Silicon Valley’s dearest bank in major trouble

The good news about Sam Bankman Fried’s bitcoin empire’s demise is that it did not cause a contagion or send shockwaves through the whole financial system. The majority of banks’ refusal to work with cryptocurrency was a major factor. Recently, American financial officials even advised them against it.

However, a tiny bank in California allegedly determined that it was preferable to take the chance of having to ask for forgiveness than to wait. Silvergate, situated in La Jolla, invested heavily in cryptocurrencies in recent years, building connections with more than 1,600 industry participants, including hedge funds, exchanges, and token initiatives.

This includes accused scammers like Bankman-Fried as well as a number of other dubious businesses and people who used Silvergate to move a trillion dollars into — and out of — cryptocurrency exchanges all around the world. After the volatility of the previous year, regulators and investors alike are keeping a closer check on the cryptocurrency market. As a result, Silvergate now has unanswered questions regarding its crypto products and its overall future economic prospects.

Perhaps Bankman-Fried himself has the finest way to sum up the bank’s disproportionate contribution to the recent crypto bubble and fall. The indicted FTX founder stated in a since-deleted testimonial on the bank’s website:

Life as a cryptocurrency corporation may be separated into two phases: before Silvergate, and after Silvergate

The extent to which it altered banking for blockchain enterprises cannot be overstated.

Following FTX’s demise, detractors of the bank’s methods worry that additional regulatory examination of what happened will put Silvergate in an untenable position. Porter Collins, portfolio manager at Seawolf Capital and one of the characters in The Big Short, claims that it was one of the largest entry points into the cryptocurrency industry. He started shorting Silvergate last summer as the cryptocurrency disaster gathered steam because he believes the long-term bull market in cryptocurrencies is ended, as well as Silvergate’s part in it. (Shares of the bank have fallen more than 80% in the past year.) Outspoken Silvergate short seller and investor Marc Cohodes contends that the bank’s clients exhibit “a highly troubling pattern of possibly criminal behavior” that will have detrimental effects on the institution.

In addition to FTX, Silvergate has been the go-to bank for more than a dozen crypto businesses that ended up being under investigation, shut down, penalized, or in bankruptcy, according to papers obtained by Intelligencer. These include Huobi, a formerly Chinese-based offshore exchange (now with a Seychelles address), whose CEO, Justin Sun, is also under investigation for money laundering, according to The Verge. Binance, the largest cryptocurrency exchange in the world, is also being investigated, according to Reuters. Additionally, according to court records, Silvergate worked with the recently insolvent cryptocurrency firms Voyager, Celsius, and BlockFi. At the same time, a video posted online depicts the cryptocurrency lender Nexo, which recently reached a $22.5 million settlement with the Securities and Exchange Commission, advising clients to send money to a Silvergate bank account.

According to an SEC lawsuit, Silvergate also created 12 accounts for Stefan He Qin, an Australian crypto Ponzi schemer who has subsequently been found guilty. In addition, Bittrex, a cryptocurrency exchange that was once a customer and shareholder of Silvergate and was advertised on the bank’s website, has been blacklisted by American authorities for handling funds for countries like Iran and Syria.

Failure of regulation takes the blame

Large, U.S.-regulated cryptocurrency companies were simultaneously served by the bank. According to an internal Silvergate investor presentation that Intelligencer was able to get, it served as the bank for Coinbase, a publicly traded company, and stablecoin issuer Circle, which is backed by Goldman Sachs.

Elizabeth Warren is one of three senators who recently questioned if Silvergate might have helped FTX commit the alleged fraud and doubted that Silvergate was vigilant in adhering to anti-money-laundering and know-your-customer banking regulations. The difficulties Silvergate is facing also seem to be the driving force behind new regulatory recommendations for banks that would curtail, if not completely stop, the practices it is engaging in and make it very difficult for cryptocurrency players to bank elsewhere in the United States. (A bank spokeswoman declined to respond to my inquiry regarding whether Silvergate is the subject of a law enforcement investigation or to address the criticisms directed at it.)

As of late 2021, more than 70% of Silvergate’s crypto clients’ deposits totaling $10 billion have been withdrawn from the bank in the previous 12 months. According to a Federal Reserve assessment, this deposit run on Silvergate is worse than any that occurred during the Great Depression.

According to Ari Paul, the founder of BlockTower Capital, a cryptocurrency investment company that has banked with Silvergate for years, “everyone was afraid; everyone was primed to fear counterparty risk.” Paul said, “It didn’t surprise me that you have that big flight of cash out of Silvergate, albeit he would not confirm whether BlockTower had withdrew its funds. Everyone, including myself, is feeling particularly risk-averse right now. He continued by saying that his company is currently looking for more financial partners, albeit it might be a challenge.

The underbanked and new crypto industry seemed to Silvergate CEO Alan Lane, who joined the bank in 2008, like a certain method to increase the bank’s deposits after the global crisis. Lane said that his and Silvergate’s path into cryptocurrency began after he learnt that crypto companies were “being booted out of banks” due to worries about money laundering in a 2019 interview with cryptocurrency evangelist Anthony Pompliano. Barry Silbert’s SecondMarket, which has subsequently changed its name to Genesis Trading and is a part of the Digital Currency Group, a crypto conglomerate Silbert oversees, was Lane’s first cryptocurrency client by the year 2014.

In the disaster that cryptocurrency has evolved into over the past nine months, Silbert is dealing with his own problems. On Friday, Genesis filed for bankruptcy, and Cameron Winklevoss, the co-founder of cryptocurrency exchange Gemini, which has almost $800 million in client funds with the company, has demanded that Silbert step down and accused him of fraud. (After Bloomberg reported that the SEC and federal prosecutors were looking into Digital Currency Group, the SEC accused Gemini and Genesis of selling unregistered securities.)

In more prosperous times, Silbert introduced Silvergate to other cryptocurrency players, which assisted in the company’s transformation from a sleepy local bank that had avoided the 2008 housing collapse into a kind of casino dealer for the crypto ecosystem. Ahead of the bank’s IPO in 2019, DCG also served as the lead investor in a $114 million private placement for Silvergate.

Despite their opposition to “fiat” money, cryptocurrency enthusiasts nonetheless require and desire access to traditional currencies (or euros). According to Hilary Allen, a legal professor at the American University Washington College of Law,

People aren’t native crypto users. When they exit cryptocurrency, they want their money back in fiat currency, which is where they started with it.

So there needs to be a connection with the established banking system to make it happen.

In the 2019 interview, a confident-sounding Lane explained that Silvergate soon gave its institutional crypto clients what they wanted — the ability to move money around 24/7 without “friction” — by developing what it called the Silvergate Exchange Network. Lane was dressed in the required black turtleneck à la Steve Jobs.

The 2021 cryptocurrency boom was made possible by the simple trading encouraged by SEN, as Silvergate’s customers could even borrow money from the bank against their bitcoin holdings to purchase further cryptocurrencies on its internal network. The bank stated that as of July, more than 20% of its loans were made via this method.

Lane acknowledged that SEN’s leverage product had not received regulatory approval when it was developed, nevertheless.

He made the unnoticed remark in a 2021 interview Silvergate had sponsored on an investment website, “It’s not like it’s an approved product,” It is not a prohibited item.

Since the bank first let cryptocurrency businesses to deposit their money at its bank, which is insured by the Federal Deposit Insurance Corporation, $1 trillion has allegedly been exchanged on its network. At the end of 2021, Silvergate’s deposits reached a height of $14 billion, with most of that amount coming from its crypto customers. However, Silvergate revealed earlier this month that by the end of 2022, its deposits had fallen to $3.8 billion as a result of the FTX fiasco. Silvergate lost about $1 billion last year as a result of having to liquidate investments to meet withdrawals, which is more than the bank has made since it started trading cryptocurrencies in 2014.

Although it is not a “too large to fail” bank, Silvergate did receive assistance from a government-backed organization. According to recently made public company papers, Silvergate received $4.3 billion from the Federal Home Loan Bank of San Francisco late last year, which was first revealed by The American Banker. The majority of the $4.6 billion in cash that the cryptocurrency-friendly bank now has on hand came from Home Loan Bank lending. Additionally, Silvergate has access to public funds via the Federal Reserve Bank of San Francisco.

The FTX connection

Senator Warren, together with her Republican counterparts John Kennedy and Roger Marshall, grilled CEO Lane about the bank’s handling of what are now thought to be unlawful transactions carried out by Alameda Research and FTX a week before Bankman-Fried was detained in the Bahamas. The three mentioned the “bank’s failure to notify these suspicious transactions” in a letter to Lane.

The transfer of customer contributions meant for the FTX Exchange, an offshore business, into Alameda Research, Bankman-Fried’s hedge fund, lies at the core of FTX’s alleged fraud. In order to conceal the fact that the money was going to Alameda, the SEC claims that cash meant for FTX were put into the Silvergate account of an Alameda subsidiary called North Dimension. On a now-defunct website, North Dimension claimed to be an online retailer of electronics; however, because nothing could be purchased there, it appears to have been a hoax.

Before Bankman-Fried was detained but after the FTX bankruptcy filing, Lane claimed Silvergate had “conducted substantial due diligence on FTX and Alameda Research.” He later told the senators that the bank was looking into the disputed transactions but declined to address any particular questions, citing bank policies and the need for confidentiality. He has not spoken further. Last week, during an investor conference call, Lane declined to respond to a query on FTX. (He did mention that the bank was discontinuing the sale of some crypto goods and was firing some of its clients, but not due to any “scrutiny” of them.)

The naysayers don’t believe Lane’s justifications. Cohodes claims that none of these, specifically those Alameda, North Dimension, and FTX transactions, “would have passed the smell test” if Silvergate’s SEN network were properly run, which it isn’t. The co-founder of Silvergate and its chief anti-money-laundering and sanctions officer have both subtly left the bank in the meantime.

The argument over how much illicit activity occurs in the cryptocurrency industry has been revived by the alleged fraud at FTX.

Crypto advocates have claimed that criminality is only a minor portion of everything. However, short sellers who have seized on Silvergate contend that one reason its bank accounts were sought for is that they provided room for potential legal loopholes.

Dollars deposited at Silvergate could be transferred without a hitch between several SEN clients who were buying and selling cryptocurrencies, and then they could be taken out of the bank. No one would be the wiser, according to Cohodes, making the technique perfect for thieves trying to cover up the source of the cash they’re trying to launder.

Banks of all sizes have recently received billion-dollar fines for failing to follow compliance and anti-money-laundering regulations. This is why the dispute over Silvergate is not unusual in the banking sector. The latest meltdown gives an opportunity to tighten the rules for how crypto companies handle money and to make it more difficult for those assets to enter the traditional banking system, but U.S. regulators and prosecutors now appear to be taking a tougher approach to crypto.

The headlines are already referencing that regulatory pressure. The Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC appeared to specifically criticize the type of business Silvergate has conducted through its internal network in a statement they released on January 3 about the risks presented by cryptocurrencies:

The agencies have significant safety and soundness concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto sectors.” They pledged to “closely monitor banking companies’ exposures to cryptoassets.

The chief investment officer of macro-trading company Dorr Asset Management, David Dorr, claims that Silvergate was “certainly hit across the bow” by those shots.
The regulators’ position has been noted by Silvergate’s clients as well. According to BlockTower’s Paul, “the main risk for Silvergate is on the regulatory side.” “No one knows how strict the regulators will be.”

According to Paul, the New York-based Signature Bank appears to be the sector’s “backup” while Silvergate’s crypto consumers search for alternatives. Although BlockTower already has a bank account with Signature, Paul claims that his company is working to “onboard” two more financial institutions as soon as feasible.

That may be challenging for businesses like BlackTower, at least initially. Contrary to Silvergate, the far larger and more successful Signature places less of a focus on cryptocurrency users. (Despite being smaller, Silvergate was a pioneer and its network saw greater cryptocurrency trade volume than a comparable but more recent Signature product.) Even though Signature hasn’t been connected to FTX, the bank recently declared it was scaling back its cryptocurrency operations, citing a $12 billion drop in customer deposits over the previous year. According to Bloomberg, the bank is also refusing to process cryptocurrency transactions worth less than $100,000.

In terms of credit, Paul observes that “crypto” lending is somewhat frozen.

Everyone realized we were lending to one another and trusting counterparties very willy-nilly, and that obviously produced horrible outcomes.

He acknowledges that the issue is that there is no better mechanism in place to deal with it.

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