With the growing adoption of blockchain technology and thousands of cryptocurrencies, a whole array of companies has popped up to support the sector — from asset managers to banks to crypto miners. And as the price of the world’s largest cryptocurrency, Bitcoin (BTC -4.10%), has dropped more than 52% this year, crypto stocks have followed suit.
However, one crypto stock in particular has proven remarkably resilient. While the company’s stock price has dropped off at times, its business is operating incredibly well even through the volatility.
A durable business model
The crypto bank Silvergate Capital (SI 0.51%) went public in 2019. It offered critical infrastructure for institutions looking to trade cryptocurrencies with crypto exchanges, as management saw early on that cryptocurrencies would be investable assets.
Silvergate has developed a proprietary real-time payments system called the Silvergate Exchange Network (SEN), which allows multiple parties on the network to transfer funds 24 hours per day and seven days a week, all year round. The U.S. banking system doesn’t operate around the clock, while cryptocurrencies do, making SEN a very efficient way to trade crypto.
Silvergate doesn’t hold any cryptocurrencies on its balance sheet, but benefits when SEN clients bring large sums of non-interest-bearing deposits to the bank. The bank doesn’t pay any interest on these, and it can invest them into the bond market or into loans and make money on the spread. Not only does Silvergate not pay interest on these deposits, but SEN has also helped the bank rapidly grow deposits.
While there’s debate whether Bitcoin can be a hedge against inflation due to its finite supply, Silvergate’s business model definitely makes it an inflation hedge — as interest rates rise, so do the yields on bonds and many of its loans. We saw this dynamic play out in the second quarter of the year when Silvergate, despite the plummeting price of Bitcoin, generated a record $1.13 in earnings per share. That’s because it was able to grow the revenue from loans and bonds by nearly 40% from the first quarter.
Credit quality continues to be strong
Two big concerns during the second quarter led investors to sell the stock: how deposit levels would trend, and whether there would be any forced liquidations or losses on Silvergate’s specialized lending product, SEN Leverage.
SEN Leverage is a U.S. dollar line of credit collateralized by Bitcoin. The product seems very safe because Silvergate has borrowers heavily collateralize the U.S. dollar loan amount with an equivalent amount of Bitcoin, and sometimes more. Furthermore, Silvergate keeps the collateral with partner custodians, and since Bitcoin trades around the clock, it’s arguably the most liquid form of collateral.
In March, Silvergate issued a $205 million term loan to the business intelligence and Bitcoin buyer MicroStrategy (MSTR -5.70%), which used the proceeds to buy more Bitcoin. Some investors may have worried when MicroStrategy said in May that if the price of Bitcoin fell below $21,000, it could trigger a margin call.
It is possible this happened at some point over the past few weeks, but with no forced liquidations, Silvergate’s credit still had a clean bill of health in the second quarter. Furthermore, Silvergate still has incredibly high levels of capital. On the Q2 earnings call, CEO Alan Lane said of SEN Leverage that “I don’t think you’re going to see this as … high multiples of our capital base.”
For the first time since going public, the bank saw average digital currency deposits fall from $14.7 billion in the first quarter to $13.8 billion in the second.
Obviously, deposits are a big driver of profitability for the bank, so this isn’t what investors want to see. But considering that the price of Bitcoin fell from over $45,500 at the end of Q1 to less than $20,000 at the end of Q2, things certainly could have been worse. Interestingly, there was also a huge variation in average deposit levels during Q2, with the high being $17.6 billion and the low being $12.6 billion.
Management attributed the wide range of deposit levels to “significant dislocation that occurred throughout the broader ecosystem, which was in part impacted by the collapse of various digital asset platforms.” However, Silvergate didn’t lose any customers due to these events, and still pays out no interest on its deposits. In fact, SEN added 85 customers in Q2, bringing the total to 1,585 customers. Lane also said that the pipeline of customers remains “robust,” with 300 prospects.
Silvergate has the first-mover advantage as the first bank to launch this kind of network, so its network becomes more attractive the bigger it gets. It also takes a lot of time to get onboarded onto SEN, so it seems like clients are taking a somewhat long-term view of the crypto industry when they decide to join the network.
I continue to believe that the model Silvergate has implemented with SEN is sustainable through the ups and downs of the crypto cycle. When rates rise, the company is able to make more money on its deposits, and SEN Leverage loans are highly collateralized and extremely liquid.
While Bitcoin might fall in the near term, in the long term I believe both Bitcoin and crypto trading are here to stay; this makes the infrastructure Silvergate offers very attractive and valuable, especially as the network grows. I remain bullish on the stock.