We recently published A Complete Guide to Investing in Blockchain Stocks which turned some heads. That’s because we challenged what the analysts at Golden Slacks put forth as blockchain stocks. Tesla and Facebook are blockchain stocks? That’s hard to argue. In the piece, we pointed to a few stocks we thought might be viable plays for the cryptocurrency boom, and incidentally, blockchain – Coinbase (COIN) and Silvergate Capital (SI).
We’ve written before about Coinbase, but not Silvergate Capital. Our last comments on the latter were as follows:
It’s an interesting little company with consistently growing revenue streams and a rapidly growing list of institutional customers, but with too many moving parts for our liking.
That didn’t bode well with some of our subscribers who challenged our conclusion, saying we should work harder to figure it out. And they have a point. It’s easy enough to dismiss a special purpose acquisition company (SPAC) because they don’t have enough information, but not a publicly traded company. We should either say “it’s too complex” and leave it, but not say “this thing looks really interesting but we’re too lazy to do the heavy lifting.” Today, we’re going to figure out what Silvergate Capital does, and whether or not they’re a blockchain stock that should find its way into our portfolio.
About Silvergate Capital Stock
The best way to understand the company 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 for the growing digital currency industry.” If all the other banks are just starting to think about cryptocurrencies, Silvergate is two steps ahead of them.
People deposit money with a bank and then the bank uses their money to generate a return while also charging their customers fees. Typically, a bank has to pay customers for the privilege of holding their money – interest – the amount of which is dictated by some governing body, depending on the country. Since cryptocurrencies don’t require interest to be paid because governing bodies haven’t even figured them out, Silvergate Capital has over $7 billion in funds that they can use to generate yield from without paying a penny. It’s free money that only gets more valuable as interest rates go up. So where is all this free money coming from?
Institutions make up Silvergate’s clientele which is growing rapidly in response to the popularity of crypto.
The reason for that is the Silvergate Exchange Network (SEN) in which Silvergate acts as an intermediary between traders and exchanges by allowing the exchange of crypto for U.S. dollars. Of course, that comes at a cost, which means Silvergate’s transaction fees are growing at a pace that matches their client growth.
Transaction fees are a fraction of Silvergate’s total revenues (about 23% in 2020), the remainder of which comes from investments they’re making and money they’re loaning out (more on this in a bit).
Silvergate’s 10 largest depositors account for $2.5 billion in deposits, or approximately 47.5% of the Bank’s total deposits. A single customer withdrawing their money could have a big drain Silvergate’s available cash, which is why they leave quite a bit laying around.
Deposits from digital currency exchanges represent approximately 47.2% of Silvergate’s overall deposits and are held by approximately 76 exchanges. The success of Silvergate, and nearly half their customers, relies on the success of cryptocurrency which is being propped up – at least in many cases – by greater fools. Crypto currently has the masses fixated, the vast majority of whom can’t explain to you what they’re actually “investing” in. What Silvergate invests in is also difficult to understand because there are a lot of moving parts.
Silvergate’s Yield Strategy
If you’re holding cash and you want to get some yield from it, depositing in a bank won’t get you squat these days. The way Silvergate Capital generates yield on their $7 billion is through two primary areas – securities and loans.
We’ll gloss over the fact that the majority of their securities are labeled MBS/CMO, two acronyms that would give anyone who lived through the subprime mortgage crisis the shakes. Let’s look at the “loans” segment which presents some of its own risks. The first is that 8.9% of their loan balances are “in modification” due to The ‘Rona. That means “either full payment deferral or resumed partial interest only payments.” As one would expect, the hospitality industry is taking a drubbing with 85% of loans in modification.
There’s no reason to believe that this diversified loan portfolio will suffer all that much, provided that things don’t get worse. The first quarter of this year, Silvergate’s loans in modification increased from 8.5% to 8.9%. Investors better pay close attention to that number and hope it starts falling rather than rising.
Perhaps even more concerning is Silvergate’s new “SEN Leverage product,” which was piloted during 2020, and is now one of the company’s core lending products. SEN Leverage allows SEN customers to borrow U.S. dollars against the value of the digital currency bitcoin. Given the volatility of bitcoin, that’s about as risky as it sounds. By now we have enough information to make an informed investment decision.
To Buy or Not to Buy
The bull case is easy enough to understand, and we suspect will have plenty of people looking for it. If cryptocurrency is the future, then why not invest in a cryptocurrency bank? Most risk averse investors would avoid complexity, and there’s a much simpler way to play the cryptocurrency “pick and shovel” thesis.
Roughly 90% of Coinbase’s revenues in 2020 came from fees – trading transactions mainly, and services such as storage and analytics. As long as cryptocurrency is booming, Coinbase makes money. They don’t need to worry about underperforming loans, or major depositors pulling out large amounts of cash. While shares of Coinbase are currently trading around double of what we’d be willing to pay – $128 a share – we’d much prefer an investment in Coinbase over Silvergate Capital given that the latter operates as a bank which adds multiple layers of regulatory complexity that the majority of investors – ourselves included – can’t keep track of without making it a full time job.
We believe that cryptocurrency is very overheated right now with hype driving the mania. Look no further than NFTs, the next manifestation of ICOs, or Elon Musk trolling the heck out of the world’s greatest fools by promoting Dodgecoin, 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 sit in bitcoin, and that’s largely because we found ARK Invest’s bitcoin thesis to be somewhat credible. Investors need to ask themselves, what happens to a company like Silvergate if cryptocurrency wanes in popularity? What will happen to the 76 exchanges that are responsible for nearly half of Silvergate Capital’s deposits? It’s unknowns like this which lead us to believe that Silvergate Capital should be avoided.
Warren Buffett advises to only invest in what you understand. Looking under the hood of a bank is a humbling exercise, no matter how many advanced degrees in finance you have. Spend some time listening to a risk manager drone on about capital ratios and you’ll realize it’s also extremely boring. Then there are crypto currencies which are exciting, but which few people understand.
Silvergate is a cryptocurrency bank, and the complexity of their operation means there are risks we can’t even imagine – Rumsfeld’s unknown unknowns. If you’re bullish on cryptocurrency, buy some. If you want exposure to the overall success of cryptocurrencies as an asset class, buy shares of Coinbase. But there’s no reason to take on the added risk of a complex banking operation that’s solely dependent on the success of cryptocurrency.
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