May 15, 2020 | 2:00 PM by Jay Kunstman | jkunstman@jaguaranalytics.com

Silvergate Capital (SI) – California Crypto

California-based Silvergate Capital is a provider of financial infrastructure solutions and services for the growing digital currency industry.

This stock appeared on my radar this week after reports surfaced that JPMorgan (JPM) was set to take on two bitcoin exchanges (Coinbase and Gemini Trust) as banking customers, the first time the bank has approved customer accounts related to crypto currencies. According to the reports, JPMorgan is primarily providing cash-management services and handling dollar-based transactions including wire transfers, ACH and deposits.

Keefe Bruyette & Woods analyst Michael Perito was out with a note shortly after this announcement commenting that while the headline might initially be perceived as a net negative for Silvergate due to the potential for increasing competition, they think there are a few angles to consider here:

• For starters, JPMorgan is banking two of the larger and most highly regulated crypto exchanges, which doesn’t necessarily mean the bank has interest in targeting all institutional crypto industry participants such as Silvergate.

• Secondly, KBW believes another more established entrant into the space provides further validity to the crypto currency asset, which longer term supports Silvergate’s business model and increases franchise value.

• Lastly, these two larger customers have not left the Silvergate Exchange Network (SEN) or closed their accounts with the bank, with these actions likely either part of broader diversification efforts by the exchanges or a greater focus on retail customers. As a reminder, Silvergate doesn’t do any transactions with retail participants, with a singular focus on institutional clients given the better transparency related to BSA/AML and other due diligence issues.

Turning our focus back to the company’s Exchange Network, KBW said after meeting with management earlier this month that the most critical element of the Silvergate story at this phase is additional efforts to monetize the network. Over the past couple of years (2018/2019), the bank made several investments to add new products and services to its platform, with non-interest expense growing 59% and 9%, respectively. “We think the bank seems closer to more significant revenue recognition in 2020 from these prior investments, as it can continue to add customers to the SEN with minimal incremental investment (albeit continued technology and due diligence costs).” The three most significant revenue opportunities based on our meetings include:

1) Its recently launched FX platform
2) SEN leverage
3) Opportunities for products and services related to Stablecoin.

Management provided an interesting anecdote that digital currency customers don’t have traditional prime brokerage services, with SI trying to fill this hole. Silvergate already provides banking products and services to regulated Stablecoin issuers in the United States, but there continues to be a lot of activity in this area. “With interest rates falling to zero in Q1, management believes the business model for these Stablecoins might have to change since they rely on holding reserves and making a yield off the spread. For now, it seems the bank is content to offer cash management services in this arena, although clearly has a close eye on the longer-term market opportunity and how additional revenues could be made given the bank’s exchange network.”

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