It is tough for retail investors to play digital currencies like bitcoin or ethereum.
Buying a position means wire transfers and digital wallets, the worry of hacks or hard drive failures. Many of us are still nervous about sending a sizable chunk of our net worth out to the crypto-ether.
For a time, it seemed like digital currency miners might be a viable alternative. But that had its own pitfalls – not the least of which was that the miners were not very profitable.
There was constant equipment upgrades and accelerating mining difficulty – not to mention the volatile price – and most of the public miners have had to dilute to keep the lights on.
At InvestingWhisperer I am on always on the look-out for new ways to play digital currencies without having to buy the tokens. We made a good bet recently by betting on blockchain adoption – a key part of the Overstock (OSTK – NASDAQ) story that has become a huge winner for subscribers.
Another way to play the adoption angle is via Silvergate Capital (SI – NASDAQ). Silvergate stands to benefit as more investors get into the space.
Silvergate is a picks and shovel play on digital currencies. They do not operate on the blockchain or even directly hold Bitcoin. Instead, Silvergate is a bank; in many ways, a plain vanilla bank—but one with a twist.
Most of Silvergate’s operation looks a lot like any other small bank. Silvergate takes in deposits and lends out money. They lend to all same, traditional borrowers that any other bank does. They make loans to single family homes, multi-family residences, commercial real estate, and mortgage loan warehousing.
Source: Silvergate Third Quarter Earnings Presentation
Where Silvergate is different is on their deposits. 95% of their deposits are from digital currency participants.
Silvergate’s depositors include 64 crypto exchanges, including some of the largest, like Coinbase, Genesis Kraken, and Bitstamp. They also have nearly 600 institutional investors as well as 250 other participants such as miners, stablecoin issuers, and blockchain platform operators.
A couple of points about these deposits:
1) these are ALL US dollar deposits. Silvergate does NOT hold Bitcoin or any other digital currency directly.
2) These are non-interest-bearing deposits.
Non-interest-bearing means just what you’d think—the bank does not pay interest. HELLO! That is attractive because the bread and butter of banking is net interest margin – ie. the difference between the yield on the loans less the yield on deposits. It’s kind of like having zero cost on your COGS (Cost Of Goods Sold).
When Silvergate started out on this path in 2014 they were just looking to attract a cheap source of deposits. But as they began to onboard large exchanges and investors, they realized they were uniquely placed to help their customers solve their problems.
Silvergate saw that their customers had a lot of friction with money transfers.
Getting cash from one exchange to another…or…from an investor onto an exchange…had to follow all the traditional channels – and that meant it took days. Transfers had to be completed during banking hours, they had to pass through manual human touchpoints, paperwork often had to be signed.
Silvergate realized that since they had the customers all under one roof, they could automate these processes, make them available 24/7 and reduce the time and resources required to get money moved.
This ended up being the Silvergate Exchange Network (SEN).
Source: Silvergate S-1 Filing
The above slide may look a little cluttered, but it tells the story. Each one of the little bank-like structures in the diagram represent exchanges, each one of the groups of people represent investors or funds or other market participants.
Because all these customers belong to SEN they can all transact with one another via the network. They can do so with less friction, no counterparty risk and more liquidity.
The traditional wire transfer/ACH transaction pathways are circumvented.
Silvergate does not charge to be part of SEN. Silvergate rightly realizes this is early days, and that barriers to adoption need to be low.
That means all the money Silvergate makes from SEN are from the same, boring banking fees (wire transfers, ACH transfers, foreign exchange transfer) as any other bank.
But those fees add up and they are growing fast. Fee income from digital currency customers grew 36% quarter-over-quarter.
Source: Silvergate Third Quarter Investor Presentation
Silvergate benefits as transaction volume increases and as customers on the exchange increase.
In the third quarter the price of Bitcoin (which has gone up) certainly helped fee income. but a large part of Silvergate’s growth is just plain old-fashioned customer adoption. Silvergate added customers in the third quarter and many of those customers were large – their average institutional client added in Q3 brought onboard $9 million versus an average of $1 million from the existing cohort.
Source: Silvergate Third Quarter Investor Presentation
Silvergate is not a huge bank (a market cap of $450 million) so the increase in fee income is material. Net income for the quarter was $7.1 million.
The next steps for Silvergate are to expand their offerings.
First, Silvergate just launched a lending product backed by Bitcoin – called SEN Leverage. This will allow institutional investors to apply for loans backed by their bitcoin.
Silvergate speculated that if their 600 institutional investors each asked for a $0.5 million loan, that would be $300 million – which would generate a decent return at the expected mid to high single digit interest rate.
The second area that Silvergate seems likely to turn is to custody services.
A custodian for digital currencies is a bit of a different beast because it means physically holding the Bitcoin in some digital storage.
Silvergate admits that building a custody solution from the ground up might not be the best path. Instead, expect existing partnerships to expand (they are partnered with the custodian Anchorage) or they may buy an existing custodian to get into that space.
Silvergate has a head start but the big banks are starting to get in the game.
In June, the Office of the Currency Controller (OCC) announced that banks could now be custodians of digital currency. This opens the door for the traditional prime brokers (like Goldman Sachs, JP Morgan and the like) to wade their foot into the space.
JPMorgan is the first to get their feet wet. While still not quite offering a “platform” JPMorgan has opened the door to deposits from digital currency exchanges. In June they took on Coinbase and Genesis as customers.
Silvergate’s “moat” is really their mover advantage and the network they have built. Silvergate has a network of clients onboarded and transacting with one another.
The “network effect” is a catch phrase, but it is appropriate here. The more clients Silvergate onboards, the more these clients benefit from frictionless transactions within the network.
On top of the existing 800+ customers, Silvergate has another 200 in the pipeline.
Expansion of their customer base and expansion of offerings is their recipe for success.
Meanwhile Silvergate’s stock does not trade like a digital currency moonshot. It trades like what it actually is – a bank.
Bank stocks are valued off book value and Silvergate has a valuation of 1.5x their tangible book—a middle of the road valuation.
Silvergate has a relatively low-risk portfolio of assets, with nearly 50% of their assets in securities, not loans. While this weighs on interest margins and earnings, it is aligned with their strategy to rely on fees to grow the bank.
The stock, however, has had a huge run-up into their third quarter earnings. Even though those earnings were good, the stock has taken a pause. It may pullback further.
Despite the fact that SI doesn’t OWN any Bitcoin, the Market will almost certainly trade it (for awhile anyway) as a bitcoin pure play; i.e. if Bitcoin tops out then the stock will almost certainly do the same. That’s just what the Market does.
But a couple things could happen in the coming year. If the next few quarters show good traction on these Bitcoin backed loans, well, that’s a high margin business by bank standards these days. And they don’t pay interest on the deposit. That sounds like a banker’s dream!
And if, over time, their first mover advantage gives them traction, they obviously become a big takeover candidate by a larger bank.
But if you want exposure to digital currency adoption without having to buy the coins directly, Silvergate is an intriguing pick and shovel play.
I’m long 1000 shares at $23.67.