An Obscure Bank Found Its Key to Success. Then FTX Collapsed

(Bloomberg) — Silvergate Capital Corp. was dealing with the same problem many small US banks face: How do you differentiate yourself when larger competitors do everything you do, only better?

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The solution it found was to focus on a sector other banks didn’t want to touch: cryptocurrency. Over the course of a decade, the La Jolla, California-based company transformed itself from a bank catering to small businesses into a publicly traded firm known for providing banking services to major crypto clients such as Coinbase Global Inc. and Gemini Trust Co. — as well as Sam Bankman-Fried’s FTX and Alameda Research.

The arrangement was going well, with Silvergate shares soaring to an all-time high of $222.13 in November 2021 as digital-asset prices set records. Then a painful crypto winter set in, with the value of virtual coins sinking. Capping off what was already a difficult year for the industry, crypto exchange FTX and its sister entities spiraled into bankruptcy last month, and are now facing probes from regulators including the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Department of Justice over missing funds and trading on the platform.

The collapse raised questions about how regulators, investors and the retail traders who lost everything fell for what may have been a scam. But it also raised questions for Silvergate, which held deposits for FTX units and Alameda Research, the hedge fund at the heart of the crypto exchange’s collapse. Now, lawmakers are scrutinizing the bank as short sellers circle, with Silvergate stock slumping to less than $23 a share. They dropped as much as 6.2% in intraday trading Friday.

While Silvergate said this month it has “a resilient balance sheet and ample liquidity,” and analysts call its financials sound, the bank is today contending with a question as difficult as the one that led it to crypto in the first place: whether the experiment was worth it.

The thesis behind Silvergate’s crypto-focused payment platform, known as the Silvergate Exchange Network, is a relatively simple one. Crypto companies that might otherwise have trouble finding a banking partner can put their money on the platform and send it to each other in exchange for digital assets. Silvergate’s network is only for US dollars and euros, and virtual-currency transactions don’t take place on the platform.

Tokens that exist on the blockchain can change hands almost instantly, and companies that swap them for US dollars want a way to complete these fiat-currency transactions at the same speed they carry out their digital ones.

Silvergate’s network lets clients do exactly that — but the deposits placed on the system don’t pay interest, giving the bank an almost-free method of funding its activities. Deposits from digital-currency customers swelled to more than $14 billion at the end of last year from $1.2 billion two years earlier.

“When Silvergate got into this business, it was a commercial bank in Southern California, and the deposit market was competitive, and they just really were trying to explore opportunities for lower-cost funding,” said Michael Perito, an analyst with Keefe, Bruyette & Woods. “When you have a low-cost deposit base, you can make good return on acceptable risk. It’s not rocket science.”

One hitch is that banks historically have been squeamish about dealing with crypto firms, given the absence of clear regulations governing a sector infamous for fraud and financial malfeasance.

Silvergate introduced its crypto payments platform in early 2018, according to a filing tied to the bank’s initial public offering. In November of that year, the company sold its small-business-lending division and a retail branch to HomeStreet Bank as part of an effort to “increase its focus on its digital-currency initiative and its specialty-lending competencies,” according to a regulatory filing.

Silvergate hasn’t been charged with any wrongdoing. Neither has Bankman-Fried, but federal prosecutors in Manhattan have begun investigating FTX’s collapse due in part to an unexplained $8 billion shortfall in funds. Other probes into FTX and related entities are ongoing.

‘Difficult’ Weeks

A Silvergate representative, in response to a request for comment, referred to a Dec. 5 message from Chief Executive Officer Alan Lane, in which he said that it’s “been a very difficult few weeks for the digital-asset industry, as we have all come to terms with the apparent misuse of customer assets and other lapses of judgment by FTX and Alameda Research.”

Silvergate “monitors transaction activity for every account and identifies activity outside of the expected usage. When we identify certain kinds of activity, we are required to file suspicious activity reports, and we do so routinely,” Lane wrote. “Silvergate conducted significant due diligence on FTX and its related entities, including Alameda Research, both during the onboarding process and through ongoing monitoring, in accordance with our risk-management policies” and legal requirements.

In a letter to Lane, lawmakers including Senator Elizabeth Warren, a Democrat from Massachusetts, raised questions about the bank’s controls, including anti-money-laundering practices. The senators suggested those measures should have caught allegedly suspicious transactions between Alameda Research and FTX, which they said should have been reported to the Financial Crimes Enforcement Network.

‘Egregious Failure’

“Your bank’s involvement in the transfer of FTX customer funds to Alameda reveals what appears to be an egregious failure of your bank’s responsibility to monitor for and report suspicious financial activity carried out by its clients,” Warren and fellow Senators John Kennedy and Roger Marshall wrote in the Dec. 5 letter. “The public is owed a full accounting of the financial activities that may have led to the loss of billions in customer assets, and any role that Silvergate may have played in these losses.”

The lawmakers cited reporting by Bloomberg News that indicated FTX customers were directed to wire funds to a Silvergate bank account belonging to Alameda.

“We have received Senator Warren’s letter and are reviewing it,” Silvergate said in a statement.

Red Flags

Those transactions wouldn’t necessarily raise red flags because of how banks look for fraud and suspicious activity, according to Joseph Silvia, an attorney with Dickinson Wright who advises banks and doesn’t work with Silvergate. Bankman-Fried has attributed the loss of customer funds to loose accounting practices, and the exchange’s new CEO has cited weak controls throughout the organization.

Amid the turmoil in the crypto industry, Silvergate has been targeted by short-sellers betting against the company’s stock. As of Thursday, about 29% of the bank’s shares available for trading were sold short, up from 11% a month ago. Silvergate shares have plunged 85% this year.

Silvergate is now valued at roughly half its book value, compared with an average multiple of 1.5 for comparable banks, data compiled by Bloomberg show. In February 2021, Silvergate’s price-to-book valuation of 11 was almost six times that of its peers.

If FTX directed clients to send funds to an Alameda account on the Silvergate Exchange Network, the bank wouldn’t typically have visibility into the relationship between the parties transacting or the reasons for the transactions, Silvia said. There’s a limit on how closely a bank can investigate its clients, he added.

‘Rabbit Hole’

“At some point, you ask so many questions and you go down the investigative rabbit hole with your own customers, and they don’t stay your customers,” Silvia said. “They just move on.”

One question raised by the implosion of FTX is how a firm with such shoddy book-keeping gained access to the traditional financial system in the first place. Bankman-Fried has said it took longer for his exchange to secure a bank account than it took Alameda Research. And regulators tend to shy away from telling banks not to do business with firms unless they’re engaged in illegal activity.

“There’s been a big controversy generally about whether regulators should tell banks, ‘You just can’t do business with certain entities,’” former Federal Deposit Insurance Corp. Chair Sheila Bair said in a Bloomberg Television interview earlier this month. Bair is on the board of Paxos, a stablecoin project listed as a Silvergate client in the bank’s prospectus. “If a business is legal, then to tell a bank not to have dealings with them I think is hard, and I am unaware that any of the entities doing business with US banks were illegal.”

Growing Pains

Silvergate pushed into the world of crypto in the years after the global financial crisis. CEO Lane has said that he bought his first Bitcoin in 2013, and that curiosity propelled him and the bank deeper and deeper into the world of digital assets.

“Recognizing that neither the US dollar nor Bitcoin were likely to disappear anytime soon, connecting these two worlds has been my profession and passion ever since,” Lane said in a Nov. 21 letter to customers.

Building a deposit base off of an industry known for volatility and uncertain regulatory regimes in the US and elsewhere wasn’t a painless process. Former Silvergate employees said it was challenging to expand the bank quickly enough to keep up with the rapid growth in deposits from digital-asset customers. The burgeoning workloads brought on by the sudden expansion contributed to high turnover, said the former employees, who asked not to be identified discussing private matters at the bank.

The bank’s workforce grew to 279 full-time employees at the end of last year from 208 two years earlier. Among the firm’s executives are Chief Technology Officer Chris Lane — the CEO’s son — and Jason Brenier, manager of correspondent banking, a son-in-law of the CEO. Another son-in-law, Tyler Pearson, previously held the title of chief risk officer.

A Silvergate representative declined to comment on the expansion challenges or family ties among the bank’s management. Silvergate’s CEO “does not directly supervise or evaluate the performance” of his family members, the bank said in a regulatory filing.

Signature’s Move

Not everyone who has taken the plunge into digital assets is willing to continue stomaching the risk. Signature Bank said earlier this week that it plans to cap the overall share of its deposit base contributed by digital-asset customers and limit the percentage of deposits from individual crypto clients.

In a note, BTIG analysts led by Mark Palmer identified the move as a potential opportunity for Silvergate to capture more market share.

Signature Bank’s “pivot away from crypto is also likely to have a negative impact on the network effects” offered by its Signet payments platform, the analysts wrote. “At the same time, the potential influx of new clients to the Silvergate Exchange Network that have been using Signet could serve as an accelerant for its network effects.”

–With assistance from Matt Turner and Philip Lagerkranser.

(Updates with share price in fourth paragraph, price-to-book multiple under Red Flags subheadline.)