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#46 - Form letters, yet another meltdown, and a cookie market

I’d planned for a very different newsletter this week, but Things Happened. As the poet says: “Everybody has plans until they get hit for the first time.”

So instead I’m going to talk about meltdowns. Don’t worry, the end is much nicer. There are cookies.

Crypto meltdown form letter

It feels like every week in crypto is an episode of “That’s Not How This Works.” One with a quick-fire round called “Could We … Not?”

Every time I write about the latest crypto meltdown, the words just feel too familiar. I swear that I’ve written this already. And that’s because I have.

Maybe I should create a form letter for this? Something to the effect of:

Last week, [crypto entity] collapsed. This happened because they tried to make money appear in multiple places at once. The laws of physics (and probability) eventually caught up to them and their luck ran out. In summary: FAFO.

And then I could tack on some quip in Latin for flavor.

But it’s getting harder to find something unique to each meltdown story. That’s my sign that it’s time for boilerplate.

Things Go Wrong™: Silvergate Linings Playbook

No matter how many smart moves you make, only the last move matters.

Off to a good start

Silvergate didn’t start off in the crypto business. They were originally a plain-vanilla bank that spotted an opportunity. Other banks avoid eye contact with crypto companies, so Silvergate would welcome them with open arms. The plan worked. Silvergate’s deposit base ballooned as major crypto players set up accounts there.

Their next move was even smarter. They created the Silvergate Exchange Network (SEN), a system by which customers could instantly move money between other Silvergate accounts. SEN operated nights and weekends – outside of normal business hours – which was important because cryptocurrency trades in a 24/7 market. As long as both parties (or their brokers) used Silvergate, traders could settle instantly instead of having to wait hours or days for a wire to clear.

So far, so good. Our heroes had tons of money on hand. They had innovated to make their customers happy. What could go wrong?

A banking interlude

People generally lump all financial services under the “banking” umbrella, but there’s a real zoo of business lines in there. Each one has its own practices, revenue streams, and incentive structures.

Take trading, for example. Creativity is a survival skill in this field because you’re constantly scanning for an edge in a big swarming mass of activity where everyone else is trying to beat you to the punch. Retail banking, by comparison, is supposed to be dull. The entire job is to make sure that you always have a customer’s money when they come calling for it. So in an ideal world, you would simply stash all of their deposits in a vault and patiently wait until they came to reclaim it.

Emphasis on “in an ideal world.”

In reality, retail banks don’t want to be dull. They like to get creative, like making money off of those customer deposits while no one’s looking. They usually invest the deposits in boring vehicles like mortgage loans and government debt. This is mostly safe. Mostly. But anything they do with those so-called “idle” deposits reduces the chances that the money will be there when the rightful owners – the depositors – want it back. It mostly works because it’s very rare that a lot of people want their money back at once.

A friend calls this the Schrodinger’s Cash scenario_:_ until you actually attempt to make a withdrawal, the money is both there and not there.

Back to Silvergate

All of this is to say that Silvergate got creative. But only slightly so.

The unique composition of Silvergate’s balance sheet also played a key role in its demise. Silvergate didn’t pay interest on the deposits it accepted from crypto clients, meaning it had a free pool of funding it was able to plow into investments such as government debt and similarly liquid assets. Among its portfolio were mortgage-backed securities and bonds sold by state and local governments.

These securities tend to be pretty tame. The problem? This just happened to be a bad time to hold them:

This setup — although not uncommon for any bank — proved problematic as the Federal Reserve hiked interest rates, eroding the value of a chunk of Silvergate’s securities.

When interest rates rise, bond prices go down. That’ll become useful in a moment.

When the crypto industry faltered

Ahem “when FTX fell over.”

and clients rushed to withdraw money — driving the lender’s non-interest bearing deposits down from $12 billion at the end of September to just $3.9 billion at the end of last year — Silvergate had to sell securities to pay for those withdrawals. But the bonds were worth less than the company paid for them, forcing it to sell them at a loss and inflicting a $1 billion hole on its earnings late last year.

Silvergate chose to halt operations before things got worse. They thankfully did so while they had enough money to repay all deposits. Still, we all know the story by now:

Last week, Silvergate collapsed. This happened because they tried to make money appear in multiple places at once. The laws of physics (and probability) eventually caught up to them and their luck ran out. In summary: FAFO.

Why this is more of the same …

It’s important to note that while Silvergate was a bank for crypto customers, what happened wasn’t unique to crypto. This is an issue with banks, in general.

Consumers don’t often see the pointy end of this plan because banks have gotten pretty good about avoiding problems. But “pretty good” is not “perfect.” Just ask any Northern Rock Silicon Valley Bank customer: bank runs – those rushes of depositors all wanting their money back at once – most certainly still happen. It’s practically built into the retail banking business model. Remember the point about Schrodinger’s Cash?

… and what sets this apart

Earlier I noted that it’s gotten tougher to discern between the various crashes and bank runs. Thanks to this week’s other run, on Silicon Valley Bank (SVB), I now see what sets Silvergate’s meltdown apart from the rest.

Both banks are accused of being too highly concentrated on one customer segment. There is some truth to this. By being “the crypto bank” and “the tech startup bank,” Silvergate and SVB were not properly hedged against problems in those areas.

Then there’s the other side of the concentration risk: crypto and tech put too many of their eggs in one bank’s basket. When tech startups tremble, SVB hurts. When SVB hurts, tech startups tremble. Flip-sides of the same coin.

How did this happen? It helps to remember that Silvergate and SVB were willing to fill a void in the marketplace and provide services to companies that other banks wouldn’t touch.

So before we place too much blame on the fallen banks for the concentration risk, let’s also take a moment to remember why that concentration existed in the first place. Had more banks been willing to work with tech startups and crypto companies, problems in Silvergate and SVB would have still hurt their customers; but those customers would not have represented such a large portion of an entire sector.

A real market rally

I prefer to end the newsletters on a high note. Not always easy when you write about crypto … but today I’m talking about Girl Scout cookies.

It’s no secret that there’s an active underground market for these treats. They’re practically a currency in some groups. (One plan for market collapse? A stash of Thin Mints in the freezer.)

This year, the Girl Scouts have released a new flavor called Raspberry Rally. And it’s a little more popular than expected:

Single boxes of the cookies, which have a crispy raspberry-flavored center coated in chocolate, cost from $4 to $7, but they are selling for as much as five times the usual price on the secondary market.

(Also, since that NYT piece landed, those prices have climbed even higher.)

Hmmm. What’s the official take on this unexpected popularity? Going back to New York Times article:

Girl Scouts of the U.S.A. has expressed dismay over the situation. The organization said in a statement that most local Girl Scout troops had sold out of the “extremely popular” Raspberry Rally cookies for the season and emphasized that it was “disappointed” to see unauthorized resales of the flavor.

“While we are happy that there’s such a strong demand for our cookies year over year,” the Girl Scouts said, “we’re saddened that the platforms and the sellers are disregarding the core mission of the cookie program and are looking to make a profit off of the name without supporting our mission and the largest girl-led entrepreneurship program in the world.”

This is pretty wild. (Insert your favorite joke about Girl Scout cookies moving like contraband.) It’s also an opportunity.

What if, say, every transaction made it into a public ledger? What if people could verify how often the product had changed hands, and at what price? What if the Girl Scouts were getting a slice of that secondary market activity?

This … this sounds like a job for crypto.

Hear me out:

Instead of selling the boxes of cookies directly, why not sell NFTs as digital twins? Buyers could guarantee that the secondary market purchases were legitimate. Tracking prices in a public, centralized location would limit certain kinds of arbitrage opportunities. The Girl Scouts would get a cut of the action. The whole thing could teach the young entrepreneurs about marketplaces, variable-priced assets, and sales of digital goods. (Say what you will about web3, but that kind of knowledge is poised to be useful for the long haul.)

Oh, you think it’d be crazy to establish a marketplace for claim checks for cookies? Then you probably wouldn’t want to hear about commodities markets, where people trade claim checks for silos full of wheat or corn. And you definitely wouldn’t want to hear about a digital market for socks. Not “stocks.” “Socks.”

The wrap-up

This was an issue of Block & Mortar.

Who’s behind Block & Mortar? I'm Q McCallum. I've spent the past two decades in the emerging-tech space. And I'm very interested in web3 use cases.

Credit where it's due. Big thanks to Shane Glynn for reviewing early drafts. Any mistakes that remain are mine.

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