real estate connection proved useful for Silvergate in 2022. In the final quarter of the year, Silvergate received at least $3.6 billion in funds from the Federal Home Loan Banks, a 1930s-era system that originally also involved mortgages .

To pay it back, Silvergate sold more bonds. This is not ideal and is part of the reason Silvergate is having problems. “If you’re a bank, you don’t want to point in the wrong direction, because that becomes self-fulfilling,” he writes Bloombergit’s Levine. And indeed, this is why many of Silvergate’s big customers are terrified. Levine believes this may make some regulators interested in crypto-banking.

In fact, the Ministry of Justice is already interested. There are some questions about strange transactions that took place at Silvergate.

For example, Binance. Its supposedly independent arm, Binance.US, transferred more than $400 million to a trading company called Merit Peak Ltd. Reuters mentionted. This company is managed by Binance CEO Changpeng Zhao. “Binance.US CEO at the time, Catherine Coley, wrote to a Binance financial executive in late 2020 asking for an explanation for the transfers, calling them ‘unexpected’ and saying ‘no one reported them.’ Reuters He wrote. These transfers took place on Silvergate’s dedicated network, SEN.

This is similar to some of the issues Silvergate is having around FTX. Alameda Research, the trading firm also owned by Bankman-Fried, opened an account at Silvergate in 2018. Bankman-Fried admitted to using Alameda accounts for FTX funds, commingling client funds with those of the trading firm.

I don’t know if Silvergate did something wrong. Possibly he didn’t! But should the feds start asking questions? This is a headache and a distraction. It’s the last thing a troubled bank needs.

Many companies that banked with Silvergate have talked about how they have minimal exposure to it, which historically isn’t a great sign. (See: Bankman-Fried’s infamous “FTX is fine. Assets are fine” tweet.)

But you know what? In this particular case, I’m inclined to believe them. First of all, a lot of money has already left Silvergate. Second, though, SIlvergate was a clearinghouse for crypto. it held no reserves and paid no interest. The problem here is less that some exchange or stablecoin is going to suffer a huge loss of customer money and more that it is now even harder for crypto companies to bank.

The crypto industry desperately needs banks. But both of Silvergate’s competitors, Metropolitan and Signature, were pulling out of the business even before this disaster. Metropolitan said in January that it was getting out of crypto altogether. And in December, Signature said it was going to get rid of $8 billion to $10 billion in funds related to digital assets.

I don’t know if Silvergate will address this. But I strongly suspect that it just got a lot harder to get into crypto dollars and from crypto to dollars. Silvergate dealt with liquidity and a liquidity problem can become a solvency problem very quickly. The entire crypto industry just got a lot more fragile.