Crypto Regulatory Concerns For Silvergate Capital May Be Overblown Right Now

Following the proposal of the Basel Committee on Banking Supervision (BCBS) of June 10 to regulate crypto assets in banks, Capital of Silvergate (NYSE: SI) saw its shares drop nearly 10% over the next two days. Investors appeared concerned that the regulations, which would essentially require banks to hold much more capital to safeguard certain crypto assets on their books, could hamper Silvergate’s growth. However, while the BCBS proposal is still preliminary, I think these regulatory concerns may be overstated. Here’s why.

Does Silvergate Acquire or Hold Crypto Assets?

Silvergate Capital specializes in the trading and trading of banking cryptocurrencies. To do this, it primarily uses its proprietary Silvergate Exchange (SEN) network, a real-time payment network that can instantly clear US dollar transactions between two network users. This is ideal for institutional crypto traders and crypto exchanges, as cryptocurrencies trade around the clock.

BCBS, which essentially creates the framework for most banking regulations around the world, recently released a proposal that would call for banks to hold a lot of capital for the volatile crypto assets they acquire, including bitcoin (CRYPTO: BTC).

Image source: Getty Images.

The BCBS proposal would essentially require banks to hold $ 100 of capital for every $ 100 of bitcoin they acquire, or potentially more, which is far more capital than a bank could hold to safeguard even some of the its riskiest loans. BCBS is concerned about the volatility of many cryptos and therefore wants banks to be prepared to cover their entire loss. In reality, BCBS is essentially telling banks not to own and trade crypto assets.

It’s understandable that investors are worried about the effects of regulation on Silvergate, as the bank is undoubtedly in the crypto space. But I’m not sure the proposed regulation would prevent or inhibit Silvergate as much as some think.

On the one hand, Silvergate does not acquire or hold any crypto assets. SEN is a platform that allows institutional traders and exchanges to perform payment transactions. These customers bring large dollar deposits to the bank to transact with each other, but all deposits Silvergate holds on its balance sheet are in US dollars and are insured by the Federal Deposit Insurance Corporation (FDIC).

Now, since these deposits come from digital currency customers and are likely moved more frequently due to all the trading done by network participants, deposit balances at Silvergate may be more volatile, but they are still in US dollars. . This is nothing new for Silvergate, which keeps a lot of excess cash.

Potential issues for SEN leverage

I’ve also seen concerns about how the regulations might affect Silvergate’s new loan product, SEN Leverage, a US dollar line of credit secured by bitcoin. The company has big plans for this product. Again in this case, Silvergate does not acquire crypto assets because the bank holds the loans in US dollars and the collateral is used as a hedge against the credit risk. But there could certainly be regulatory issues for SEN Leverage if the BCBS proposal were adopted, as it touches on collateral:

For securities financing transactions (SFT) and margin loans involving group 2 crypto-assets [such as bitcoin], to calculate their counterparty credit risk exposures, banks should apply the comprehensive approach formula defined in the credit risk mitigation section of the standardized approach to credit risk. Group 2 crypto-assets are not eligible forms of collateral in the Global Approach and, therefore, when banks receive them as collateral, they will not receive any recognition for the purpose of calculating the net exposure to the counterparty. .

Basically, Bitcoin would not count as eligible collateral for loans, as it would be classified as a Group 2 crypto asset, which could be problematic for SEN Leverage. Collateral makes loans more secure, because if a borrower defaults, the bank can step in and still recover some of the value of the loan.

Think about a residential mortgage: if the homeowner can’t make the mortgage payments, the bank can step in after a while, repossess the house, and sell it to get back some of what the borrower owes. But another important part of collateral is that it reduces the risk weight of a loan because it reduces the likelihood of large losses.

The risk weighting of a loan determines the capital that the bank must set aside for that loan in the event of default by the borrower. With collateral behind a loan, the bank doesn’t have to hold as much capital, but without it, the bank would have to hold more.

While I’m not sure what Silvergate’s risk weight is for its SEN leveraged loans, I imagine that if this BCBS proposal were implemented in its current form, Silvergate would have to increase the capital it holds. for these loans. While this would increase the overall capital that the bank must hold and therefore potentially inhibit the growth of SEN leverage, I don’t think it would require Silvergate to hold roughly the same amount of capital as for crypto assets, because again, the loan is in US Dollars.

The loan could be considered unsecured, which would increase its risk weight, but probably not in the same way as acquiring or holding crypto assets the way Bitcoin would.

This is an overly strict regulatory approach – not counting bitcoin as collateral – when you look at how Silvergate underwrites SEN Leverage loans. Currently, SEN Leverage borrowers set up a bitcoin collateral amount equal to or greater than the US dollar loan amounts. What Silvergate does next is work with third-party custodians such as crypto exchanges to hold the collateral and liquidate it if the price of bitcoin (and therefore collateral) falls below a certain threshold set out in the collateral. ‘loan agreement.

During Silvergate’s Q1 earnings call, an analyst actually asked if there had been any margin calls on SEN leveraged loans on a specific day when the price of Bitcoin fell 15%. . Silvergate CEO Alan Lane said there hadn’t been any, as the bank has a 75% or 80% collateral coverage requirement, and SEN Leverage borrowers pay more Bitcoin. or equal to the loan amount, so a 15% drop in Bitcoin’s value still hasn’t triggered a margin call.

Although SEN Leverage is still relatively new, Silvergate has been piloting and using the product for at least a year now, and Lane said: “We still haven’t suffered any losses in this portfolio. We had no major problems.

What will be the overall effect?

It is still too early to say how this will unfold. This is only an initial proposal from BCBS, and banking regulations may take years to finalize. It’s important to note that Silvergate is a bank that holds a ton of capital anyway. The bank ended the first quarter with a Class 1 Common Equity (CET1) ratio, a measure of a bank’s capital base expressed as a percentage of total risk-weighted assets, of around 55%.

Now that’s sky-high, as Silvergate has raised capital to support its future growth, but the bank has operated with a CET1 ratio above 23% for the past four quarters, when most banks its size lie between 7 and 10%.

Ultimately, Silvergate does not acquire, hold, or trade crypto assets. Do I hope BCBS will eventually change its stance on Bitcoin collateral? Absolutely yes. But I don’t think the BCBS proposal, even if implemented without change, would necessarily prevent the growth of SEN leverage as many believe.

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 motley! 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.

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