What the collapse of SVB and Silvergate means for the Crypto Ecosystem

It felt like Thanos picked up his gauntlet and snapped his fingers. Only this time, it was directed at the Banking system, specifically those with some sort of crypto exposure.?

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But if you thought Crypto was part of what cause SilverGate and Silicon Valley bank to go down last week, then you must read on! Becuase this edition of The Fintech Chronicler is dedicated to busting some of those myths around the collapse of two prominent banks, which were known for supporting Innovation!

If you are new here, then hello and Welcome! I started writing The FIntech Chronicler, becuase I realsied some body needed to cut through the buzz (aka Noise) and get to the real meat of the matter. And that is what I try to do every week. No faltu gyaan, or unnecessary pitching. So, if the Fintech space interests you, read on. And if you like what you read, share it with others. And subscribe. Keeps me going. So, lets get back to basics, shall we?

When interest rates rise by 500 basis points up from zero in the blink of an eye, banks will be left holding low- yeild bonds trading at a significant discount to their original purchase price. coupon, or periodic payments serving as interest to the holder, is specified as an absolute amount; as interest rates rise, less capital is needed to generate an amount equivalent to the coupon, lowering the value of the coupon-bearing security which was what happened when the Fed raised rates to combat inflation.

And if banks that hold a large quantity of such securities are compelled to liquidate them quickly to meet the demands of panicking depositors, the institutions will suffer severe losses and will require a large amount of new credit to prevent an asset-liability mismatch, bankruptcy, and other disasters. But, that is exactly what unfolded with SVB and SilverGate in the last week.?

Now, while Silver Gate and SVB were not systemically important banks, SVB was about one 18th the size of JP Morgan, still, they were kind of omnipresent when it came to startups and crypto ecosystem. And the risk their collapse poses, ranges from investors not being able to withdraw their funds, to employers fialing to pay the salary to their employees.

So, how did it reach this stage, and that too so fast? Before that, let us spend a minute to understanding how these banks grew in the last few years.?

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A Brief History of SilverGate and SVB

?SilverGate promises a banking platform as innovative as the entrepreneurs they serve, and according to their website, has been at the forefront of this innovation for the last 2 decades. In fact, back in 2013 when crypo was still an infant in its cradle, SilverGate did invite a lot of crypto related firms to discuss their needs with them, and helped develop on-ramp solutions from Fiat to Cryptocurrencies for several decentralised exchanges. ?

For Silvergate to lawfully serve these customers as a state-regulated bank, the company had to demonstrate a thorough understanding of bitcoin to regulators in the summer of 2014. The bank's success can be traced back to its willingness to share information and work closely with regulators in order to forge strong connections and innovate quickly. In 1988, Dennis Frank, a former Goldman Sachs banker, created Silvergate as a thrift, then in the 1990s, he restructured the company. Frank's experience as CEO of Coastal Banc during the savings and loan crisis of the late 1980s has helped Silvergate weather market volatility and establish itself as a frontrunner in the cryptocurrency industry.

By 2019, it has grown into the largest cryptocurrency bank in the United States, with 1,600 of the world's leading cryptocurrency miners, exchanges, and custodians utilising it to deposit and transfer billions of dollars each month.

In 2021, deposits increased from from $2 billion in 2020 to over $10 billion. The sum of all of their assets is now $16 billion. Shares of Silvergate Technology, which debuted on the New York Stock Exchange at the year's end 2019 at a price of $12, have since risen to over $200.

However, that ride came to an abrupt halt late last year, when Silvergate became the focus of US senators probing the failure of Bankman-FTX, which has been accused of mishandling deposits from customers.

A group of senators from the United States wrote to Silvergate Bank CEO Alan Lane claiming that the company "appears to be at the centre" of how those monies were moved throughout Bankman-crypto empire of his Exchange and the investment arm Alameda Research. Silvergate may have broken anti-money-laundering regulations if it failed to notice this "scheme," according to the report.

I wanted to crack down their exposure on FTX. However when I tried downloading their latest annual report, maybe because of the ongoing crisis, I faced this strange error. And that too for the 2021 report!

Well, maybe investors are looking for a way to claim back their money ?

Anyway, moving onto Silicon Valley Bank.

In Oct’23 it would have completed 40 years of innovation and serving customers. Bill Biggerstaff and Robert Medearis , two ex Wells Fargo guys, came up with the idea for Silicon Valley Bank while playing poker. The bank was founded to meet the banking needs of the region's burgeoning start-up technology industry. Roger Smith, the company's initial chief executive officer, led the charge to enter this sector at a time when traditional financial institutions, which look at a company's assets and income to determine whether or not to extend credit, ignored it.

The area's proximity to major colleges, as well as its strong scientific background, openness to exchanging information, lack of fear of failure, and overall climate, all contributed to the success of the area's technology enterprises. This is where Silicon Valley got its start. Yet, tech startups needed financial backing to get off the ground.

As a result of their unfamiliarity with the nuances of startup funding, traditional equity investors and debt lenders such as banks were hesitant to collaborate with new businesses. They didn't have high hopes for these ventures and thought they were too dangerous to pursue. Roger Smith, Bill Biggerstaff and Robert Medearis saw value in enabling this segment, and that was the start of Silicon Valley Bank.

Venture Capital has a special space in helping the Tech Startups blossom. Which SVB realised early on and had dealings with more than 600 VC firms, established their own VC subsidiary, and introduced a VC analytics service. This way the money doesn't actually leave the bank's coffers if the bank deals with both the borrowing startup and the venture capital firm that wants to invest in the startup.

And by 2017, their services included several Crypto related companies as well.

And Crypto had a decent run, up until 2021. But really, the fall of Both SilverGate and Silicon Valley Bank have little else in common apart from a decent Crypto exposure and customers demanding back their deposits all at once. You’ll see why.

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FED interest rate hikes and its impact on Crypto and startups

?You’ll remember, back in 2021, Jerome Powell assured all of us that Inflation was just transitory and nothing really to worry about. And Silicon Valley Bank and SilverGate really took that to heart, and shored up lots of long term, seeming low risk, treasury bonds and 10 year + Mortgage Backed Securities to back their deposits. While both these have pretty low credit risk, do you notice something similar with them both?

Yes, the tenure for both these were pretty long term, which meant they faced another kind of Risk. Interest Rate Risk.

So, as the Fed started hiking interest rates, the value of these “assets” started declining. But, a smart person would ask, how then did no one realise that, by simply looking at their balance sheet.

That is where Held-To-Maturity accounting comes into play. While its true your assets have fallen in value. You aren’t required to capture that, because your promise is to hold them to maturity when you’d be theoretically paid back the principal + interest. So it didn’t really matter, unless you’re liquidating, what the fair value of these bonds were at present. Or did it?

(fair value means the value the bonds were trading in an open market)

The first tree to fall in the forest was the crash of Terra-LUNA (read more here ) followed by the collapse of FTX. Several people rushed to pull their money out of SilverGate at that time, panicking over the contagion it would cause. Sure enough Silvergate had to liquidate, at a loss, in order to honor all those deposits. It come under massive regulatory scrutiny too, for enabling Alameda to pilfer away FTX’s customer funds, without raising a peep.

This made other crypto firms uneasy, and their once envious clientele, started severing ties like never before. So much so, that the company’r CEO announced that their scheduled annual filings would be delayed, and that they weren’t sure if they could continue to operate as a going concern!

For Silicon Valley Bank, the problem started with the fall in valuation of startups, and the lower ticket sizes being written to the ones who were raising funding. In fact, I quite liked Parth’s script of how the events unfolded, so I’ll leave it at that.

Bank Run on SilverGate and SVB

?The problem was not just that the Fed’s rapid interest rate hikes, and their Hawkish stance of economic indicators. A part of the problem was also the oh-so-long crypto winter, and the Funding pinch startups witnessed. In fact, by the admission of the SVB’s CEO, we know that they would not have collapsed had depositors waited out a few more months, till the Fed started lowering interest rates.

But really, why were depositors in such a hurry to get back their money ?

It all comes down to cashflows!

When money was easy, VCs really made it easier for startups to access money in order to grow. Growth at any cost. The cost was well, poor expense management. Most startups burnt through their funding, under the visage of Custmer acquisitions (read, Freebies). And figured they’d know how to monetise that customer base, once they grew big enough.

Unfortunately, they all, just like SilverGate and SVB, assumed that the economic conditions would stay just as they were at the moment.

So, they all went scrambing when VCs started asing them to show them the ROI, or return on their investments.

Some smart person in their accounts department realised that their Banks (for most tech startups, thanks to the YC connect, it would be SVB) were giving them 0% interest, whereas short term US treasury was up 5.22%. Well, who was it who said, make your money work for you even as you sleep? SO my unused VC funds can at least give me some returns right ? And that should be enough to assuage the investors concerns and help us get more funding?

So when the first troop of startups started pulling out Money, SVB had to sell their long term bonds, and take a loss of $1.8 Billion. Their share price plunged the next day on the news of this loss. As if to add salt to the injury, several erstwhile friends (VCs) started advising their portfolio companies to reduce their exposure to SVB.

Something similar had unfolded with SilverGate too. And so the board took the decision to wind down the bank. The result of which was liquidating all assets, and paying back their depositors. Shareholders though were wiped out in the process.

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How far will this contagion spread?

?Then, Gregory Becker, the CEO of SVB did something funny.

He called for a press conference, to send out a rather convoluted message, to let depositors and shareholders know that they were working on the situation. And “To not panic”. I swear, if it were an in-person conference, I am convinced that you could have heard a collective gasp go around the room. And a stampede would have ensued.

However the next day property managers at a few of SVB’s branches had to call the local authorities, to escort out a few gentlemen who had appeared to forcefully withdraw their holdings. The situation snowballed quickly, with the FDIC taking over. Not to mention the stock price taking a beating that it had to stop trading on the exchange on Thursday.

Now normally, banks do not really pay too much attention to their stock price, as long as they have good set of assets. But as we saw, SVB was forced to sell lots of their assets, at a huge discount.

But, my sense is that this collapse of two banks, in rapid succession, will not spread to the larger financial sector. And definitely not to Asia and India.

Why?

Simply because, unlike the Bear Stearn collapse, these banks weren’t really systemically entrenched. They were pretty deep rooted in their sector, the tech and the crypto space. Sure, they both did have some exposure to the real estate market, but that is a cyclical market, and by and large, most people have de-risked and accounted for that cyclicity.

Also, lets admit that after the GFC, the regulators did put in place a lot of guidelines and frameworks so that banks take on lesser risk than before. And one last point. This “contagion’ even if it spreads, will only to restricted to a few small, regional banks alone! Which is why you saw Signature bank quickly pull back on their crypto exposure two weeks ago.

But that is not where the story ends. A month back, we heard Greg, the CEO of SVB, mention, that they’d be the biggest beneficiary if the Fed took the pedal off the rate hikes. And even in his “Do not panic” conference, he did mention, that there wouldn’t be any losses, if they could just hold to maturity as designed.

And yet, we saw the CFO and the CEO liquidate a significant chunk of their holding in the company. With no clarification whatsoever.

What is next ?

?Honestly, the board of directors and executives must absolutely be held accountable for their actions. And not given a free pass like we saw during GFC. I mean, so many founders are having sleepless nights, trying to figure out how theyre gonna pay their staff come Monday (today!).

But as a system, what comes next?

We do have regulations in place, but we need better systems to monitor them. Like this entire thing, was clearly a mismatch of assets and Liabilities. You do not safeguard Short term liabilities with long term assets. Eve \n if that means slightly etter profits in your books.

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Coming to crypto, yes I do believe things will get harder. Why?

Well, SilverGate did have plans for their own StableCoin which given their presence in crypto, could have well been the ramp to help decentralised currencies replace the Dollar Dominance. While id love to scream conspiracy, I simply do not have the facts to back it all the way.

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So until then, I am going to keep my eyes open. And will keep you posted if I find something.

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See you next time!