Silvergate Bank: Sometimes it pays to be bold

What is behind the success of Silvergate Bank?
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Silvergate Bank grew from its humble beginnings in 1988 to a leading banking services provider for the US crypto industry. Where every other bank saw unacceptable risks and regulatory headaches, Silvergate recognized a huge opportunity. The key to Silvergate’s success in the industry was strong leadership, deep industry knowledge, and active dialogue with the regulators.

It all began in 2008

“I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.”

With these words, Satoshi Nakamoto introduced his new invention of Bitcoin. The year was 2008, and almost nobody paid any attention.

In the same year, Alan Lane joined the Silvergate bank as CEO—Silvergate was a small institution established in 1988, with 40 employees and a modest $300 million in assets. As the banking world around was on the verge of collapse, nobody paid any attention to the small bank.

Compared to many other US banks, Silvergate was in a very good position in 2008. Its board of directors suspected the mortgage market had been overheating for years already and things would get ugly sooner or later. Although the bank was mostly focused on real estate lending, they chose the path of deleveraging in an overleveraged market. As a result, the bank’s balance sheet shrank before 2008 and grew between 2008-2013 with assets growing from $300 million to $800 million. The reason for such growth was that Silvergate remained one of the few banks capable of lending in the post-crisis environment, as its balance sheet wasn’t loaded full of toxic assets. Huge demand for lending services forced Alan Lane to look for new sources of business deposits—and he found struggling Bitcoin businesses, which were growing rapidly but were rejected by practically every bank in the country.

Knowing where to look

“Where other people see risks, oftentimes if you can figure out how to mitigate this risk, there’s an opportunity.” —Alan Lane, Silvergate CEO

Lane began attending Bitcoin conferences and talking to startup founders. In a community bent on building a bank-less financial system, a middle-aged banker must have stuck out like a sore thumb. Nevertheless, the Bitcoin companies—especially the exchanges—needed bank accounts and Lane knew it. He became passionate about Bitcoin and the opportunity it could bring to the small bank, spread his passion to Silvergate’s board of directors, and got to work.

The first industry client that Silvergate banked in 2013 was SecondMarket, the first US regulated Bitcoin broker-dealer that was later acquired by Nasdaq. SecondMarket was an obvious pick for Silvergate, as the company was backed by professional investors like Chamath Palihapitiya’s Social capital (Series C, 2011) and had a strong drive to be regulatory compliant. The only thing that prevented SecondMarket from having a reliable banking partner was the irrational Bitcoin stigma.

One of the key reasons why Silvergate never got into trouble with regulators was the strong understanding of Bitcoin infrastructure. When onboarding clients such as SecondMarket, Silvergate requested transaction IDs (TXID) related to the client’s brokerage/exchange services. This way, Silvergate staff could check via blockchain explorer that the amount of money flowing through Silvergate accounts matched the amount of bitcoin sold and there were no shenanigans taking place. The transparency of Bitcoin blockchain was the key to risk mitigation in the crypto banking business—but few banks made the effort to truly understand the nature of Bitcoin.

Just the right amount of cypherpunk

Bitcoin arose from the cypherpunk movement—a hacker collective focused on increasing privacy and censorship resistance through technological means. Satoshi arrived at his invention by merging multiple technologies developed by active cypherpunks like Adam Back. The cypherpunk ethos within Bitcoin has been strong since day one, and this fact greatly helped in keeping Bitcoin open, free for everyone to engage with, and unchangeable in its key points, namely the monetary policy. Companies attempting to build their business on top of Bitcoin either accepted the nature of Bitcoin early on or learned the hard way later.

For Silvergate and its clients, this manifested itself in accepting Bitcoin as it is and bending their internal policies to conform to the existing regulatory environment. Since onboarding their first client, Silvergate set up a strong compliance program and proactively engaged in dialogue with the regulators to explain in detail what they were going to do. Financial regulators usually don’t like surprises, and emerging cypherpunk networks like Bitcoin are full of possible surprises. So the one condition Silvergate set for their potential clients was the willingness to fully comply with existing regulations. For Silvergate, the problem wasn’t dealing with Bitcoin itself, but rather with the fiat infrastructure—and this required full compliance.

Through this approach, Silvergate was able to expand its range of services offered to crypto companies soon. In the early years (2013–2015), providing the Bitcoin businesses with simple checking accounts was more than enough. By 2016 the industry and businesses expanded, and along with it the needs for further financial products. Silvergate had to focus on improving liquidity, eliminating frictions and counterparty risks. The main problem was that banking infrastructure was working on an 8/5 basis at best (barring any holidays), while Bitcoin has always been running 24/7. This discrepancy caused many headaches and lost opportunities for the Silvergate clients—the banking infrastructure simply had to catch up with Bitcoin.

Thus the Silvergate Exchange Network was born.

Silvergate Exchange Network

To truly become a full-fledged bridge between traditional finance and Bitcoin, Silvergate had to solve the banking infrastructure problem, which was that it worked less than 25% of the time (just 40 hours out of weekly 168). In the years preceding the establishment of Silvergate Exchange Network (SEN), Silvergate already had a solid API infrastructure in place. And Silvergate’s API wasn’t just the usual passive API for checking the balances—taking a note from Bitcoin exchange APIs, the Silvergate built transactional APIs, allowing clients to initiate transactions without the necessity to log into the internet banking interface.

The transactional API infrastructure was instrumental in launching the SEN in late 2018. Under the hood, SEN is “just” a network of API commands that makes global, instant, and free transactions in USD possible for the Silvergate clients. And since Silvergate already banked most of the US crypto exchanges, trading desks, and institutional investors, linking them all together via an instant transfer network was the next logical step.

By bringing USD transactions in line with the crypto industry, the following problems were solved:

1) Capital efficiency

Investors, traders, and other actors no longer need to hold large deposits at exchanges and trading desks, as they can move over funds whenever needed, be it day, night, or public holiday.

2) Institutional-grade leverage trading

Professional investors had a hard time entering margin trades before SEN, as there was no way to quickly move funds to the exchange in case of a margin call. Stablecoins were always a possibility, but these necessarily carry a risk of their own. Having the ability to instantly deposit real dollars made institutional-grade leverage trading possible. SEN Leverage, as the product is called, was launched in Q1/2020 in partnership with Bitstamp, one of the oldest and largest European crypto exchanges.

3) Institutional-grade Bitcoin-collateralized loans

The same benefits apply to bitcoin-backed loans. When borrowers can instantly and automatically pay back a part of their loan in case of a Bitcoin price dump to avoid liquidation, they will have a much easier time borrowing against their Bitcoin. This is potentially a huge market—as Michael Saylor (MicroStrategy) explains in various interviews, there is no need to sell your Bitcoin for the next 100 years if you can borrow against it.

In a short time of two years, SEN has grown to almost $60 billion in quarterly transfer volumes:

sen-transfer-volume (1).png

Chart source: The Block.

How does Silvergate monetize the SEN? In two ways: first, it provides the bank with a very low cost of deposits (which fell over the years from 0.84% to 0.01%—per Q4/2020 earnings presentation, p.5) and allows the bank to expand its portfolio of conservative assets (mostly residential/commercial securities and conservative loans—same source, p.9). Second, Silvergate acts as a creditor towards its SEN Leverage clients, which generates attractive risk-adjusted returns.

Silvergate goes public & big

Silvergate went public in November 2019, when it offered 3,333,333 of Class A common stock to subscribers on the NYSE. The IPO yielded $40m at $12 per share. The subsequent Bitcoin bull market favored Silvergate’s stock price as well—the price has risen over 1,000% to the current $121 per share.

Silvergate currently holds over $5 billion in deposits, more than 95% coming from the crypto industry. Among Silvergate’s 1,000 clients are the world’s largest crypto exchanges (e.g. Kraken, Coinbase, Gemini) and all the regulated stablecoin companies (USDC, TUSD, Pax dollar, Gemini dollar). Silvergate’s assets have risen from $300 million when Alan Lane joined the bank in 2008, to today’s $5.5 billion—an eighteen fold growth in 12 years.

In the past year, other US banks have finally started to wake up to the trend and started providing the crypto industry with accounts as well. And not just any banks: JP Morgan took in Coinbase and Gemini as its first crypto clients; a huge step forward for a bank whose CEO called Bitcoin a fraud just a few years ago.

Competition isn’t a surprise for Silvergate bank; the bigger surprise is it took so long for the other banks to do their homework and join. With a head start of more than five years and a growing network effect of the SEN, Silvergate has little to fear.

“Going to the bank is an errand of the past. Today we manage our money on our phones, we pay for things on our watches, checks are a thing of the past, cash is increasingly going away and the next step for money to truly become digital. I believe that digital money is Bitcoin.” —Alan Lane, Silvergate CEO

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