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Leonid Sukala
In 2020, I bought Silvergate Capital (NYSE:SI) at $16 a share. This was my first attempt at a crypto investment. It was dead money for a few months, and then the stock skyrocketed and I had a quick 10-bagger. Now the stock price is way off its highs, and my family has been adding shares in this environment. This is one of my favorite stock ideas. Here’s why I’m bullish on Silvergate.
It was first-mover in providing banking services to the crypto industry
Almost a decade ago, Silvergate decided to recruit the crypto trading exchanges as clients for the bank. In order to do that, Silvergate solved a pain point in the crypto industry. Coinbase (COIN) and other crypto exchanges wanted the ability to allow their clients to trade crypto 24/7. The problem these exchanges were running into is that banks do not operate 24/7, and so any dollars in a crypto trade would not exchange hands for several days.
To solve this problem, Silvergate invested in networking capabilities, and created the Silvergate Exchange Network, or SEN, to facilitate crypto trading for large institutions. This created a huge windfall for the bank. The money it made facilitating the crypto trade started to overshadow the rest of its operations. As its crypto business grew and grew, Silvergate eventually shut down most of its ordinary banking activities and focused on providing banking services to the crypto industry.
Specifically, Silvergate is focused on the institutional side of crypto trading. So ordinary people (you and me) are not going to be opening an account at Silvergate. This makes SI a highly unusual bank with less than 2,000 customers.
In Q2, the company reported that it had 102 digital currency exchanges as customers of the bank. This includes names like Coinbase (COIN), FTX (FTX-USD), Gemini (GUSD-USD), Kraken (KRAK-USD), Crypto.com, and many more. The bank also has about 1,000 institutional investors as clients. This includes hedge funds, private equity, venture capital groups, and asset managers, all of whom want the ability to trade crypto for their clients. In addition, Silvergate has almost 500 customers that are developing new crypto platforms and applications.
How Silvergate makes money
Silvergate is not a crypto custodian. It merely holds the dollars (in some cases, euros) involved in a crypto trade. How does this work?
Suppose a venture capitalist (VC) wants the ability to trade millions of dollars in crypto 24/7. The VC might open up an account at Gemini, a crypto broker. The VC would simultaneously open a deposit at Gemini’s bank (Silvergate) and house its dollars there in a trading account. So when the VC makes a trade on Gemini’s platform, say it’s an order to buy $1 million worth of Solana (SOL-USD), Gemini provides the crypto and houses it for the client. Meanwhile, at Silvergate the dollar amounts change hands from the VC’s account to Gemini’s account.
In Q2, Silvergate reported $13.8 billion in deposits at the bank. From these deposits, Silvergate pulled in $70 million in interest payments. Overall the bank brought in $80 million in the quarter, so receiving interest on its deposits is the primary way Silvergate makes money right now. The accounts at Silvergate are trading accounts, so it doesn’t pay out any interest.
While rising interest rates are negative for crypto, for Silvergate this environment has a silver lining. The bank has $13.8 billion in deposits; higher interest rates produce more money for the bank. According to CFO Tony Martino, every time the Fed raises interest rates a quarter percent, Silvergate will make an additional $16 million over the next year.
Since Martino said those words during the last conference call (July 19), the Fed has jacked up the interest rate 1.5%. So that rise in interest rates will add approximately $100 million to the top line over the next year. Silvergate brought in $240 million over the last 12 months, so an additional $100 million will be a rather significant increase, all due to the rise in interest rates.
The stock is down about 66% off its highs
Of course, the prices of various cryptocurrencies have dropped significantly in 2022. And Silvergate stock pretty much tracks the overall crypto market, and especially market leaders like Bitcoin (BTC-USD) and Ethereum (ETH-USD). When the crypto market goes negative, that definitely affects the market’s view of Silvergate stock. And it’s not irrational. In a bearish crypto market, one might expect the demand for Silvergate’s banking services to drop. And, yes, there have been trading declines. The SEN had $191 billion in trading volume in Q2, down from $240 billion a year ago, when crypto prices were going through the roof.
Yet the institutional customer list continues to grow. Silvergate had 542 institutions on its platform back in 2018. By 2021 that number had grown to 1,381. And it’s still jumping higher, with almost 1,600 institutions now on the platform and another 300 waiting to be added.
Despite the fall in trading volumes, Silvergate’s revenues jumped almost 90% in Q2. In part, this growth happened because of interest rate increases. The Fed raised rates 0.5% in May and another 0.75% in June, so that goosed the numbers. The June raise happened late in the second quarter, so it probably had a minimal effect on Silvergate’s numbers in Q2. I’m expecting a very nice spike in revenues in the second half of the year. Just on the interest rate increases alone, Silvergate’s numbers will be very nice.
As for the stock, it’s gotten a lot cheaper. The price/earnings multiple has shrunk from 52 a year ago to 22. So right now there are many reasons to be bullish. Revenues are up 90% in the most recent quarter, and are likely to spike higher still in Q3 and Q4. The bank’s profit margins are a beautiful 45%. The multiple has shrunk and the market has gotten very pessimistic about crypto (and tech stocks in general). So there’s a lot of room for an upside surprise.
What are the risks?
The main risk for Silvergate is fairly obvious – crypto might go to zero. That’s what Warren Buffett says, and a lot of bankers feel that way. If crypto is tulip mania all over again, then this will be a bad stock to own.
Personally, I’m very bullish on a minority of the crypto universe that I think has a strong future. And yet I would also agree that most of the crypto universe is essentially worthless. It reminds me of the internet industry 25 years ago. The vast majority of startups flopped and went nowhere. But the internet itself has been a hugely rewarding area for investment. I think crypto is like that – there will be a few massive winners and a lot of potential sinkholes.
The people who are negative on crypto are only looking at the “currency” aspects, and are ignoring the blockchain revolution. Software developers are very excited about the blockchain. In fact, the big fight over crypto is a fight between software developers (who are very passionate believers in this new technology) and traditional bankers (who are very skeptical about a value add).
Alan Lane and his team at Silvergate are highly unusual bankers in that they saw the possibilities in crypto almost a decade ago. Your average banker might believe that crypto is “worthless,” but these same bankers are now offering crypto services to their clients.
Another risk is that Silvergate enjoys a high multiple that’s way bigger than your average bank. And of course multiples can fluctuate (as we’ve seen in 2022). So it’s possible Silvergate’s multiple might get squeezed some more.
The upside is significant
Silvergate strikes me as a relatively safe way to invest in the overall rise of the crypto industry. The SEN (and the network effect) gives this first mover a huge advantage over other banks. Because of its trading platform, Silvergate has a magnificent moat, which is why all the major crypto exchanges are clients of the bank.
Silvergate has a small market cap ($2.5 billion), and a major head start over rivals in providing banking services to the crypto industry. And while Facebook (FB) (META) has bailed in its partnership with Silvergate, I remain very bullish about Silvergate’s future release of a stablecoin (crypto that is designed to track the dollar).
I believe Silvergate’s status as a regulated bank might give future investors in its stablecoin an insurance that other stablecoins do not enjoy. Specifically, there’s a possibility that FDIC insurance might protect the bank’s stablecoin. That would make it very attractive, as one of the downsides of crypto investment is there is no federal insurance for it.
With its SEN, Silvergate has already made itself indispensable to the crypto industry. It’s now engaging in more traditional banking functions, like making loans (using crypto as collateral). So in the future we will see a bank that is not as dependent on interest rates as it is today. So while I’m very bullish on Silvergate in the short term because of the rise in interest rates, I’m even more bullish about its long-term prospects. I think the future upside for this stock is highly significant as Silvergate brings more and more of crypto under its banking umbrella.
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