Silvergate Capital Corporation (SI) Earnings Call Transcript & Summary

Good afternoon, everyone. My name is Eugene Koysman, and I cover U.S. banks, along with my colleague, Jason Goldberg, at Barclays. Welcome to the Silvergate Capital fireside chat. With us today are the CEO, Alan Lane; CFO, Tony Martino; and Head of Corporate Development, Ben Reynolds. [Operator Instructions] With that, Alan, Tony and Ben, I want to welcome you to our first -- to your first appearance at our conference. Maybe we can start with a quick introduction of the company, what you do and what sets you apart, especially for investors who are new to the space.

Sure. Thank you, Eugene. It's great to see you, and really appreciate this opportunity to present the Silvergate story. And for those new to Silvergate, we believe Silvergate is the leading provider of innovative financial infrastructure solutions and services to the nascent but growing digital currency community. We have entered the digital currency industry on purpose back in 2014 after initially doing some research on what was then bitcoin only. There are a lot of other digital currencies that have been developed since then. But back then, it was primarily bitcoin. And what we discovered back in 2013 was that there was a need for banking services for new businesses that were being formed to provide services to the digital currency ecosystem. And what started out as a deposit, a basic deposit services for this industry has grown into a global platform. We have customers around the globe who rely on the connectivity that we provide. We've created a network effect, it's referred to in the industry as the Silvergate Exchange Network, or the SEN. We have close to 900 customers in the digital currency space. It is an institutional focus. We connect digital currency exchange platforms such as Coinbase, Gemini, Bitstamp, Kraken to institutional investors. Those are hedge funds, money managers, proprietary traders, folks that are pursuing digital currencies as an asset class. And we connect them over our -- over to SEN, so that they can conduct their business 24 hours a day, 7 days a week, 365 days a year. We believe we are the first bank in the world to bring the legacy banking system that only operates during -- business hours during the week into the 24/7 cryptocurrency markets that just they never sleep. And so with that as an introduction, we're happy to take the conversation wherever you like to take it.

Excellent. So maybe you can talk about how your businesses evolved since the IPO last year, both on the regulatory front and in terms of new business initiatives. I think a lot of investors have had a pretty good overview when you were going public and it would just be good to refresh it as well.

Sure. Happy to do that. And I'm glad you brought up the regulatory aspect because one of the things that I failed to mention in my intro was that we obviously are -- remain in very regular contact with our regulators. This is a highly regulated space. There are a lot of eyes on it. And going all the way back to 2014, when we first entered the space, we invited the Federal Reserve and the California state banking department into our offices to discuss with them how we were thinking about this industry. And they've been with us every step of the way through our annual exams, our periodic BSA compliance exams, et cetera. And we would not be able to be in this business if it wasn't for that relationship that we have with our regulators. As far as how we have been doing since the IPO, we IPO-ed in the fourth quarter of last year. So when we were on the road, I'm talking with potential investors, we were referring back to third quarter 2019 metrics. And just to get some of the high-level metrics there as we move through to the end of the second quarter of 2020, our customer growth has been about 17%. That's not an annualized number, that is literally a 3-quarter from third quarter to second quarter of 2020, 17%. The number of transactions moving across the SEN has exploded. That has grown by 180% during the last 3 quarters. The dollar transfers over the SEN has grown by 133%. And to give you a point of reference, in the third quarter of 2019, there were just under $10 billion transacted across the SEN. That grew to $22.4 billion in the second quarter of 2020. Fee income is growing nicely, up about 50%. The deposit's up about 16%. By the way, this is a non-interest-bearing deposit initiative. DDA represents 94% of our total deposits. And so those metrics are just outstanding. In terms of new products, last year, when we went public, we were talking about a new foreign currency exchange product. That is progressing nicely and contributing to the growth in fee income, the 50% number that I just referenced. We also were talking about the potential to start lending against bitcoin. That's a product that we refer to as SEN Leverage. We introduced a pilot in January of this year. And so for the first 6 months of 2020, that pilot has been performing exactly as we would have hoped, and we're really looking forward to providing an update at the end of the third quarter in how we're doing with SEN Leverage. Other items that we can talk about, if we have time, digital asset custody. The OCC made a recent announcement that, that is a permissible activity for national banks. We already knew that, but it's great to have that validation. And then also the proliferation of U.S. dollar-backed stable coins. So lots of opportunity for Silvergate. And so things are -- have been going very well, notwithstanding the pandemic. And let me just finish off on that point because while we certainly didn't anticipate a pandemic, all of the moves that we've been making over the last several years to position Silvergate to be the leader in this digital currency industry has really positioned us well to not only survive but thrive in a digital-first economy.

So one of the questions that we get a lot is trying to size up the market for institutional traders, so trading in additional currencies and bitcoin specifically. You mentioned over $20 billion in transfers on the SEN. And I believe you have 560-some-odd institutional clients and over 60 exchanges. How much room do you think is there for more traders coming into the space? Meaning, is there opportunity for additional large institutional traders to join? Or is it mostly the smaller players are trading?

Yes, that's a great question. And Ben answers this question really well. I mean when you think about the size of the market, the crypto market is still being very, very small compared to the broader financial market. So Ben, do you want to touch on that a little bit?

Sure. Yes. So if you start with bitcoin, and you look at bitcoin that has a total market value today of roughly $200 billion, and then you think of bitcoin as a digital store value, similar to gold or an asset of that, there's a lot of people that believe that bitcoin has a way to go in terms of just the store value use case alone. So that's sort of one data point. And then when you think about sort of what's going on in the macro environment in terms of fiscal and monetary policy, what we're seeing is we're seeing macro investors look at the asset class and make an allocation to bitcoin. And I guess 2 of the examples that I would highlight are Paul Tudor Jones earlier in the year, and then recently, a publicly traded company called MicroStrategy that trades on the NASDAQ. MicroStrategy, I think, sort of took everyone some -- for a surprise in the sense that they've looked at -- they've clearly done their research on bitcoin. And just this morning, announced that they've upped their allocation in bitcoin to $425 million. To put that number in perspective, they have a total market cap, they trade on the NASDAQ, and their market cap is about $1.3 billion. As of quarter end, I think their total balance sheet was about $850 million. So what they've said is -- and they're a business intelligence firm for those that don't know. But what they've said is they're going to keep 1 year's worth of working capital in cash. And beyond that, they're going to keep -- they're going to hold bitcoin for some of the inflationary reasons and whatnot. What's significant about that, I think, is that was a treasury decision that they made. And when you think about all of the corporations that are out there and all of the treasury departments, I think after this news, some of those folks need to start thinking about putting some bitcoin on their balance sheet. And so that's something I think that caught a number of people by surprise. And those -- so then to tie that into kind of how that relates to Silvergate, as Alan was mentioning, Silvergate has built this two-sided network of exchanges on one side of the network and market makers and institutional investors on the other side of the network. And so in order to settle those transactions in U.S. dollars, our clients use SEN in order to do that 24 hours a day, 7 days a week. So the last thing I'll say on this point is just in addition to kind of the trader universe, we know that there's a number of pension funds, endowments and traditional money managers that are looking at the space and have been doing research.

Right. So I think you have about 566 institutional investors in total as of -- for the second quarter. What -- how does that compare to the total number of traders in the space? Meaning, how much more room you have for adding clients? And I think you've been adding a couple of hundred clients a quarter or so.

Yes. It's really hard to estimate how many -- how many traders there could be. What we've seen over the years is folks that are trading traditional asset classes, equities and derivatives, are taking some of those same strategies and putting them into digital currencies and trading on platforms like Coinbase and Gemini and Bitstamp and Kraken, folks that are customers of Silvergate. So it's hard to say how many of those kind of conventional traders would move into digital assets. But when you just think about, as you mentioned, the 560 compared to capital markets as a whole, it feels like there's definitely some room to grow there.

Got it. And maybe we can talk about your new product, the SEN Leverage. Can you talk about the rollout over the last 2 quarters? And also how much market demand you see for it today? And where do you think it goes in the next year or 2?

Sure. So SEN Leverage is a product that we began working on it almost 18 months ago. We started working on it in the first quarter of 2019 and had our first regulatory conversations in July of 2019. Importantly, I mentioned earlier that we stay in regular conversation with our regulators. And when we first approached them about bitcoin collateralized lending, they kind of chuckled and said, "Well, we've been expecting this." And so it was a great dialogue. We went through with them how we were thinking about the pilot, and we officially launched the pilot with 1 servicing partner in January of this year. And we've been very open and upfront with the fact that we intend to be very careful with this rollout, very prudent. We have very good credit metrics in the rest of our portfolio, and we actually believe this could be some of the best lending we've ever done because the bitcoin collateral is liquid. It's a bearer asset. If you compare this to lending against any other asset, if your borrower doesn't pay you back, then you've got to get control of the asset, liquidate it. In this case, we have the asset in our possession when we make the loan. And it's a market that trades 24/7. So as far as the pilot goes, we announced a second partner, servicing partner in the month of May. And the pilot is progressing exactly as we would have hoped in terms of our dialogue with customers, with additional servicing partners. We are continuing to work on adding both new customers, new borrowers as well as new service providers. And we'll provide an update at the end of the third quarter as to the status of the pilot. But in general, based on what we see with other lenders out in the space, and I may ask Ben to touch on this briefly, there are a couple of other lenders out there who are customers of ours, who have had significant demand and significant success of lending against bitcoin and other cryptocurrencies, so that gives us confidence that there is a significant market opportunity there. Ben, do you want to touch on -- yes, I'm sorry.

See if you can talk to the competition in the space.

Yes, sure. Ben, do you want to -- you want to take over from there?

Yes. So one of the firms that Alan referenced that's been the most public is a firm called Genesis Global Capital. And they announced at the end of the second quarter that they have about $1.4 billion outstanding in a loan portfolio related to digital assets. And Genesis has said publicly that they have about 50 clients that are making up that $1.4 billion number. So as we think about the opportunity for Silvergate, we have those 566 clients that you mentioned, Eugene. And most of those clients are looking for some type of capital efficiency or leverage on their bitcoin. So if you just took a round number and said, 300 of those 566 would be looking for, and I'm just making that number up, but looking for the loan product, and then you say, if it's $1 million, then it's a $300 million opportunity. If it's $10 million, then it's a $3 billion opportunity. So it's hard to say exactly where that number will go, but we -- just based on the dynamics of digital -- of the digital currency industry, I'll touch on that in a second, we think that there's pretty significant demand. Back to the dynamics, prime brokerage doesn't really -- conventional prime brokerage does not exist within digital currency market. So if you're an institutional investor and you want to trade the asset class, you need to have dollars and digital assets on these different platforms in order to trade. And so because of that, there's really this incredible demand for a leveraged product.

And how does Silvergate set pricing for some leverage? And what's the right pricing model here?

Yes. So we are still in the exploration phase. There's publicly available information on some of the other platforms that Ben was referencing. The way we framed this for -- when we've spoken about it publicly is that we believe that the yield opportunity is in the mid- to high single digits. Which -- and we haven't changed that as the entire world has kind of moved into a 0 interest rate environment. We still believe that we should be able to achieve mid- to high single digits in terms of yield on this product, which is obviously a very attractive yield in a 0 interest rate environment.

And Alan, you also mentioned some fee income initiatives, the FX. How much are you looking to invest? How much money do you still need to invest to build out the fee income initiatives? And any thoughts on trying to charge for SEN? How has that evolved to date?

Sure. In terms of investments, most of the investment has been made. We started, for instance, let's take one product that is rising in income growth, which would be foreign currency exchange. That's something that we've been working on now for the past 18 months or so. And so a lot of the heavy lifting has been done there. There's a lot of work that goes in upfront to establishing correspondent banking relationships with other banks around the world, so we can trade currencies directly with them. But there's not a significant additional technology spend that needs to happen there. Similarly, just with the SEN in general, that is a -- that's an API-driven platform that we developed internally. And we have tested it at multiples of what our current volumes are with no degradation of service whatsoever. So we believe that we have a very scalable platform that will not require a significant additional increase in overhead expense. Now when we turn to the rest of your question there, in terms of charging for SEN, that's something that we consider on a regular basis. As we've discussed in the past, we have been focused on developing the network and keeping the barriers to adoption as low as possible. And so we continue to look at the value that we're providing to our customers. And so I wouldn't rule out anything in the future, but as it stands today, we are not charging -- we're generally not charging percent participation.

Right. And just looking at the FX, treasury management, do you have any internal milestones that you could share with us in terms of what your revenue targets there are as you're trying to replace some of the revenue streams that are off the table right now given more interest rates?

Yes. Maybe I'll turn that over to Tony. We -- I think you know, Eugene, we typically don't provide guidance per se, but maybe Tony could share some of his thoughts on.

Sure. Yes. Thanks, Alan. Thanks, Eugene. So while you're right, net interest income represents a significant proportion of our revenue stream, our strategy has been to evolve the business to fee model generation as we continue to build customers and they adopt the platform. So as of today, as of the second quarter, our fee income reached a level of $2.4 million, that's more than double the corresponding prior year second quarter. And that fee income, the primary driver of that fee income is cash management solutions such as wires and ACH. The other major component is FX transactions, as Alan alluded to, and we've generally, other than in a couple of instances, not started yet charging for use of the SEN to keep the barriers to adoption low. In the near term, our focus is to really expand our FX offering. So we did indicate in the second quarter that we've established banking relationships with like-minded banks. And so we've launched direct client access to euro and Swiss franc, and we plan on continuing to expand that direct offering to other major currencies over the course of the year. In terms of the long term, we'll continue to build out the fee income components with our customers, as Alan had mentioned some of the initiatives at the outset of the call. So our focus definitely is to continue to build the proportion of our revenue and to increase the proportion from fee income generation and reduce reliance on net interest income over time.