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Increasing crypto-friendly banks vital for financial stability: insights on the Silvergate case.

March 8, 2023

It's 2023, crypto assets existed for more than a decade and the world is still grappling with how to regulate and deal with them. For years, traditional banks had refused to do business with crypto companies due to lack of clear rules, leaving a void that was filled by a few banks that were willing to take the risk. One of the biggest of these was Silvergate, a bank that had positioned itself as a crypto-friendly institution. 

However, this concentration around just one player proved to be risky, as it led to the possibility of a classic self-fulfilling bank run. We believe that having more banks equipped to deal with crypto would be beneficial, as it would prevent deposit outflows from causing the collapse of financial players and further contagion.

So, what happened? 

Silvergate had become the biggest crypto-friendly bank, with over 90% of its deposits coming from the crypto sector. In just a decade, the bank had grown from a small regional presence to a major US bank with $12B in deposits by Q3 2022, servicing major crypto institutions.  

The bank not only accepted deposits from crypto exchanges and traders, but it also built its own payments network for crypto settlement - SEN (Silvergate Exchange Network). SEN was an innovative infrastructure solution, allowing for the almost instantaneous movement of U.S. dollars between SEN participants 24/7/365. 

The combination of crypto-friendliness and innovation at Silvergate ultimately led to its problems. Importantly, Silvergate lost money not by making risky overleveraged loans against crypto collateral (like in the case of 3AC, Celsius, or FTX), but by doing boring regular banking. It’s been taking deposits from crypto firms and allocating them to a bond portfolio.

The bank had attracted a lot of crypto deposits, and as knock-on effects of FTX contagion started to catch up, the banks faced deposits outflow. This forced them to sell off bonds, resulting in material losses as interest rates increased recently.  As a result, a downward spiral ensued with rapidly worsening capital adequacy ratios, which led to more clients withdrawing funds.

While crypto is volatile and deposit outflows is not something new in the banking industry, if such outflows were distributed across the banking system, it could be easily absorbed without any negative consequences.

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