Silvergate Capital Corporation (SI) Earnings Call Transcript & Summary

Yes. So I'm sure that your audience here probably follows the other banks that are in the space and they're getting into crypto. So I won't name them specifically or talk about them, but just in general, the -- we launched the SEN back in 2017, and it's API-enabled. And what that means is that firms like Coinbase, Gemini and Kraken, but also Square, and PayPal and Robin and all of those folks have coded to our API. And so when they think about -- when these firms think about financial infrastructure, they're not trying to think about like, okay, well, is Silvergate a little cheaper than this other one -- than this other bank or how are the service levels. I mean service matters, of course. Rates matter, of course. But what matters more than all of that to this category of customers is the quality of the technology and whether or not it's scalable. What they're worried about is, they're worried about that next bull run when Bitcoin is going to $100,000. They've got new retail customers coming on the platform like crazy, and they need to make sure that they can provide them with with Bitcoin or whatever digital asset they want as quickly as possible. And so the way to do that is to make sure that they have enough deposits at Silvergate, and then they have access to the SEN, and the market makers that are on the other side of the network in order to source those digital assets for those trades. And so we never want to discount competition that's coming into the space, but we really do feel good about the technology that we've created and how it solves problems for our customers. And we're just -- we're not hearing about losing customers to the competition.

Got it. I guess shifting gears a little bit. I guess, 99% of your deposits are noninterest-bearing. Maybe Tony for you, but talk to us around how you think about deploying those deposits into longer-duration assets? Is it still too early to start putting this money to work where you need to understand client behavior? And what are your expectations if and when interest rates begin to go higher, how quickly would you have to pay? Like what are your expectations around some of these noninterest-bearing balances moving actually into interest-bearing deposits?

Sure. Thanks for the question. So the way we think about the deposit base is, somewhat the deposits in the ecosystem, the core strategy is not necessarily to raise deposits. The deposits are somewhat of a byproduct of the platform and network effect and the platform, the [ 24/7 ] nature of the platform that we're creating for our clients. So although the bulk of those deposits are operating, we have had mechanisms such as off-balance sheet sweeps even before we were in -- not in a 0 interest rate environment. So we're not -- we don't intend to necessarily -- we don't -- it's not our intention to pay interest on those deposits. We view those deposits as operating deposits, and there's a necessity, as Ben and Alan have been describing, there's no necessity to keep the deposits on platform and available to be able to take advantage of the 24/7 nature of the SEN. So to your other question about how we think about deploying the deposits, I mean, we have over the course of the year to deploy the deposits into the securities portfolio on quite a substantial basis. We think about that. We continue to preserve liquidity and safety of -- and high quality of the deposits is kind of critical. That hasn't changed. That strategy hasn't changed. Our expectation on the asset side also is to build and continue to develop the SEN Leverage lending product. It's also obviously at attractive risk-adjusted yields given our [ 0 ] cost funding base. So that's how we're thinking about the balance sheet size -- the asset side of the balance sheet. We're not necessarily looking at things that aren't core strategic or distraction to the strategy. So in the near term, we'll continue to deploy the way we have in the past.

Got it. I guess maybe good segue to talk about SEN Leverage. Actually, we've alluded to that a little bit earlier. Your 25% growth, I think, close to $320 million in commitments. Correct me if I'm wrong there, but just talk to us around, again, the use of the -- part of the leverage and the lending. When it started out, it felt like the biggest use case was to buying more crypto assets. How is that evolving? And any initial early learnings from having this product out there on the lending front?

Yes. Great questions and good observation on the initial use case. And there's this intersection between -- I mean, we're just really excited about this. I've said in the past, this could be some of the best lending that I've ever done in my career. And we'll talk a little bit about why that is. But I also want to bring in one of Ben's points around solving problems for our customers because the initial use case, as you mentioned, was around traders who were looking for additional capital, if you will, to deploy into the asset. And so as you know, Prime Brokerage doesn't really exist in crypto, right? And so where -- the first use case for SEN Leverage was essentially solving the credit component of the Prime Broker kind of model, which is if one of our trading customers who's actively trading is long Bitcoin and they want more capital to deploy, they can actually pledge their Bitcoin with us. They actually lock it up with us, and then we will lend them U.S. dollars to buy more Bitcoin on the platform, okay? So that's the trading use case and that's the initial one that we launched back in January of 2020. And so a lot of our customers back then at that time were benefiting from the basis trade. They were matching up a spot and a future position. And so they're monitoring this -- their positions 24/7. As Ben mentioned, the SEN is 24/7. SEN Leverage is 24/7. And this now gets into the observation that this could be some of the best lending we've ever done because in any other asset class when you're taking that asset as collateral, even if you theoretically have possession, let's say you're doing a stock margin lending and you're a Prime Broker, well, there are things such as trading hours in traditional markets. And so it's not uncommon for stock to close at one price on a Friday and open at a different price on a Monday morning. Where in the Bitcoin markets, this is a 24/7 market. There's a bid and ask every second of every day. And as this this market gets bigger and bigger, the liquidity pools just get that much larger as well. And it's a better asset, right? So whoever has possession of the Bitcoin owns the Bitcoin at that point in time. And so we can liquidate 24/7, if we need to, and there's always a price. So that's the initial use case. But as we've evolved through time, some of those same characteristics make this a great asset for anybody to own and for us to lending. And so the corporate treasury use case where folks are starting to put Bitcoin on their balance sheet and then they're looking to turn it into cash, but they don't want to sell it, we'll lend them dollars against their Bitcoin. And so we just view this as a wide open opportunity. We've been going slow intentionally, and we've been talking about this ever since we launched the pilot in the first quarter of 2020 is that we're going to make sure this is working. We're going to add partners. So we've been creating, just like the SEN is a network, we've been creating a network of custodians and service providers with the idea that our customers can hold their Bitcoin with us and with one of our partners with whoever they choose, whether it's Bitstamp and the trading use case, Anchorage, Fidelity Digital Assets, Coinbase Custody, we've been creating this network so that our customers don't have to move their Bitcoin off one platform on to another. All they do is pledge it with us and then we'll lend them dollars.

Got it. And just any thoughts at around risk weightings on these loans? How that's impacting your appetite to, as you mentioned, to have these on the balance sheet versus not have your balance sheet?

Yes, it's a good question. We've -- these are currently risk-weighted 100% on our balance sheet in the risk-weighting category. And there was a proposal earlier this year, a Basel proposal that would suggest that digital assets should have a much higher risk weighting. But that's -- number one, it's a proposal out of Basel that would have to be adopted and then work its way through the U.S. regulatory system. But even if that was to happen because of our own internal concentration limit where we've currently said, we're not going to take this beyond 100% of our capital. And as you pointed out, we grew the book nicely in the third quarter, but it's still roughly about 1/3 of our capital in terms of commitments as of the end of September. So we've got a lot of room to go. Having said that, we've also been anticipating that as we approach our own internal limit, we'll look to move some of this off balance sheet. We will look for participants, and we can actually turn this into a little bit of an asset management line of business, where we're originating loans on behalf of others. And we continue to service them, clip a little spread and pass on a really nice yield to our participants.

Got it. And in terms of -- you mentioned the regulators and clearly, they were involved with this report that came out a couple of weeks ago. As you think about getting additional guidance from U.S. -- from banking regulators, where do things stand to the extent you can talk about it? And are we essentially in a wait-and-watch mode until all the banking agencies have new leadership and once in place before we get a lot more sort of visibility as a regulated institution to understand the rules of the game.

Yes, it's important to just -- if we step back just a little bit, there are clearly existing regulations on the books that we've been applying to this business for the last 8 years. So many of our customers are considered money service businesses. There is a clear regulatory framework for banking money service businesses. When we look at SEN Leverage aspect of our business, we look at that is collateralized lending. We have a license to lend. And so every time we look at launching a new product, we look at the existing regs, we look at how those regs will be applied. We look at legal permissibility. We then engage early with our own regulators and say, this is the opportunity. This is how we think it should be, how the regulations apply. This is how we're thinking about rolling it out. And that -- the regulators, by that engagement, it really allows them to then properly scope their exams. So when they come in, number one, they're not surprised. Number two, they can bring in their own subject matter experts from wherever in the country they need to draw them in order to look at the specific things that we're doing. And then to the extent they have incremental guidance for us, then we're very quick to adopt that. And it's been a really good kind of process over the last 8 years in building a really solid business with the existing regulations and then adapting as new regs come out.

Got it. I guess just shifting gears. We have 5 minutes to go. There's a lot of talk about digitization in all things, banking. Now clearly, for what you are doing, hyper-focused. Your clients are extremely sophisticated. The ecosystem around digital assets evolving very fast. Talk to us around investment dollars, where are you spending? What are the key sort of 1 or 2 priorities as you think about investment spend over the next year or two? Is it human capital? Is it technology?

Yes, it's a little bit of both. I'll turn it over to Ben in just a second to talk in a little bit more detail on this, but yes, we are -- we continue to add to the team. As Ben mentioned earlier, we did build the SEN, the API, that's our own tech. We own it as proprietary. And then as we roll out new things like SEN Leverage and the ability for our customers to actually advance on a loan 24/7. I don't know if there are many banks out there that can do that for an institutional player. Certainly, you can do with a credit card, but can you do it with a line of credit to an institution. So that marriage of the software engineering team, the project management teams and then building the tech. We're always on the lookout for acquisitions, and maybe I can ask Ben to talk a little bit about how we look at potential acquisition opportunities as well.

Yes. So on the acquisition side, I mean, it really is about -- it really comes back to solving problems for our customers. And so we're very product focused, and we're looking for those opportunities that you can almost think of them as bolt-ons to the SEN or things that interact with the SEN, where ultimately, 2 plus 2 equals 8. Obviously, there's not a lot of -- when you look at sort of what's happening in the broader market, tech firms are expensive and venture capital is abundant. And so -- but that said, we are very mindful of what our customers' needs are and how we might be able to solve problems for them. And so one of the points I wanted to make kind of as related to product is that prior to becoming a public company and really prior to the DM announcement, our history has been to sort of develop products in the backdrop, right? So when we built the SEN, kind of no one knew that the SEN was coming. When we were building SEN Leverage, no one knew that SEN Leverage was coming, and we were doing all of the difficult work behind the scenes with regulators, with attorneys, with software engineers, with the operational teams to get the product ready. And so I think it's an important distinction because a lot of times people look at Silvergate relative to other players in the digital currency space, who are making announcements all the time about the things that they're planning on doing 6 to 12 months from now. For us, our culture is a little bit different. And so similar to the way that we have built those things while being profitable, we continue to develop new products and think about it that way. And we talked a lot about stablecoin infrastructure so you can bet that we're working on that. We've also been talking about the trading vertical and how that -- those are really the customers that we serve today. And so we couldn't be more excited about what the next 6, 12, 18, 24 months looks like from a product perspective, but unfortunately, don't have anything to announce today.

That is helpful, Ben. And you mentioned DM. Give us an update in terms of your announced exclusive partnership, I think, back in May, where do things stand with that?

Yes. I'll -- we unfortunately don't have a specific update, but I do want to tie my response to what Ben was just saying because when you think about the way we used to do things prior to being public, as Ben said, nobody would know until we launched, right? And now we're in this position where as we were working earlier this year with DM, and we continue to work with them. But as we were working with them earlier this year and we started to get other participants involved, we collectively started worrying about, gosh, what if word gets out? We're a public company now. And so we essentially felt that in May that we were in a position to where we had to announce something so that we could make sure that we control the narrative and so that we didn't have rumors floating around out there. Having said that, we obviously announced it before we were ready to launch, and we were in dialogue with the regulators. They were already telling us that there was going to be this joint task force working on this. And so we're really excited to be at the point where that President's Working Group report is now out. Anyone that's read that report will understand that it essentially starts out by asking for legislation, but then goes on to say, in the interim, these are some of the things. And so we're focused on those interim steps, recognizing that legislation can take years. And so we wouldn't be talking about it with this much enthusiasm if we didn't feel like there is still a really prominent place for Silvergate to play as a regulated financial institution in conjunction with the President's Working Group on the stablecoin initiative. And unfortunately, we don't have anything more specific that we can say today.

Got it. I guess one last question, Alan. Turning out of time. But just give us a vision as we think about the next 3 to 5 years. Clearly, it seems like there's a lot in the works in terms of even the next year or two, the verticals you are building out, et cetera. As you think about the evolution of this platform, what does this look like a few years out? And do you see Silvergate potentially being a part of a larger institution? Just given the expertise that you have, I think that's going to be much sought after by larger players who are looking to play catch up.

Yes, that's a really fair question. And we certainly look at that question internally ourselves. We benefit from our size and the fact that we're nimble that we can move quickly that we can be responsive to companies like Coinbase and Kraken and Gemini and DM. And so in terms of the longer-term view, we are pretty transparent in terms of telling folks this is what we're working on. We think the stablecoin opportunity is huge. We think the institutional market of the crypto trading is -- that continues to grow. SEN Leverage, we're just getting started with that. And so we view this -- Ben was talking earlier about the way money moves, and a lot of us in the U.S. say, well, hey, I can transfer money right now with the Cash App or with Venmo. But we all know that there's a settlement that happens in the background, right? But with dollars on a blockchain is instant, it's 24/7. And so we feel really blessed to be at this point. And if we need to partner with somebody down the road or if someone is interested in partnering with us then we're certainly willing to have those conversations. But we are focused -- we're heads down focused on creating value for our shareholders and serving our customers and solving their problems.

At that, I'd like to thank you, Alan, Tony and Ben for taking the time and joining us. Have a great day.

All right. Thank you. It's great to see you.