There’s never a dull moment in crypto. Over the last couple of days there have been ups, downs, and plot twists that have kept us all on our toes wondering what would happen. In this post I will attempt to explain some of the context leading up to the Silicon Valley Bank fiasco, its consequences, and where we go from here.
Sometimes the events in the world of finance seem inspired by the dadaistic rants of a Lovecraftian deity with a propensity for humor and absinthe, in equal measures.
Just a few weeks ago, we were all talking about the maximum interest rates of central banks and how they affect the economy. Today we are wondering if we are facing a systemic crisis with the banking system at the epicenter, from regional banks in the United States to the hyper-regulated financial giants. In reality, these are two sides of the same coin. Or the same polyhedron. So let's take a moment to absorb the news.
Up until 24 hours before this writeup, SVB was a trusted 40-year-old California-based bank, popular among tech companies and venture capital firms. It had assets of around $200 billion and ranked 16th among US banks. So, when news broke about its collapse, it came as a shock to many startup founders. It must have felt like finding out that the Pope had secretly been running a nightclub during the weekends.
So, what happened?
The Bank For VCs And Startups
During the past golden years of cheap capital and the “everything bubble” era, SVB collected funds from venture capitalists and startups. With a seemingly endless supply of money flowing in, SVB invested in low-risk, but long-term, government and federally guaranteed mortgage bonds. So, even at a first glance, SVB had intrinsic concentration risks by collecting from essentially only one type of business client. As for the nature of their long-term investments, they were certainly considered safe but also had substantial duration risks.
After the tightening of monetary policy by the Fed and other central banks, the wonderful and voluminous world of whipped cream and cotton candy of start-ups and venture capital suffered a jolt: funding rounds became less frequent and valuations progressively diminished. This normally leads to down round sales.
The once abundant river of money flowing into SVB and other banks started to dry up, with data from the fourth quarter of 2022 showing a staggering 65% decrease in funding compared to the previous year, and at an all-time low since 2013. Meanwhile, start-ups continued to start up - i.e. burning through cash on investments, salaries, and founders’ lifestyles. This "cash burn" ultimately led to a decrease in deposits, even at SVB.
At a certain point, the bank found itself forced, in order to meet withdrawals, to sell some of its long-term bond holdings. The sale occurred at a loss, given that when market yields rise, bond prices decrease, especially for long-term bonds.
A Mismatch Of Deadlines
After the capital hole was discovered and communicated to the bank by rating agencies, SVB attempted a $2.5 billion capital increase. But, alas, it was all for naught. The ghost of future insolvency already began to whisper its dark prophecy to the ears of VCs, who have the same degree of objectivity and patience of a herd of terrified antelopes when their money is at stake. As a result, calls to withdraw money from SVB flooded in, resulting in a whopping $42 billion worth of deposits flowing out by the end of the day. A classic self-fulfilling prophecy.
With no white knight in sight to save the day, the capital increase was aborted, and panic spread like wildfire across the financial world, with a “flight to quality” and consequential yields’ nosedive. The California authorities finally stepped in, halting the bank while it was still open and putting the FDIC in charge of an extraordinary administration.
Starting today, account holders can withdraw up to $250,000 per account and receive an advance payment on the remainder based on the initial liquidation of assets. But let's be real, the remaining proceeds from the sale of assets - mainly government bonds and mortgage bonds - are going to be sold at market prices, which are much lower than the purchase prices. It's like buying a brand-new car and then crashing it the next day - the value plummets faster than a rock. And yet, in these hours of turmoil, everyone is scrambling for protection, driving up the prices of these assets.
Questions And Not Many Answers
Now that the dust has settled, we're left with more questions than answers.
Is the collapse of SVB really a systemic issue, or is it contained to just one institution?
It's too early to say for sure, but one thing is certain: the trust premium is going to be at an all-time high. Account holders will want reassurance, starting with regional banks, and this reassurance is going to come at a cost in the form of higher deposit rates. It's likely that interest margins will be compressed in the short term, at the very least.
But that's not all. The uncertain future of the startup industry is another pressing issue. With funding rounds becoming less frequent and valuations on the decline, the SVB collapse has only added to the uncertainty. Will the industry recover, or will it continue to spiral downward? It's a question that's on everyone's mind.
And then there's the potential risk to the banking system as a whole. SVB's collapse has exposed the lack of oversight and lobbying by regional banks for exemptions from liquidity regulations. This could have a ripple effect across the industry, as other banks scramble to make sure they're not caught in the same predicament as SVB. It's a wake-up call for the banking industry and one that they can't afford to ignore.
Why did SVB insist on keeping the bulk of their funds in long-term securities, even as the Fed started raising rates?
This looks like a clear case of mismanagement and poor decision-making, and one that SVB will likely regret for years to come. Those securities had very low coupons, and therefore very low income flows, destined to be overwhelmed by deposit costs. Ironic, considering that they boasted about practicing top-class risk management in their brochures.
Aren't there supervisory rules that control banks' liquidity?
Speaking strictly about the US, while supervisory rules do exist for larger banks, many smaller ones - starting with organizations at a regional level - successfully lobbied for exemptions from key ratios, such as the Liquidity Coverage Ratio and the Net Stable Funding Ratio (i.e. ratios requiring banks to maintain a minimum level of high-quality liquid assets and stable funding), under the Trump administration. If these guidelines had been followed, the maturity and liquidity mismatch that caused SVB's collapse may not have been as lethal. But now, we can expect a regulatory crackdown on regional banks too, as the consequences of such exemptions become more and more clear. Sadly, the horses will likely bolt from the stable before the regulators can even begin to close the door.
Besides SVB, who else is to blame for this mess?
Some might point the finger at central banks, who have tightened monetary policy in an attempt to regain lost credibility. It's a risky move that could lead to unpleasant consequences along the way - consequences that we may now be starting to see. While central banks may not be solely responsible for SVB's collapse, their actions and decisions certainly played a role in the larger financial landscape.
What will happen to the startup ecosystem in the wake of SVB's collapse?
At the ecosystem level, credit funds have already started to buy startup deposits at a steep discount. A natural secondary market for credit securities towards SVB is also likely to develop. But the effects of the collapse are already being felt beyond the borders of the US, particularly in the UK, where founders are panicking and calling for Treasury intervention. It remains to be seen what public role, if any, will be played as a lender of last resort.
DeFi Does Not Fix This (But RegDeFi Might)
Of course when we speak about the unforeseeable and unpredictable, crypto always finds a way to steal the headlines, with its baggage of mystical finance and liquidity curses.
Circle, the company that created and manages the USDC stablecoin, and shares most of the market with Tether, has announced that it has around $3.3 billion of reserves out of $40 billion stuck at SVB. The stablecoin must maintain a stable parity ratio with the dollar and invests reserves in short-term government securities and bank deposits. The quotation has fallen as low as 0.81 cents per dollar. Despite a quick recovery and the reassurances of Circle’s CEO, USDC is still trading at a big discount for a stablecoin, as the market is still uncertain about the direction that the FED will indicate.
This time, the situation is more complex because of the nature of the clients of SVB. The bank's depositors are mostly corporate clients, with 96% of deposits exceeding the $250,000 insurance threshold. Many startups may be unable to pay their salaries due to the lack of cash, depending on the diversification of their banking relationships, which tend to be limited. Distressed credit funds have already emerged to buy the deposits of startups at a more or less significant discount. A secondary market for credit securities related to SVB will likely develop, as it was clear from the market actions following USDC’s price discrepancies.
The weakness of USDC has bubbled to the surface all the limitations of the DeFi ecosystem, which underwent a systemic liquidity shock following its depegging.
Many DeFi protocols rely on USDC as collateral, and with the value of USDC dropping significantly, a wave of liquidations and a sudden shortage of liquidity was triggered, especially in decentralized money-market funds and DEXes such as Aave, Curve, or Kyber.
Moreover, the depegging of USDC highlights the need for a more decentralized and resilient financial system. While stablecoins are designed to maintain a stable parity ratio with fiat currencies, normally the US dollar, they still rely on centralized reserves held by trusted third parties. This creates a concentration risk that is antithetical to the decentralized ethos of DeFi.
To address these issues, and despite their history of insolvency and frailty, some have even suggested getting back to exploring algorithmic stablecoins.
As we reflect on the crisis that has befallen Silicon Valley Bank, it's worth considering how new technologies like RegDeFi could help prevent similar situations from happening in the future.
One of the key benefits of RegDeFi is that, like DeFi, it inherently helps in reducing concentration risk by leveraging the creation of a decentralized and global marketplace for a wide variety of user profiles to transact upon. However, unlike DeFi, RegDeFi’s goal is to bring bonds and other regulated assets to such a marketplace. With smart contract technology, parties can set up self-executing agreements that automatically execute when certain conditions are met. This could solve (or at the very least mitigate) any duration risk by ensuring that funding and bond maturities are better aligned, thus avoiding the risk of a sudden funding squeeze.
A final benefit of RegDeFi would be giving companies the option to custody their own assets. As it currently stands companies and users have no choice but to entrust their assets to banks. With RegDeFi companies would be to take advantage of autonomy and self-custody, and choose to lend out their assets if they wished and consciously take on that risk, rather than it being the only choice available to them.
While we at Dusk Network are working hard to launch a suitable RegDeFi protocol suite, we can analyze the current events and already draw some conclusions. As it appears, SVB’s demise was not due to a crisis caused by financial engineering on opaque products, but by a mismatch between funding and lending maturities, aided by regulatory loosenings on certain types of banks.
It is certainly a consequence of the rising market yields, one of the many we have seen and will continue to see in the coming weeks and months. There are reports of spillover effects on SVB's foreign branches, particularly in the UK, where founders are panicking and calling for government intervention which was eventually resolved with HSBC purchasing SVB UK for £1. The eventual public role as a lender of last resort should be observed as we start paying the costly bill for detoxing from easy money.
The US government has stepped in to backstop SVB and another bank, Sovereign Bank, was also shut down with the US government guaranteeing deposits there too. So for now, it seems like deposits will be able to access their funds, make payroll, and continue as before.
US bank stocks are heavily down on Monday 13th, with the trading of bank shares being halted at the moment. There is considerable turmoil and we’re all waiting to see how it plays out, and if there’s a swift recovery or not.
USDC is close to repegging and currently stands at around 0.99c, with Circle resuming redemptions in the morning.
It’s difficult to predict what will happen from here, but the markets are likely to be in for some turmoil, and a lot of people just remembered why Bitcoin was created in the first place.