Last week, Morgan Stanley analyst Ken Zerbe began covering the crypto bank Silvergate Capital (NYSE:SI) with an “overweight” rating, meaning he expects Silvergate to outperform the banking sector. The initiation of research coverage along with a rally in the cryptocurrency market boosted Silvergate shares by roughly 30% during the past week. Zerbe called Silvergate the “widest risk-reward” of any bank his team covers.
And it makes sense. Although Silvergate has a traditional banking license, its main business and draw for investors is its activities in the cryptocurrency market, which as we’ve seen during the past year can be volatile. But let’s dig into what Zerbe was referring to in his research and see if the risk is worth the reward.
Why Silvergate is a great banking business
Management at Silvergate saw what was going on in the cryptocurrency market years ago and had the savvy to realize that digital coins like Bitcoin (CRYPTO:BTC) would be an investable asset that would find its way into the financial system. Management also saw an opening in the fact that the U.S. doesn’t operate on a real-time payments system and that cryptocurrencies trade all day, seven days a week, 365 days a year.
So Silvergate built the Silvergate Exchange Network, a payments system to clear transactions instantly between any two parties on the network. As SEN adds more clients, most of which are institutional traders and crypto exchanges, its appeal increases because there are more parties on the network for conducting transactions. This platform proved to be a boon for the bank because customers on SEN bring lots of non-interest-bearing deposits to Silvergate that the bank can then use to originate loans or invest in securities. Silvergate is also able to sell other traditional banking services to these clients, such as standard currency transfers and foreign-exchange products. Over the past few quarters, the bank has also rolled out a product called SEN Leverage, which issues lines of credit collateralized by Bitcoin.
All of this has created a bank already turning a solid profit and that generates a lot of low-cost deposits, interest-earning assets, and potentially faster loan growth than the industry as a whole. The bank’s cost of funds, a key metric bank investors look at, is just 0.01%, meaning the bank practically gets all its deposits for free. This deposit base should prove a lot more valuable for Silvergate as interest rates rise and banks start to compete more intensely for deposits because SEN customers didn’t come to Silvergate seeking yield on their deposits in the first place.
Fee income in the second quarter of this year increased 371% from a year earlier, and total deposits have grown to $11.3 billion. Deposits come in so fast that the bank had only about 13% of its deposits into loans at the end of the second quarter, which is practically nothing. The bank has soaked up some of this excess liquidity by…