Silvergate Capital Corporation (SI) Earnings Call Transcript & Summary

Good afternoon, and welcome back to our 19th Barclays Global Financial Services Conference. I am Eugene Koysman, and I cover large and mid-cap banks with Barclays. With us today, making their second appearance at our conference are Silvergate's, CEO, Alan Lane; CFO, Antonio Martino; and Head of Business Development, Benjamin Reynolds.So to start, I wanted to ask Alan for investors in the audience that are not fully familiar with your business model. Can you please give us a quick overview with a focus on what sets you apart from other banks active in the crypto space, specifically Signature Bank?

Sure, Eugene. It's great to be here. Thank you again for the opportunity and we love talking about our flagship product, which is the Silvergate Exchange Network or the SEN and that is the ability for our customers to transact with each other via API 24 hours a day, 7 days a week, around the clock, around the world. We are the first bank in the world to bring the legacy banking system, which only operates 40 hours a week during normal business hours into the 24/7 cryptocurrency market that never sleeps. And we've been banking this ecosystem now since early 2014. So, we are going on 8 years. So, we also enjoy a first-mover advantage, which we have capitalized on over the years, but it's really the network effect of the SEN that sets us apart, the fact that all of the major players in this digital currency ecosystem are customers of Silvergate and they can transact with each other 24/7 across our platform. And so that's really what sets us apart. It is the springboard from which we launch other products and services that our customers view such as foreign currency exchange, such as our SEN leverage products, which enables our customers to borrow against their bitcoin, and last but certainly not least, it is the infrastructure that the stablecoin market uses to issue to mint and burn. U.S. dollar backed stablecoin, again 24 hours a day, 7 days a week. So it's really quite a platform and we enjoy great relationships with over 1,200 customers in this business.

Thank you and would it be fair to assume that your near and medium-term catalysts are mostly tied to the bitcoin trading environment and the longer-term growth prospects are mostly on your stablecoin space.

Yes. It certainly -- potentially a concise summary, but if it's okay with you, I'd like to turn it over to Ben, who is our Chief Strategy Officer and ask Ben to comment a little bit more on our immediate and longer term prospects. Thank Alan. Thanks for having us, Eugene. So one of the ways that we often frame this is really the 2 use cases for digital currencies. So thus far, we've really been focused on digital currencies as a new asset class and helping exchanges and traders move U.S. dollars through the ecosystem, 24/7 over the SEN. But the second use case is really around digital currencies as a payment rails. And so when we think about some of the payment rails that exist, some of the friction that exists when you want to send money cross-border or through commerce over the Internet that use case for the technology is really pretty exciting.

That's really helpful. And just saying the very high level and I promise that's the last one and then we'll get into more detail. What do you think are the key misconceptions among investors around Silvergate and your business model? How you really address these -- talk with investors?

Yes. I mean, I can't really put myself in the shoes of others to understand what their misconceptions might be. What -- the way I would think about the answer to that question, Eugene, is just really pointing out that it is the financial infrastructure that Silvergate provides as opposed to just the deposit opportunity. So, if I could frame it that way, I mean, in the early days of this initiative, going back to 2014, it was clearly a deposit play, a deposit opportunity for Silvergate. But at that time, we were under $1 billion in assets. Today, we're over $12 billion in assets. All of that growth has really been on the back of SEN and while it is, again, clearly a deposit led initiative, it's really more about enabling capital efficiency for our customers over the SEN. And so again, I mentioned briefly, we have over 1,200 customers. These are institutional customers. We are not a direct-to-consumer business. Importantly, we provide the critical infrastructure for our institutional customers, customers exchange as digital currency exchanges, such as Coinbase and Gemini and Kraken as well as others. And they, in turn, have, in many cases, millions of consumer clients, as well as institutional clients who are using their platform. And those exchanges use the Silvergate exchange network and the API to scale their businesses. So for us, it's all about enabling transactions and enabling our customers to have the maximum amount of liquidity and importantly, the appropriate amount of liquidity on the right platform at the right time, 24 hours a day, 7 days a week.

Actually, what I wanted to add is that in the early days, one of the questions that I would always get from clients would be does Silvergate hold bitcoin on the balance sheet. And obviously, the answer is no. So that's -- but I wanted to now dive a little deeper and maybe we can talk about your partnership with Diem. And specifically how Silvergate was selected, what made you the best partner in the space? And also, what do you think are the near-term and medium-term revenue generation opportunities are here?

Sure. I'll touch on it briefly and then kick it over to Ben. And just to frame this for those in the audience, the stablecoin is essentially a tokenized dollar. So, it's a U.S. dollar riding on top of a public blockchain. And currently, there are 4 U.S. dollar backed stablecoin projects in the United States that are regulated in the U.S., the largest one being Circle's USDC. There's also the Gemini dollar, the PAX dollar and then TruUSD. All 4 of those issuers utilize Silvergate, utilize the SEN and our API for minting and burning of their stablecoin token. And so for the first part of your question, what do we think brought Diem to us? It's likely the fact that we're already doing this business in the United States and supporting the existing stablecoin issuers, but importantly, I think it's also our regulatory framework and just the way we think about things at scale. And let me turn it over to Ben to give you a little bit more color on our interactions with Diem.

I mean, we've been in this industry for over 8 years now. And I don't know if they -- I don't believe that there's another bank that's in that space. And so I think that there's a lot of desire by Diem to do this the right way to live up to the promises that they made to Congress when Diem was first announced in terms of making it safe for the end user, making sure that the reserves were invested the right way. And so the combination of Silvergate being a regulated bank and the SEN network and its ability to essentially get dollars from fiat accounts into dollars on the blockchain, 24/7, I think we're some of the differentiators. The last one I'd probably touch on is the industry participants that Silvergate already banks. So, customers such as Coinbase, Gemini, Kraken, Robinhood, Square, PayPal, those types of firms. I think all of them see a place for stablecoins in their businesses, and all of those folks are already connected to the SEN network. And so if you're really trying to achieve scale and achieve distribution, Silvergate is a really nice way to do that.

I wanted to touch on your competitive moat around your businesses. First one on the SEN. It seems like you're the only bank really offering the service, but one could argue it's because the market is relatively small, but with the minting and burning stablecoins, with Diem relationships, that seems to be a much bigger market. What's your competitive advantage here longer-term as more players enter the market? What are your thoughts here?

Yes. So we talk a lot about network effects. And sometimes, everyone's heard network effects, but oftentimes people have different definitions. The definition that we use is that every time you add a user, every time you add a customer from Silvergate onto the network, it creates incremental value for all of the other users that are on the network. Right? And there's Metcalfe's law, if you really want to go deep into the academic thought process for it. And so we just -- when you look at the SEN network, as of the end of the second quarter was on pace for roughly $1 trillion in volume on an annual basis versus $10 billion in deposits. So our customers are turning their funds 100 times on an annual basis. And so what you see in network effects businesses is this concept of co-tenanting, right? It's Uber and Lyft are -- but the difference between those networks and what we've created is that there really isn't a cost if you're a writer on one of those platforms to have both and just see what you get. You can download the app, you can be a customer of both and it doesn't really cost you anything. Here, we're talking about capital efficiency. And so the most efficient network possible is to just have all of the participants in one place and all the deposits in one place. If you then have 2 different banks where that's going on, just the math is that your capital is going to be less efficient because you're breaking it now between 2 parts and you're not sure where the trading opportunities are going to exist. So then if you go from 2 to 4, then your capital gets even more inefficient. And so there really is real cost to the end customer to use a different network other than to use Silvergate's SEN network.

So that leads me to the next one. So that should be a relatively easy exercise to try and monetize this because customers see the benefit for -- or at least on paper.

Yes. I think -- so maybe if I could respond back a little bit. I think long term, it's easy to see how to monetize it. I think the question is, in the short term, how do you monetize it and what's the best option. And so clearly, the path that Silvergate has taken is to say that we're focused on long-term value creation for shareholders. And we believe that the best way to do that is to add products to the SEN network. And so SEN leverage is an example of that. We have 0 cost funding. We're charging between 600 and 800 basis points for that product. So we're generating a nice return there. And so we have no question if we wanted to just strap a fee on to it and charge $10 per transaction, our customers would gladly pay it. We could make an extra $600 million or $700 million a year and be on our way, but we think that that might be leaving money on the table long-term because when we think about some of these new use cases around stablecoins for commerce and remittance, there's potentially an opportunity for us to charge a spread on the volumes that are taking place.

Thanks. And do you think that the technology -- the blockchain technology and the technology behind stablecoins, is that in the right place today for mass adoption? Or is there still a need for advancement in the tech? And how long do you think it takes to get there? Then the technology is able to handle enormous number of transactions and higher volumes?

Yes. it's a great question, Eugene. And one that as the bankers, we're probably in the best place to answer. But we know a little bit about this just because we're interested and Alan probably knows more than I do. So, I'll let him chime in second here. But the scalability issues are real and when you look at bitcoin's scalability and the fact that the blockchain only updates once every 10 minutes roughly and oftentimes, you have several transactions -- several confirmations needed. So, it might take an hour for that transaction to post. And then you look at the scalability of Ethereum, and the gas fees that people are paying in order to get in on the NFT craze as an example, those are not -- tend not to be highly scalable blockchains. But there are other more scalable blockchains out there, folks like what Diem has created with their blockchains that does allow for a lot more throughput, a lot more transactions per second, if you will, then what's currently possible with some of the older blockchains. So, I think I probably stole Alan's thunder, but...

Yes, that's quite right, Ben. Just to add in there and to go where I think you were going is, Eugene, there are trade-offs. If you try to optimize for speed then that would argue for perhaps a more centralized type of a protocol with fewer nodes, fewer participants, which could then reduce the confirmation times that Ben is talking about. But then you lose some of the benefits of the decentralization. So, these really are trade-offs and when tether -- we haven't talked much about tether, it's the other very large U.S. dollar backed stablecoin, but it's not regulated inside the U.S. So we don't currently bank them, but they are the largest stablecoin out there currently, U.S. dollar backed stable point. And when they were first launched, they were launched on a version on top of bitcoin, the bitcoin protocol. And then they converted over to an ERC 20 token on Ethereum because it had faster throughput. And then since then, it's been put on other blockchains as well. Back to your point, Eugene, on always looking for that optimization between decentralization, speed of transaction, throughput number of transactions you can get. So, the one thing that I'm pretty confident in is the technology, it's not done evolving. So there will continue to be enhancements on all of these protocols.

Right. We're obviously deep in the weeds here and the reason I ask is because if we look forward and expect to see stablecoin take a big role in money transfers and what banks are doing for their global transaction services businesses and also in consumer payments, obviously, scalability and speed are really important in that space. So that's really what I was trying to understand. And maybe we can talk about some recent developments in the crypto space, namely the designation of bitcoin as legal tender by El Salvador and then funding of the crypto trading from Radicle by hedged on heavyweights. So, I suspect that Radicle probably will be one of your clients on the SEN. But what are your thoughts? How does that really drive this kind of reduction? How does that drive the market?

Yes. Let me -- if you don't mind, since you kind of clarify what you were talking about previously on the scalability question with regard to stablecoin. The one thing I do want to say is that the promise of transacting with dollars over blockchain is instant final settlement, okay, which is not currently possible in the traditional ways that we transact. If you think about SWIFT, the Fedwire system, ACH. Those are batch systems, which only operate during business hours, notwithstanding the fact that the Federal Reserve has the Fed now project, which is promised at some point in the future. But it is important, I think, to make a distinction between these kind of legacy systems, which work really well and they're built to scale, but there's a lot of inefficiency in the settlement times and the way they're batched and the promise of dollars over a blockchain, if you will, is the fact that you can have instant settlement right now, 24 hours a day, 7 days a week, and it happens very quickly in real time. So now -- and Ben, I don't know if you want to pick up on Eugene's questions, but I just wanted to touch back on the stablecoin.

Yes. I mean -- so what's going on in El Salvador is really, really fascinating, right? And one of the things that I'm constantly reminding myself is that is how tied this all is to the broader macro econ, right? And part of what's -- people get excited about El Salvador adopting bitcoin, but it's really coming out of a state of crisis as it relates to their own currency, right? And so one could argue that the decision that they're making is whether or not to get more utilization of the U.S. dollar or more reliance on the U.S. dollar or look for something that's sort of self sovereign like bitcoin. So there's an interesting narrative there. And I know that some of the platforms that are out there that are trying to solve some of the scaling issues of bitcoin around Lightning and layer 2 solutions really become pretty critical as nation states are adopting bitcoin as legal tender. But it's going to be an interesting experiment. And -- but one -- it's -- I think it's difficult to say whether it's going to be successful or unsuccessful and it's difficult to say whether it's good or bad because of the broader kind of backdrop of kind of why they're using bitcoin in the first place, if you will. So as you can tell, on a personal level, I've sort of mixed feelings about it.

At least it feels that when the country adopts bitcoin that should bring forward all the issues with the scalability and the speed. So that will get addressed. At least that's how I'm thinking about it. Is that fair assumption?

Yes. I mean, Ben touched on Lightning as a layer 2. And I think it's worth just explaining that a little bit more. And one of the analogies that you could use is, if you think about the Fedwire system, when I walk into Starbucks to buy a cup of coffee, I'm not going to wire that money, right? It's -- the wire system is built to handle fewer transactions, but larger dollar volumes. And so there are layer 2 protocols, if you will, on top of the Fedwire system, which is I haven't accounted at my bank and I have a debit card. So I can use the debit card, going got to go through my bank and then in turn, it's going to -- at some point, there's going to be a settlement between banks that might occur via the Federal reserve. So if you think about that in the traditional markets, bitcoin and Lightning -- so bitcoin would be equivalent of the Fedwire system, which is -- it's more secure, it's going to have fewer transactions, perhaps higher dollar value transaction. Then Lightning is a layer 2 protocol that is built for speed and for final settlement at speed. But -- so it's going to have faster throughput, but it's likely not going to be used for the same level of dollars. So one of the important parts of the El Salvador project, if I call it that for purposes of this discussion, is that they've adopted a bitcoin as legal tender, but the way -- if you peel back and look at how that came about, there's already -- Lightning is being used as a protocol for moving bitcoin across this layer 2 protocol amongst individuals within El Salvador already. And so part of this is kind of a little bit of a groundswell because they've already been using bitcoin and Lightning in communities in El Salvador. And so now the government is recognizing it as legal tender.