Uh-oh! The crypto collapse has reached the real financial system

Update, March 8, 7 pm ET: silver door has announced that it will closethe original story follows below.

Silvergate, one of the biggest banks in crypto, is in big trouble. Maybe existential problems.

Silvergate didn’t start out in crypto. He started in the real estate sector. But in January 2014, the bank jumped into Bitcoin, a volatile year — Bitcoin started the year at $770 and closed above $300 in December. “Some of the companies that were being formed at the time to service this fledgling Bitcoin space, many of them were struggling to find and maintain bank accounts,” he said. Silvergate CEO Alan Lane in a June 2022 episode of odd lots podcast. “So that’s really where we started.”

The focus at the bank was institutions, other companies, some of which work with consumers. For example, Genesis, the now-bankrupt DCG crypto lending subsidiary, was one of Silvergate’s early clients. The bank developed the Silvergate Exchange Network, which was a way for crypto institutions like Coinbase, Gemini, and Kraken to transact dollars 24/7. “We have all of them,” Lane said in 2022. “All of the major ones. Anyone who is serious about regulation.”

Also among Lane’s clients: FTX. Federal prosecutors are now examining Silvergate’s role Banking on Sam Bankman-Fried’s Fallen Empire. The most pressing issue is that the FTX crash scared other Silvergate customers, resulting in a bank run of $8.1 billion: 60 percent of your deposits going out the door in just one quarter. (“Worse than the average bank experienced to go out of business in the Great Depression,” He Wall Street Journal very well explained.)

In its earnings presentation, we discovered that Silvergate’s results last term was absolute bullshit, a billion dollar loss. Then, on March 1, Silvergate filed a surprise regulatory filing. He says that actually quarterly results were even worseand it is unclear whether the bank will be able to stay in business.

In response, coin baseGalaxy Digital, Crypto.com, Circleand paxos have said they will stop using Silvergate, as have other less notable clients. Tether, the controversial stablecoin that has had its own banking problems, He kindly popped in to remind us that he wasn’t using Silvergate.

The long list of clients helps explain why Silvergate’s problems are terrifying. Very few banks will touch cryptocurrencies because they are so risky, and most traditional banks do not allow cryptocurrency customers to transact dollars 24/7. Access to banking that moves at the pace of cryptocurrency is rare, and only one other US bank can do it.

“If Silvergate closes, it will push funds and market makers further abroad.” Ava Labs President John Wu said Barron’s. The problem is how easy it is to get real dollars in cash, which in financial terms is called liquidity. Less liquidity makes transactions more difficult. There is already a wider gap between the price at which a trade is expected to take place and the actual price at which it is executed, Wu said.

So the Silvergate issues are a problem for the entire cryptocurrency industry.

The Silvergate SEN was a major on-ramp and off-ramp from the almighty dollar (and the almighty euro) into crypto. In 2022, Lane said that all “regulated US dollar-backed stablecoin issuers” were banked at Silvergate.

But for the stablecoins issued by Circle, Paxos and Gemini, among others, the SEN was important for making and burning their tokens, which were issued when someone deposited a dollar into their Silvergate bank accounts, Lane said.

Silvergate was a crossing point for cryptocurrencies. Stablecoins that are backed by dollars at least theoretically having cash or cash-like assets in reserve somewhere. (The reason Tether is controversial is that there are questions about the existence and value of that reserve.) Silvergate’s job was to create a token when someone invested a dollar, say, in USDC and burn a token when someone took out a dollar. “We are this critical piece of infrastructure where people, when they exit the ecosystem and want to go to cash, those dollars go through Silvergate,” Lane said in 2022.

You’ll notice I’m saying “was.” That’s because on March 3, Silvergate announced that it would suspend SENeffective immediately.

The dollar side of the transaction meant that Silvergate customers had to have plenty of cash available at the bank to pay each other and anyone who wanted to withdraw money. To make money here, Silvergate could do a few things. The safest thing to do is buy, like, one-month Treasury bills at the Federal Reserve and call it a day.

Now, this being finance, taking more risk can also mean more profit. So Silvergate appears to have bought bonds. (Edge favorite Matt Levine in Bloomberg has a more in depth analysis of how this worked if you want the gory details.) The problem isn’t that the bonds were super risky, it’s that FTX caused a mass exodus of dollars, and Silvergate suddenly had to find a lot of money. Unfortunately, that meant selling his bonds at a loss to pay off his obligations. Ironically, the bonds were quite safe: “If their depositors had kept their money at Silvergate, their bonds would have matured with plenty of money to pay them back,” Levine notes.

Silvergate has another way to touch stablecoins besides serving as an on-ramp and off-ramp for your transactions. It bought assets of Facebook’s failed stablecoin attempt Libra, later renamed Diem, in January 2022. At the time, Silvergate said it would start make Diem available by the end of the year. The goal was a digital payment network.

One of the other services that Silvergate offered was the ability to lend dollars against Bitcoin. now silvergate said in january in its fourth-quarter earnings call that “all of our SEN leveraged loans continued to perform as expected, with no losses or forced liquidations.” Maybe these loans are okay! Silvergate does not appear to have done anything exceptionally risky elsewhere.

But if you want to use your Bitcoin to get a dollar loan, I think it got more difficult.

Silvergate had a life before crypto: was a small bank focused on real estate deals in southern California. During that time, he never had more than $1 billion in deposits, according to financial time. And Silvergate needed deposits. When Lane took the company into crypto, his business skyrocketed. By 2021, Silvergate had more than $10 billion. He bank went public in 2019 to $12 per share and peaked at over $200 per share in 2021. (Shares closed at $5.77 on March 3.)

Real estate became less and less of a focus because cryptocurrency was a rocket ship for the bank. However, that real estate connection turned out to be useful for Silvergate in 2022. In the last quarter of the year, Silvergate secured at least $3.6 billion in funding from Federal Home Loan Banksa system from the 1930s that originally also dealt with mortgages.

To pay for that, Silvergate sold more bonds. This is not ideal and is part of the reason Silvergate is in trouble. “If you’re a bank, you don’t want to be pointing in the wrong direction, because that becomes self-fulfilling.” writes Bloombergit’s levine. And indeed, that’s why many of Silvergate’s top clients are scared. Levine believes this may get some regulators interested in crypto banking.

In fact, the Justice Department is already interested. There are some questions about strange transactions that took place at Silvergate.

For example, Binance. Its supposedly independent arm, Binance.US, wired over $400 million to a trading company called Merit Peak Ltd, Reuters reported. That firm is managed by Binance CEO Changpeng Zhao. “Binance.US CEO at the time, Catherine Coley, wrote to a Binance finance executive in late 2020 asking for an explanation of the transfers, calling them ‘unexpected’ and saying ‘no one mentioned them.’” Reuters wrote. Those transfers were made on Silvergate’s special network, SEN.

This is similar to some of the issues Silvergate is facing at FTX. Alameda Research, the trading company also owned by Bankman-Fried, opened an account with Silvergate in 2018. Bankman-Fried admitted that it used Alameda accounts for FTX funds, mixing client funds with those of the trading company.

I don’t know if Silvergate did something wrong. Possibly it was not! But for the feds to start poking around, asking questions? That’s a headache and a distraction. It’s the last thing a troubled bank needs.

A lot of companies that have banked with Silvergate have been here talking about how they have minimal exposure to it, which historically isn’t a great sign. (See: The famous “Bankman-Fried FTX is fine. Assets are fine” tweet.)

But you know what? In this specific case, I am inclined to believe them. First of all, just a lot of money has already left Silvergate. But secondly, Silvergate was a go-to bank for cryptocurrencies; did not retain reserves and did not pay interest. The issue here is less that some exchange or stablecoin is going to suffer a massive loss of client money and more than now. even harder for cryptocurrency companies to access banking.

The crypto industry desperately needs banks. But Silvergate’s two competitors, Metropolitan and Signature, were pulling away from the industry even before this debacle. Metropolitan said in January that it was get out of crypto completely. And in December, Signature said it was going to get rid of $8 billion to $10 billion in funds related to digital assets.

I don’t know if Silvergate is going to get over this. But I strongly suspect that it has become much more difficult to exchange dollars and cryptocurrencies. Silvergate traded on liquidity, and a liquidity problem can become a solvency problem really fast. The entire crypto industry became much more fragile.