From Crypto to Venture Debt: The Rise and Fall of Silicon Valley Bank
What really happened?
America saw its second largest bank failure last week. It is undoubtedly the largest failure of a financial institution since the economic collapse of 2008. Here’s how that actually happened —
Alright, so Silicon Valley Bank (SVB) is the 16th biggest bank in America and has been shut down by regulators and its operations have been seized by the Federal Deposit Insurance Corporation (FDIC) just three days after silvergate bank, another California bank announced it would be winding down its operations and liquidating.
Silvergate and Silicon Valley Bank cater to niche markets that weren’t well served by larger banks. For regular customers, the convenience and safety of a big bank is hard to beat, so newer banks like silvergate and SVB had to offer their clients something that they can’t get at JP Morgan or Bank of America.
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Silvergate Bank — Rise and Fall
Silvergate was established in 1988 but grew rapidly from 2016 when it started offering banking services to cryptocurrency users. Other banks don’t like this space because crypto is too often used for money laundering, criminal activities, and fraud. Anti-money laundering and know your customer laws meant that banks had to verify that any of their customers money coming from crypto was obtained legitimately.
It’s very difficult and expensive for a bank to audit cash from the sale of a cryptocurrency, because it could have come from a long-term investment but it could have just as easily come from selling illicit items online or conducting one of the countless crypto rug pulls.
Silvergate saw a gap in the market and was willing to offer financial Services to this group for a fee.
One of their most loyal customers was a crypto exchange platform called FTX which used silvergate to hold their fiat reserves. The bank used to proudly display a review of the bank services by Sam Bankman-Fried on their home page, although that has since been removed.
Another key feature of Silvergate bank was their SEN(Silvergate Exchange Network), which enabled cryptocurrency exchanges, institutional investors, and wealthy clients to exchange crypto for fiat currencies. SEN also had a lending facility which would loan fiat cash by using Bitcoin as a collateral.
Margin loans and fiat exchanges were actually revenue generators for the bank, but their trust relied on the cryptocurrencies they loaned against not losing value. When Bitcoin fell by over 70%, it caused a panic.
The bank’s exposure to billions of dollars worth of unbacked debt and their association with the fraudulent crypto platform was enough to make the depositors start withdrawing their funds and moving it into traditional banks. The bank chose to go into voluntary liquidation and it will start the process of selling off its assets to cover depositors.
If any funds held in fiat currency can’t be recovered, the FDIC will cover the account holders for their first $250,000 with the institution. If they had more than that on deposit, their only hope is that the bank finds enough cash to cover it during the liquidation process.
Bank runs in the U.S generally don’t happen very often and the collapse of silvergate is huge news, but it was completely overshadowed by Silicon Valley Bank, which is a much larger bank that also failed last week but for different reasons.
The root cause of the failure here was a sudden and significant increase in interest rates and that part of the job of a bank is to manage interest rate risk and that didn’t happen here. — Greg Baer
Enter, the Silicon Valley Bank
Silicon Valley Bank didn’t have significant exposure to cryptocurrencies. Their selling point over traditional banks was the services they provided to silicon valley startups and venture capitalists. It was called the investors’ investor, as they had a venture capital and credit arm that would directly invest into funds such as Sequoia Capital, Ribbit Capital, Spark Capital, and Greylock. Basically, the who’s who of institutional investors in Silicon Valley.
The bank was also a pioneer of venture debt — which is a type of loan made to early stage high-growth companies, who can’t get funding anywhere else because they are too risky. Generally, most new businesses fail. So, traditional banks aren’t going to lend to any company that can’t show consistent profits or put up adequate collateral.
Just like silvergate saw a gap in the market to serve risky crypto businesses, Silicon Valley Bank saw a gap to serve new startups. And, one of the reasons that tech startups like banking with SVB instead of the big banks was that it offered a great networking opportunity. It would host client events where startup founders and venture capitalists would get acquainted with each other presenting incredible business opportunities to all parties.
The bank holds hundreds of billions of dollars in deposits, primarily coming from their target market of new startups. When startups raise money, they would deposit it with SVB. A lot of these new companies were not yet profitable and some of them didn’t even generate any revenue. So, that money in their account was the only thing that allowed them to operate.
With over $200 Billion in deposits, the biggest challenge for Silicon Valley Bank was putting that money to good use. The bank had traditional loan products like mortgages, but normal people had no reason to bank with SVB unless they were also a startup CEO, so that didn’t make them a lot of money. Their venture debt desk didn’t bring in revenue, but they still couldn’t give out enough loans for it to make much money. Anything they had left they, invested into government treasuries that had low but predictable yields.
The bank’s problem started when interest rates began to rise. To keep their deposits, they had to start paying interest on the firms keeping money with them or those firms would move to other banks, where they could make up to 4% on the money sitting in their business account.
Roku, the video streaming company, reportedly had $500 Million deposited with SVB, which could have been earning them S20 Million a year in interest.
The bank fell apart because of cost on both sides of its balance sheet. It had to keep up with interest rates for depositors, but it was also losing money on its treasury. SVB purchased most of its treasuries between 2020 and early 2022 when the interest rates on Bonds were very low. These treasuries are not very attractive to a bond buyer now because they could purchase newer bonds that are paying much higher yields. If SVB needs to sell these bonds urgently, they need to offer a discount to bond buyers to compensate them for the lower rate that they will earn holding their worthless 2020 bonds. In fact, they could buy straight from the government today.
Since VC investment has been slowing down, deposits at the bank started to drop which forced the bank to sell their bonds at a loss to cover withdrawals. If this happens enough, and the bank was unable to call back its extremely risky venture loans, they ran the risk of not having enough cash to honor withdrawals.
Bank Run Begins
News of these challenges were circulated last week by a group of venture capitalists looking out for the startup projects they were funding. They told their portfolio companies to withdraw their deposits from SVB. This cost a bank run and the FDIC stepped in.
As of Sunday morning, a joint press release from the FDIC, the treasury and the Federal Reserve indicated that all deposits at SVB would be available Monday morning meaning that depositors will be guaranteed 100% of their deposits instead of just the $250,000 insured by the FDIC. However, they also hinted that Signature Bank, which like silvergate was a big depositor for crypto companies had also failed, and that their depositors too will be made whole.
I believe the bank will soon open with a new name and deposits will be a 100% safe.
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