What happens if Silvergate fails?

Banks depend on customer deposits, which fell when Silvergate’s key client, FTX, went bankrupt and crypto companies counted on the worsening bear market. At the time of FTX’s collapse, approximately 90% of the bank’s deposit base came from crypto companies. It immediately felt the effect, with the bank suffering outflows of $8.1 billion in digital asset deposits in the fourth quarter of 2022 alone. By the end of December, total deposits were around $6 billion.

Although CEO Alan Lane insisted the bank’s mission had not changed, the writing was on the wall for Silvergate’s crypto-focused approach. Its share price has fallen nearly 95% since mid-August, currently hovering around $6, and US senators have begun to question Silvergate’s relationship with FTX.

The bottom fell out on Wednesday when Silvergate announced it would not be able to file its annual report with the Securities and Exchange Commission on time, citing the need to reassess its business strategy and “ability to continue.”

After crypto companies had turned to the bank for years as one of the only financial partners that would serve the volatile industry, some of the sector’s biggest firms announced that they were reducing or cutting their relationships, including Coinbase, Paxos, Circle and Crypto.com.

Onlookers speculated that the Federal Deposit Insurance Corporation would put Silvergate into receivership as soon as Friday, and begin the process of finding another bank to buy Silvergate or take over the deposits. A source in crypto banking told Fortune that Wells Fargo was rumored to be the buyer.

“Silvergate is really a cautionary tale,” said Joseph Silvia, the former adviser to the Federal Reserve Bank of Chicago and a partner at Dickinson Wright. “But there are still opportunities out there, and I still don’t think cryptocurrency in general is going anywhere.”

“Almost Nothing You Can Do”

Perceived by many traditional institutions as renegades, crypto companies often struggled to find banking partners – which is understandable for self-styled disruptive firms – but they still needed traditional banking services for their payrolls and growing customers, and accounts to hold their coffers.

While many banks were dirty, Silvergate jumped at the opportunity and rode the wave of crypto’s historic bull market. The share price increased by more than 1,500% between November 2019 and November 2021, with Silvergate serving more than 1,500 digital assets and fintech companies by the end of 2022.

The share price began to wobble with the start of the crypto bear market after the collapse of TerraUSD in May 2022, and the bankruptcy of industry giant FTX made it worse – crypto companies no longer had money to deposit with Silvergate.

As Silvia explained, deposits are the lifeblood of a bank. “When it starts to deteriorate, and deteriorates so quickly, there’s almost nothing you can do to stop the bleeding,” he said.

With its share price down, Silvergate also could no longer rely on the capital markets for funding, resulting in its SEC filing on Wednesday in which the bank said it was “less than well capitalized.”

John Popeo, a former attorney at the FDIC, analyst at the Federal Reserve Bank of Boston, and current partner at the Gallatin Group, said banks could fail from reaching a critical level of capital or an exodus of depositors.

If Silvergate fails to meet certain capital requirements, it will receive a corrective action notice from the FDIC and its chartering authority, or the California Department of Financial Protection and Innovation. Silvergate would then have 90 days to raise capital or sell itself to another bank.

In the case of more immediate financial distress, the FDIC can take over at any time — usually on a Friday night, to minimize disruption to the broader financial system. In this scenario, the FDIC may be looking for a buyer now. Although Wells Fargo is rumored to be a contender, Popeo cautioned that onlookers without direct knowledge are ill-equipped to speculate.

As of Saturday, Silvergate is still operating, although on Friday night it announced that it would be discontinuing the Silvergate Exchange Network, a crypto payment solution between different firms. Although other deposit-related services remained operational, share prices fell around 2% in after-hours trading.

A shrinking universe

Crypto companies have already started fleeing Silvergate, but the downstream effects may only be beginning. Silvia said Silvergate’s exit from the crypto ecosystem — and other banks’ growing reluctance to work with the sector — will make it harder for crypto firms to get deposit accounts and other critical services. As a result, banking will become more expensive for crypto companies as they explore other options, from credit unions to other types of fintech companies.

“It shrinks the universe of potential partners very quickly,” he said.

Some in the crypto industry have pointed fingers at banking regulators, who have issued a series of statements in the wake of FTX’s collapse warning about liquidity risks associated with crypto. Nic Carter, a crypto-focused venture investor, described the apparently coordinated effort by various federal regulators to deny banking services to crypto firms as an “Operation Chokepoint 2.0,” a term that has since caught on.

Silvergate’s failure, Silvia added, has much more to do with FTX than regulators. “It’s just a lot of problems that the banks are seeing, without much reward,” he said Fortune.

Even the other US bank to establish itself as crypto-friendly, Signature, has shown more reluctance to work with the industry. In December, it announced it would shrink deposits linked to cryptocurrencies.

“We’re not just a crypto bank, and we want that to come out loud and clear,” CEO Joe DePaolo said at an investor conference.

Despite the retreat of the traditional financial sector, Silvia expressed optimism that crypto would survive – just with fewer companies. And the survivors will still need banking services.