Silvergate Bank (NYSE:SI) — a broad wager on the long-term success of the crypto sector
Silvergate Bank is perhaps the most crypto-friendly bank in the U.S. Since its IPO on November 7th its stock (NYSE: SI) has rallied strongly, increasing 34% from its IPO price of $12 to today’s closing price of $16.02. There’s a case to be made that SI has much more room to grow, as the bank is well positioned to take advantage of future growth in the crypto sector. At the same time, Silvergate’s business has long-term growth drivers and is somewhat insulated from the short and mid-term price volatility of cryptocurrencies. SI stock can be a less risky way to gain exposure to the crypto sector through the vehicle of a regulated bank stock.
Silvergate’s favorable market position and its competitive edge — the SEN
Even more so than the crypto exchanges, Silvergate represents a great “picks and shovels”-type business in the crypto sector. Think of this as a diversified bet on whether U.S. crypto investors, projects, exchanges (including U.S. arms of Binance, OKEx, etc.), and other entities will continue to have a growing need for fiat banking services in the coming years. From H1 2018 to H1 2019, Silvergate’s interest income increased by 22% and net income by 13%, despite the average price of BTC during those periods falling 39%. This is in part thanks to Silvergate’s blue chip customer list — among many others it includes Coinbase, Kraken, Genesis, Polychain Capital, Figure, Kava, Bitstamp, and Blocktower.
At SI’s closing price of $16.02 today, it has a market cap of $299M and a P/E ratio of 10.14 on TTM earnings:
SI is priced attractively on a P/E basis, and shows strong ROE compared to its peers. Quarterly revenue growth was more modest, but in-line with sector averages. Another bright spot is a $1.1M (33% YOY) increase in noninterest income, primarily due to “increases in foreign exchange and wire transfer fees and analyzed checking fees associated with our digital currency initiative”. This is driven by increased use of the Silvergate Exchange Network (SEN), a proprietary platform that allows business customers of Silvergate to exchange fiat between each other electronically via API, 24/7 and near-instantaneously.
While Silvergate appears to have a tidy lending business like many regional banks, the real growth potential for the bank comes from the SEN. While intrabank transfer systems exist at other banks, they don’t have this level of availability and functionality, and there doesn’t exist a critical mass of crypto businesses at any other bank. With crypto markets operating 24/7 globally, it’s easy to see how the ability to move $10M in seconds via the SEN, even in the middle of the night, is an incredible differentiating feature for Silvergate. Recognizing the SEN as their key driver of growth, Silvergate is rapidly planning additional services to the network, with crypto lending services scheduled to launch in Q4 2019. For businesses that hold large crypto positions in highly-liquid assets like BTC or ETH, this will significantly expand their working capital and allow them to leverage their balance sheet to fund future growth. Silvergate is also expanding the SEN to foreign currencies, laying the groundwork for relationships with the international entities of major exchanges, funds, and projects.
While SEN revenue remains a relatively small percentage of total revenue (11%), it is growing rapidly and has additional strategic benefits as clients become more reliant on the SEN and its network effect grows.
It’s not possible to separate out exactly what the associated costs are for the SEN, but it’s safe to assume internal transfers between Silvergate customers have virtually zero cost to the bank, so margins and profit contribution should be excellent for these transfers. But the true value of the SEN should be its contribution to customer retention and driving greater deposit balances. For customers that integrate the SEN API as a key part of their operations, switching costs to other banks and transaction methods likely won’t be trivial. Kraken exchange, for example, recently announced instant deposit/withdrawals to Kraken Pro customers using the SEN.
Competition from other banks
Signature Bank is the most significant competitor offering banking services to crypto businesses, but using non-interest bearing deposits as a proxy, these crypto businesses make up only 32% of bank deposits, vs. 80% for those of Silvergate. The rest of Signature’s business is focused on more traditional banking activities like commercial and RE loans, headlined by the numerous loans they’ve made to the Trump Organization. If your goal is to invest in a bank stock for exposure to the crypto sector and its future growth, SI is the more focused vehicle to achieve that.
In addition to their first mover advantage and the natural monopoly of the SEN clearinghouse, it doesn’t seem likely that major banks will soon take on the challenge of becoming crypto-compliant (as recently as July, the major U.S. banks were still actively closing accounts that dealt in cryptocurrency). It’s a classic case of the incumbent having too much to lose (from a regulatory standpoint) and not enough to gain (relative to their current massive profits). But an upstart like Silvergate could see massive returns on their modest $2.2B balance sheet. If we take it as given that the crypto sector will grow 10x+ in the coming 5–10 years, will there come a day when WFM, JPM, et al dive in and offer similar services to Silvergate’s SEN? Most likely, and they’ll have greater resources to throw at the problem. But that wouldn’t come to pass without first Silvergate’s assets and profits have grown many times over from the current levels.
An investment in Silvergate is not without risks; while its revenue and earnings are moderately insulated from the short-term swings in crypto prices, fundamentally it is tied to the health of crypto exchanges, investment funds, and companies/projects, which respectively make up 50%, 36%, and 14% of total deposits at the bank. If crypto trade volumes decline the exchanges will hold less user funds, if investment dries up there is less capital to hold at Silvergate, and as time goes on project teams will continue to spend funds and reduce their treasury balances. All these factors will result in lower deposits for Silvergate, and in turn lower revenues and profit, and in fact crypto-related deposits have declined 11% from 6/30/19 to 9/30/19 per Silvergate’s 11/8/2019 IPO prospectus, coinciding with a sharp drop in crypto trading volumes. That said, if you expect a long-term secular decline in crypto usage, volume, and investment, Silvergate is not the best bank for you to invest in anyway.
The second major risk for Silvergate is compression of their Net Interest Margin. Banks traditionally make their money by taking in deposits, paying their customers an interest rate on those deposits, and using those deposits to make loans at a higher interest rate. The difference in those rates is the Net Interest Margin, and it’s how most banks make their money. While generally banks benefit from higher interest rates, because there is more room to build a spread between lending and deposit rates, Silvergate is currently in a unique situation. As one of the ‘only games in town’ for crypto businesses, they can get away with paying 0% on 80% of their deposits, because there simply isn’t much competitive pressure on them. Coinbase likely can’t take their business to Wells Fargo or JP Morgan, so their negotiating position is limited. That may hold true when the Federal Funds Rate is 1.75%, but in an elevated rate environment more in line with historical levels, Silvergate may be forced to move to a more competitive spread. But if Silvergate’s customer stickiness remains, there’s no reason to think this advantage wouldn’t persist in higher rate environments. For customers whose operations are heavily integrated with the SEN, switching costs would not be trivial. Maybe Silvergate can’t get away with non-interest bearing accounts, but if they can keep deposit rates at 54 basis points below-market for regional banks (the current spread they have achieved), that’s still an enormous competitive advantage. Or maybe we’ll just stay in a zero/negative rate environment forever! Exciting times if you’re into market distortions.
The longer-term risk is if the crypto sector grows large enough to become interesting to the major banks, with their resources they could get up to speed quickly and start offering similar products as Silvergate. This may form a cap on Silvergate’s growth, as the more profitable it becomes, the more likely major banks will be to jump in to compete (as with any market). In this case, Silvergate would need to rely on the strong banking relationships they’ve built early with the major crypto players, and continue to engineer strong network effects with the SEN to prevent disruption by a larger player. In any case, this scenario only plays out after SI stock would have returned strong growth to shareholders relative to its current price.
If you are looking for exposure to the crypto sector yet find the cryptoassets themselves too volatile, SI could be a great alternative. While it can be difficult to pick the winner of the fickle exchange business or early stage crypto projects, they will all need banking services and gateways to/from fiat currency to succeed as U.S. entities. Silvergate is well-positioned to be the primary supplier of those services for the foreseeable future.
Note: Author is not a licensed investment advisor. This article is not investment advice and is provided for informational purposes only.
Silvergate Bank (NYSE:SI) — a broad wager on the long-term success of the crypto sector was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.