Silvergate’s collapse could spell regulatory trouble for crypto

Silvergate Bank had a very rough week, to the point where a not inconsiderable number of people were waiting for the Federal Deposit Insurance Corporation (FDIC) to announce that the bank had gone into receivership after the close on Friday.

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Silvergate Bank announced last week that it had to delay filing its annual 10-K form because of questions it received from its independent auditors. In the same vein, under the “forward-looking statements” section, Silvergate announced that it was facing inquiries from banking regulators, an investigation by the US Department of Justice, congressional scrutiny and concerns about its ability to be a “going concern” over the next year. Generally speaking, these are all bad signs.

Silvergate is (was?) the bank in crypto. It counted some of the industry’s largest companies (in the USA) as its customers. The fact that it is now in a position where it could soon fold does not bode well for the rest of the industry, and gives regulators a good example of what happens if the banking sector gets too close to crypto.

Silvergate had a very bad week. The stock is down 61% in the past week, with most of the fall coming last Thursday, sending the stock ( SI ) down to $5.41. That’s actually down 94% over the past year, and obviously slightly lower than the all-time high of $212.

It is not inconceivable that the bank will have to go bankrupt in the near future. It may still recover – the bank may have more capital than we realize, or it may receive a bailout from an investor – but many of its most prominent crypto customers have already left, and the bank has shut down its most attractive product, Silvergate Exchange Network, last Friday.

Silvergate appears to have sold billions of dollars worth of bonds at market losses to keep up with withdrawals, which in turn meant it no longer met certain regulatory requirements that indicated it was all right.

The main result is that crypto firms have to look for other banks. Some companies will find this easier than others. The established titans of this industry will not, I imagine, have too many difficulties. If you’re a company with a history of running smoothly, you’ll probably be able to convince a bank that what happened with Silvergate wasn’t your fault (and in a way it wasn’t).

If you are starting a business, it can be more difficult. Startups in this industry have traditionally had trouble getting banking services, and that won’t be made easier by federal banking regulators warning financial institutions under their charge that they need to be careful, or may need permission, when dealing with crypto.

Banking services such as deposits aside, companies may also have difficulty accessing payment services, at least in the short term. Circle, for example, has already cut ACH support, at least temporarily.

A spokesperson pointed to Silvergate. “Amid growing concerns about Silvergate Bank, Circle has accelerated plans to write off some services and transfer others to multiple banking partners, completing a process that began last year to reduce risk to our customers, our business and USDC. We are communicating with customers and have taken steps to ensure access to customer funds via alternative payment and redemption channels,” the spokesperson said in a statement.

All this will become a backdrop for regulatory reactions. Banking regulators have already gone out of their way to warn about crypto. But beyond that, we’ve already heard from officials like Acting Comptroller of the Currency Michael Hsu, who warned months ago that there could be “risk of contagion.” Just this week, Hsu gave another speech, saying that last year’s FTX collapse reminded him of a major bank failure, the Bank of Credit and Commerce International (BCCI).

To date, despite the fall of FTX and a dozen or so bankruptcy filings last year, there hasn’t been a major risk of contagion from crypto to the traditional financial sector. That may finally change.

To be clear, Silvergate didn’t fail just because it bankrolled crypto. But if crypto companies rushing to withdraw their money – creating a bank run – caused Silvergate to sell off its bonds, which in turn caused it to become undercapitalized, which has now caused the bank to approach receivership, then this was another victim of last year’s massive error and evidence of the risk of infection.

Regulators will likely continue to warn that crypto is fraught with danger, and have a perfect example to point to.

It remains to be seen if Silvergate truly fails or if it finds a way to survive. It also remains to be seen who will pick up their former clients – Signature Bank, the second-friendliest bank to crypto, or another of the myriad institutions out there or even a crypto-native company that has successfully run the gauntlet of Federal Reserve Board Application Process.

Grayscale Investments will finally have its chance to argue that the US Securities and Exchange Commission has no choice but to allow it to convert its Grayscale Bitcoin Trust (GBTC) product into an exchange-traded fund (ETF).

Disclosure: Grayscale is a subsidiary of Digital Currency Group, the parent company of CoinDesk.

Grayscale received support in the form of five different amicus (friend of the court) briefs, signed by The Blockchain Association, Chamber of Digital Commerce, Coin Center and Chamber of Progress; Coinbase; the Chamber of Commerce; NYSE Arca; and a group of individuals.

Grayscale’s main argument seems pretty simple: It argues that the SEC’s decision not to approve the GBTC conversion — or indeed any spot bitcoin exchange-traded product — despite previous approvals of bitcoin futures ETFs is “arbitrary at its core.”

“The central assumption – that the exchange’s monitoring sharing agreement with the CME provides adequate protection against fraud and manipulation in the bitcoin futures market, but not the spot bitcoin market – is illogical. Any fraud or manipulation in the spot market will necessarily affect the price of bitcoin futures, and thus affect the net asset value of a [exchange-traded product] to hold either spot bitcoin or bitcoin futures as well as the price investors pay for such an ETP’s shares. Either CME monitoring can detect spot market fraud affecting both futures and spot ETPs, or monitoring cannot do so for either ETP type,” the company said in its summary.

The company also argued that the SEC was inconsistent in how it approached futures markets.

The SEC, for its part, argued that futures-based ETFs and spot ETFs “are fundamentally different products,” with different monitoring sharing agreements and oversight mechanisms.

Similarly, for futures products, CME has monitoring sharing agreements with NYSE Arca and Nasdaq, the SEC said, again noting that CME is where the actual bitcoin futures contracts are traded.

“Due to CME’s extensive monitoring efforts and the one-to-one relationship between the regulated market (CME) and the underlying assets (CME tradable bitcoin futures), the Commission concluded that CME’s monitoring ‘can be reasonably relied upon’ to capture the effect of attempts “to manipulate the proposed futures ETP by manipulating the price of CME bitcoin futures contracts, whether that attempt is made by direct trading on the CME bitcoin futures market or indirectly by trading outside the CME bitcoin futures market; “” the SEC’s filing said.

The judges seemed largely skeptical of the SEC’s arguments.

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