Silvergate Capital: Don't Buy The Dip, There Is An Alternative

Summary The significant outflow of Silvergate deposits, that the company has experienced, is indicative of a significant crisis of confidence. Along with the deposits, Silvergate will almost certainly lose its network effect, the main competitive advantage. One of the beneficiaries of this storm could be Signature Bank, which also provides payment infrastructure for the crypto market. Signature's potential losses from crypto are limited, which can attract large clients looking for a haven for their capital. Investment Thesis The recent collapse of Silvergate Capital ( SI ) stock, fueled by catastrophic deposit outflows and gigantic losses, has prompted some investors to buy the dip, in line with the old adage that “you should buy when there’s blood in the streets.” But you shouldn't. In less than three months, the bank lost $8.1 billion in deposits, of which only $150 million came from clients who filed for bankruptcy. Customers take money out of fear that the bank will go under. This could become a self-fulfilling prophecy. One of the key competitive advantages of the SEN platform was the network effect. However, Silvergate may lose it as customers are forced to look for an alternative. In October, one of the largest crypto exchanges, a former client of SEN, switched to Signet from Signature Bank ( SBNY ). Signature's potential losses from crypto are limited, which attracts not only investors but also large clients looking for a haven for their capital. Through a conservative approach to financial management, Signature Bank can become an example of Nassim Taleb's antifragility, and emerge from the crisis as the market leader in infrastructure for crypto companies. Don’t Buy the Dip Through the Silvergate Exchange Network [SEN] platform, the company provides a payment infrastructure for crypto clients that brings together the largest players in the industry and allows them to conduct transactions between themselves 24/7. Like traditional banks, Silvergate earns mainly on the spread between the cost of attracting earning assets (the cost of deposits) and their profitability (the interest on loans issued). Silvergate deposits are interest-free as they are the money of crypto clients on the SEN platform. On January 5, Silvergate Capital lost 48% of its market value after the crypto bank reported a catastrophic drop in deposits and giant losses. A series of challenges that the crypto industry has faced over the past year has forced customers to withdraw their money from the platform, causing deposits from digital asset customers to drop from $11.9 billion on September 30 to $3.8 billion. The bank sold $5.2 billion of debt securities to maintain balance sheet liquidity, resulting in a loss of $718 million, more than double its net income over the past seven years, including previous expectations for 2022. On September 30, digital deposits accounted for 89% of all Silvergate deposits. Assuming that the balance of other deposits remained unchanged, then the bank's total deposits collapsed by about 61% in less than a quarter, which is comparable to outflows during the Great Depression. Notably, only ~$150 million came from clients who filed for bankruptcy. This tells us about a deep crisis of confidence in Silvergate. Customers withdraw money not because they need cash, but because they fear the bank will go under. This could become a self-fulfilling prophecy. One of SEN's key competitive advantages was its network effect. Early market entry allowed Silvergate to connect crypto market leaders to the platform. Their presence encouraged other players to join SEN as well. Silvergate management is optimistic that although customers have withdrawn their money, they remain on the platform: "That said, we didn't have any clients that said that they were exiting the space altogether. Perhaps there will be some that do, but we didn't receive that feedback. And our clients were generally supportive of Silvergate despite the fact that they pulled their deposits. And just really given the overall circumstances, decided to take that action. And -- but seemed to be committed to the space and willing to come back when market conditions are right." – Ben Reynolds, Chief Strategy Officer . So, management expects that clients will return the money when (read IF) a new rally begins in the crypto market. The problem is that large companies are not individual investors. They cannot sit back on cash and wait for the market to turn around. Crypto exchanges, hedge funds, and mining firms have to perform regular operations to serve their customers, and they need infrastructure. If at the time of prosperity, the switching costs for Silvergate customers were high, now they will certainly pay it to continue their operations. When (read IF again) the crypto market reverses, the switching costs will rise again, but they will need to be paid to return to SEN. Alternative for Investors Surely, the remaining customers are already wondering whether they should save their money on the SEN, or is it better to switch to Signet from Signature Bank. Unlike Silvergate, Signature remains a classic bank with a strong loan portfolio and a low Loans-to-Deposits ratio. However, most importantly, digital deposits account for only 22.9% of all bank deposits. Even if all crypto clients leave Signet, the Loans-to-Deposits ratio will be 93.1%, which is still significantly lower than during 2019, when the indicator was at the level of 96.4-101.6%. The Signature loan portfolio is of high quality. The bank has a lower ratio of total net write-offs to average loans than that of the top 50 US banks. With a total loan portfolio value of $73.8 billion, only $100 million comes from crypto-backed loans. While Silvergate's SEN Leverage accounts for 64% of total loans held-for-investment. The conservative approach to lending does not make Signature less innovative. Both companies earn interest, but Silvergate accepts volatile bitcoin as collateral, while Signature accepts real estate and equipment. Thus, Signature’s potential losses from crypto are highly limited, which can attract not only investors but also large clients looking for a haven for their capital. Along with the deposits, Silvergate will almost certainly lose its network effect, the main competitive advantage, and Signet will become a potential beneficiary. In October, Coinbase ( COIN ) announced that it would settle with its institutional clients through Signet. This event is likely directly related to Silvergate's difficulties since COIN was previously a participant of SEN . You can learn more about Signature Bank in our recent research . Conclusion The significant outflow of Silvergate deposits, that the company has experienced, is indicative of a significant crisis of confidence. One of the beneficiaries of this storm could be Signature Bank, which also provides payment infrastructure for the crypto market. Signature's potential losses from crypto are highly limited, which can attract not only investors but also large clients looking for a haven for their capital.