XREX | Closure of Silvergate and Silicon Valley Bank Could Trigger Chain Reaction! Understanding the Causes and Predictions at Once

This article is authorized to be reprinted from Winston Hsiao, Co-founder and Chief Revenue Officer of XREX

In just one week, two American banks, Silvergate Bank and Silicon Valley Bank (SVB), have faced crises. Silvergate Bank is known to be relatively friendly towards cryptocurrency businesses, and SVB is one of the banking partners of Circle, the issuer of the global major stablecoin USDC. Many people mistakenly believe that this crisis is from cryptocurrency burning towards traditional finance, but in reality, it is the opposite. Moreover, this is a systemic crisis within the banking sector, and the worst-case scenario could lead to panic, a run on banks, followed by a series of bank failures.
We have received many inquiries from investors, users, and friends. What we need most now is rationality because markets are most prone to losing control in irrational situations, leading to the unavoidable worst-case scenarios. Therefore, through this somewhat lengthy post, I hope to explain the ins and outs of the situation and how blockchain financial institutions like XREX Exchange assess, analyze, deduce, and respond.

Silvergate and SVB Collapse: What Does It Signal?

First and foremost, I must say that the ongoing crisis appears very pessimistic. I have deep concerns, and Silvergate and SVB are definitely not the only ones. I believe many commercial banks are facing similar pressures, and it is highly likely that we will see more banks experiencing difficulties, triggering a domino effect, which is something we do not want to see.

As a co-founder of XREX Exchange, even though we are not exposed to Silvergate and SVB, we always imagine and simulate extreme scenarios based on the information we have and have activated appropriate risk control measures. Frankly speaking, what we are most concerned about at the moment is not dealing with the existing information seen in the news or markets, but rather how, as exchange operators, we can maintain service and operations if things deteriorate to the worst-case scenario, ensuring the most proper protection of user assets.
As I mentioned at the beginning, the crisis at Silvergate and SVB is not caused by the cryptocurrency industry. What is the main cause? It is the risk control and asset allocation of traditional banks, and what directly affects all this is the crazy interest rate hikes by the Federal Reserve of the United States over the past year.

I have previously mentioned in the "Web3 DaXiJin" podcast that finance is finance, whether it is traditional finance or blockchain finance, and this crisis is relevant to everyone. With an economics background, before delving into this discussion, I want to quote two famous economists from different schools of thought: one is Adam Smith of the classical school: "invisible hand," and the other is Keynes of the Keynesian school: "In the long run, we are all dead."
These two sentences cleverly illustrate the contradictions we are facing today, the struggle and balance between "free markets" and "government intervention." This article is not written for the blockchain industry but for the cause and effect that we all need to be highly alert to, and the impact of all this on tomorrow's finance and economy, with cryptocurrency players being just one role in it.

Market Mechanism: The Invisible Hand

Adam Smith advocated that in conditions of perfect competition, the economy operates without the need for government intervention because government intervention is not a natural product, and it may temporarily solve current problems but not address the root cause. Everything should return to the free market mechanism. The classical school believes that as long as market information is fully transparent and free, producers and consumers will pull each other in pursuit of maximizing their own interests, and all supply, demand, and prices in the market will rely on the invisible hand of the market mechanism to control and balance, ensuring the full and proper allocation of resources and achieving the goal of national prosperity.

Economic Crisis Requires Active Involvement of Fiscal and Monetary Policies

Unlike the classical school, the Keynesian school, led by Keynes, believes that in times of economic crisis, the government should intervene actively, using its fiscal and monetary tools to interfere. Although this may result in budget deficits during the intervention process, once the problem is resolved, tax revenues will increase, resolving the deficit problem naturally.

This is also why Keynes has the famous saying "In the long run, we are all dead." He believes that leaving the free market to self-heal, although may have fewer consequences, will cause suffering to people at the moment, and since everyone is living in the present, in the long run, we are all dead. Therefore, the function of the government is to focus on solving the economic crisis we are facing.

The market mechanism and government intervention will always be a tug-of-war without a conclusion. Since the global financial crisis in 2008, we have seen a sharp increase in government intervention, the most recent being the unprecedented massive printing of money due to the impact of the COVID-19 pandemic. These doses of medicine are not without side effects, and until now, we are discussing the crisis of top-performing banks like SVB without warning, all related to these events.

It is only by looking back at the roots of yesterday that we can understand what we are truly experiencing today and what kind of tomorrow we are facing.

The Root of the Crisis: Talking About the 2008 Global Financial Crisis

The crisis of Silvergate and SVB banks, in my opinion, must be traced back to 2008. The subprime mortgage crisis at that time, triggered by cascading debts, caused the most severe global economic crisis since the Great Depression of 1929. Several historical banking giants such as Lehman Brothers, Merrill Lynch, and Bear Stearns faced liquidity crises, bankruptcy, takeovers, and acquisitions, leading to the instantaneous collapse of the global financial order. The shock caused by Iceland's national bankruptcy crisis in that year is still vivid in our memories.

It was against this backdrop that the government decided to intervene heavily with fiscal policy and monetary measures. The usual way to regulate the economy is to prioritize fiscal policy, meaning the government would lead with "increasing government spending" and "reducing taxes." If this does not work, then monetary policy is employed. Monetary policy to regulate the economy involves adjusting interest rates and the money supply. Since 2008, these terms should be well known to everyone, determining whether the Federal Reserve will be dovish or hawkish, how many basis points to raise interest rates, and the speed of interest rate hikes, all affecting stock markets, foreign exchange markets, currency markets, and various market reactions.

From shallow to deep, even the most influential U.S. government can only intervene in the most extreme ways, including:

• Injecting an unlimited amount of money into the market
• Arbitrarily adjusting interest rates between two extreme values, one being zero
• Directly acting as the banker in credit and asset market transactions
• Endless borrowing

All of the above, we have witnessed in just these few years.

The two rounds of quantitative easing (QE) in response to the 2008 financial crisis achieved a hemostatic effect within a certain range but opened Pandora's box of this dangerous weapon. Essentially, QE involves injecting a massive amount of money into the market, directly lowering interest rates to near zero. If not properly controlled, this could lead to runaway inflation.

Fortunately, the implementation of the first two rounds of QE not only achieved their goals but also did not trigger high inflation. Ideally, it was time to exit and tidy up, gently retrieving the excess funds from the market to restore the appropriate mechanisms. Unfortunately, the government, seizing the opportunity with elections looming, chose to implement the third round of QE in September 2012, which remains controversial to this day. Unexpectedly, the outbreak of the COVID-19 pandemic in 2019 occurred.

COVID-19 Causes Instant Economic Standstill

The COVID-19 pandemic made the third QE launched by the United States a doomed gamble. The U.S. had hoped to use QE to reverse high unemployment rates and accelerate domestic economic growth. The plan was that as the international economy recovered, financial markets would become active, the U.S. unemployment rate would effectively decrease, and everything would return to prosperity.
This decision initially worked, and the U.S. began to handle the aftermath of the third QE. However, the global economy came to an instant halt due to the COVID-19 pandemic, and the accumulated problems from three rounds of QE were like being caught off guard without time to prepare, forcing the implementation of the fourth QE to prevent a complete economic collapse.

From Mild Aftermath to Bloodshed: QE Transformation

The successive four rounds of QE have led to a severe excess of funds in the financial markets, showing signs of inflation. If funds are not effectively recovered, it could escalate into uncontrollable hyperinflation. This is why we have transitioned from "crazy money printing" to the current "crazy interest rate hikes." In March 2022, the U.S. Federal Reserve radically began the process of raising interest rates, simultaneously signaling to the market a message of "raising interest rates infinitely until the problem is resolved."

Looking back less than a year, the Federal Reserve has raised interest rates 8 times, totaling 450 basis points (25 basis points per notch), pulling interest rates from near zero to close to 5%:

• 2022-03-17: Raised by one notch to 0.25%–0.5%
• 2022-05-04: Raised by two notches to 0.75%–1.0%
• 2022-06-16: Raised by three notches to 1.50%–1.75%
• 2022-07-28: Raised by three notches to 2.25%–2.5%
• 2022-09-22: Raised by three notches to 3.0%–3.25%
• 2022-11-03: Raised by three notches to 3.75%–4.0%
• 2022-12-15: Raised by two notches to 4.25%–4.5%
• 2023-02-02: Raised by one notch to 4.5%–4.75%

Unlimited QE Requires Unlimited Borrowing

The U.S. Treasury's national debt reached the statutory limit of $31.38 trillion in January this year. Congress is currently pushing to "eliminate the debt ceiling" and warning that failure to pass it would increase the risk of default for the U.S., as banks play a crucial role in the overall financial and monetary policies of the government and directly participate in the bidding of public debt. Starting from this point is what we are witnessing today with the bankruptcy crisis of Silvergate and SVB.

National Debt and Interest Rate Pressure on Commercial Banks

Commercial banks and investment banks are different. The business focus of commercial banks is to attract customer deposits, provide interest, and use funds to issue loans, which is the core of the monetary market. In other words, the main profit of commercial banks comes from the "interest spread" between deposits and loans rather than investments. In this profit model, the assets and liabilities of commercial banks mainly consist of customer deposits. To cope with the demand for instant withdrawals from savings account holders, they must maintain a certain proportion of liquid assets.

Generally, commercial banks do not heavily allocate their investment positions to long-term bonds. However, due to the Fed's QE leading to lower bond interest rates, short-term bond rates are not attractive. In this situation, long-term government bonds offer better rates, prompting commercial banks to shift their positions to long-term government bonds. But as the Fed enters an interest rate cycle, market rates rise, causing bond prices to fall. The longer the maturity, the more the price is affected by bond yields. The unprecedented rate hikes by the Fed have directly led to the bankruptcy crisis of Silvergate and SVB banks.

It is possible to say that this is also due to inadequate risk control by the banks. However, bank investments and risk control are mostly based on historical data for judgment. The extreme measures taken by the Federal Reserve have no precedent, making judgment deviations inevitable. Moreover, this time, the issue is not with banks with poor credit ratings and past poor performance but with traditional financial top performers like SVB.

Silvergate and SVB Holding a Large Amount of Long-Term Bonds, Defying Logic

Based on Silvergate's report, they have gradually used up to 80% of their deposits to purchase long-term bonds, with a significant portion being bonds with a maturity exceeding 10 years. According to SVB's current data, they have sold all sellable bonds, valued at $21 billion and recognized $1.8 billion in losses, most of which are U.S. government bonds.

Objectively speaking, this is illogical, especially in the tragedy of Silvergate. Any banker with a bit of common sense would not make such a move, let alone the fact that Silvergate is not inherently a daring bank.

Also, because U.S. government bonds can be recognized using the Hold to Maturity (HTM) method, without having to recognize losses based on market value in every quarterly financial report. Therefore, in Silvergate's strategy, as long as they can ensure the smooth operation of client withdrawals and transfers, that is, good liquidity management, they can obtain higher returns through long-term bonds.

However, this favorable plan was crushed by the crazy interest rate hikes. The pressure of rate hikes on corporate clients increased, the liquidity of customer deposits became higher, and the default rate of loans issued increased. A series of impacts forced Silvergate to liquidate these HTM bonds at market prices for repayment, instantly recognizing losses, and ultimately unable to produce financial reports because the accumulated losses had reached a point where liquidation and bankruptcy were inevitable.

Is All of This Caused by the Cryptocurrency Industry?

From the previous discussion, it should be clear to everyone that the crisis at Silvergate and SVB and the cryptocurrency industry are not directly related. In fact, it should be said that the cryptocurrency industry, like many other businesses and individuals who keep their money in these two banks, are victims as well.

Although the closure of the world's second-largest exchange, FTX, caused many to panic, sell off cryptocurrencies, and even convert stablecoins back to USD, indirectly causing a bank run on these banks, this is a characteristic of the cryptocurrency industry that banks are aware of when undertaking related business. When the cryptocurrency industry is stable, it also provides these banks with the most stable source of deposits, with many even having to pay high management fees to the banks.

Unfortunately, when such a crisis erupts, many opinions tend to blame the cryptocurrency industry, partly due to a lack of understanding of the global financial changes since 2008 and partly due to misconceptions and biases against the cryptocurrency industry. The crisis has put pressure on USDC issuer Circle because it is a depositor of SVB, facing immense market redemption pressure. However, the recent instability of USDC in the past week was actually caused by banking issues. On the other hand, as soon as Silvergate went under, many immediately labeled it as a "cryptocurrency bank," which is not only unfair to the cryptocurrency industry but also makes it easier to misjudge the ongoing financial crisis.

What Can the Cryptocurrency Industry Do Now?

From a macro perspective, I would like to appeal to everyone not to FUD (Fear, Uncertainty, Doubt) because we know very well that this crisis comes from traditional finance, and the cryptocurrency market is affected, but since we are also part of the global economy and finance, we cannot be completely isolated.

If you want to hedge or get rid of stablecoins like USDT and USDC out of fear, under permissible conditions, you can exchange USDT and USDC for mainstream cryptocurrencies like Bitcoin or Ethereum. This can reduce the redemption pressure on Circle and Tether, the two stablecoin issuers, and prevent them from forcing bank runs. As I mentioned at the beginning, I believe that many commercial banks are currently facing some degree of difficulty, and I do not want to see a dramatic chain of bank failures.

This time, the collapse crisis of Silvergate and SVB is different from the previous incident at the FTX exchange. The root cause is not USDT and USDC, but the traditional banks encountering systemic risks that have affected them. As an exchange operator myself and a believer in blockchain technology, I certainly do not agree with the trouble that banks have caused today. However, I believe that both Circle and Tether are actively addressing the issue, but their capabilities are indeed limited, and the banks' assets are still there; it just takes time to regain stability.

This problem is definitely not unique to banks that have a friendly attitude towards the cryptocurrency industry, but rather to a large part of U.S. commercial banks that have done the same things. This is a systemic problem, and while commercial banks are at the forefront and need to take direct responsibility, the collapse of the overall system is the biggest issue. I believe and hope that the government must take correct and timely action because we really cannot afford a dramatic chain of bank failures before rational, correct, and swift government action is taken.