Following the Basel Committee on Banking Supervision's (BCBS) proposal on June 10 for regulating crypto assets at banks, Silvergate Capital (SI) saw its shares drop nearly 10% over the next two days. Investors seemed concerned that the regulation, which would essentially require banks to hold much larger amounts of capital to back up certain crypto assets on their books, might hamstring Silvergate's growth. However, while the BCBS proposal is still preliminary, I believe these regulatory concerns may be overblown. Here's why.
Does Silvergate acquire or hold crypto assets?
Silvergate Capital specializes in banking crypto traders and exchanges. The main way it does this is through its proprietary Silvergate Exchange Network (SEN), a real-time payments network that can clear transactions in U.S. dollars instantly between two users in the network. This is ideal for institutional crypto traders and crypto exchanges, because cryptocurrencies trade around the clock.
BCBS, which essentially creates the framework for most banking regulation around the world, recently issued a proposal that would call for banks to hold a lot of capital for the volatile crypto assets they acquire, including bitcoin (BTC 2.57%).
The BCBS proposal would essentially require banks to hold $100 of capital for every $100 of bitcoin they acquire, or potentially even more, which is significantly more capital than a bank might hold to back up even some of its riskiest loans. BCBS is worried about the volatility of many cryptos and therefore wants banks to be prepared to cover their full loss. In reality, BCBS is basically telling banks not to hold and trade crypto assets.
It's understandable for investors to be concerned about the effects of regulation on Silvergate, because the bank is undoubtedly in the crypto space. But I am not sure that the proposed regulation would prevent or inhibit Silvergate as much as some think.
For one, Silvergate doesn't acquire or hold crypto assets. SEN is a platform that allows institutional traders and exchanges to conduct payment transactions. These clients bring large-dollar deposits to the bank to transact with one another, but all of the deposits that Silvergate holds on its balance sheet are in U.S. dollars and are insured by the Federal Deposit Insurance Corporation (FDIC).
Now, because these deposits are from digital currency clients and are likely moved more frequently due to all of the trading by network participants, deposit balances at Silvergate may be more volatile, but they are still in U.S. dollars. This is nothing new for Silvergate, which keeps plenty of excess liquidity.
Potential issues for SEN Leverage
I have also seen concerns around how the regulation might affect Silvergate's new lending product, SEN Leverage, a line of credit in U.S. dollars collateralized by bitcoin. The company has big plans for this product. Again in this case, Silvergate is not acquiring crypto assets, because the bank owns the U.S. dollar loans, and the collateral is used as a hedge for credit risk. But there could certainly be some regulatory issues for SEN Leverage if the BCBS proposal were to pass, because it does touch on collateral:
For securities financing transactions (SFT) and margin loans involving Group 2 cryptoassets [such as bitcoin], to calculate their counterparty credit risk exposures banks should apply the comprehensive approach formula set out in the credit risk mitigation section of the standardised approach to credit risk. Group 2 cryptoassets are not eligible forms of collateral in the comprehensive approach and therefore when banks receive them as collateral they will receive no recognition for the purposes of the net exposure calculation to the counterparty.
Basically, Bitcoin would not count as eligible collateral for loans, because it would be classified as a group 2 crypto asset, and that could be problematic for SEN Leverage. Collateral makes loans safer, because if a borrower defaults, the bank can go in and still salvage some of the loan's value.
Think about a residential mortgage loan: If the homeowner can't make the mortgage payments, the bank can go in after a time, repossess the house, and sell it to recoup some of what the borrower owes. But another important part of collateral is that it reduces the risk weighting of a loan, because it reduces the likelihood of significant losses.
The risk weighting of a loan helps determine how much capital the bank needs to set aside for that loan in case the borrower defaults. With collateral behind a loan, the bank doesn't have to hold as much capital, but without it, the bank would have to hold more.
While I am not sure how Silvergate is risk-weighting its SEN Leverage loans, I imagine that if this BCBS proposal were implemented in its current form, Silvergate would have to increase the capital it's holding for these loans. While this would increase the overall capital the bank needs to hold and therefore potentially inhibit growth of SEN Leverage, I don't think it would require Silvergate to hold nearly the same amount of capital as for crypto assets, because again, the loan is in U.S. dollars.
The loan might be considered unsecured, which would up its risk weighting but likely not in the same way as acquiring or holding crypto assets like bitcoin would.
This is an overly strict regulatory approach -- not counting bitcoin as collateral -- when you look at how Silvergate is underwriting SEN Leverage loans. Currently, SEN Leverage borrowers are putting up an amount of bitcoin collateral that is equal to or greater than U.S. dollar loan amounts. What Silvergate then does is work with third-party custodians such as crypto exchanges to hold the collateral and liquidate it if the price of bitcoin (and therefore the collateral) falls below a certain threshold set forth in the loan agreement.
On Silvergate's first-quarter earnings call, an analyst actually asked if there had been any margin calls on SEN Leverage loans on a specific day when the price of Bitcoin had fallen 15%. Silvergate CEO Alan Lane said there hadn't been, because the bank has a collateral coverage requirement of 75% or 80%, and SEN Leverage borrowers are putting down an amount of Bitcoin greater than or equal to the loan amount, so a 15% dip in the value of Bitcoin still didn't trigger a margin call.
Although SEN Leverage is still relatively new, Silvergate has been piloting and using the product for at least a year now, and Lane said, "We still have had no losses in this portfolio. We've not had any significant hiccups."
What will be the overall effect?
It's still too early to tell how this will play out. This is just an initial proposal from BCBS, and banking regulation can take years to finalize. It's important to note that Silvergate is a bank that operates holding a ton of capital anyway. The bank ended the first quarter with a common equity tier 1 (CET1) ratio, a measure of a bank's core capital expressed as a percentage of total risk-weighted assets, of roughly 55%.
Now, that's exorbitantly high, because Silvergate has been raising capital to support future growth, but the bank has operated with a CET1 ratio over 23% in the four preceding quarters, when most banks its size run in the 7% to 10% range.
Ultimately, Silvergate does not acquire, hold, or trade crypto assets. Do I hope that BCBS eventually changes its stance on Bitcoin collateral? Yes, absolutely. But I do not think the BCBS proposal, even if implemented unchanged, would necessarily prevent growth of SEN Leverage like many think.