Silvergate Bank Becoming Latest Victim of Crypto Business
What happened to Silvergate is actually nothing new. This incident was the result of a violation of the prudence principle and inadequate risk management.
By
ARDHIENUS
·5 minutes read
Cryptocurrency has taken another hit with the collapse of Silvergate Bank, a financial institution that played a strategic role in the United States economy. Silvergate Capital Corporation (SCC), which is the holding company of Silvergate Bank, decided on 8 March to close down Silvergate Bank and liquidate it.
The SCC’s decision was initially triggered when, in the fourth quarter of 2022, Silvergate customers withdrew funds (bank run) amounting to more than US$8 billion. Silvergate was forced to sell its securities at a discount to cope with the massive fund withdrawal.
As a result, the California-based bank, which entered the cryptocurrency business in 2013, suffered huge losses amounting to $1.05 billion. In the third quarter of 2022, it still earned a profit of $40.6 million.
Bank runs have indeed become the most concerning threat among financial lenders because of its almost always implosive effect on a bank, whether it is ailing or healthy.
How did crypto assets contribute to Silvergate's collapse? Different from common banking practices, Silvergate accepted third-party funds (DPK) from holders of crypto assets, especially crypto exchanges and institutional investors. Not surprisingly, Silvergate was deemed an investment-friendly bank for crypto business.
Interestingly, Silvergate did not pay an interest on savings. To attract holders of crypto assets to place their funds with it, the bank provided a crypto trading platform under the Silvergate Exchange Network (SEN). The SEN operated as a payment network for crypto companies to exchange fiat money (US dollar and euro) with each other without time limits.
The SEN outperformed the existing payment system that takes days to complete crypto asset transactions. As a result, it handled transfers of US$117.1 billion during the fourth quarter of 2022, an increase of 4 percent from the third quarter of 2022.
As for the assets, the majority of funds from customers were invested in securities or placed with other banks, with only a small portion reallocated as credit. With such a balance sheet structure, Silvergate's operations earned a sizable profit. It was because the interest expenses that Silvergate had to bear was quite low, as the deposits from crypto asset holders were not subject to interest.
This business model demonstrates incorporation of the crypto industry and traditional banking. Banks’ involvement in crypto assets is of serious concern to world financial authorities, such as the International Monetary Fund (IMF), as well as many central banks, because it is feared they could trigger a new type of world financial crisis.
The upheaval in crypto assets, especially in Q4 2022, partly due to impacts from the Fed's interest rate increase and the collapse in November 2022 of FTX, the world's largest crypto exchange, triggered a crisis of confidence throughout the digital assets ecosystem. This prompted many industry players to switch to risk-off investments across digital asset trading platforms.
This spread to Silvergate, resulting in its significant outflow of customer deposits during the same quarter. As a result, Silvergate took several actions to maintain the liquidity. It started using $4.3 billion in wholesale funds from the Federal Home Loan Bank of San Francisco. However, because this could not be extended, Silvergate was forced to sell its securities worth $5.2 billion in the face of customer withdrawals while maintaining liquidity.
The urgent need for large funds prompted Silvergate to conduct a fire sale for its securities amidst the discouraging bond sales in the stock market, due to the Fed’s monetary tightening policy. In early March, the SEN platform also lost clients in the digital assets industry, such as Coinbase Global Inc., Galaxy Digital Holdings Ltd., and Paxos Trust Co., which led to the SEN halting its operations. This added to the grim future of Silvergate.
What happened to Silvergate is actually nothing new. This incident was the result of a violation of the prudence principle and inadequate risk management. First, the bank was too dependent on short-term deposits placed as assets over a longer duration. There was a maturity mismatch between liabilities and assets.
Second, the majority of third-party deposits mainly came from crypto exchanges and institutional crypto investors. In the third quarter of 2022, the number of Silvergate depositors reached 1,677 with a total deposit value of $11.87 billion. In the fourth quarter of 2022, the depositors were 1,620 with total deposit value of $3.83 billion. It means only 57 depositors withdrew their funds, at a total value of $8.04 billion.
What happened to Silvergate is actually nothing new. This incident was the result of a violation of the prudence principle and inadequate risk management.
Although this looks profitable because the deposits were not subject to interest, the value of crypto assets is very volatile, making it vulnerable to market shocks and subsequent withdrawals. Moreover, digital assets are intangible, with their value being determined only by the balance between supply and demand. One thing that appears to be of some reassurance regarding the reverberating effect, though considered minimal, is that Silvergate will repay all of its customers’ funds.
Even so, the Silvergate case still calls for vigilance among the world's financial authorities. This is because there is the largest bank that serves crypto asset industry, namely Signature Bank, which had assets of $110.36 billion in 2022, or 10 times the assets of Silvergate.
Indonesian financial authorities need to continue to monitor this potential risk. It is necessary to regulate the crypto asset business strictly and its relation to banks to prevent a similar case.
Ardhienus, Deputy Director of Financial System Surveillance at Bank Indonesia