The cryptocurrency-centric bank Silvergate Capital (SI +0.00%) reported a mixed bag of results for the third quarter on Tuesday.
On a positive note, its earnings per share hit a record level of $0.88. However, usage of its Silvergate Exchange Network (SEN) platform declined. SEN, a real-time payments platform, allows parties on the network to clear transactions instantly, which comes in handy for institutional cryptocurrency investors and exchanges. The quantity of transfers on SEN dropped from nearly $240 billion in Q2 to about $162 billion in Q3.
But I found Silvergate's Q3 earnings conference call to be much more interesting than the report's raw numbers, as it partially answered several questions that will be much more important for the bank's overall long-term outlook. Here are the three most important things I learned from the earnings report and the conference call.
1. SEN Utilization is correlated with cryptocurrency spot trading
For the first time in more than a year, SEN utilization did not increase sequentially; it fell roughly 32% from the second quarter. Management said that the dip was correlated with spot trading volumes of Bitcoin (BTC 0.77%) and Ethereum (ETH 0.65%), which also fell in the quarter, as prices were less volatile. This makes sense. SEN is a platform used for cryptocurrency trading, so lower trading volumes should translate into less utilization. However, SEN utilization dipped by 32% while cryptocurrency spot trading fell 43%.
Image source: Silvergate Capital Q3 investor presentation.
Although SEN utilization is a big driver of overall activity at Silvergate, it's not like the bank saw no growth at all. As of the quarter's end, deposits were only up by about $300 million, but its average deposits across the period were up by roughly $1.3 billion. The bank added about 80 new customers to SEN, and while transaction revenue was down from Q2, it was still the bank's second-highest quarter of transaction revenue. Lastly, the bank also grew its SEN Leverage lending product -- a line of credit collateralized by Bitcoin -- by $64 million in Q3.
This correlation is certainly a good way to gauge how Silvergate is doing in the quarter, but I'm hopeful that as the bank ramps up more products and services, this correlation will fade. I like the fact that the bank operates more on the transactional side of the cryptocurrency space as opposed to just holding or mining tokens. As time progresses, I think this can be a stock that gives investors exposure to Bitcoin without the same level of risk.
Image source: Getty Images.
2. Tracking Diem
Earlier this year, Silvergate announced a partnership with Facebook (FB 0.80%) under which it will be the exclusive issuer of the social media giant's long-hyped stablecoin, Diem, which will be pegged to the U.S. dollar. Facebook is partnering with Silvergate to use SEN to mint and burn the stablecoins.
Management believes this is the next big opportunity for the bank, and Silvergate CEO Alan Lane said on the second-quarter earnings call that the bank would be disappointed if it couldn't launch the pilot before the end of the year. However, the bank looks less likely to make good on that schedule after Lane said on the third-quarter call that he did not have an update on the timing of the launch.
Lane indicated that the holdup -- or rather, the lack of an update per se -- had to do with the fact that President Biden's Working Group Financial Markets may soon come out with recommendations and guidance in regards to the regulation of stablecoins.
Waiting to act until that guidance is made public would give Silvergate and Facebook "an opportunity to tweak or adjust anything on the margin that might be necessary prior to launch," he said. "But we're waiting, just like everybody else, for that guidance to come out. And you can rest assured, as soon as it's out, we'll adjust accordingly and be out to the market."
3. How management is thinking about cryptocurrency regulation
Ever since the Basel Committee on Banking Supervision issued a set of recommendations for how banks worldwide should regulate cryptocurrencies, I've wondered how its proposals might impact Silvergate's business. The biggest of them is to essentially require banks to hold $1 of capital for every $1 of cryptocurrency on their balance sheets. Now, Silvergate doesn't hold any cryptocurrency assets directly, but SEN Leverage does have exposure to them, considering the loans are collateralized by Bitcoin.
An analyst on the earnings call asked how the bank is thinking about capital requirements if Basel's proposal makes its way into U.S. banking regulations. Lane replied that while the regulation remains far from passage into U.S. banking law, Silvergate doesn't intend to have SEN Leverage volume exceed its regulatory capital right now, which means the bank would be compliant even if the Basel recommendations went into effect. SEN Leverage at the end of Q3 hit nearly $323 million, while the bank's total risk-based capital at the end of Q2 was nearly $872 million.
Now, obviously, if the bank wants to grow, this strategy is not a long-term solution. Lane said the bank is thinking about solutions for a tougher cryptocurrency regulatory climate, including the possibility of setting up a model where the bank would originate and service SEN Leverage loans, but sell the actual loans to investors. I'm hopeful that it won't come to that because I think management is already taking strong precautions. The Bitcoin collateral for SEN Leverage is equal to or exceeds the amount of the U.S. dollar loans. Silvergate has seen no losses on these loans nor has it had to liquidate any of the Bitcoin collateral, despite some significant volatility in the price of Bitcoin. And again, the bank is already maintaining very high capital levels. Still, it's good to see management preparing for some pretty hard situations.
