Silvergate Capital (SI 10.17%) is a small bank in California that's been around for over 30 years. Back in 2013, the bank noticed the rise of interest in cryptocurrencies like Bitcoin (BTC -0.06%). The bank wanted to land all the new trading exchanges like Coinbase (COIN 8.59%) as customers and provide banking services to them and all the institutions that wanted to trade this new digital currency.

So Silvergate created the Silvergate Exchange Network, or SEN, to enable these clients to trade Bitcoin and other forms of crypto 24/7. The way it works, institutions that want to trade crypto open an account at the bank. Then when they trade cryptocurrency on Coinbase or one of the other trading platforms that are aligned with Silvergate, that platform handles the crypto exchange while Silvergate transfers the dollars into its customer accounts.

A businessman yanking open his shirt to show the Bitcoin insignia on his chest.

Image source: Getty Images.

This has been an immensely profitable venture for Silvergate, and it is just getting started. All of these funds are in trading accounts at the bank. And Silvergate doesn't pay any interest on the deposits. So this is a windfall for the bank.

Consider for a moment if inflation takes off and interest rates begin to rise. High interest rates are very beneficial for this bank. Since Silvergate doesn't pay any interest to holders of its trading accounts, it will be more and more profitable as interest rates go up and up. 

Indeed, the whole rise of cryptocurrency is based on a distrust of fiat currency and the debt levels of governments. Crypto in that sense works like gold, as a store of value. In an inflationary environment, demand for crypto will increase, so this will be a virtuous cycle for Silvergate. The inflation of the dollar will cause demand for alternative investments like crypto. More and more institutions will deposit cash at Silvergate in order to buy cryptocurrencies. Meanwhile, as interest rates go up to combat inflation, Silvergate makes more and more money off its interest-free accounts.

Silvergate is highly profitable even when interest rates are low

Right now, we're in a very low-rate environment. And Silvergate is doing just fine with its 33% profit margins. The bank has almost $4 billion in net cash. But it's sobering to think that if inflation starts to rise, this bank will do a lot better. 

Despite low inflation right now, people are buying crypto -- not as a hedge but in the belief that these currencies will be more valuable in the future. Silvergate has seen dramatic growth in its deposit base and trading numbers over the last few months. As CEO Alan Lane reported on the first-quarter 2021 conference call, "In the first quarter, activity on the SEN continued to grow at a record pace with nearly 167,000 transactions and more than $166 billion in SEN volumes, up 84% on a sequential basis."

This current demand for crypto can be traced to major companies supporting the currency back in the fall. Square (SQ -0.42%) announced in October 2020 that it was buying $50 million worth of Bitcoin. And recently it bought another $170 million. PayPal Holdings (PYPL 0.10%) has also jumped into the crypto space in a major way.

These moves have increased the demand for Bitcoin, and Silvergate is seeing an influx of cash. "Average deposits from digital currency customers grew by $3.8 billion to $6.4 billion compared to an average of $2.6 billion in the fourth quarter of 2020," Lane said.

Not surprisingly, the stock has zoomed higher as demand for the bank's services has skyrocketed.

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Silvergate is just getting started

What's notable about Silvergate is how small it is compared to these other crypto players. Square has a $111 billion market cap. PayPal is a $311 billion giant. Even Coinbase is a big company, with a $58 billion valuation. Silvergate is a tiny bank with a $3 billion market cap. So it's very much in its early days, and there's a lot of room for this stock to run higher.

What will really be a cash cow for the bank is SEN Leverage. As Lane said on the conference call, "Last year, we introduced our collateralized lending product called SEN Leverage, through which institutional investors receive U.S. dollar financing by entering into a loan agreement with Silvergate." 

Loaning out money is how banks make money. The money Silvergate has made off the SEN so far is small potatoes compared to this new lending program. In the first quarter, Silvergate announced partnerships with Coinbase and Fidelity to act as digital custodians. These larger financial partners, and others like them, will store the digital currencies. And Silvergate will make loans using those assets as collateral.

As Benjamin Reynolds, chief strategy officer for Silvergate, noted on the conference call, "We're not aware of any significant new competitors that are willing to provide U.S. dollar funding that's collateralized by Bitcoin." It's a greenfield opportunity for the bank.

Silvergate had amazing numbers in the first quarter, with deposits more than doubling from the fourth quarter of 2020. The bank has billions sitting in its trading accounts. But the real money will be made when Silvergate starts making loans to its institutional clients and charging interest. That's the future for this crypto bank. And it will be a highly lucrative one.