Over the span of just one week, two U.S. banks, Silvergate Bank and Silicon Valley Bank (SVB), have experienced one crisis after another. The contagion caused a third bank, Signature Bank, to experience a run and eventual closure by U.S. regulators. Given Silvergate Bank’s relatively friendly posture towards cryptocurrency businesses and SVB’s partnership with Circle, a major issuer of the U.S. dollar stablecoin USDC, many mistakenly believe that this crisis was first triggered in the cryptocurrency space and then propagated to the traditional finance space. The truth quite likely is the opposite.
The events that transpired could well represent a systemic crisis in the banking system, and the extreme scenario could mean a further spread of panic, bank runs and even bank failures.
What has to prevail at this moment is a dose of rationality, simply because markets have a tendency to spiral out of control under irrational conditions, manifesting into reality the worst-case scenario that could well have been avoided. Having a macro perspective will help us understand the full picture and instill rationality.
Alarm bells from the bank collapses
Silvergate, SVB and Signature are not likely the only banks to go through difficulties by the time you read this. It is possible that many commercial banks are facing similar pressures, and we might see more banks experience distress.
Whether traditional or blockchain finance, this crisis is relevant to everyone. The biggest focus at the moment is not how to opportunistically capitalize on movements in the markets (as some inevitably do), but think about how operators of exchanges and other market players can maintain services and operations and ensure that user assets are properly protected should the worst-case scenario materialize.
If the cryptocurrency industry is not the root cause of this crisis, what is?
Since the global financial crisis in 2008, we have seen a significant increase in government intervention. The most recent example is the unprecedented money-printing in response to the impact of the Covid-19 pandemic. It’s inevitable for all these interventions to be free from side effects.
The root of the current crisis goes back to 2008
In 2008, the mass default of subprime mortgages triggered the most severe global economic crisis since the Great Depression of 1929. Against this backdrop, the government decided to intervene heavily with fiscal and monetary policies. The usual way to regulate the economy is through fiscal policy, which includes increasing government spending and reducing taxes as leading measures. If that fails, monetary policy is then used. The two major tools of monetary policy to regulate the economy are adjusting interest rates and adjusting the money supply.
In response to the 2008 financial crisis, two rounds of quantitative easing (QE) policies were introduced — injecting a massive amount of money supply into the market and directly lowering interest rates to almost zero. It achieved a certain level of hemostasis but also opened Pandora’s box of woes.
The first two rounds of QE not only achieved their objectives but also did not trigger hyperinflation. Instead of gradually retrieving the excessive funds flooding the market and allowing the market to return to its proper state where the market mechanism acts as the main force, the government became addicted to this approach. With an added incentive of the election, it implemented a controversial third round of QE in September 2012.
The pandemic that caused an economic standstill
The U.S. had hoped to use QE to reverse high unemployment and accelerate domestic economic growth. As long as the global economy recovered, financial markets would become active, and the U.S. unemployment rate would effectively decrease, leading to a restoration of prosperity.
Initially, this decision worked, and in the years that followed, the U.S. had begun to clean up after the third round of QE. However, the Covid-19 pandemic caused a sudden halt to the global economy. To prevent a comprehensive economic collapse, the U.S., having limited room for resuming the clean-up, had to implement a fourth round of QE.
The fourth round of quantitative easing that made clean-up costly
The consecutive four rounds of QE caused a serious overflow of funding in the financial market, and signs of inflation began to emerge. If the funds are not effectively retrieved, it could escalate into uncontrollable hyperinflation. This is also the beginning of the shift from “unbounded money-printing” to today’s “interest rate hiking.” In March 2022, the U.S. Federal Reserve radically began to raise interest rates and simultaneously released the message to the market that they would hike interest rates until the problem is solved.
In less than a year, the Federal Reserve has raised interest rates eight times, a total of 450 basis points, and has raised interest rates from near zero to almost 5%.
|Time||Interest Rate Hike (unit: Bps)||Interest Rate Range|
Unbounded borrowing and risk of default
The U.S. Treasury’s national debt reached the statutory limit of US$31.38 trillion in January. Currently, Congress is pushing to “cancel the debt limit” and warning that if this does not come to pass, the U.S. will be unable to fulfill its debt obligations and face an imminent risk of defaulting. Banks are the most important part of the government’s overall financial and monetary policy, and they directly participate in the bidding for government bonds.
This is where the bankruptcy crises of Silvergate and SVB played out most substantially.
National debt and rising interest rates exerting pressure on commercial banks
Unlike investment banks, commercial banks profit from the “interest spread” between deposits and loans, and not necessarily from investment returns. Customer deposits constitute the main liabilities of commercial banks, and in order to cope with withdrawals, they must maintain a certain proportion of their assets being highly liquid at any one time.
Commercial banks typically do not invest heavily in long-term bonds. But the series of QEs by the Fed led to a decrease in bond interest rates, making short-term bond rates relatively unattractive. On the other hand, long-term treasury bonds provided better interest rates, thus incentivizing commercial banks to shift their positions. However, when the Fed subsequently turned hawkish and pivoted to raising interest rates, lending rates rose and bond prices fell. The longer the bond tenure, the greater the downward pressure of rising bond yields on bond prices.
The unprecedented speed of the Fed’s interest rate hikes is thus quite likely the main contributor to the bankruptcy crises of Silvergate and SVB.
Against common sense: holding a large amount of long-term bonds
According to Silvergate’s report, they have gradually invested up to 80% of their deposits in long-term bonds, with the vast majority surprisingly being bonds with a maturity of over 10 years. SVB’s data showed that they have sold all the bonds that can be sold, worth US$21 billion, and recognized a loss of US$1.8 billion, most of which are U.S. government bonds.
Such moves quite obviously go against common sense, especially in the case of Silvergate, which is not known to be a particularly risk-inviting bank.
Also, because U.S. Treasury bonds can be recognized as “hold to maturity” (HTM) securities, mark-to-market losses do not have to be recognized in quarterly financial reports. As long as Silvergate could ensure smooth withdrawals and transfers for their customers (i.e., do well in liquidity management), they could have potentially obtained higher returns through their long-term bond holdings.
However, rapid interest rate hikes placed pressure on corporate customers, amplifying liquidity demand for customer deposits, and increasing the default rate of outstanding loans. A series of blows forced Silvergate to liquidate these HTM bonds at market prices, resulting in instant recognition of losses. Ultimately, the accumulated losses had become so severe that bankruptcy was the only option.
Is the cryptocurrency industry to be blamed for all of this?
FTX’s collapse caused a panic selling of cryptocurrencies, even to the point of converting stablecoins back to U.S. dollars. Although this indirectly caused a run on the banks, it was a known risk accepted by the banks when they took on cryptocurrency businesses. When the cryptocurrency industry is stable, it also creates the most stable source of deposits for these banks, many of which also require high management fees to be paid separately.
The crises at Silvergate and SVB are not directly related to cryptocurrency. The cryptocurrency industry, along with many other businesses and individuals who have money stored in these two banks, are all victims. During this crisis, USDC issuer Circle faced enormous market pressure due to it being one of SVB’s depositors.
Many point fingers at the cryptocurrency industry when crises like this break out. This is due to a lack of understanding of the global financial changes since 2008, as well as misunderstandings and biases against the cryptocurrency industry.
What can the cryptocurrency industry do now?
This is not another FTX crisis, as it arose from traditional finance. However, since we are unable to isolate ourselves from the global economy, it is important that the crypto industry stays rational and avoid FUD (fear, uncertainty, doubt).
The root of the problem lies not in USDT or USDC, but in traditional banks being affected by systemic risks. To a larger extent, most U.S. commercial banks are facing the same risk, not just banks that have a friendly attitude toward the cryptocurrency industry. While commercial banks at the front line need to bear the most direct responsibility, the potential collapse of the entire system is the biggest problem. We cannot afford to wait until a longer chain of bank failures happens. We need rational, correct and speedy government actions.