Collapse of Silicon Valley Bank and Stablecoins (EN)
On March 10, 2023, Silicon Valley Bank (SVB), the 16th largest U.S. bank, closed due to insufficient liquidity and insolvency, resulting in the largest bank failure since the 2008 financial crisis. The total market capitalization of U.S. bank stocks was reduced by more than $10 billion, and following SVB’s failure, Signature Bank, a New York-based bank, also closed for the same reason. In addition, when it became known that Circle, the issuer of $USDC, one of the considered safest stablecoins, had deposited funds in SVB, $USDC also broke its peg to $1, causing major disruptions in the crypto industry. With that in mind, this article aims to explain the main reasons for the bankruptcy of SVB and the banks, why $USDC broke its peg, and what this means for the future of stablecoins.
SVB Bank Run
The main reason for SVB’s bankruptcy is the losses incurred during the sale of bonds to respond to massive withdrawal requests from depositors. To understand this in more depth, it is important to understand the structure of banks and bonds.
Structure of a Bank
A bank’s revenue structure is broadly categorized into interest income and non-interest income. Interest income is commonly divided into interest income from loans and interest income from investing deposited funds in bonds, while non-interest income is divided into credit card fees, foreign exchange fees, etc. However, most of the bank’s revenue comes from interest income, and SVB’s income statement below shows that about 70% of its revenue comes from interest income.
SVB operated by investing customer deposits in U.S. Treasury securities to earn interest, and had approximately 55% of its total assets of $212B invested in bonds. During the course of this incident, SVB sold approximately $21B of its bond holdings in response to customer withdrawal requests.
Structure of a Bond
To understand why SVB lost money selling the bonds, it is necessary to understand the relationship between interest rates and bond prices. In general, the price of most bonds and interest rates have an inverse relationship (i.e., when interest rates fall, bond prices rise, and when interest rates rise, bond prices fall). Here’s a simple example to help with comprehension.
- Example) Let’s say that when the market interest rate is 2%, a person named A pays $1,000 for a 10-year bond that pays 4% interest. Nine years later, when A needs money and wants to sell the bond, the market interest rate rises to 10% and a new bond with a 1-year maturity and 10% interest is being issued for $1,000, so no one will buy A’s bond for $1,000. If someone buys the new bond, they will receive $1,000 in principal and $100 in interest after one year, but if they buy A’s bond, they will only receive $1,000 in principal and $40 in interest after one year, so A’s bond will be priced around $940 instead of $1,000. In other words, as market interest rates rise, lower-yielding bonds issued before them will be less attractive, resulting in a price discount. Also, in this example, the remaining term was one year, but if the bond had a longer maturity and more interest payments, the price of A’s bond would drop even more.
In fact, according to the dot plot released by the FOMC in December 2021, interest rate expectations for 2022 were around 0.75% ~ 1%. However, continued high inflation led to an unexpected series of 50 basis point and 75 basis point hikes, eventually bringing US interest rates to 4.25% ~ 4.5% in December 2022, well above expectations. As a result, bonds that investors bought when rates were low suffered some of the worst losses in history, especially those invested in long-term bonds.
SVB Case
The SVB bank run was triggered by a shareholder letter announcing that SVB was raising approximately $2.25B in capital to offset losses on bond sales. According to SVB’s “Strategic Actions/Q1'23 Mid-Quarter Update” released on March 8, 2023, SVB sold ~$21B of bonds to respond to funding requests in Q1'2023, resulting in a ~$1.8B loss.
*AFS stands for Available-for-sale, and the bonds held by the bank are divided into 1) Held-to-maturity (HTM) bonds that will be held to maturity and 2) AFS bonds that can be sold in the interim to meet customer withdrawal requests.
Following the release of the shareholder letter, SVB’s stock plummeted by around 60%, and a number of venture capital firms, including Peter Thiel’s Founders Fund, Coatue Management, and Union Square Ventures, warned startups to withdraw their funds from SVB. Consequently, about $42B was withdrawn on Thursday alone, and SVB eventually filed for bankruptcy, citing insufficient liquidity and insolvency.
Government Response
On March 12, in response to the SVB crisis and to prevent a cascade of bank failures, the Federal Reserve established the Bank Term Funding Program (BTFP). A significant factor contributing to the bank failures was the forced selling of bonds at a loss due to massive withdrawal requests from customers. To address this issue, the BTFP provided loans for approximately one year at “par value” (the amount displayed on the face of the bond when issued) using the banks’ U.S. Treasury and mortgage bond holdings as collateral. This measure enabled banks to meet customer withdrawal requests without incurring losses from selling bonds. Moreover, although the Federal Deposit Insurance Corporation (FDIC) in the U.S. typically protects up to $250,000 per bank account in case of bank failures, the Fed announced that the FDIC would specifically guarantee the full amount of SVB deposits in this instance.
$USDC and the Crypto Market
Shortly after the SVB incident happened, crypto companies began sharing their exposure on SVB, with the most impactful announcement coming from Circle, the issuer of $USDC. On March 11, Circle announced on Twitter that a total of $3.3B of its $43.5B reserve is held in SVB, and shortly after Circle’s announcement, $USDC began to break its peg to $1. There was a lot of discussion on Twitter and elsewhere about the proper value of $USDC, and since $3.3B is about 7.5% of Circle’s reserves, $USDC saw a lot of trading with support at $0.92, a 7.5% discount to $1. However, at one point, $USDC plunged to $0.8 as Circle’s announcement fell on a weekend when banks were closed and investors thought “anything can happen in crypto,” especially with the Luna and FTX debacles. However, after the Fed’s announcement that deposits would be fully insured, $USDC is now trading close to $1.
Apart from $USDC, the closures of Silvergate and Signature Bank, which occurred both before and after the SVB debacle, are also having a significant impact on crypto liquidity. Silvergate and Signature Bank were also shut down for the same reasons as SVB, and both were key infrastructure providers of US dollar deposit and withdrawal services as leading crypto-friendly banks. In particular, Silvergate used a payment platform called Silvergate Exchange Network (SEN) to enable seamless dollar transfers between institutions/exchanges, and provided overall prime brokerage services to a number of well-known crypto companies, including Coinbase, Circle, Paxos, Crypto. The bankruptcies of Silvergate and Signature Bank are therefore leading to a lack of infrastructure available to institutions, which is likely to manifest itself in lower liquidity in the crypto market for some time to come.
The Future of Stablecoins
While it’s not appropriate to think of the SVB debacle as just a crypto or $USDC issue, it does bring attention to the future of stablecoins.
- Status of $USDT:$USDC was perceived by investors as safer than $USDT due to its transparency regarding its reserves. Ironically, in the case of SVB, the transparency of $USDC triggered the de-pegging, which negatively impacted its status as the safest coin, causing a massive outflow of funds into $USDT. While Tether’s reserves remain somewhat unclear, investors trust $USDT because of its long history and the fact that it successfully redeemed $10B within two weeks during the Luna crisis. It is expected that $USDT’s position in the market will grow stronger for the foreseeable future, particularly since most derivatives on major centralized exchanges are traded in $USDT.
- Emergence of New Stablecoins: With the halt of new $BUSD minting, $USDT and $USDC currently hold the majority of the stablecoin market share. However, due to the potential risks and lack of trust in both $USDT and $USDC, new stablecoins like $TUSD are likely to emerge as competitors. For instance, Binance has issued around $50M of $TUSD since the suspension of $BUSD, leading to an increased share for $TUSD. Additionally, it is expected that more attempts at creating stablecoins with new structures will emerge, such as NakaDollar, a stablecoin announced by Arthur Hayes that is not a simple overcollateralized stablecoin.
- Stablecoins in DeFi: $USDC currently holds the dominant position in the stablecoin market on the Ethereum chain. It serves as the preferred quote currency for most DeFi projects and acts as a common underlying asset for various DeFi products. However, many DeFi protocols hard-code $USDC at $1, which created significant risk when $USDC’s peg was broken. This event highlighted potential vulnerabilities in DeFi protocols, as they could have failed to properly value collateral, potentially leading to chain liquidations. For example, when the $USDC peg was broken, $DAI, a decentralized stablecoin with 40% of its collateral in $USDC, experienced a price drop to $0.88. Even though $USDC’s recovery to its peg averted a DeFi chain liquidation, this incident is likely to encourage the development of initiatives aimed at reducing reliance on specific stablecoins by exploring alternatives such as multi-collateral or algorithmic stablecoin models.
Conclusion
- The extent of the impact of high interest rates remains to be seen. The SVB situation may be viewed as a side effect of rapidly rising interest rates, with the U.S. experiencing an unexpected 4.5% interest rate hike within a year. This has led to various macro events beyond SVB, including concerns about potential bank runs, particularly for banks like First Republic following Silvergate, SVB, and Signature Bank. The SVB situation could also significantly impact market liquidity in the future due to new policies, such as the Fed’s interest rate policy and the BTFP. As a result, it is crucial to remain vigilant about high volatility and stay informed on the latest developments.
- As discussed in “Stablecoins vs Tokenized Deposits,” a reevaluation of how stablecoins will evolve is necessary. The recent $USDC debacle, despite being considered the safest, has reinforced investor perceptions that no stablecoin is immune to risk. Consequently, the search for improved stablecoins is expected to intensify, sparking numerous discussions on reducing stablecoin risk across the crypto industry. Potential solutions may include the development of new stablecoin models, such as decentralized or algorithmic stablecoins, as well as increased regulatory scrutiny and oversight. Ultimately, the market is likely to witness a more diverse and resilient stablecoin ecosystem that addresses the challenges and risks highlighted by recent events.
Disclaimer
All content in this article is intended to communicate and provide information and is not intended as the basis for investment decisions or for recommendations or advice for investment. The contents of the text are not responsible in any shape or form including matters that pertain to investment, law, or tax matters
