California community bank’s bet on crypto pays off – American Banker


Silvergate Capital has carved out a niche catering to cryptocurrency exchanges at a time when digital assets might seem like a risky business for some mainstream banks. So far, the bet appears to be paying off.

The $12 billion-asset bank in La Jolla, California, provides an alternative payment rail to facilitate transactions between institutional investors and crypto exchanges such as Coinbase, Kraken, Gemini and Bitstamp. Silvergate also enables stablecoin issuers to mint their digital currency.

While regulators and even some banks remain skeptical about the security and business potential of crypto, Silvergate is honing a specialty that other banks have tried to mimic. Both exchanges and institutional investor companies use the bank’s Silvergate Exhange Network, which allows the buying and selling of bitcoin at night and on weekends when normal payment rails like the automated clearing house and FedWire are off.

Silvergate Bank CEO Alan Lane says he has become a convert to the power of cryptocurrencies to disrupt the financial system in a good way.

“I’ve drunk the Kool-Aid as it relates to bitcoin and decentralization and all of that,” Lane said in an interview. “I believe that this is a better financial future for our kids and grandkids. … I want to leave them not only with a healthy planet, but also with a healthy financial system. And I think that bitcoin can help with that.”

Silvergate’s strong second-quarter results, growing customer list and selection to issue Diem — the digital currency originally known as Facebook’s Libra — are signs that the community bank’s pivot into cryptocurrency is working.

In the second quarter, total volume of dollar transfers over the Silvergate Exchange Network increased 44% from the prior quarter, to $240 billion. This was an increase of 968% from last year’s second quarter.

The number of Silvergate’s digital currency customers grew to 1,224 in the second quarter, compared with 1,104 in the first quarter and 881 in June 2020. Digital currency customer deposits grew by $4.3 billion to $11.1 billion as of June 30, 2021, from $6.8 billion on March 31, 2021. Overall assets and deposits have seen strong growth over the past year, largely as a result of bitcoin-related business.

Analysts said Silvergate’s strong second-quarter performance coupled with the decline in bitcoin’s value showed the resiliency of its business model.

“I absolutely believe that this is a first mover and it’s an industry leader in what it’s going after,” said Michael Del Grosso, research analyst at Compass Point Research & Trading in Miami.

A few new entrants have tried to follow the lead of what Silvergate has built, including Signature Bank with its blockchain-based digital payments platform Signet, and BankProv with ProvXchange, which lets clients exchange money with each other in real-time without the delays of traditional payment rails.

“But right now, at least in terms of what they’re building for digital currency-focused hedge funds, for exchanges, for stablecoin providers, in network terms, Silvergate is the Visa of the space,” Del Grosso said.

Despite the strong quarter, the number of crypto transactions facilitated on the bank’s network actually decreased by 17% compared with the first quarter to 137,947. This was still an increase of 242% from the 40,286 transactions handled in the second quarter of 2020.

Lane says the decrease in transactions was caused by the drop in the price of bitcoin in the second half of the quarter, especially in June. Many institutional customers sold down their positions and went to cash, or moved dollars around the system, he said.

“They were doing fewer transactions on a daily basis, but those transactions were bigger in dollars,” Lane said.

ILC origins

Silvergate Bank opened in 1988 as a state-chartered industrial loan company, affording it backing from the Federal Deposit Insurance Corp.

Lane joined the bank in December 2008, during the financial crisis and just before the first bitcoin block was mined in January 2009. The bank had $280 million of assets and 40 employees.

Before joining Silvergate, Lane was president and chief operating officer at Southwest Community Bank in San Diego. Before that he was CEO of Business Bank of California.

“I was attracted to Silvergate because of its size, but importantly, because it was clean,” Lane said. “It had no credit quality issues and strong capital ratios for a small bank. Therefore it was a potential platform that could be built upon.”

The bank’s branches gathered high-rate CDs and money market accounts, and made residential and commercial real estate loans.

“I was looking for a bank that was already up and running, but that could be molded and changed,” Lane said.

Within three months of joining the bank, Lane converted Silvergate’s ILC charter to a commercial bank charter and started hiring people.

A market that ‘never sleeps’

In 2013, Lane saw the rising popularity of cryptocurrency and realized there was an opportunity to create a network that would reduce friction and counterparty risk in cryptocurrency transactions.

“The ‘aha’ moment for us several years ago was that there was this friction that existed between the traditional banking system and the digital currency system, because traditional banks only operate 40 hours a week, Monday through Friday,” Lane said. “And they’re reliant on the Federal Reserve payment system or Swift in Europe. Yet the digital currency markets trade 24 hours a day, seven days a week, they just never sleep.”

The proprietary Silvergate Exchange Network enables institutional investors to buy and sell crypto assets by facilitating transactions between the investor and the crypto exchange. Using the SEN, both investors and exchanges can transfer U.S. dollars between their accounts in near-real-time, 24 hours a day and seven days a week. Silvergate maintains a ledger through which these trades occur.

“Today, literally anybody who is anybody in crypto is on the Silvergate Exchange Network,” said Joe Vafi, a fintech analyst at Canaccord. “All the big exchanges, all the institutions, the enterprises that are getting into this, are connected via Silvergate.”

SEN transactions are free. The bank does charge fees for use of ACH, wire transfers and foreign currency exchange. Stablecoin issuers are charged a monthly subscription fee.

“We take the approach that these are transfers across our platform, essentially going from one customer’s account at Silvergate to another customer’s account at Silvergate, and they’re free to us,” Lane said. “And so we pass on that zero cost to our customers.”

Silvergate also makes money through a loan product called SEN Leverage, through which institutional investors can borrow against the bitcoin they own.

“You can think of it like a margin loan,” Lane said. “If customers pledge their bitcoin to us for a loan, we will lend them dollars to buy more bitcoin.”

Lane acknowledges there is risk because bitcoin is volatile. However, the bank has had no losses and no forced liquidations on these loans, which it began offering in January 2020.

He attributes the low loan losses to the low loan-to-value ratio on these loans. The bank monitors the loans 24/7, he said.

“If someone has $1,000 worth of bitcoin, maybe we’ll only lend them $650,” Lane said. “So the price of bitcoin could go down by 35% before there’s any paydown or liquidation needed. Yet we have a trigger in there that says if it gets to 80%, then we’re going to liquidate. So we’ve got built-in safeguards.”

A third way Silvergate makes money is by offering digital asset custody. Most of the time, customers have Silvergate hold their bitcoin because they want to borrow against it.

The bank still has one branch and does some traditional banking activities.

“This whole digital currency initiative has really dwarfed what we used to do,” Lane said.

Crypto focus brings new risks

Silvergate’s unusual business model comes with unusual risks.

One is the chance of a mass exodus of institutions from crypto, Del Grosso noted.

“Silvergate bet the farm, so to speak, on those types of customers,” he said. “That said, I think this is a strategy that has staying power.”

There is also regulatory risk. Treasury Secretary Janet Yellen, Federal Reserve Board Chair Jerome Powell and some members of Congress have all raised the idea of new regulations and supervision over cryptocurrency. President Biden’s working group on financial markets plans to issue recommendations for new cryptocurrency regulations.

“What I hope will happen is that members of Congress will do the hard work to really understand what bitcoin is and what some of the other use cases are,” Lane said.

“There’s this narrative that it’s only used by bad actors, but clearly that’s not the case,” he said.

Looking ahead

Silvergate’s future venture is that it expects to begin issuing Diem, the digital currency that Facebook originally tried to launch as Libra, by the end of the year.

That Silvergate was chosen to issue Diem “goes to show that all the big players in this industry look at Silvergate as a key resource for different parts of their business to get it over the finish line, make it better, to make it more profitable, to make it more efficient,” Vafi said.

With the weight of Facebook and others behind it, Diem could escalate Silvergate’s growth.

It could also make Silvergate the target of a potential acquirer, Del Grosso said.

“It would make a lot of sense for a large bank to come in and buy Silvergate if they wanted to break into the crypto space and they weren’t there already,” Del Grosso said.

Lane acknowledges this threat.

“If we didn’t consider that at least as a possibility, we’d be pretty naive,” he said. The two banks where he worked previously were both sold to bigger banks.

“We’re certainly not building Silvergate to sell it to the next bank,” he added.

If a large bank or other company came along with an offer, it would come down to a strategic and financial decision. “Are they offering us potentially more than we think we can do if we stay independent? That’s the litmus test,” Lane said.

For now, Lane would prefer that Silvergate remains independent.

What bitcoin could do for future generations, he said, is create “a financial system that is much more fair to everybody and not just for the benefit of a few,” he said.

“A decentralized, bitcoin-based financial system could provide a more fair distribution of wealth and opportunity for everybody to participate.”

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