Within one week the US Crypto industry lost both of its major banking partners. While the shocking collapse of Silicon Valley Bank has stolen the headlines and caused the Federal Reserve to put in place emergency liquidity procedures, the pain for the Crypto industry began with the announcement that Silvergate Bank would close its doors.

Since 2016 Silvergate had been a critical part of Crypto infrastructure in the US. Not only did the small Californian bank provide financial services to most of the industry, they also maintained a real time internal settlement network that allowed Crypto markets to function on a 24-hour, 7 days a week basis.

Silvergate’s settlement network, called the Silvergate Exchange Network or SEN, allowed trading firms to quickly arbitrage between exchanges, redeem stablecoins and settle over-the-counter trades. It allowed firms to keep the market liquid overnight and on weekends. SEN wasn’t the only network of its type, Signature bank maintained a similar service before it was closed, but it was the oldest and most widely used.

Almost all of Silvergate’s business was related to Crypto. It was the premier Crypto bank.

SEN was shut down on the Monday prior to the closure of the entire bank. Silvergate said it was a “risk-based decision”, which was perhaps a nod to the rumored investigations from the Justice Department and regulators.

Why did Silvergate close?

The first signs of real trouble happened a week before the ultimate shutdown. Silvergate announced that they were unable to complete their annual financial report and cited necessary revisions to accounting as well as pending regulatory inquiries and investigations.

Most troublingly, the bank said it was evaluating its “ability to continue as a going concern”

On this news the stock price plummeted. Notable short seller Marc Cohodes had already been pressuring the bank for months due to its ties to FTX. US Senators were also asking questions about the bank’s operations and potential money laundering issues.

The final death blow came as the Crypto industry withdrew their deposits, causing the bank to announce its voluntary liquidation, unable to maintain enough capital to operate.

The FTX connection

The story of Silvergate’s collapse really starts back in November. FTX had been uncovered as a fraudulent Crypto exchange and traders were pulling their money as rapidly as possible, not only from FTX but from all Crypto exchanges.

Silvergate acted as a payment provider to all of these exchanges. While some stored excess capital at other banks, Silvergate was used to store money that could be used to quickly wire to US customers. This put Silvergate at the coalface of the industry-wide run on exchanges.

In November, Silvergate saw $8.1B in deposits leave, around 70% of the bank’s deposit base.

It’s important to note that at this stage the withdrawal of deposits had nothing to do with confidence in Silvergate. The drawdown happened because exchange customers were pulling their money off exchanges rapidly, so the exchanges had to send their money out of Silvergate.

Silvergate held more than $1B in deposits for FTX, around 8% of the bank’s $12B peak in total deposits.

We later found out that Silvergate had been servicing FTX via an account held in the name of Alameda Research, the affiliated trading firm. Customers were directed to send deposits to this account, which ultimately enabled part of the misappropriation of funds at FTX.

It’s widely suspected that this conduct was just the tip of the iceberg of poor banking controls at Silvergate.

As Silvergate was servicing most of the Crypto industry via its SEN network, the bank would have been able to settle transactions internally. Nothing has been proven or alleged yet, but this likely meant that much less scrutiny was applied to these transactions than if there was a second bank as a counterparty.

Stopping the Run

Despite the brutal bank run, Silvergate survived November. They looked healthy enough and operational. It later became clear that the damage ran deep.

Silvergate had taken $4.3B in emergency loans from the Federal Home Loan Bank (FHLB) of San Francisco to service withdrawals during the run. This is a completely normal part of the banking system. The FHLB, which was established during the Great Depression, slowly changed over the years from a source of cheap capital for mortgage businesses to a provider of liquidity for holders of Mortgage Backed Securities.

Although Silvergate no longer had a significant mortgage business, they were still entitled to access funds from the FHLB.

The Senators who had been critical of Silvergate criticized these loans. While it was entirely legal to tap liquidity from the FHLB, politically it was a horrible look. In January the loans were called in on short notice. We still don’t know why.

Selling Underwater Bonds

If you’ve been following the broader US banking crisis you will understand that the heart of the issue is that the banking sector has a significant mark-to-market impairment on a sizable chunk of its reserve holdings. Put simply, banking deposits ballooned  in 2021 and short term bonds at the time were yielding basically nothing.

So banks moved out in duration to chase some yield.

Others have written extensively on the topic of how these underwater bond portfolios are causing problems, so I’ll refer you to some of those articles for a more in depth view. The brief point is that when interest rates began to rise in 2022 these longer maturity bonds dropped in value on the open market, meaning that banks became much more illiquid.

Across the banking sector this issue was dealt by placing the longer dated bonds into ‘Hold to maturity’ (HTM) portfolios. This meant that banks were intending to sit on the bonds until they matured, paying back their full face value and wouldn’t need to be sold at a loss.

It turned out that across the entire banking system around $650B in unrealized losses had been generated on HTM portfolios.

Silvergate was a particularly extreme example. The bank had more than doubled in size during 2021 with the Crypto markets booming. They grew their deposits most rapidly in the first half of 2021, while the Federal Reserve was still saying that there would be no rate hikes until 2024 and that inflation was transitory. They took a risk in buying longer dated bonds to back these deposits, but there really was no viable short term alternative.

This was all viewed as fine and safe. Regulators approved this action. There was no trouble as long as they didn’t lose a large amount of deposits.

Silvergate did lose their deposits. During the November run they were forced to liquidate a large amount of the bonds they thought they would never have to sell at a gigantic loss.

Silvergate made $1B in losses during Q4 of last year.

That’s not even including the ongoing losses in January and February as Silvergate sold more of their HTM portfolio to pay back the $4.3B loan from the FHLB. By any measure the bank was deeply underwater, Silvergate’s only hope would have been to ride out the drawdown and slowly recover deposits.

Was it a Hit Job?

Despite all of these losses the bank was fine until the FHLB loans were wound down. There hasn’t been any solid reporting of why this happened. It’s possible that Silvergate had lost so much capital it was no longer a qualified lender. It’s also possible that political pressure was put on the FHLB to execute the struggling Crypto bank. The FHLB now denies that they called in the loans. We will likely never know for sure.

With the FHLB loans in place Silvergate was not in a healthy state but it could continue to operate. As we now know, the balance sheet problems at Silvergate were present right across the community and regional banking sector. Silvergate may have been a little unique in it’s Crypto offerings, but it wasn’t unique in having major losses on its books.

The final nail in the coffin was the loss of confidence from the Crypto industry.

Pressure had ramped up throughout this year from Congressmen and Short sellers. Once Silvergate’s annual reporting was delayed, the panic set in and the Crypto industry withdrew their money. One week later the bank was closed.

The regulatory pressure had turned an underwater bank into an insolvent bank.

The only word from banking regulators was a contentious warning in January that banking Crypto customers was “unlikely to be consistent with safety and soundness principles”. Regulators weren’t telling banks that they couldn’t service the Crypto Industry, but they were heavily implying that the scrutiny would ramp up.

When Silvergate collapsed, multiple Congressman immediately began to gloat, blaming risky Crypto for the downfall.

Senator Elizabeth Warren tweeted:

“As the bank of choice for crypto, Silvergate Bank’s failure is disappointing, but predictable. I warned of Silvergate’s risky, if not illegal, activity—and identified severe due diligence failures. Now, customers must be made whole & regulators should step up against crypto risk.”

Senate Banking Committee Chairman Sherrod Brown warned:

“As the impact of FTX’s collapse continues to ripple outward, today we are seeing what can happen when a bank is overreliant on a risky, volatile sector like cryptocurrencies. I’ve been concerned that when banks get involved with crypto, it spreads risk across the financial system and it will be taxpayers and consumers who pay the price. That’s why I am continuing to work with my colleagues in Congress and financial regulators to establish strong safeguards for our financial system from the risks of crypto.”

The collapse of Silvergate should have been a warning that the banking system was impaired. That bond portfolios across the sector were underwater and needed help. Instead it was taken as an opportunity to dance on the grave of a struggling industry.

The signs foreshadowing the broader banking crisis were there, but ignored in favor of blaming Crypto.

Who knows if the broader bank failures could have been prevented if the failure of Silvergate were taken seriously. The most suspicious part is that within two weeks both of the major Crypto banks have been shut down and there is no more real-time settlement network available to the Crypto industry.

Implications for the Crypto Industry

Silvergate itself was unique not in its willingness to provide deposit accounts to Crypto firms, but in its provision of real-time settlement to the industry. We will likely see significantly worse liquidity across exchanges as trading firms will need to wait for wire transfers to arbitrage between exchanges. The liquidity will become fractured, especially on weekends and overnight, if a solution is not found.

The broader problem will be getting banking services available to the industry again. Large firms will have no problem. Coinbase, Circle and Kraken already hold accounts with the major banks and should have no issue. The problem will be ensuring that trading firms, VC firms and startups have access to banking. It’s possible that the large banks will take them all in, but for now there are a huge number of firms that find themselves without the banking services they used to have access to.

The most dangerous part of this story is that it looks a lot like additional regulatory pressure was applied to banks that dared to service Crypto firms. It’s entirely possible that the failure of Silvergate gave a reason to take a hard look at other bank’s balance sheets and fomented the broader bank runs.

We also saw that banking regulators would not step in to backstop a bank that had fallen out of political favor. Almost all of Silvergate’s deposits were not covered by FDIC insurance and would have taken months to recover at a substantial loss. Lawmakers seemed gleeful that the notorious Crypto bank had failed.

A loss of confidence in one bank can easily turn into a loss of confidence in the banking sector. This is especially true for the American public that are deeply scarred by the banking failures of 2008. Silvergate almost certainly played fast and loose with their anti-money laundering procedures, but that’s what fines are for. The Crypto industry viewed the shutdown of Silvergate as an execution.

Silvergate was the first significant banking failure since 2017. It opened Pandora’s box.