Why Financial Analysts Missed Silvergate’s Red Flags

There were numerous signs of the crypto bank’s problems, but none of the analysts following the company picked up on them. Angelo Calvello, of Rosetta Analytics, says that was partly down to their traditional investment mindset.

AccessTimeIconMar 9, 2023 at 7:35 p.m. UTC
Updated Sep 28, 2023 at 2:27 p.m. UTC
AccessTimeIconMar 9, 2023 at 7:35 p.m. UTCUpdated Sep 28, 2023 at 2:27 p.m. UTC
AccessTimeIconMar 9, 2023 at 7:35 p.m. UTCUpdated Sep 28, 2023 at 2:27 p.m. UTC

Silvergate Corp. (SI) is a publicly traded company covered by at least 10 sell-side research and financial analysts. These analysts evaluate Silvergate (and other regional banks) and issue a recommendation on the company’s stock or debt (e.g., buy, sell, hold).

To a person, these analysts continued to recommend SI, even after the news of the FTX crypto exchange collapse. For example, on Nov. 9, Canaccord analyst Joe Vafi wrote, “In the event that FTX ceases operations or some customers migrate to other exchanges, it is highly likely that Silvergate will still capture that trading volume under its operational umbrella.” Vafi gave Silvergate a buy rating and a $150 price target. Silvergate closed on Nov. 9 at $34.69 and has not traded that high since.

Angelo Calvello, Ph.D., is co-founder of Rosetta Analytics, an investment manager that uses deep reinforcement learning to build and manage investment strategies for institutional investors.

Only after many subsequently damning events – a letter from members of Congress sent to Silvergate Bank, its $4.3 billion loan from the Federal Home Loan Bank, news of a Department of Justice’s probe, a joint statement from bank regulators on “Crypto-Asset Risks to Banking Organizations,” Silvergate’s notification that it would delay the filing of its annual report in which it questioned its own ability to “continue as a going concern,” and the exodus of many of the bank’s key partners – did these analysts finally capitulate. But even then not entirely, with some downgrading Silvergate from a buy to a hold.

This change of heart was too little too late. The damage had been done. On March 8, Silvergate announced its bank would wind down operations and voluntarily liquidate.

I would argue that long before November there were the fundamental problems with Silvergate that traditional analysts failed to detect, or at least grossly underestimated. Why?

Sell-side financial analysts follow a well-trodden path. They earn an undergraduate degree in finance, economics, mathematics, etc. They take an entry-level position working for a senior analyst. And maybe get a CFA, Series 7, or MBA, and become an expert on a specific sector or subsector (e.g., regional banking).

This path provides them with a traditional finance (TradFi) lens that leaves them with a blind spot for decentralized finance (DeFi), causing them to miss the bank’s crypto-related troubles.

(The same can be said for analysts at traditional rating agencies, as they were slow to downgrade Silvergate.)

In the case of Silvergate, they missed several bright red flags.

Enough staff?

For most of its life, Silvergate was a sleepy, Southern California regional bank, offering the traditional suite of personal and business banking services. In 2016, it pivoted and went all-in on crypto, morphing into a self-described “nontraditional bank.”

In its 2019 regulatory filing, Silvergate expanded on this, stating that its “business model and vision differ from those of a traditional bank.” Alongside traditional banking services, it was “a leader in providing specialized commercial banking products and services to emerging financial technology ('fintech') companies throughout the United States and beyond.”

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The analysts’ rosy recommendations provided Silvergate with a veneer of institutional legitimacy.
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Yet, this tectonic shift in business models was not supported by a crypto-related acquisition or a meaningful capital investment, leaving one to wonder whether Silvergate had the staff and operations to run a crypto bank.

Silvergate Exchange Network

Silvergate’s flagship “specialized commercial banking product” was the Silvergate Exchange Network (SEN), which CoinDesk describes as “a 24/7 instant settlement network used by some of the largest trading entities in the space. SEN, which replaces clunky wire transactions by allowing corporates to instantly move U.S. dollars between crypto exchanges including on nights and weekends…” The company closed SEN on March 3 and removed the page describing the service from its website.

Building on SEN’s success, Silvergate subsequently offered SEN Leverage, a custom lending that “allows institutional customers to trade any asset on-platform with leverage collateralized by bitcoin or U.S. dollars,” with “near real-time loan disbursements and repayments through the Silvergate Exchange Network (SEN).” That service also closed on March 3.

While these services might represent a paradigm shift, they were also services offered by no other federally insured bank. Moreover, Alan Lane, Silvergate’s CEO, admitted in a 2021 interview that SEN Leverage was not approved by bank regulators: “It's not like it's an approved product, it's a nondisapproved product, is one of the ways we talk about it in banking circles.”

Also, these services directly tied Silvergate’s growth to the volatility and vagaries of the crypto markets. Any forecast of Silvergate’s future value would require a deep understanding of these markets and still-unfolding use cases.

Money laundering controls

SEN was the lynchpin in Silvergate’s customer acquisition strategy. And this strategy worked. Silvergate’s customer base grew from just 20 crypto customers in 2016 to more than 1,600 in 2022. These customers included hedge funds, over 100 on- and off-shore crypto exchanges, and companies doing token projects.

Importantly, customer deposits were mostly digital assets, which are not a particularly safe or stable source of funding because they directly exposed Silvergate to nontraditional risks, most notably the volatility of crypto markets. That Silvergate was lending to customers facing the same crypto-related issues compounded these risks. As one investor told me, “It all seemed like a recipe for disaster if crypto prices were to fall.” And fall they did.

Also, consider that these customers used SEN to facilitate “over $1 TRILLION IN PAYMENTS since its inception in 2017” (emphasis in the original 2022 Silvergate investor presentation).

It is incredible to think that a mid-size bank, even one that employed “twice as many compliance staff as comparable banks of its size,” would be able to perform the required anti-money laundering checks to detect and stop suspicious activities on so many clients and so many real-time currency transactions. The volume and velocity of these transactions ​– the source of many analysts’ reassuring forecasts – overwhelmed Silvergate’s compliance apparatus.

And some customers, aware of this weakness, used SEN for illicit purposes. According to court documents, FTX and sister company Alameda Research exploited the laxity of Silvergate’s compliance program and created accounts for what appears to be a fictitious subsidiary (Northern Electronics) to hide money that was used for Alameda’s trading activities.

Yet, even before FTX’s collapse there was evidence that customers were using SEN for illegal purposes as early as July 2021 and specifically for money laundering in August 2022.

A Jan. 24 New York Magazine Intelligencer story offers a sweeping indictment of such nefarious activity, describing Silvergate as “the go-to bank for more than a dozen crypto companies that ended up under investigation, shut down, fined, or in bankruptcy.” The story identifies numerous customers that have run afoul of the law (e.g., convicted Australian crypto Ponzi artist Stefan He Qin and Bittrex, a cryptocurrency exchange and onetime Silvergate shareholder and customer that has been sanctioned by U.S. authorities for moving money on behalf of Iran and Syria).

Read more: George Kaloudis - Crypto's Banking Problem Is Not Ironic

Other investors and researchers were acutely aware of Silvergate’s problems and publicly shared their views (e.g., the veteran short-seller, Marc Cohodes, told The Block that "Silvergate is a publicly traded crime scene and Alan Lane belongs in prison”), going so far as to send letters to Silvergate’s auditor and regulators describing the problems and urging them to take action.

The apparent inability of analysts to understand and assess the mismatch between management’s skills and the new business model, the bank’s tremendous crypto-related balance sheet risk, the possible regulatory risks from offering “nondisapproved” products and services, and the AML risks had serious consequences. In addition to allowing some Silvergate customers to engage in fraud and other unscrupulous activities that harmed millions of people, analysts’ rosy recommendations provided Silvergate with a veneer of institutional legitimacy.

Some are quick to point out that Silvergate is a banking failure, not a crypto failure. But I see it as yet another TradFi failure: Like the institutional investors who invested in failed lender Celsius Network and FTX, Silvergate analysts used traditional investment techniques and metrics to assess the value of a nontraditional company, causing them to miss the embedded crypto risks that ultimately caused the company's failure. If we are going to stop the crypto carnage, we need TradFi to put on a DeFi lens.


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Angelo Calvello

Angelo Calvello, Ph.D., is co-founder of Rosetta Analytics, an investment manager that uses deep reinforcement learning to build and manage investment strategies for institutional investors.