What is Silvergate? How will the Silvergate collapse affect the crypto market?

Silvergate Bank is known for its crypto-friendly stance and has served many renowned clients including Coinbase, Kraken, Gemini, Genesis, Circle, Bitstamp, Paxos, and others.

Silvergate was one of the earliest banks to get involved in digital asset investments, but a recent event has been surprising indeed. In 2023, due to improper risk management and the impact of interest rate hikes, Silvergate Bank faced huge losses and declared bankruptcy.

For non-crypto users and investors, Silvergate’s bankruptcy seems to be a reflection of a series of bankruptcies under the influence of the Federal Reserve’s interest rate hikes. However, for users and practitioners who have been involved in the crypto market for a long time, the bankruptcy of Silvergate has caused a significant impact in the wider crypto space, and discussions among users in various communities have been continual.

First, let’s take a look at what Silvergate Bank is, as well as the causes and consequences leading to its bankruptcy and liquidation.

What is Silvergate?

Silvergate was founded by Derek Eisele in 1988 as a tiny community lender in California. It focused on real estate deals in its early days.

Users who are familiar with the history of cryptocurrency may have heard about Silvergate. It is regulated by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve (Fed), and the California Department of Financial Protection and Innovation (DFPI).

This regulation enabled Silvergate Bank to develop a real-time payment system called the Silvergate Exchange Network (SEN), which allows cryptocurrency exchanges and institutions to exchange dollars or euros in real time.

The service provided by Silvergate Bank was revolutionary at the time, as most traditional banks don’t offer real-time payment capabilities that meet the 24/7 payment needs in the crypto market.

The SEN enables exchanges and institutional investors to conduct uninterrupted, instant settlements between their Silvergate accounts and the accounts of other Silvergate clients. Its RESTful JSON APIs allow clients to query wire transfer data and avoid transaction delays due to bank business hours restrictions, which is a key pillar supporting the 24-hour operation of the global crypto market.

As of Q4 2022 when Silvergate Bank faced bankruptcy, it had more than 1,600 clients using SEN and held deposits worth approximately $12 billion.

Silvergate doesn’t charge any client fee for using the SEN and pays no interest for the deposits. It earns interest differentials by investing the deposits in bonds or issuing loans, and also provides BTC-collateralized loans through SEN Leverage.

In October 2022, Silvergate Bank’s commitment to SEN Leverage hit a new high of $1.5 billion, but the subsequent bank run gradually led it into a crisis.

Silvergate’s Role in Cryptocurrencies

As a bank serving digital assets, Silvergate Bank provides a variety of blockchain-related services, mainly including:

• Digital asset deposits: The digital asset deposit service allows customers to deposit digital assets such as BTC, ETH, and LTC.
• Digital asset loans: The digital asset collateral loans service allows customers to use their digital assets as collateral to obtain loans.
• Digital asset trade settlement: The digital asset trade settlement service allows customers to settle digital asset transactions quickly and securely.
• Digital asset payment processing: The digital asset payment processing service allows customers to use digital assets for payments.
• Digital asset financing: The digital asset financing service allows customers to obtain digital asset finances to develop their businesses.

It is important to note that the digital asset loans service is realized by using SEN Leverage, where users can use BTC as collateral to obtain loans from Silvergate. This is the highest revenue-generating business for the bank.

For example, MacroStrategy, a subsidiary of Microstrategy, which was once the US-listed company with the most BTC holdings, successfully obtained a $205 million fixed-term loan from Silvergate in March 2022 using BTC as collateral.

Anyway, as the first bank to the crypto market, Silvergate successfully positioned itself as the main channel for promoting the flow of fiat funds and the conversion of cryptocurrencies between exchanges.

Silvergate’s clients include some of the largest crypto firms in the United States, such as Coinbase, Kraken, Gemini, Genesis, Circle, Bitstamp, and Paxos mentioned earlier, as well as FTX, the most well-known player in the past year. Silvergate’s bankruptcy and liquidation have a direct correlation with the meltdown of FTX.

However, as a crypto-friendly bank, Silvergate has provided an important boost to the development of the entire industry since its participation in the crypto market in 2013. Since its founding in 1988, Silvergate has never been a large-scale banking institution, with its deposits steadily being at hundreds of millions of dollars.

Due to the limitation of inadequate available funds, Silvergate adhered to a conservative business strategy for a long time. And the strategic foresight of its internal executives in the financial market prevented Silvergate from suffering significant losses during the 2008 financial crisis.

In the same year in 2008, Alan Lane became CEO of Silvergate, bringing with him extensive financial experience in the banking industry.

In 2013, after investing in BTC personally, Alan Lane shifted Silvergate’s business towards the crypto field.

Silvergate’s Development in the Crypto Market

In the early days of cryptocurrencies, it was difficult for projects and companies in the industry to obtain services and support from traditional banks.

Things turned around after Barry Silbert, the founder and CEO of SecondMarket, sought banking services from Silvergate in 2013. Alan Lane began to pay attention to the development of BTC and the broader cryptocurrency space, and led Silvergate to venture into it.

By 2017, Silvergate had clients of over 250 crypto companies, with deposits increasing to $2 billion. That same year, Silvergate proposed to ​​develop its own trading network to enable 24/7 trading of fiat and cryptocurrencies.

Silvergate’s trading network, SEN, was officially launched in early 2018 and attracted even more clients of crypto firms, with the number of users more than doubling. The introduction of SEN enabled Silvergate to convert fiat currencies and cryptocurrencies at any time, ensuring robust market liquidity and providing significant infrastructure for the crypto market at the time.

More importantly, as Silvergate accompanied the development of the crypto industry, many leading crypto companies began to use SEN to develop their own businesses, which further drove Silvergate to have a positive trend.

In 2019, Silvergate held its first initial public offering (IPO), and its stock began trading on New York Stock Exchange. Despite the bear market in the crypto industry at the time, Silvergate still grew exponentially.

By 2020, Silvergate owned nearly a thousand clients, with hundreds more wanting to join. Among the 850 crypto clients at the time, it had 61 trading platforms and 541 institutional investors. The funds that these institutional investors contributed accounted for a significant portion of the crypto market capitalization and trading volume at the time.

In 2021, along with the development of the crypto industry that had re-entered the bull market, Silvergate’s stock price experienced a parabolic trend, hitting a high of slightly over $217, a nearly 16-fold increase from its IPO price. Silvergate’s deposits increased parabolically, reaching a peak of over $14 billion, and the total transfer volume on the SEN network at that time also reached a high of nearly $1 trillion.

In early 2022, Silvergate’s performance looked favorable. It purchased Facebook’s failed cryptocurrency project Diem for $200 million. The intention behind this move was quite clear: Silvergate was trying to create its own governance token, circulate it on the SEN network, and use it for payments. This move later became one of the important reasons why Silvergate suffered regulatory scrutiny before its collapse.

With the crypto’s bear market starting in 2022, concerns about Silvergate’s solvency were mounting among its customers. The reason was that Silvergate provided BTC collateral loan services, and MicroStrategy’s $205 million loan business in March was considered quite risky by many customers. At the same time, due to the loss of user confidence caused by the crash of the world’s second largest exchange FTX, major centralized exchanges are facing a run on withdrawals.

As a bank that provides deposit services, Silvergate Bank’s crypto deposits plummeted by 68% in the last quarter of 2022, and it processed over $8.1 billion worth of customer withdrawals. This caused a serious liquidity and solvency crisis for Silvergate, resulting in cumulative losses of over $949 million, which depleted all of Silvergate’s profits since 2013.

Regarding this, Silvergate explained that when the crypto market showed signs of a crash, SEN can immediately sell any BTC used as collateral. Furthermore, compared to regular banks, Silvergate Bank was quite robust as it held both customers’ cryptocurrencies and cash.

The explanation did not boost the confidence of the majority of crypto users, as Silvergate’s main customer base is not ordinary exchange users. The best way to deal with the crisis is to have ample asset reserves. However, the earlier FTX collapse left a fatal hidden danger for Silvergate.

Silvergate and FTX

In 2018, Alameda Research opened an account at Silvergate, which apparently passed Silvergate’s review process. FTX used Alameda’s account at Silvergate to transfer customer funds. Prior to the incident, Silvergate had already sensed some crisis before the bankruptcy of FTX and Alameda.

Shortly before FTX and Alameda announced their bankruptcies, Silvergate issued a statement assuring customers that its SEN network was working as normal. In this statement, Silvergate said that if any liquidity problems arose, Silvergate Bank had the ability to borrow from the Federal Home Loan Bank.

On the same day that FTX and Alameda announced their bankruptcies, Silvergate issued another statement confirming that FTX itself had an account at the bank, but FTX’s deposits accounted for less than 10% of all deposits.

While Silvergate stock rallied due to small exposure to FTX’s issue, the recovery was short-lived. In December 2022, some people in the US political circle began to call for an investigation into Silvergate’s ties with FTX and Alameda.

In January 2023, Silvergate revealed that after the FTX crisis, it experienced frequent and high-amount bank runs, which depleted all the profits it had earned since 2013. Silvergate had to lay off 40% of its workforce to stay afloat. It later announced it had taken out a loan from the Federal Home Loan Bank.

However, BlackRock, the world’s largest asset management company, took advantage of this opportunity to buy Silvergate’s shares at a low price and now holds 7.2% of Silvergate’s shares. Stake Street, another asset management company, acquired 9.2% of Silvergate’s shares during the same period.

The U.S. Department of Justice announced in February that it was investigating Silvergate’s connections with FTX and Alameda, which came as a big blow to Silvergate. Subsequently, Silvergate’s stock became the most shorted in the market.

In early March, Silvergate announced that it would delay the release of its annual report, acknowledging that it could face further investigations and might not survive. At about the same time, Silvergate closed the SEN network, as its highest-profile clients of crypto firms abandoned it and transferred their business to other banks.

The end result was that Silvergate declared bankruptcy and went into liquidation. Its assets may be acquired by other large banks, allowing Wall Street capital to control the most valuable financial infrastructure in the crypto industry.

Impact of Silvergate’s Closure

After declaring bankruptcy, most of Silvergate’s top clients withdrew and joined other banks that offer cryptocurrency services. In theory, this was a solution to the Silvergate collapse crisis, but in practice, it caused additional problems.

Silvergate is currently the only bank with a 24/7 fiat and crypto trading network, which is desperately needed by the market and its users. Moreover, the scattered clients have limited options, with only two other major crypto banks in the US, Signature and Metropolitan.

What’s worse, in January this year, Metropolitan announced its exit from the crypto industry due to regulatory pressure from Operation Chokepoint 2.0, making Signature the only viable option for most crypto firms. This is the reason why most of Silvergate’s top clients have recently turned to Signature.

But the problem is that Signature announced in December 2022 that it would scale back its crypto exposure. It has since started limiting its banking services to some of the larger crypto companies. In January, Signature limited the USD transactions on Binance US and recently took similar actions against Kraken, which is an unprecedented restriction for the crypto industry.

Furthermore, in Q4 last year, Signature obtained $10 billion of loans from the Federal Home Loan Bank, nearly triple the loan amount Silvergate has secured.

Such a large amount of loan could lead to regulatory scrutiny of Signature. Even though Signature seems to have a healthy client network, if Silvergate were to collapse, regulators and governments would crack down on Signature and any remaining crypto banks, viewing them as a threat to traditional banks.

Even if the remaining few crypto banks are somehow allowed to operate without scrutiny, it does not change the fact that the closure of the Silvergate’s SEN network is detrimental to the normal functioning of the crypto market.

Without SEN, it is difficult for institutions to enter and exit the crypto industry. More importantly, without it, the flow of money to banks is limited by business hours, which is disastrous for the crypto market that supports 24/7 trading.

In general, Silvergate’s business model is overly reliant on the crypto market, making it easy to fall into a death spiral when faced with a crisis. After the closure of the SEN network, multiple crypto companies that had partnered with Silvergate announced the termination of their partnership.

Silvergate has announced that all user deposits will be fully reimbursed after closing its banking operations. The team is considering how to preserve the remaining assets’ value as much as possible and evaluating solutions to the claims. However, it still needs further verification whether all users’ deposits can be returned smoothly.

After the closure of SEN, a complete replacement service from other crypto banks has not yet been launched, and Silvergate’s affinity for the crypto industry is gone. Smaller crypto startups will find it increasingly challenging to find new banks to partner with, which is undoubtedly frustrating.

Although Signature has become a temporary replacement for SEN because it provides a similar payment network Signet, it appears to have little interest in expanding its crypto business. This may be due to concerns about the risks of the crypto market. In December last year, Signature even expressed a desire to reduce crypto-related deposits to less than 20% of the total deposits, with the ultimate goal being to reduce them to less than 15%.

This move is consistent with Signature’s approach to limiting the crypto firms it intends to serve.

However, what is most worrying is that US regulators may take a stricter stance on banks offering cryptocurrency services in the future due to the collapse of Silvergate.

Conclusion

The collapse of Silvergate is a major event in the crypto industry. Looking back over the past ten years, Silvergate has played a very important role in the development of the entire crypto market.

Apart from the various reasons mentioned above, the collapse of Silvergate is also attributable to the scrutiny and pressure from US regulators. After all, Silvergate was not the only bank affected for opening accounts for FTX and Alameda to transfer funds, but it was a typical case that was subject to strict scrutiny, leading to a rapid loss of user confidence. The run on deposits depleted Silvergate’s reserves in a short period of time, and became the most direct cause of the collapse.

The reason why Silvergate faced such a stringent investigation may be related to its plan to issue its own governance token. After all, the existence of governance tokens within the traditional banking system may cause more troublesome regulatory issues and even lead to the disintegration of the existing financial system in the United States.

Silvergate’s SEN network, which provides round-the-clock fund settlement services, has the same function as the fast payment system FED Now that the Federal Reserve is about to launch. And the digital dollar CBDC recently issued by the Federal Reserve is a reflection of strengthened scrutiny of digital currencies. Perhaps the regulatory plans and measures from the government are an essential cause for the fate of Silvergate.

In the future, the demand for settlement, lending, deposits and payments in the crypto industry may become the most important connection that bridges traditional finance and the crypto market. And the relevant regulation and distribution of funds may have a profound impact on future market trends. This is something that everyone should pay attention to.