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Silvergate: From a Tiny Bank To Leading the Crypto Charge To Class-action Lawsuit

Illustration by Angela Zillich.

Naturally, in a bear market, I was looking around for value plays, in and outside the crypto markets. Soon I came across Silvergate Bank, an organization I had read about in relation to the FTX collapse. Silvergate's stock, $SI, is down 87.40% this year. Similar to Coinbase $COIN, down 85.82%. These stock trajectories are much more interesting to me than a company that made a 90% gain in one year. Often the latter is overvalued, while the losers can present value plays. However, I didn't get too far into my research until news broke about a class-action lawsuit against Silvergate. The whole case around Silvergate is interesting, and I thought I'd write about it. After all, this is a conventional bank that has functioned as glue in the crypto industry for the past years.

History of Silvergate

When bitcoin was still in its relative infancy nine years ago, Silvergate Bank saw an opportunity to serve a new and growing market. The bank invited young crypto exchanges to discuss their needs and how Silvergate could be of assistance. In order to legally serve these clients as a state chartered bank, Silvergate worked closely with the California State Banking Department and the Federal Reserve Bank of San Francisco, presenting a comprehensive overview of bitcoin to the regulators in the summer of 2014. This open and collaborative approach has proven to be crucial to the bank's success, as it has continued to build strong relationships with regulators and maintain a track record of timely reinvention. Founded as a thrift in 1988, Silvergate has undergone a transformation under the leadership of Chairman Dennis Frank, a former Goldman Sachs banker who reorganized the bank into its current form in the 1990s. Frank's experience in the financial industry, including a successful run as CEO of Coastal Banc during the savings and loan crisis of the late 1980s, has helped Silvergate navigate various market shifts and emerge as a leading provider of financial services to the cryptocurrency industry.

Under the leadership of Chairman Dennis Frank, Silvergate Bank demonstrated a knack for staying ahead of market shifts. In 2005, the bank stopped its mortgage operations just before the subprime meltdown, and during the financial crisis of 2008, it was in a strong position to lend while many other banks were struggling. This ability to remain profitable during difficult economic times made it possible for Silvergate to start lending. It was around this time the current CEO Alan Lane joined.

Silvergate's Pivot to Crypto

As Silvergate looked to expand its lending opportunities, it faced a challenge in obtaining sufficient customer deposits to fund those loans. The bank found a solution in the cryptocurrency industry, establishing relationships with major players like the Winklevoss twins' Gemini exchange, Paxos, bitFlyer, and Kraken. These partnerships have been mutually beneficial, as smaller, technologically advanced banks like Silvergate have been able to fill a void left by larger banks that have largely avoided doing business with cryptocurrency companies. With a track record of timely reinvention and a focus on collaboration and innovation, Silvergate was well positioned to continue its success in the dynamic world of cryptocurrency.

In those early years, Silvergate Bank stood out for its willingness to work with cryptocurrency companies, filling a gap left by larger banks that were hesitant to take on bitcoin-related clients. Most banks either banned customers from using credit cards to buy cryptocurrency or simply ignored the small market until years later when it gained mainstream attention.

Silvergate's early involvement in the cryptocurrency industry has put it in a strong position as the market has grown. The hesitance of other banks on Wall Street created opportunities for smaller regional banks like Metropolitan Bank and Cross River Bank in Fort Lee, New Jersey, which are also serving the needs of cryptocurrency companies. Silvergate saw an opportunity when others didn't. The bank's proactive approach and willingness to collaborate with regulators has helped it navigate the complex and evolving world of cryptocurrency, positioning it for continued success throughout the crypto boom.

Later on, future giants like Coinbase and Binance started working with Silvergate. In the case of Coinbase, before Silvergate came to the rescue, they were dropped by other banks several times.

On November 7, 2019, Silvergate was listed on NYSE. That same year they had close to 800 different clients.

Silvergate's Function in The Crypto Industry

One of Silvergate Bank's key products is the Silvergate Exchange Network (SEN), a payments platform that enables its institutional clients – exchanges, hedge funds, asset managers, fintech companies, and more – to instantly settle large cryptocurrency transactions. The SEN has become critical to the smooth operation of the cryptocurrency industry, which trades 24/7 with no regulated market hours, making it incompatible with traditional financial infrastructure. Without the SEN, it can take several hours or even days for USD payments to be transferred electronically between parties, resulting in inefficiency, friction, and counterparty risk. By allowing clients to transfer payments directly from their SEN accounts to the SEN accounts of their partners, the SEN eliminates these issues and enables seamless and instantaneous cryptocurrency transactions.

While the Silvergate Exchange Network (SEN) is the core of Silvergate Bank's business, it also serves as the foundation for a variety of other services. One important service is its SEN Leverage product. This provides institutional traders participating in the SEN with access to USD loans collateralized by bitcoin. This demonstrates how the SEN can be used to build a wide range of products and services that meet the needs of the cryptocurrency industry and its participants.

The SEN Leverage product and its lending services are the primary products behind its high growth. Under normal circumstances, if no foul play is involved, Silvergate would have been in a golden position right now due to rising rates.

For most banks, the regulatory requirements involved in serving clients in the cryptocurrency industry are a major deterrent. In order to comply with laws governing money laundering, terrorism, and other illegal activities, banks like Silvergate must carefully monitor transfers in and out of accounts and ensure that their clients have appropriate compliance practices in place. This includes the ability to spot check individual transactions on exchanges, a process that can lead to delays and complaints from investors. However, the potential consequences of something slipping through the cracks, such as a transfer related to illegal activities, are even more serious, as banks could face fines and other enforcement penalties. Which leads us to the current class-action lawsuit.

Silvergate Class-Action Lawsuit

A class-action lawsuit has been filed at the California Southern District Court against Silvergate Bank, Silvergate Capital Corporation, and CEO Alan Lane, alleging that the bank played a role in the collapse of embattled crypto companies FTX and Alameda Research. The suit, brought by plaintiff Joewy Gonzalez on behalf of himself and others in similar situations, claims that: Silvergate aided and abetted FTX's fraudulent activities and the exchange's breaches of fiduciary duty through improper transfers, lending user funds, and commingling funds. According to the lawsuit, Silvergate is liable for its role in "furthering FTX's investment fraud" and has an obligation to return what is owed to the plaintiff and other investors. The plaintiff is represented by Girard Sharp and Hartley LLP, while the defendants' counsel has not yet appeared at the time of writing. The suit aims to hold Silvergate accountable for its alleged actions, which are said to have caused panic within the crypto market and ultimately led to the bankruptcy of both FTX and Alameda Research.

On December 6, United States senator Elizabeth Warren wrote a letter (co-signed by signed by Republican Senators John Kennedy of Louisiana and Roger Marshall of Kansas) to Silvergate Bank demanding answers about the firm's alleged role in the loss of billions of dollars during the collapse of FTX. It's been requested that CEO Alan Lane provide details on the bank's relationship with FTX and any information that could help shed light on the events that led to the crypto company's collapse. In addition, the letter, signed by Republican it's been questioned if Silvergate have been able to adequately identify and report suspicious activities in client accounts, as required by banking regulations.

Silvergate Have Been Quiet Since Early December

Besides the above tweet and the statement from Silvergate CEO Alan Lane, the IR and Twitter feed of Silvergate have been quiet.

A summary of the statement from Silvergate's Alan Lane

Silvergate Bank has implemented strict measures to comply with the Bank Secrecy Act and the USA PATRIOT Act, which require the bank to thoroughly vet each account and its beneficial owner, source of funds, and intended use. The bank closely monitors transaction activity and files suspicious activity reports as needed. This process, which involves a significant investment in systems and personnel, can take several weeks to complete. After accounts are opened, Silvergate continues to monitor them for any red flags and takes action as necessary. By adhering to these risk management procedures and fulfilling its regulatory obligations, the bank plays a crucial role in aiding law enforcement in identifying individuals who engage in illicit activities.

They conducted extensive due diligence on FTX and its affiliated company Alameda Research before and after opening accounts for them. This included verifying that the accounts adhered to the bank's risk management policies and regulatory requirements. Alameda Research, which operates an over-the-counter trading firm, instructed its clients to send funds to its account at Silvergate or other banking partners. When the bank received payments directed to Alameda Research and credited the funds to the corresponding account, it was following the instructions of the sender and standard industry practice. If any unusual or potentially problematic activity is detected in an account, Silvergate investigates and, if necessary, files a confidential suspicious activity report in accordance with federal regulations.

It remains to be seen what comes out of this lawsuit. I am quite confident that Silvergate will be under pressure for months to come, putting additional pressure on the stock. Long-term, the survival of Silvergate Bank is important for the growth of the crypto space. I will follow this case closely, both out of curiosity of crypto and everything that's going on, but also from an investment perspective. If Silvergate has done everything by the books, their banking model is extremely interesting, and extremely profitable. As such, in a positive scenario, the Silvergate stock may turn out to be a very good investment. However, I will wait for the dust to settle, and in the meantime I expect the stock to further decline.

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