Last week, Morgan stanley Analyst Ken Zerbe started hedging crypto banking Capital of Silvergate (NYSE: SI) with an “overweight” rating, which means he expects Silvergate to outperform the banking sector. The launch of research coverage as well as a rally in the cryptocurrency market have pushed Silvergate shares up by around 30% over the past week. Zerbe called Silvergate the “broadest risk-reward” of any bank covered by his team.
And that makes sense. Although Silvergate has a traditional banking license, its core business and appeal to investors is its business in the cryptocurrency market, which as we have seen over the past year can be volatile. . But let’s take a look at what Zerbe was referring to in his research and see if the risk is worth it.
Why Silvergate is a great banking company
Silvergate management saw what was going on in the cryptocurrency market years ago and had the common sense to realize that digital coins like Bitcoin (CRYPTO: BTC) would be an investment asset that would end up in the financial system. Management has also seen an opening in the fact that the United States does not operate on a real-time payment system and cryptocurrencies trade all day, seven days a week, 365 days a year.
Silvergate therefore created the Silvergate Exchange Network, a payment system allowing instant settlement of transactions between two parts of the network. As SEN adds more and more clients, most of whom are institutional traders and crypto exchanges, its appeal increases as there are more parties on the network to transact. This platform has proven to be a boon to the bank as SEN’s clients bring many non-interest bearing deposits to Silvergate which the bank can then use to create loans or invest in securities. Silvergate is also able to sell other traditional banking services to these customers, such as standard currency transfers and foreign exchange products. In recent quarters, the bank has also rolled out a product called SEN Leverage, which issues Bitcoin-backed credit lines.
All of this created a bank already making strong profits and generating many low-cost deposits, interest-bearing assets, and potentially faster loan growth than the industry as a whole. The bank’s cost of funds, a key metric that bank investors look at, is only 0.01%, which means the bank gets pretty much all of its deposits for free. This deposit base is expected to prove to be much more valuable to Silvergate as interest rates rise and banks begin to compete more intensely for deposits, as SEN clients have not come to Silvergate looking for a return. on their deposits in the first place.
Commissions collected in the second quarter of this year were up 371% from the previous year, and total deposits reached $ 11.3 billion. Deposits come in so fast that the bank only had about 13% of its deposits in the form of loans by the end of the second quarter, which is next to nothing. The bank has absorbed some of this excess liquidity by investing $ 6.2 billion in securities, but if long-term or short-term interest rates rise, the bank should be able to reinvest in new securities at much higher yields. higher. This should give a big boost to interest income. SEN leverage is also developing well and should help the bank generate more returns as the growth of this segment accelerates.
What is the risk?
Being a cryptocurrency player can be risky, especially for banks, among the most regulated industries. There hasn’t been a lot of oversight yet, so companies aren’t sure exactly how things will turn out.
But we got a glimpse of what crypto regulation might look like in the banking industry when the Basel Committee on Banking Supervision, an organization that helps set global rules for banks, presented a series of recommendations. Most important was a proposal to force banks to set aside $ 1 of capital for every $ 1 of Bitcoin held on their balance sheets. To put this in perspective, current regulations do not require banks to hold so much capital even for their riskiest assets. The good news for Silvergate is that it doesn’t actually hold any cryptocurrency on its balance sheet.
However, there could be some regulatory risk for SEN leveraged loans, as the Basel Committee has stated that crypto assets such as Bitcoin would not be considered eligible collateral, at least for margin loans and securities financing transactions. It’s hard to say for sure how this might affect SEN Leverage, but it could end up forcing the bank to set aside more capital for SEN Leverage loans than it currently does. However, Silvergate operates with extraordinarily high levels of capital, with a Tier 1 Tier 1 capital ratio of over 47%. Most Silvergate banks are only in the 7-10% range in size so I’m sure they have more than enough capital. The bank also requires the Bitcoin collateral to be equal to or greater than the loan amount. As of the end of the second quarter of this year, Silvergate had experienced no losses or margin calls on SEN leveraged loans, despite Bitcoin’s volatility.
Worth the risk?
I own Silvergate shares and consider the risk worth it. While there is regulatory risk as the cryptocurrency landscape evolves, I am encouraged that management appears to be focusing more on providing crypto transactional services to clients and less on owning or trading. crypto mining. Holding a traditional banking charter is also huge as it allows Silvergate to profit from inexpensive deposit taking and cross-selling other banking products. I like this title because it provides exposure to Bitcoin and other cryptocurrencies with less risk than a pure cryptocurrency game.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.