Uh oh! The crypto collapse has reached the real financial system

Silvergate, one of the most important banks in crypto, is in deep trouble. Maybe existential issues.

Silvergate didn’t start in crypto. It started in real estate. But in January 2014, the bank jumped into Bitcoin, a volatile year – Bitcoin started the year at $770 and ended above $300 in December. “Some of the companies that were formed at the time to provide services to this burgeoning Bitcoin space, many of them struggled to find and maintain bank accounts,” Silvergate CEO Alan Lane said in a June 2022 episode of Odd Lots podcast. “So that’s really where we started.”

The focus of the bank was institutions — other companies, some of which work with consumers. For example, Genesis, the now-bankrupt crypto-lending subsidiary of DCG, was among Silvergate’s early clients. The bank developed the Silvergate Exchange Network, which was a way for crypto institutions such as Coinbase, Gemini and Kraken to trade in dollars 24/7. “We’ve got them all,” Lane said in 2022. “All the major ones. Everyone who’s serious about regulation.”

Also among Lane’s customers: FTX. Federal prosecutors are now investigating Silvergate’s role in banker Sam Bankman-Fried’s fallen empire. The more pressing issue is that the collapse of FTX spooked other Silvergate customers, resulting in an $8.1 billion run on the bank: 60 percent of deposits went out the door in just one quarter. (“Worse than experienced by the average bank that closed during the Great Depression,” The The Wall Street Journal helpfully explained.)

In the earnings report, we found that Silvergate’s results last quarter were absolute crap, a loss of $1 billion. Then, on March 1, Silvergate entered a surprise regulatory filing. It says that it was actually the quarterly results even worseand it is not clear that the bank will be able to continue.

In response, Coin baseGalaxy Digital, Crypto.com, Circleand Paxos have said they will stop using Silvergate – as have other, less notable customers. Tether, the controversial stablecoin that has had its own problems with banking, helpfully appeared to remind us that it wasn’t using Silvergate.

The laundry list of clients helps explain why Silvergate’s woes are terrifying. Very few banks will touch crypto because it is so risky – and most traditional banks do not allow crypto clients to transact in dollars 24/7. Access to banking that moves at the pace crypto does is rare and only one other US bank can do it.

“If Silvergate goes out of business, it’s going to push funds and market makers further offshore,” Ava Labs president John Wu said Barron’s. The question is how easy it is to get into actual cash, which in financial parlance is called liquidity. Less liquidity makes transactions more difficult. Already, there is a wider gap between the price at which a trade is expected to go 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 an important on and off from the almighty dollar (and the almighty euro) to crypto. By 2022, Lane said, all “regulated, US dollar-backed stablecoin issuers” were knocking on Silvergate.

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

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

You’ll notice I say “was.” That’s because Silvergate announced on March 3 that it was suspending special education, effective immediately.

The dollar side of the transaction meant that Silvergate’s customers had to have a pile of cash on hand in the bank to pay each other and anyone who wanted to withdraw. To make money here, Silvergate could do a couple of things. The safest thing is to buy, for example, a one-month treasury bill at the Fed and take it for a day.

Now, this being finance, taking more risk can also mean more profit. So Silvergate appears to have bought bonds. (Guardian favorite Matt Levine at Bloomberg has a more in-depth analysis of how this worked if you want the gory details.) The problem isn’t that the bonds were super risky — it’s that FTX triggered a mass exodus into the dollar, and Silvergate suddenly had to come up with a bunch of cash. Unfortunately, that meant selling their bonds at a loss to pay their obligations. Ironically, the bonds were quite safe — “if the depositors had kept their money in Silvergate, the bonds would have matured with a lot of money to pay them back,” notes Levine.

Silvergate has another way of touching stablecoins, besides acting as a stop and go for their transactions. It bought assets from Facebook’s doomed stablecoin attempt 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 Silvergate offered was the ability to lend dollars against Bitcoin. Now, Silvergate said in January on its fourth-quarter earnings call that “all of our SEN Leverage loans continued to perform as expected, with no losses or foreclosures.” Maybe these loans are good! Silvergate doesn’t seem to have done anything exceptionally risky elsewhere.

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

Silvergate had a life before crypto: it was a small bank focused on real estate deals in Southern California. During that time, it never had more than $1 billion in deposits, according to Financial Times. And Silvergate needed a deposit. When Lane steered the company into crypto, business ballooned. 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 on March 3.)

Real estate became less and less of a focus because crypto was a rocket ship for the bank. But that real estate connection proved useful for Silvergate in 2022. In the last quarter of the year, Silvergate received at least $3.6 billion in funding from the Federal Home Loan Banks, a 1930s system that also originally dealt in mortgages.

To pay it, Silvergate sold more bonds. This is not ideal and is part of the reason Silvergate is in trouble. “If you’re a bank, you don’t want to point in the wrong direction, because it becomes self-fulfilling,” writes Bloombergis Levine. And this is actually why many of Silvergate’s big customers are scared off. Levine believes that this could get some regulators interested in crypto banking.

In fact, the Department of Justice is already interested. There are some questions surrounding the bizarre transactions that took place at Silvergate.

For example, Binance. Its supposedly independent arm, Binance.US, transferred more than $400 million to a trading firm called Merit Peak Ltd, Reuters reported. This firm is headed by Binance CEO Changpeng Zhao. “When Binance.US CEO Catherine Coley wrote to a Binance CFO in late 2020 asking for an explanation of the transfers, calling them “unexpected” and saying “no one mentioned them,”” Reuters wrote. These transmissions took place on Silvergate’s special network, SEN.

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

I don’t know if Silvergate did anything wrong. Possibly it didn’t! But the Feds starting to poke around and ask questions? It’s a headache and a distraction. That’s the last thing a troubled bank needs.

A lot of companies that banked with Silvergate have been out here talking about having minimal exposure to it, which historically is not a good sign. (See: Bankman-Fried’s infamous “FTX is good. Assets are fine” tweet.)

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

The crypto industry desperately needs banks. But both of Silvergate’s competitors, Metropolitan and Signature, pulled out of the sector even before this debacle. Metropolitan said in January that it was getting out of crypto entirely. And in December, Signature said it was getting rid of $8 billion to $10 billion in digital asset-related funds.

I don’t know if Silvergate is going to get through this. But I strongly suspect that getting into dollars from crypto and out of crypto into dollars has just become much more difficult. Silvergate traded with liquidity, and a liquidity problem can quickly become a solvency problem. The whole crypto industry just got a lot more fragile.