In the space of a single week, three U.S.-headquartered banks collapsed, prompting concerns of a banking crisis and the potential for another global financial crisis. Now the dust has settled and concerns of a collapse in the banking industry have been quelled, we are better positioned to assess what caused this, what can be done going forward and crucially, explore the burning question: was crypto to blame?
Given that Silicon Valley Bank (SVB) was the largest of the three banks to fail, the 16th largest bank in the US, and the largest bank to fail since the 2008 global financial crisis, we’ve used them as our focus to unpack these issues.
What happened to SVB and what was crypto’s role?
SVB had a reputation for being the bank of choice for tech firms. Indeed, a large proportion of its customers were in the tech sector, and many of them were in Northern California. However, it is a stretch to say that it was the bank of choice for crypto firms more specifically. In fact, SVB had long resisted taking on crypto firms and only took on some of the larger, more established firms such as Circle or those that came out of Y Combinator with whom there was an affinity.
That being said, it is accurate that the two other banks that collapsed that week, Signature and Silvergate, both had a number of cryptoasset firms as their customers. Silvergate’s exposure to FTX was part of the reason why it went into administration and wound down its services. It is important to note here, FTX plays a large role in the response to this as its collapse has had a lasting effect on US policymakers and regulators but also on market participants. While SVB were not directly affected by this, many still blamed crypto for SVB’s failure - but in fact there were a number of reasons that contributed to its collapse:
Concentration risk: SVB’s intense focus on the tech sector itself created a significant risk. It provided a large percentage of its banking services to one sector and in addition to this, a number of their customers were in the same region, which led to two key traits. The success of SVB was largely pegged to the tech sector. As the sector grew and received more investment so too did SVB, leading to it quadrupling in size in the space of six years. The secondary aspect of this is that its clients did not need to take out loans. With investment flowing in and the industry booming, there wasn’t a demand on SVB to be handing out loans to make use of all the cash that it had. Instead SVB opted to put its cash into US Treasury Bonds.
Investment strategy: Whilst US Treasury Bonds are not a high risk strategy – they are generally considered as safe – SVB had opted to go long on these bonds and hold them until maturity, perhaps to make use of better yield. However, this strategy did not take into consideration that the Federal Reserve (the Fed) may increase interest rates during the period that the bond was fixed, which in itself was risky given the historically low interest rates at the time. As such, when interest rates did go up, the value of the bonds fell, presenting in effect a loss of around US$21 billion. Given the fact that SVB held these bonds to maturity, the drop in value was not something that turned up on the its balance sheet. However, during an investor call when SVB had highlighted that they had a large exposure to US treasury bonds, there was widespread concern and customers pulled their money out, forcing SVB to sell the bonds early to be able to free up cash – thereby crystalising this loss.
Tech-enabled panic: SVB’s unique make up of a high concentration of one sector and one region resulted in news of this travelling fast. This, coupled with the use of social media and digital banking created a run on the bank like no other. One third of deposits into SVB were pulled out in one day. Whilst the run on the bank in 2008 used technology, it was nowhere near as quick as what was witnessed with SVB and it still required people queuing up and submitting requests. Here it could all be done online and instantaneously.
Deposit concentrations: Another unique feature for SVB was that 94% of its depositors has more than US$250k and therefore were not covered by the Federal Deposit Insurance Corporation. This is a remarkably high number meaning that SVB were exposed to a run and customers were not protected.
These events amount to a mismanagement of the bank through a cocktail of errors, so where does crypto come into this?
SVB did bank Circle, which held around 8% of their reserves or US$3.3 billion with them. This had a significant impact on the confidence in USDC, Circle’s stablecoin. Despite the transparency of where funds were being held, concerns hanging over from the collapse of Terra Luna, an algorithmic stablecoin, the loss of funds during the collapse of FTX and a general concern that a banking failure could put funds at risk, saw people move their funds out of USDC. As such, USDC lost its peg moving to 88 cents on the dollar. Reports of this did bring crypto into focus and people saw crypto’s involvement and were quick to point the finger. Many also considered that this would start a chain reaction of a collapse in the industry but if this were the case it would have been crypto’s exposure to traditional finance that caused the collapse as opposed to the other way around.
What has been the response so far and how will it affect crypto?
As can be expected, there were a range of responses following the collapse, including:
Those who do blame crypto: When the Fed put conditions on the sale of Signature Bank, which prevented any bid from taking on the cryptoasset part of the business,[1] many considered that the same attitude would need to be taken on SVB with concern around what exposure SVB had to crypto and growing fear of what contamination risk can come out of the traditional banking sector integrating with crypto.
Those who blame SVB leadership: That being said, many were quick to point out that this was a consequence of poor management on the behalf of SVB and that there was a lack of strategic thinking and diversification of clients. Reports suggested that many, including overseas regulators, had warned of what was likely to unfold and still nothing was done.
And the role of (de) regulation: There are others who blamed deregulation under the Trump administration for this. The administration rolled back regulatory requirements under Dodd Frank which required banks holding assets in excess of US$50 billion to have to adhere to stringent regulations such as annual Federal Reserve stress testing and maintaining certain levels of capital and liquidity to ensure that there is not a systemic failure. The new 2018 Law, enshrining this, increased this threshold to US$250 billion, to improve competition in the market and take the regulatory burden off of smaller banks, such as SVB. Within the new law, there is a provision that the Fed had the right to choose to apply the regulation to certain banks that had at least US$100 billion in assets and they would still face periodic stress tests.
In 2016, SVB was below the US$50 billion threshold and by the time of its collapse was just short of the US$250 billion threshold but was well above the US$100 billion threshold for the Feb to be keeping an eye on them.
Although there is no way of knowing whether the collapse would have been prevented should deregulation not have taken place, it is reasonable to assume that had SVB been under the additional requirements under Dodd-Frank, these issues may still not have been addressed. While the stress tests would have simulated a recession, it may not have caught what impact a sharp rise in interest rates would have had on SVB. Noting this, this may lead to calls for stronger measures and stricter rules for stress testing to cover a wider range of measures. In doing so, it could lead to knock on effects for the cryptoasset industry. The concern is that by introducing tougher banking rules, it will increase the compliance cost for banks and squeeze out smaller banks who are not able to cope. This in turn leads to fewer banks but also leads to higher scrutiny and greater caution. This could result in banks being less willing to offer banking services to crypto firms and further reducing services for crypto firms. This in itself creates an issue as it once again leads to a concentration risk in a small number of banks that do offer this service.
To compound the issue, strong rules from the Basel committee around holding crypto funds, requiring banks to hold a 100% risk weighting of the digital assets that they hold in fiat, makes it incredibly expensive for them to hold cryptoassets which in itself makes it difficult for banks to interact with the industry. This is a key obstacle to overcome and sets the tone for the industry and could lead to crypto being squeezed out of the traditional financial services sector or concentrated to just a few firms.
The debate over regulation moving forward
There is push back on the need for more regulation. Questions are raised as to why existing powers were not better utilised to notice the shortcomings of SVB. Regulators could have used existing tools that they had in order to be able to detect the concentration risk in location and sector of the bank or the exposure that SVB had to long term bonds. Had this had been done, there could have been a different outcome.
As mentioned earlier, a defining feature of the collapse of SVB was that in the digital age withdrawing funds is a lot easier. Whilst much of this was still available in 2008 financial crisis, the speed of withdrawals was much faster with SVB. Rather than having to queue up to take out money, people were able to move their money almost instantaneously creating a run on the bank quicker than ever seen before. It is imperative to learn from this and understand what is required of a regulator and what is required from the bank to be able to safeguard both the business and the consumer.
One area of potential reform is assessing whether the existing reporting requirements and tools available to regulators are sufficient. The industry has evolved and it is clear that the tools that regulators have are not fit for purpose. For example quarterly reporting is not sufficient, the markets are moving much faster and data that is 3 months old is no longer good enough – banks are more dynamic than that.
The natural response is to say more reporting and stricter requirements. However there is a case to be made for integrating the very technology that regulators are concerned by. Regtech solutions are vital if we are to be on top of these things in the future. Crypto has taught us of the benefits of reg tech and solutions that allows for real time monitoring and analysis and these solutions need to be implemented with regulators to ensure that they are able to detect and prevent occurrences. This will continue to allow for the growth of finance but ensure that there is a robust approach in place.
What does the future hold for crypto?
As well as the regulatory response, it is interesting to see the response of the crypto community. In the aftermath of the collapse and the realisation that Circle held a large amount of client funds at SVB, many customers removed their funds from Circle and instead moved it to their own private wallets. This was an interesting trend which gives an indication of consumer sentiment. FTX certainly would have been on the mind of users. Where there is a lack of trust in custodians and more issues occur around centralised exchanges will we see more of a movement towards self-hosted wallets? To amplify this point, there is also a growing amount of investment into self-hosted wallets. This raises a number of regulatory questions around the treatment of self-hosted wallets should there be an increase in transacting through these wallets. Recent regulatory responses such as the EU’s AML package tries to limit the interaction of traditional financial institutions with self-hosted wallets; however, this may have to change if there is a large movement of people to self-hosted wallets.
Regardless, in Silvergate and Signature Bank, crypto lost two big banks which gave them access to banking services. This will affect the On and Off ramps into the traditional finance world and it will be something that will either hurt the industry or lead to more being retained in the ecosystem.
As noted above, reducing the access to banking services will lead to a concentration in a handful of banks. It is prudent practice to diversify where the deposits are kept, however this will not be the case if there are not enough banks and it will lead to situations similar to SVB where there is a concentration risk for crypto themselves. Regulatory requirements should be put in place that ensure protection but give confidence to banks to offer services to cryptoasset firms. There is a clear desire to do so and capitalising on this will unlock the industry. Perhaps in doing so there will be a greater comfort around the technology which can deliver the tools required to better monitor the market and provide better regulatory outcomes whilst enabling a growing industry.
[1] Whilst there has been disputes as to whether this was in fact the case