Silvergate – A Strategy that S(t)ank

Silvergate wrote a Naked Put on the price of Bitcoin and it blew up!

“Only when the tide goes out do you discover who's been swimming naked”. Warren Buffet

Silvergate’s Golden Goose

In its 2019 annual report, Silvergate, the latest casualty of the crypto rout, ?crowed about its innovative corporate ‘growth’ strategy.

“Our digital currency initiative has contributed significantly to an increase in our noninterest bearing deposits, which has driven the Bank’s funding costs to among the lowest in the U.S. banking industry. This has allowed us to generate attractive returns on lower risk assets through increased investments in interest earning deposits in other banks and securities, as well as funding limited loan growth. Our low risk asset strategy supports a net interest margin of 3.47%[i] for the year ended December 31, 2019”.

Silvergate had obviously discovered the Golden Goose.

It was easy! Take in free deposits, lend them out to the market (not real people), and watch the money roll in. Why didn’t everyone think of that (we are so, so clever)?

The trick of course, as it is in banking everywhere, is getting money for free – the lending to the market is the easy bit – if you are a bank.?And Silvergate was a bank, originally an S&L, but converted into a real bank in the mid-1990s.?

Silvergate was an early convert to Crypto and found that there were lots of long-haired dudes investing in and running crypto-exchanges who had the need to find a short-term ?home for the oceans of cash that was flowing into their coffers as a result of the phenomenal rise in the price of Bitcoin at the beginning of the Bitcoin Bubble.

Although they did not believe in banks, the crypto dudes were not stupid – they needed somewhere to park their spare cash – few questions asked!?Where better than a fully chartered, regulated bank, such as Silvergate?

And Silvergate obliged. They took the crypto fiat money (sounds funny when you say it like that?) and ‘invested’ it in blue chip securities, admittedly not paying huge interest but, given the freeness of the money, sufficient to make a very tidy profit.

The Glory Days

On the face of it, Silvergate had struck a deep vein of solid silver; it was Banking 101: take in cheap deposits, and ?lend them out to high-quality borrowers.

But who were the depositors??There were not many of them, but they were BIG.

In its annual reports, Silvergate gloried in how few actual customers it had.?For example, in 2019, there were only 804 customers: some 60 Digital currency exchanges; 509 ‘Institutional investors’, venture capitalists etc; and 235 others, such as crypto miners.?

By 2022, these numbers had not grown much, only 1,381 customers in its final annual report for 2021. It was certainly not a retail business.

So Silvergate’s depositor base was very highly concentrated in the real inner sanctum of the crypto world. And Silvergate went further and built a network, the Silvergate Exchange Network (SEN), to allow this Cabal to exchange real money between themselves. And like many banks before them, Silvergate moved into providing technology for their customers.

“Instrumental to our leadership position and growth strategy is the Silvergate Exchange Network (the “SEN”), our proprietary, virtually instantaneous payment network for participants in the digital currency industry which serves as a platform for the development of additional products and services. The SEN has a powerful network effect that makes it more valuable as participants and utilization increase. The SEN has enabled us to focus on significantly growing our noninterest bearing deposit product for digital currency industry participants, which has provided the majority of our funding over the last two years.”

Stop for a moment to take in the irony of that proposition: Silvergate built a blockcahin-based network to exchange fiat for firms that were trying to, if not destroy but at least, bypass the real banking network.

At this point, a prudent banker would worry about ‘concentration risk’ or that the success of a venture is invested in too small an area, such as a customer base.

Clouds on the Horizon

And Silvergate did worry (at least on paper).?In its 2019 SEC 10-K filing, the Board noted:

“The Bank has several large depositor relationships that are concentrated in the digital currency industry generally and among digital currency exchanges in particular, the loss of any of which could force us to fund our business through more expensive and less stable sources.”

In other words, if any one of our big customers was to go belly up, we would be in trouble; and this did indeed happen with one of its biggest customers – FTX.

And Silvergate was also heavily concentrated in blockchain technology through its SEN network:

“The slowing or stopping of the development or acceptance of digital currency networks and blockchain technology may adversely affect our ability to continue to grow and capitalize on our digital currency strategy.”

There it was, right at the beginning!

Silvergate had identified the serious risks in its corporate growth strategy, namely that its tiny customer base would contract, and its technology and business would be unprofitable.

Silvergate had bet EVERYTHING on growing its customer base and, of course, the customer base would only grow IF the price of Bitcoin (the biggest crypto in the jungle) kept growing.

In effect, Silvergate had placed a big bet on a rise in Bitcoin prices, to entice more customers into the market. They had sold a Put on the price of Bitcoin and were swimming naked!

In 2020 and 2021, however, that looked a very smart bet indeed, as Bitcoin prices roared off – to the moon! But November 2021, Bitcoin prices hit a peak, of over $65,000 and then started to fall, to around $21,000 in March 2023, when Silvergate closed its door.

The option on the crypto world expanding forever expired with horrendous implications for Silvergate.

The End

The end for Silvergate was relatively quick.

In parallel to, not as a result of, the implosion of the Bitcoin prices in 2022, central banks were forcing interest rates to rise making ‘safe’ investments lose money as yields rose. And Silvergate was bleeding money terminating its supposed ‘short term’ funding.?Silvergate also terminated its investment in the SEN blockchain racking up losses on writing down ‘intangibles’,

Silvergate had run out of money - ironic isn’t it?

Not the First

Silvergate was not the first bank to lose all in pursuing a growth strategy while ?forgetting the basics of banking.

There is a close parallel with Northern Rock (the only other big ‘bank run’ this century) where its ‘world class’ funding strategy blew up during, but not as result of, ?the ?Global Financial Crisis. There is also parallel with Bear Stearns where a clever strategy to make money on the latest whiz-bang thing - Collateralized Debt Obligations (CDO), turned out not to be so clever and ran out of money at the first stiff breeze.

History is littered with banks, such as Bank of Scotland, Anglo Irish Bank, Lehman, Royal Bank of Scotland, and Washington Mutual, that embarked on a growth strategy that initially paid dividends (and massive bonuses) but eventually blew up with disastrous consequences.

Silvergate is just the latest to fall foul of the so-called Beanstalk Syndrome

Will bankers ever learn? Probably not!

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[i] In 2019, JPMorgan’s Deposit Margin was almost a full 100 basis points lower than Silvergate’s.