Silvergate Capital Stock – A Cryptocurrency Bank

We recently published A Complete Guide to Investing in Blockchain Stocks that turned a few heads. This is because we took issue with what analysts at Golden Slacks put forward as blockchain stocks. Are Tesla and Facebook blockchain stocks? It is difficult to discuss. In the article, we highlighted a few stocks that we believe could be viable games for the cryptocurrency boom, and secondarily, blockchain – Coinbase (COIN) and Silvergate Capital (SI).

We have already written about Coinbase, but not about Silvergate Capital. Our last comments on the latter were as follows:

It’s an interesting small business with steadily growing revenue streams and a rapidly growing institutional client list, but with too many moving parts for our liking.

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That didn’t bode well with some of our followers disputing our conclusion, saying we should work harder to figure it out. And they are right. It is quite easy to fire an ad hoc acquisition company (After-sales service) because they don’t have enough information, but not a listed company. We should either say “this is too complex” and leave it, but not say “this thing looks really interesting but we are too lazy to do the heavy lifting”. Today we’re going to figure out what Silvergate Capital is doing and whether or not this is a blockchain stock that should find its way into our portfolio.

About Silvergate Capital Stock

The best way to understand business is to think about how a bank works. That’s because Silvergate Capital is a bank – “a Federal Reserve Member Bank and the leading provider of innovative financial infrastructure solutions and services to the growing digital currency industry.” While all of the other banks are just starting to think about cryptocurrencies, Silvergate is two steps ahead of them.

People deposit money in a bank and then the bank uses their money to generate a return while charging their customers a fee. Typically, a bank must pay customers the privilege of holding their money – interest – the amount of which is dictated by a governing body, depending on the country. Since cryptocurrencies don’t demand payment of interest because governing bodies didn’t even understand them, Silvergate Capital has over $ 7 billion in funds that they can use to generate a return without pay a dime. It is free money that becomes more and more valuable as interest rates rise. So where does all this free money come from?

Silvergate customers

Institutions constitute Silvergate’s rapidly growing customer base in response to the popularity of crypto.

Credit: Silvergate Capital

The reason is the Silvergate Exchange NOTnetwork (SEN) in which Silvergate acts as an intermediary between traders and exchanges by allowing the exchange of crypto for US dollars. Of course, this comes at a cost, which means Silvergate’s transaction fees are increasing at a rate that matches their customer base growth.

Credit: Silvergate Capital

Transaction fees are a fraction of total Silvergate revenue (around 23% in 2020), the remainder of which comes from the investments they make and the money they lend (more on that in a bit).

Credit: Silvergate Capital

Silvergate’s 10 largest depositors account for $ 2.5 billion in deposits, or about 47.5% of the Bank’s total deposits. A single customer withdrawing their money could have a big drain on Silvergate’s available money, which is why they are dragging it out a bit.

Credit: Silvergate Capital

Digital Currency Exchanges deposits represent approximately 47.2% of total Silvergate deposits and are held by approximately 76 exchanges. The success of Silvergate, and almost half of its customers, hinges on the success of cryptocurrency which is backed – at least in many cases – by bigger fools. Crypto currently has the obsessed masses, the vast majority of whom cannot explain to you what they are actually “investing” in. What Silvergate invests in is also difficult to understand as there are a lot of moving parts.

Silvergate Return Strategy

If you have cash and want a certain return on it, depositing in a bank won’t get you squatting these days. How Silvergate Capital generates a return on its $ 7 billion goes through two main areas: securities and lending.

Silvergate assets other than cash

We will ignore the fact that the majority of their titles are labeled MBS / CMO, two acronyms that would make anyone who lived the subprime crisis tremble. Let’s look at the “loans” segment which has some of its own risks. The first is that 8.9% of their loan balances are “in the process of being changed” because of The ‘Rona. This means “either a full deferment of payment or a resumption of partial interest payments only”. As you might expect, the hospitality industry is taking a beating with 85% of loans in modification.

Credit: Silvergate Capital

There is no reason to believe this diverse loan portfolio will suffer so much, provided things don’t get worse. In the first quarter of this year, Silvergate’s loans under modification fell from 8.5% to 8.9%. Investors had better pay close attention to this number and hope that it starts to go down rather than increase.

Perhaps of even more concern is Silvergate’s new ‘SEN leverage product’, which was tested in 2020, and is now one of the company’s main lending products. SEN leverage allows SEN clients to borrow US dollars against the value of bitcoin in digital currency. Considering bitcoin’s volatility, this is about as risky as it sounds. We now have enough information to make an informed investment decision.

To buy or not to buy

The bull affair is quite easy to understand and, we suspect, many people will be looking for it. If cryptocurrency is the future, then why not invest in a cryptocurrency bank? Most risk-averse investors would avoid the complexity, and there’s a much easier way to play the cryptocurrency’s “pick and shovel” thesis.

About 90% of Coinbase’s revenue in 2020 came from fees – mostly from business transactions and from services like storage and analytics. As long as the cryptocurrency is booming, Coinbase is making money. They don’t have to worry about underperforming loans or large depositors taking out large sums of money. While Coinbase shares are currently trading for around double what we would be willing to pay – $ 128 per share – we would much prefer an investment in Coinbase over Silvergate Capital given that the latter operates like a bank that adds. several levels of regulatory complexity. that the majority of investors – including us – cannot follow without making it a full-time job.

We believe the cryptocurrency is very overheated right now with the hype that breeds the mania. Look no further than NFTs, the next manifestation of ICOs, or Elon Musk dragging the world’s biggest fools by promoting Dogecoin, a cryptocurrency that started out as a joke. That’s not to say we don’t have some exposure to crypto. Less than 2% of our total assets are in bitcoin, and that’s largely because we found ARK Invest’s bitcoin thesis to be somewhat credible. Investors need to ask: What happens to a company like Silvergate if the cryptocurrency loses popularity? What will happen to the 76 exchanges which are responsible for almost half of Silvergate Capital’s deposits? It’s unknowns like this that lead us to believe that Silvergate Capital should be avoided.

Conclusion

Warren Buffett advises investing only in what you understand. Looking under the hood of a bank is an exercise in humility, no matter how many graduate finance degrees you have. Spend some time listening to a risk management drone on capital ratios and you’ll find it’s extremely boring, too. Then there are the cryptocurrencies which are exciting, but which not many people understand.

Silvergate is a cryptocurrency bank, and the complexity of how it works means there are risks we can’t even imagine – Rumsfeld’s unknown strangers. If you are bullish on cryptocurrency, buy it. If you want to be exposed to the overall success of cryptocurrencies as an asset class, buy shares from Coinbase. But there is no reason to take the added risk of a complex banking transaction that depends solely on the success of the cryptocurrency.

Blockchain technology has a lot of potential but many pitfalls to avoid. While we believe cryptocurrencies should be avoided like the plague, we also hold bitcoins. You’d like to know why ? Become a Analyze Premium subscriber and immediately get unlimited access to all of our premium items.

Sallie R. Loera