Last week, Morgan Stanley analyst Ken Zerbe began covering the crypto bank Silvergate Capital (NYSE:SI) with an "overweight" rating, meaning he expects Silvergate to outperform the banking sector. The initiation of research coverage along with a rally in the cryptocurrency market boosted Silvergate shares by roughly 30% during the past week. Zerbe called Silvergate the "widest risk-reward" of any bank his team covers.

And it makes sense. Although Silvergate has a traditional banking license, its main business and draw for investors is its activities in the cryptocurrency market, which as we've seen during the past year can be volatile. But let's dig into what Zerbe was referring to in his research and see if the risk is worth the reward.

Why Silvergate is a great banking business

Management at Silvergate saw what was going on in the cryptocurrency market years ago and had the savvy to realize that digital coins like Bitcoin (CRYPTO:BTC) would be an investable asset that would find its way into the financial system. Management also saw an opening in the fact that the U.S. doesn't operate on a real-time payments system and that cryptocurrencies trade all day, seven days a week, 365 days a year.

So Silvergate built the Silvergate Exchange Network, a payments system to clear transactions instantly between any two parties on the network. As SEN adds more clients, most of which are institutional traders and crypto exchanges, its appeal increases because there are more parties on the network for conducting transactions. This platform proved to be a boon for the bank because customers on SEN bring lots of non-interest-bearing deposits to Silvergate that the bank can then use to originate loans or invest in securities. Silvergate is also able to sell other traditional banking services to these clients, such as standard currency transfers and foreign-exchange products. Over the past few quarters, the bank has also rolled out a product called SEN Leverage, which issues lines of credit collateralized by Bitcoin.

All of this has created a bank already turning a solid profit and that generates a lot of low-cost deposits, interest-earning assets, and potentially faster loan growth than the industry as a whole. The bank's cost of funds, a key metric bank investors look at, is just 0.01%, meaning the bank practically gets all its deposits for free. This deposit base should prove a lot more valuable for Silvergate as interest rates rise and banks start to compete more intensely for deposits because SEN customers didn't come to Silvergate seeking yield on their deposits in the first place. 

Fee income in the second quarter of this year increased 371% from a year earlier, and total deposits have grown to $11.3 billion. Deposits come in so fast that the bank had only about 13% of its deposits into loans at the end of the second quarter, which is practically nothing. The bank has soaked up some of this excess liquidity by investing $6.2 billion in securities, but if long- or short-term interest rates increase, the bank should be able to reinvest in new securities at much higher yields. That should give a big boost to interest income. SEN Leverage also is growing nicely and should help the bank earn more yield as growth in this segment accelerates.

Digitzed drawing of bank and other gadgets.

Image source: Getty Images.

What's the risk?

Being a cryptocurrency player can be risky, especially for banks, among the most heavily regulated of industries. There hasn't been much oversight yet, so companies don't know exactly how things will shape up. 

But we got a glimpse of what crypto regulation in banking could look like when the Basel Committee on Banking Supervision, an organization that helps set global rules for banks, laid out a series of recommendations. The big one was a proposal to require banks to set aside $1 of capital for every $1 of Bitcoin held on their balance sheets. To put this in perspective, current regulations don't require banks to hold that much capital for even their riskiest assets. The good news for Silvergate is that it doesn't actually hold any cryptocurrency on its balance sheet.

However, there could be some regulatory risk to SEN Leverage lending because the Basel Committee said that crypto assets such as Bitcoin would not count as eligible collateral, at least for margin loans and securities financing transactions. It's hard to say for sure how that might affect SEN Leverage, but it could end up requiring the bank to set aside more capital for SEN Leverage loans than it does now. However, Silvergate is operating with extraordinarily high capital levels, with a common equity Tier 1 capital ratio of more than 47%. Most banks Silvergate's size are only in the 7% to 10% range, so I'm sure it has more than enough capital. The bank also requires the Bitcoin collateral to be equal to or greater than the amount of the loan. As of the end of this year's second quarter, Silvergate had experienced no losses or margin calls on SEN Leverage loans, despite the volatility in Bitcoin.

Worth the risk?

I own Silvergate shares, and I view the risk to be worth the reward. While there is regulatory risk as the cryptocurrency landscape evolves, I am encouraged by the fact that management seems to be focusing more on providing crypto transactional services to clients and less on holding or mining crypto. Holding a traditional banking charter also is huge because it allows Silvergate to take advantage of inexpensive deposit gathering and cross-selling of other banking products. I like this stock because it provides exposure to Bitcoin and other cryptocurrencies with less risk than a pure cryptocurrency play.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.