Navigating the Realm of Crypto-Friendly Financial Institutions and Recent Events
by Valentin Kalinov on Mar 23, 2023 4:02:00 PM
At its core, the banking system relies on a foundation of trust, with customers depositing their funds based on the assurance that they can access their money whenever needed. To the depositor, a dollar held in the bank is perceived to be as secure and valuable as the physical currency in their possession. Consequently, they expect uninterrupted access to their funds through ATMs or other banking services. However, the reality of banking operations is more complex, as banks do not simply store deposited funds in a static state. Instead, these institutions use customer deposits to generate loans or invest in bonds, retaining only a fraction of the total deposited amount for immediate withdrawals. If all customers simultaneously requested their money back, the bank would be unable to fulfill these demands. Despite this inherent vulnerability, the banking system remains functional due to the widespread confidence that banks will indeed have the funds when customers need them. This collective trust, in turn, minimizes the likelihood of large-scale withdrawals and ensures that the system remains solvent. Thus, the very belief that banks hold the necessary funds effectively renders it true, underscoring the delicate balance between trust and operations within the financial sector.
Authors: Valentin Kalinov, Christian Viehof
A Closer Look at Silvergate Capital Corp.
In the rapidly evolving world of digital assets, finding a banking partner that is both knowledgeable and supportive of the cryptocurrency sector can be crucial for industry players. Silvergate Capital Corp. has emerged as a leading choice for prominent US-based cryptocurrency exchanges and traders. Silvergate was highly attuned to the needs of its clients within the digital asset ecosystem, not only by accommodating deposits from crypto exchanges and traders but also by developing its own bespoke payment infrastructure for efficient cryptocurrency settlements.
This proprietary payment network, known as the Silvergate Exchange Network (SEN), facilitates seamless and secure dollar-based transactions between Silvergate account holders. For instance, if two parties within the network wish to transact in Bitcoin for dollars, they can effortlessly instruct Silvergate to debit the requisite dollar amount from the buyer’s account and credit it to the seller’s account. This streamlined process significantly enhances the user experience for digital asset transactions, catering specifically to the needs of crypto professionals and finance experts alike.
What went wrong?
In short, Silvergate experienced a bank run. Unlike previous failures like Celsius, Silvergate did not make risky Bitcoin loans. It actually made the mistake of borrowing short (taking deposits from crypto companies) to lend long by buying Treasuries. Unfortunately for Silvergate, its customers decided to withdraw their money before the bonds matured. Since the depositors of SIlvergate were crypto companies like exchanges, their customers wanted their money back, and these companies had to pull their money from Silvergate. The trouble started in late 2022 when FTX collapsed, and users lost trust in the crypto industry.
FED raising rates
In a low-interest-rate environment, customers with ample liquidity tend to deposit significant amounts of cash into financial institutions, often eschewing loans due to a lack of necessity. Consequently, banks may opt to invest these funds in longer-dated bonds. However, this strategy can expose institutions to potential losses when interest rates rise, leading to a devaluation of these securities.
Silvergate bank underestimated the interest rate hikes and found itself under a financial strain having customers withdrawing their funds. This cycle can create a precarious situation for banks, as financial losses and perceived instability may trigger further customer withdrawals. In turn, institutions may be forced to sell additional securities to cover these withdrawals, compounding their losses and exacerbating the precariousness of their financial standing.
In summary, it is crucial for financial institutions to carefully consider the potential ramifications of interest rate fluctuations on both their investments and clientele in order to mitigate risk and maintain stability in a constantly evolving economic landscape. Silvergate did not have the best strategy.
Silicon Valley Bank and USDC depeg
USDC lost over 10% of its value as SVB failed. Circle (the company operating USDC) had $3.3B stuck in the failed bank. SVB was called the startup bank because many of the Silicon Valley startups were holding their cash deposits with SVB. As many know, startups are usually cash-burning machines and do not tend to invest their treasuries or seek credits. This type of customer posed a huge risk for SVB if the interest rates rose.
SVB had a similar strategy to Silvergate and had a similar type of customers. It borrowed short (taking deposits from crypto companies) to lent long by buying Treasuries. When interest rates rose, the bank had no choice but to sell its bond portfolio at a loss in order to meet the user demand for withdrawals. Circle got caught in the storm, and the markets reacted by pushing the price of USDC downwards.
The issue of trust
The crypto markets soared from late 2020 through 2021 partly because central banks were infusing unprecedented amounts of liquidity into the financial markets. With low-interest rates, credit was as cheap as it ever could be. As a result, the tech sector, as well as crypto, were hitting new all-time highs. However, when the markets realized that raising interest rates was inevitable because of high inflation, liquidity got pulled from the markets. The FTX crash added even more oil to the fire. Many investors were unwilling to take more risks in the crypto market, pushing the prices to test new lows.
With SVB bank's and Silvergate bank's failures, we are witnessing a similar scenario for banks. With high-interest rates, many banks find themselves in a difficult situation. We have seen Credit Sussie failing and First Republic bank on the brink of bankruptcy. Central banks had to step in and announce liquidity support for struggling banks around USA and Europe.
On the other hand, the crypto industry can not rely on the help of a lender of last resort. If a crypto startup fails, there are no bailouts.
The International Token Standardization Association (ITSA) e.V.
The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.
- The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
- The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to market capitalization of classified tokens.
- ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.
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Christian Viehof is an Executive Director at the International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database including a classification framework and unique token identifiers and locators. He completed his Bachelor in Economics at the University of Bonn, the Hong Kong University and the London School of Economics and Political Science with a focus on Behavioral Economics and Finance. Currently pursuing his Master of Finance at the Frankfurt School of Finance and Management, you can contact him via email@example.com and connect with him on Linkedin, if you would like to further discuss ITSA e.V. or have any open questions.
Valentin Kalinov is an Executive Director at International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database, including a classification framework and unique token identifiers and locators. He has over five years of experience working at BlockchainHub Berlin in content creation and token analysis, as a project manager at the Research Institute for Cryptoeconomics at the Vienna University of Economics and token analyst at Token Kitchen. You can contact Valentin via firstname.lastname@example.org and connect on Linkedin if you would like to further discuss ITSA e.V. or have any other open questions.