Uncovering the truth behind data

Silvergate Capital Corporation (SI), once one of the only three crypto-friendly banks in the US (the other two are Signature Bank and Metropolitan Bank), has played a significant role in the circulation of fiat and cryptocurrencies between institutions and exchanges. It has the highest proportion of crypto business and the most aggressive business development in this area. During the bull round for cryptocurrencies, Silvergate was one of the most attractive stocks in US stock market, reaching a high of $239.26 in November 2021, up from its initial public offering price of $12.75 per share in November 2019. However, in 2022, following the FTX scandal, the market speculated that Silvergate had business dealings with FTX and Alameda, causing a large number of traditional funds, including Soros Fund, to short SI, making it the most shorted stock in the US. Recently, Silvergate announced a delay in submitting its 2022 audit report to the SEC, citing significant risk to its business continuance, causing its stock price to plummet to an all-time low of $5.77. A large number of crypto-compliant institutions have stated that they will stop doing business with Silvergate. In this article, the author analyzes the reasons why SI's business is on the brink of collapse and reveals the truth behind the data by examining SI's 2021 annual report, unaudited financial data for 2022, and multiple public documents.

From SI's disclosed annual report, SI's main sources of revenue come from the following:

• Absorbing user deposits at zero cost, depositing them into other banks, and earning interest rate spreads.

• Investing in low-risk fixed-income products, such as mortgage-backed securities (MBS), to earn investment income.

• Providing 7*24 fiat-to-crypto and crypto-to-fiat trading for its own customer base through its self-built SEN network and charging transaction fees.

• Providing USD loans collateralized by BTC to institutions within the crypto industry through its platform SEN Leverage and earning interest income.

Before 2022, along with the overall development of the crypto industry, SI's revenue continued to grow rapidly. From 2017 to 2021, SI's net income was $7.64 million, $22.33 million, $24.84 million, $26.03 million, and $75.51 million, respectively. In the first three quarters of 2022, SI had a cumulative net income of $40.6 million, 108 exchange customers, and 1,069 institutional customers, but suffered a net loss of $1 billion for the full year. The main business losses occurred in the fourth quarter of 2022 after the FTX scandal. The rest of this article analyzes each of SI's revenue sources.

Firstly, as the largest crypto-friendly bank in the US, SI has always been proud of its ability to absorb huge amounts of USD demand deposits from customers at zero cost, which means that customers can withdraw these demand deposits from SI at any time. For a bank, customer deposits are liabilities, and the financial data below shows that customers' USD deposits were withdrawn by $4.706 billion in the fourth quarter. It can be seen that although SI disclosed that its business dealings with FTX were limited to deposits, customers did not see it that way.

As mentioned before, SI invests a small proportion of its customer deposits in other banks to earn interest rate spreads, while most of them are invested in fixed-income securities and issued USD loans to institutions through SEN Leverage. At the end of the third quarter of 2022, other bank deposits, investment securities, and SEN Leverage accounted for 9.09%, 80.79%, and 9.67% of SI's total assets, respectively. So, what assets do these investment securities include? As shown in the table below, these assets include real estate loans, commercial and industrial SEN loans, and bonds held to maturity.

In the fourth quarter of 2022, SI had to sell most of its investment securities to cope with large customer withdrawals, resulting in a significant unrealized loss. Here's an explanation. The debt-like bond products that SI invested in low-interest-rate conditions faced a decrease in face value as interest rates rose in 2022, resulting in an unrealized loss on its balance sheet. After selling it in a short period, this loss was realized in that period. As shown in the profit and loss statement below, this is the main reason for the $887 million loss in 2022.

In other words, SI invested short-term capital from customer deposits to relatively long-term securities or loans, leading to a liquidity crisis caused by users' withdrawals. In the fourth quarter of 2022, what other accidents happened to SI still need to wait for the annual report to SEC after the audit. As ordinary investors, what they are more concerned about is whether there are other institutions that may continue to collapse due to this. The public's attention has turned to MicroStrategy, a leveraged BTC holder who disclosed their application for SEN Leverage.

According to MicroStrategy's announcement in March 2022, its wholly-owned subsidiary MacroStrategy borrowed $205 million from Silvergate Bank through SEN Leverage. After reviewing this announcement and the detailed loan agreement, the author learned the following information. The initial Loan-to-Value (LTV) ratio for SEN is 25%, which means that customers need to pledge BTC worth four times the loan amount to apply for a loan. During the loan period, if the BTC price drops to less than twice the total pledged amount, that is, when the LTV is greater than 50%, the customer needs to supplement the pledged asset value to return to four times the loan balance, which is to reduce LTV to 25%. Based on the requirement of a 25% pledge rate and an average BTC price of $42,000 on March 20, MacroStrategy pledged at least 19,500 BTC and should have replenished the pledged assets when BTC fell to $21,000. If these pledged BTCs are sold off at once, it will indeed have a significant impact on mainstream exchanges with low liquidity and daily trading volumes around 10,000 BTC. Fortunately, in this loan agreement, SI can only sell the pledged BTC without informing the customer if the customer defaults. Judging from MicroStrategy's publicly disclosed data, it currently holds 132,000 BTC and obtained liquidity through selling BTC in the fourth quarter, with $50.86 million in cash on hand. Judging from the disclosed interest rate of about 6%, it pays about $1.02 million in SEN Leverage interest per month, and the probability of default is not too high.

SI's unaudited financial data for the fourth quarter of 2022 shows that the SEN Leverage balance was $335.8 million, which decreased to $301.7 million at the end of 2022. During the period of coping with large customer withdrawals in the fourth quarter, SI did not retrieve liquidity by reducing the size of SEN Leverage. From MicroStrategy's disclosed loan agreement, SI did not stipulate the clause of early repayment. Therefore, before SI discloses more annual report data, the impact on the overall crypto market's volatility is limited for now.

Reference:

1. Silvergate Bank 2021 Annual Report: https://www.sec.gov/ix?doc=/Archives/edgar/data/0001312109/000131210922000051/si-20211231.htm

2. Silvergate Bank 2022 Financial Data: https://ir.silvergate.com/news/news-details/2023/Silvergate-Capital-Corporation-Announces-Fourth-Quarter-2022-Results/default.aspx

3. MicroStrategy's wholly-owned subsidiary MacroStrategy's loan agreement with Silvergate Bank for $205 million: https://www.sec.gov/Archives/edgar/data/1050446/000119312522087494/d312252dex41.htm

4. MicroStrategy's 2022 Financial Data: https://www.microstrategy.com/en/investor-relations/press/microstrategy-announces-fourth-quarter-2022-financial-results_02-02-2023

Disclaimer:

All information contained in this article is for reference only and does not constitute investment advice to anyone. The source of the information contained in this article is believed to be reliable.