silver gate (NYSE:IF) is a regulatory game on the Bitcoin ecosystem, with a profile to take advantage of higher interest rates. The company is taking advantage of the Bitcoin adoption trend by securing zero-cost funding from institutions using the SEN network. The company applies these funds to high quality assets (mainly floating rate). Silvergate has also introduced a loan product called SEN Leverage. It is a bitcoin-backed loan product that allows its customers to use their bitcoin as collateral for funding.
The reason here is very simple. The bank is an FDIC-insured institution operating in the crypto ecosystem, and there aren’t many of them at this point in the crypto scene. Most startups in the field don’t even try to be regulated, and those that do have been through regulatory hell. Therefore, Silvergate is in an advantageous position to take advantage of the growth in crypto. At the same time, it is in a good position to take advantage of rising rates.
Silvergate’s business model
Silvergate is a traditional bank that got involved in Bitcoin because it needed funding alternatives. In 2013, CEO Alan Lane started researching Bitcoin. After concluding that institutions in the Bitcoin ecosystem had huge problems that traditional Wallstreet banks weren’t interested in solving, the company saw an opportunity. The company has developed the Silvergate Exchange Network (“SEN”). This network allows customers to move payments in real time. Additionally, as mentioned earlier, the company has developed the SEN Loan, a financing solution for Bitcoin holders.
Other than that, Silvergate is a traditional bank. However, I believe that their success around Bitcoin will push them further and further into the crypto ecosystem.
However, at present (2Q22), the bank is very traditional in its activity. It obtains funds from clients while investing in prime mortgage-backed securities (97% AA- or higher). More than 50% of the securities are variable rate, which means that the company is also well positioned to take advantage of a scenario of rising rates.
The innovative footprint of Silvergate’s business model is the SEN Network which has allowed them to grow and obtain more funding to invest, while the SEN Leverage expands its options to offer loans.
Their old-school banking approach is great for a regulated company entering the crypto ecosystem. This will likely lead them to avoid the most outrageous business experiments and opt for the most down-to-earth ideas. Since crypto-remortgage is one of the main sources of trouble for centralized companies operating in the field, and Silvergate seems very conservative in its approach, they will likely avoid significant problems.
The company applies a bread and butter approach to its business. On the one hand, it provides valuable assistance to customers who need to transfer payments in exchange for cheap financing. On the other hand, they leverage their network to offer oversecured loans. Along the way, they collect substantial interest margin and fees while retaining the option for further growth (expanding SEN and stablecoins further).
Silvergate Growth Prospects
The company extends the SEN network to other currencies such as the euro. Giving their customers the ability to move Euros 24/7 is a valuable addition to their service offerings.
Today, SEN leverage also powers its yield-generating applications. The growth has been incredible, around 600% year-on-year, while generating zero losses and no forced liquidations. It should be noted that in the SEN Leverage Direct Lending Program, Silvergate acts as the custodian, holding the client’s Bitcoin, and then the bank lends the money through the SEN network directly to the client’s account. The company also provides indirect SEN Leverage Loans which could use third parties for custodial or digital currency services. In all cases, the company can liquidate the collateral, if necessary. In addition, collateral coverage is fixed in the event of liquidation to yield an amount greater than the customer’s loan.
Silvergate has already revealed plans to run a stablecoin network. He even bought Diem’s assets from Meta (META). The company sees the potential in stablecoins to become global payment rails. Since the bank is an insured depository institution, it could become one of the first regulatory compliant institutions to offer stable services and products. This will likely drive the next stage of business growth.
The strategy launched in 2013 has yielded impressive results. The SEN network allowed the company to increase its non-interest bearing deposits and became its main source of funding.
The table above only represents deposits related to the digital initiative (total deposits are $14.2 billion). The SEN has also proven valuable in generating a source of non-interest income, particularly fees for services and products associated with the SEN network.
The impact on the income statement is simply incredible. Interest income increased rapidly, while interest expense decreased over the same period. If there is a holy grail in banking, it should be as close as possible. Obviously, net income has also improved significantly, as has earnings per share. From 2017 to 2021, EPS rose from 0.79 to 2.91. In short, most measures performed incredibly well.
As I mentioned, the company invests a substantial portion of its investments in floating rate instruments. Assuming a static balance sheet, a 25 basis point rise in interest rates will increase net income by $16 million year-over-year, the company said. However, it can also go the other way.
On the other hand, crypto prices tend to be listed as a significant risk for Silvergate. The company’s stock price tends to follow the Bitcoin price. In my opinion, the available data rejects the idea that a drop in Bitcoin price is bad for business. The way Silvergate’s business model is structured has enabled revenue and net income growth even after huge drops in crypto prices.
However, there are risks associated with crypto. If the industry shrinks permanently (for example, tighter regulation), Silvergate would be at risk due to its reliance on this funding. Additionally, even though the business model is not directly affected by the listing of Bitcoin, it will impact the adoption and, therefore, the growth of Silvergate.
SEN leveraged loans are another potential source of risk. The first quarter earnings call included a mention of a MacroStrategy loan (MacroStrategy is a subsidiary of MicroStrategy). The company explained that this loan is part of the SEN Leverage segment. After the explosion of several crypto companies (Luna, 3AC, Voyager), many fear that SEN loans carry much more risk than we think. However, publicly known details of the loan suggest it has a low likelihood of affecting Silvergate. MacroStrategy put up $800 million worth of Bitcoin to back the $200 million loan. The loan grant took place as Bitcoin was trading at around $47,000. Since then, the warranty has more than halved. However, it is still close to double the loan amount.
Finally, all this growth has its downside. It triggers the need to raise capital. In my opinion, this type of capital increase is benign. The money is used to grow the business, not just to mask past unfortunate decisions. Pruning, however, increases the risk of stand accidents.
Investor Action Update
In a previous article, I argued that the company has the potential to generate around $2.7 per share if it raises capital to increase SEN filings and target a 1% ROA. The original table is below:
I built it over a year ago. Now, the company has just released its 2Q22 results, and for the first half, it reported EPS of $1.92. The estimate of $2.67 in the table is for an entire year. We will probably exceed that this year. I think the prospects are exciting.
How did the stock price behave then? Bad Very bad. Since I wrote this article, Silvergate has fallen over 50%.
There are several reasons for this. One of them being that the macro backdrop is dire, with valuation squeezes across the board.
More than ever, I think this stock is a good investment opportunity, even for crypto skeptics. If you are one, bear with me for a second. Silvergate has a conservative management team, running an old-school bank rooted in a high-growth industry. They apply the same orthodox tactics that have given the upper hand to so many old school bankers in the past. At the same time, they extract value from one of the fastest growing fintech sectors.
I won’t ask any skeptic to drop all their assets and go all out, but I would say that if there’s one good thing for them to enter the crypto scene, it’s Silvergate. Trading at 15 forward PE, the company appears to be a value stock with growth potential. One of those opportunities that rarely presents itself. You can also look at it in the following way. The company last raised capital in 2021 at $145. Now he has successfully deployed that capital and is already reaping the rewards of that decision. Nevertheless, the market now offers the possibility to enter at around half the price. What’s not to love about a diversified portfolio?