With a market cap that is down more than $2 trillion from peak last year, the cryptocurrency correction is sending shockwaves across the whole ecosystem. Digital asset brokerage Voyager filed for bankruptcy protection earlier this month, after Three Arrows Capital, the crypto hedge fund that saw its AUM go from $10 billion to zero, couldn’t pay back the roughly $670 million it had borrowed from the company.
Celsius, which promised returns exceeding 18% without much risk to its clients, has frozen their deposits and has also filed for bankruptcy protection, while Coinbase, one of the world’s largest cryptocurrency exchange platforms, is to cut headcount by 1,100 people, or 18% of its workforce in anticipation of a crypto winter, which would significantly affect its trading revenue.
Obviously, there could be many more casualties in this environment in coming weeks and months. Nevertheless, as equity prices have plummeted almost indiscriminately across the space, differentiating between business models, and understanding risk and growth drivers is key; first, to avoid blow-ups and second, to closely monitor the names that could stage a sustained rebound when general market conditions improve.
Among the firms that have developed a sound business model with balanced risks, crypto banks stand out.
Silvergate Capital (a portfolio company), which started as a commercial banking and lending institution in 1988, has become a pure play crypto bank. The bank operates the Silvergate Exchange Network (SEN), established around 2013, which enables real-time cash transfers and immediate availability of funds between network members. These very important features in the 24/7 crypto trading world naturally attracted many crypto institutional investors and exchanges on the SEN platform (Binance, Gemini or Bitstamp), sparking a massive growth in customer deposits to almost $14 billion in Q2 from $6.4 billion in early 2021 and making crypto customers the main source of funding for the bank.
Another example of a traditional commercial bank having implemented blockchain and cryptocurrency services within its operations is Signature Bank, which launched a payments platform, codenamed Signet, based on Ethereum for its institutional clients in 2019. Like SEN, Signet allows them to deposit USD money in and from crypto trading accounts with real-time settlement and no transaction fees. Signature has more than quadrupled its crypto-related deposits over the past year to almost $30 billion, representing about a third of the bank’s deposits. And non-interest bearing deposits stood at 40% of total deposits.
Interestingly, these crypto-related deposits don’t generate fees but allow Silvergate and Signature to have a very low cost of funding (near zero for Silvergate), to reinvest these deposits in high-quality assets (98% rated AA- or better for Silvergate: municipal bonds, residential MBS, commercial MBS…) and pick up the spread. As these securities are mostly variable-rate instruments, both banks’ earnings are then highly leveraged to rising interest rates. Based on Silvergate forecasts, assuming a static balance sheet and a positive 25 basis point interest rate move, the company’s net interest income would grow by close to 15%.
Despite the challenging environment for cryptos, both banks’ core business has been highly resilient, and their profits have been insulated so far from the crypto market volatility, as illustrated by Silvergate’s net income that reached $38.6 million in Q2, compared to $27.4 million in Q1 and $20.9 million in Q2 last year.
Both banks’ balance sheets obviously benefited from higher rates. More surprisingly, deposits from crypto customers barely declined in Q2 as institutional interest in crypto kept growing and an increasing number of crypto customers held large account balances with Silvergate and Signature to facilitate their crypto transactions. Silvergate for instance added 122 crypto customers in Q2 up from 76 in Q1, bringing the total to 1,503.
The trend could be here to stay, notably as a recent UBS survey found that a quarter of family offices are investing in crypto or considering it. That said, if the current downturn was to last, deposit outflows would be a likely scenario.
If we then view the core business as a source of resilience in the current environment, some of the growth initiatives could turn into material risks in the short term. Notably, Silvergate has introduced a lending product, SEN Leverage, that allows customers to obtain US dollar loans collateralized by Bitcoin. This is an attractive financing option for crypto miners for instance (Marathon Digital…) that used to sell their Bitcoins or to raise equity to pay for their capex needs and that could now keep their Bitcoins on their balance sheet and/or avoid dilutive equity transactions.
But with liquidity and credit quality issues rising fast in the crypto sphere in recent weeks, SEN Leverage could represent a short-term headwind even if we understand that Silvergate has been handling these loans and the loan-to-value accompanying them very cautiously (e.g. 20% LTV for the loan granted to crypto investor Microstrategy). The way assets are managed thus show that the conduct of traditional banking operations remains deeply rooted in Silvergate and Signature’s business models.
More promising initiatives include Silvergate’s $182 million acquisition of Diem, Meta’s blockchain technology, that could make the company the only stablecoin issuer under the control of the Federal Reserve. Assuming that stablecoins become global payment rails, the opportunity for Silvergate could be massive, while the risk appears reasonable. Usage of cryptos as a means of payment indeed keeps rising fast, notably among younger generations and high-income consumers. According to a PYMNTS.com survey, 16% of consumers in the US own cryptocurrencies and 30% of them made an online purchase with their digital assets while 21% did the same in a physical store in the 30 days prior to the survey.
Cryptos are also making inroads in the remote workers population, specifically in emerging markets, as cryptos allow these workers to circumvent FX controls and to get protected from local hyperinflation. 5% of all payments accepted by remote workers were taken in crypto in the first six months of the year, up from 2% in the last six months of 2021, according to a Deel survey.
In conclusion, despite the current crypto winter and the risks associated with it (potential deposit outflows and loan loss provisions), Silvergate and Signature appear as high quality, defensive plays in the crypto space thanks to resilient business models, high profit margins and reasonable valuation multiples (13x forward PE on average). Importantly, as major providers of picks and shovels for the crypto payment infrastructure, they are leveraged to increasing crypto adoption, with a regulatory moat that limits competition from start-ups.
