Silvergate: the bank driving the cryptocurrency boom from a small local lender

According to a quote by Sam Bankman-Fried that was posted on the website of the San Diego bank he used to transfer client funds to his digital asset exchange FTX, “life as a crypto firm can be divided up into before Silvergate and after Silvergate.”

Life as a crypto firm can be divided up into before Silvergate and after Silvergate. It’s hard to overstate how much it revolutionised banking for blockchain companies –SBF

It was highly improbable that Silvergate would end up being the bank responsible for the $40 billion cryptocurrency exchange that filed for bankruptcy last month.

With three locations in southern California and less than $1 billion in assets, it operated as a small community lender for the majority of its 30-year history, specializing in financing small real estate deals. But by 2019, 1,600 of the top cryptocurrency miners, exchanges, and custodians in the world were using it to deposit and transfer billions of dollars each month, quickly making it the largest cryptocurrency bank in the US.

Deposits increased dramatically from about $2 billion in 2020 to over $10 billion in 2021. Total assets had risen to $16 billion by this year. Silvergate’s stock price reached more than $200 just ten months after it debuted at $12 per share on the New York Stock Exchange at the end of 2019.

One former employee remarked

“This was a tiny real estate lender that went all-in on cryptocurrency. It was entirely strange”.

However, the ride abruptly came to an end last week when US senators looking into the collapse of Bankman-FTX, Fried’s which has been accused of mishandling customer deposits and now faces losses of up to $10 billion, focused on Silvergate.

US senators wrote to Silvergate’s CEO Alan Lane saying that the bank “appears to be at the center” of how those funds were moved around Bankman-crypto Fried’s empire. It stated that Silvergate may have broken anti-money laundering laws if such a “scheme” had not been discovered.

In a public letter published last week, Lane attempted to allay market concerns regarding its connections to FTX by accusing short sellers of disseminating “speculation” and “misinformation.” He claimed that the bank had “significantly investigated FTX and its related entities.”

The admiring tribute from Bankman-Fried has been quietly removed from Silvergate’s website along with all references to its former client. Two of the bank’s top clients were eliminated by the FTX collapse.

Approximately 10% of Silvergate’s total assets belonged to FTX, and among its clients was the crypto lender BlockFi, which suffered greatly as a result of the fallout. According to its bankruptcy filings, FTX and its “related entities” had around 20 different accounts at Silvergate.

To respond to the letter and offer a “full accounting of its relationship with FTX,” the bank has until December 19 to do so.

Silvergate’s remarkable shift in strategy over the past few years is the brainchild of Lane, a 60-year-old Temecula, California, devout Catholic and grandfather to more than 20 children.

When the bank was failing in 2008, Dennis Frank and Derek Eisele, the founders of Silvergate, hired Lane with the intention of turning it into a full-service commercial bank, according to people familiar with the company. He had already turned around a number of small neighborhood banks.

But Lane began experimenting with cryptocurrency in 2013. That year saw a record run for Bitcoin, a young technology that had been around for four years, rising nearly 7,000% to reach $1,000 for the first time. Crypto was gradually starting to become more widely known.

Ben Reynolds, the president of Silvergate who was hired by Lane in 2016 to accelerate its cryptocurrency strategy, said: “We needed deposits and Alan started seeing that companies like Coinbase were getting kicked out of banks.” “So, the thought was that deposits could be found if we could bank Coinbase. The Federal Reserve agreed when Alan went there and said, “We want to provide basic banking services to Bitcoin companies.”

Major financial institutions started refusing to bank cryptocurrency exchanges and began blocking transfers made by customers to purchase cryptocurrencies out of concern for an emerging asset class that had been connected to money laundering and illegal drugs. Additionally, traditional banks were not designed to accommodate cryptocurrency traders’ need for weekend money transfers.

According to the former worker, Lane and Reynolds recognized the void and the inefficiency in the quickly expanding market and took advantage of the chance. He declared, “The two of them in the same room just exploded.” The founders of Silvergate were both involved in real estate, but they embraced the shift in strategy because it was profitable.

The business banking team at Silvergate was sold off, and the company’s real estate division was reduced over the subsequent six years by Lane and Reynolds. Its clientele of cryptocurrency businesses increased from 20 in 2016 to over 1,000, including Xapo, Paxos, and Bitfury, and its management began investigating riskier ways to strengthen its balance sheet, such as launching a stablecoin and structuring loans against cryptocurrencies.

In 2017, they introduced the Silvergate Exchange Network (SEN), a platform that allowed cryptocurrency users to instantly and around-the-clock transfer US dollars from their bank accounts onto a cryptocurrency exchange, provided that both the exchange and the user were Silvergate customers.

Then, in March of this year, Silvergate made its largest-ever foray into lending US dollars backed by Bitcoin by making a $200 million loan to a company owned by American crypto billionaire Michael Saylor.

Alan’s mentor, former boss, and Silvergate investor Frank Mercadante said,

“Alan saw this opportunity in crypto, which I still don’t fully understand, and he’s built it into something that I s quite an operation.”

But there were dangers involved. According to two former employees, Silvergate had to hire twice as many compliance personnel as comparable banks of its size. A new cryptocurrency exchange typically needs six months to open a bank account. One of the people said, “The key risks are know-your-customer and anti-money laundering and those were seriously considered back in 2014” — when Silvergate won its first cryptocurrency client. For unspecified reasons, Silvergate ended its partnership with Binance, the largest cryptocurrency exchange in the world, in June 2021.

According to a source close to the company, “When they got into it, crypto was this little new thing, and I think they didn’t realize it would take off as fast as it did.” They placed all of their chips in that direction, but it quickly outgrew them and grew significantly larger.

Uncertainty and risk in the unregulated cryptocurrency sector

The bank will be forced to consider its exposure to an unregulated sector where the risk of fraud and bad actors seems to be higher than ever as lawmakers scrutinize Silvergate’s partnership with FTX.

According to a person familiar with Silvergate, “the bank has no real responsibility for stopping transactions between entities that look legitimate.” “This is the key to why there isn’t enough regulation of cryptocurrency firms. No one is required, for instance, to maintain a segregated account with only customer funds.

Although at $23, Silvergate’s share price is still nearly twice what it was at its initial public offering, it has fallen to half its pre-FTX collapse level and is down nearly 85% this year. According to analysts at Morgan Stanley, the bank is dealing with a lot of uncertainty regarding its digital deposits, which are down 60% so far this quarter. They continued, “The collapse of FTX could also lead to litigation and headline risk across the crypto ecosystem.”

The current environment presented challenges to the plan we had going into the year, and we are still processing what transpired, said Reynolds.

“You have to ask those questions about where digital assets are going from here. This is a pretty significant reputational problem for the industry.”

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