This crypto stock has proven resilient through Bitcoin’s fall

With the growing use of blockchain technology and thousands of cryptocurrencies, a whole host of companies have emerged to support the sector – from asset managers to banks to crypto miners. And as the price of the world’s largest cryptocurrency, Bitcoin (BTC -3.97%)has fallen more than 52% this year, crypto stocks have followed suit.

However, one crypto stock in particular has proven remarkably resilient. While the company’s share price has fallen at times, the business is performing incredibly well even through the volatility.

A sustainable business model

The crypto bank Silvergate capital (SAY 0.51%) went public in 2019. It offered critical infrastructure for institutions looking to trade cryptocurrencies with crypto exchanges, as management saw early on that cryptocurrencies would be investable assets.

Silvergate has developed a proprietary real-time payment system called the Silvergate Exchange Network (SEN), which allows multiple parties on the network to transfer money 24 hours a day, seven days a week, all year round. The US banking system does not operate 24/7, while cryptocurrencies do, making SEN a very efficient way to trade crypto.

Image source: Getty Images.

Silvergate has no cryptocurrencies on its balance sheet, but benefits when SEN customers bring large sums of non-interest-bearing deposits to the bank. The bank pays no interest on these, and it can invest them in the bond market or in loans and make money on the spread. Not only does Silvergate pay interest on these deposits, but SEN has also helped the bank grow deposits quickly.

While there is debate as to whether Bitcoin can be a hedge against inflation due to its limited supply, Silvergate’s business model definitely makes it an inflation hedge – as interest rates rise, so do the yields on bonds and many of the loans. We saw this dynamic play out in the second quarter of the year when, despite Bitcoin’s falling price, Silvergate generated a record $1.13 in earnings per share. That’s because it was able to increase its income from loans and bonds by nearly 40% from the first quarter.

Credit quality continues to be strong

Two major concerns during the second quarter led investors to sell the stock: how deposit levels would develop, and whether there would be any forced liquidations or losses on Silvergate’s specialist lending product, SEN Leverage.

SEN Leverage is a line of credit in US dollars that is secured by Bitcoin. The product seems very safe because Silvergate has borrowers who largely collateralize the loan amount in US dollars with an equivalent amount of Bitcoin, and sometimes more. Furthermore, Silvergate retains the security of partner custodians, and since Bitcoin trades around the clock, it is arguably the most liquid form of security.

In March, Silvergate issued a $205 million loan to business intelligence and Bitcoin buyers Micro strategy (MSTR -5.70%), which used the proceeds to buy more Bitcoin. Some investors may have worried when MicroStrategy said in May that if the price of Bitcoin falls below $21,000, it could trigger a margin call.

It’s possible this happened at some point in the past few weeks, but without foreclosures, Silvergate’s credit still had a clean bill of health in the second quarter. Furthermore, Silvergate still has incredibly high levels of capital. On the Q2 earnings call, CEO Alan Lane said of SEN Leverage that “I don’t think you’re going to see this as … high multiples of our capital base.”

Deposit trends

For the first time since its IPO, the bank saw average digital currency deposits fall from $14.7 billion in the first quarter to $13.8 billion in the second.

Obviously, deposits are a big driver of profitability for the bank, so this is not what investors want to see. But considering that the price of Bitcoin fell from over $45,500 at the end of Q1 to less than $20,000 at the end of Q2, things could certainly be worse. Interestingly, there was also a wide variation in average deposit levels during Q2, with the highest being $17.6 billion and the lowest being $12.6 billion.

Management attributed the wide range of deposit levels to “significant dislocation occurring throughout the broader ecosystem, which was partially impacted by the collapse of various digital asset platforms.” However, Silvergate did not lose any customers due to these events, and still pays no interest on its deposits. In fact, SEN added 85 customers in Q2, bringing the total to 1,585 customers. Lane also said the pipeline of customers remains “robust”, with 300 prospects.

Silvergate has the first-mover advantage as the first bank to launch this type of network, so the network becomes more attractive as it grows. It also takes a lot of time to get on board with SEN, so it seems that clients take a bit of a long-term view of the crypto industry when they decide to join the network.

Looking forward

I continue to believe that the model Silvergate has implemented with SEN is sustainable through the ups and downs of the crypto cycle. When interest rates rise, the company is able to make more money on its deposits, and SEN Leverage loans are highly secured and extremely liquid.

While Bitcoin may fall in the short term, I believe in the long term that both Bitcoin and crypto trading are here to stay; this makes the infrastructure Silvergate offers very attractive and valuable, especially as the network grows. I remain bullish on the stock.