Silicon Valley Bank’s failure shows that TradFi and DeFi are heavily intertwined
In stunning fashion, Silicon Valley Bank (SVB) became the second-largest bank failure in US history, in only a matter of approximately 24 hours.
Silicon Valley Bank’s recent bankruptcy filing speaks to both major issues native to traditional financial services (TradFi), but also its interconnectedness with the decentralized finance (DeFi) sub sector. SVB was firmly rooted in TradFi, providing a vital link between Silicon Valley startups and venture capital firms in need of financing, with some of these customers driving Web3 and DeFi projects. Notably, Roblox and Roku ($487 million) disclosed exposure to SVB in previous SEC filings, as well as Circle, the stablecoin issuer. Some of those customers supporting Web3 and DeFi have had spillover effect from their reliance on TradFi products and services.
In this blog post, we will take a look at what has transpired so far (and changing by the hour), how the US. Federal Government and Federal Reserve is taking action, and how this is intertwined with Web3 and DeFi.
An Overview of Silicon Valley Bank's Failure & What It Means for the Financial Industry
SVB's recent bankruptcy was a shocking event for the financial industry as it uncovered lax practices and revealed serious flaws in risk management procedures. Analysis has found that the bank took too many risks with its portfolio that appear to have not been managed with appropriate portfolio diversity, guardrails and hedging. These risks ultimately left the institution unable to meet customer demands when economic conditions deteriorated and had to be declared bankrupt.
This unfortunate incident is raising important questions about how banks should comprise their portfolios to ensure long term returns and stability. While SVB was a Top 20 bank with over $200 billion in assets, SVB also falls well short of institutions like Bank of America or Morgan Stanley, which are known as globally systemically important banks (G-SIBs) and hold assets worth trillions of dollars. This will hopefully serves as an opportunity for financial institutions to reevaluate their risk management systems and protocols to protect against similar events in the future, if not additional scrutiny and regulatory policy from the US Federal Government. With effective steps put into practice, there is potential for progress in restoring confidence with TradFi institutions, especially regional banks and those with a very unique business model like SVB.
It seems as though the collapse comes down to a discrete set of events and factors:
SVB experienced a significant increase in its deposit base post-COVID; in 2019, SVB held $71 billion in total assets, and then held over $200 billion in total assets in 2022 just prior to the crash
SVB chooses to heavily expose itself to held to maturity MBS products and long term Treasury's yielding a 1.79% return, far below the current 10-year Treasury yield of around 3.9%.
SVB, at the time of the crisis, was potentially not properly hedged against this exposure (although I have not seen this confirmed or covered by a major news source)
SVB was required to raise over $2 billion in capital, subsequently with shares falling 60%
SVB also sold $21 billion worth of securities to raise cash and reposition its balance sheet toward assets with a shorter duration, taking a $1.8 billion loss
93% of the bank’s deposits are not covered by FDIC insurance, which only applies to those below $250,000
These events triggered a bank run, and a spiral out of control resulting in government intervention which is further detailed below
In addition, some peer TradFi’s have been impacted as well to include First Republic Bank, as well as a parallel shutdown of Signature Bank
This great visualization from Genuine Impact further details out the decomposition of SVB's assets, liabilities and equities at the time of collapse:
Figure 1: SVB balance sheet issues as visualized by Genuine Impact
The Immediate Actions Being Taken By the Federal Reserve And U.S. Federal Government To Solve The Issue.
In response to the issue, the Federal Reserve and U.S. Federal Government have taken a number of immediate actions.
On March 10, SVB was shuttered by the California Department of Financial Protection and Innovation (DFPI) on Friday, marking the second bank to shut down within days, according to CoinDesk.
The DFPI said in a statement that it had taken possession of the bank, “citing inadequate liquidity and insolvency.”
On Sunday, March 12, the Federal Deposit Insurance Corporation (FDIC) took SVB into receivership. According to the FDIC’s announcement, in order to protect insured depositors, the FDIC created the Deposit Insurance National Bank of Santa Clara (DINB). At the time of closing, the FDIC as receiver immediately transferred to the DINB all insured deposits of Silicon Valley Bank. Additionally, for assurance, it was also announced that all insured depositors will have full access to their insured deposits no later than Monday morning, March 13, 2023
Currently, the FDIC is auctioning SVB assets, with a very short turnaround of today, March 13, as the deadline for final bids. Treasury Secretary Janet Yellen stated that at this time, a government bailout is not part of the plan, given the fact that the banking system is significantly more capitalized and regulated post-2008 financial crisis.
On March 13, the Federal Reserve also brought more assurance to the markets, announcing it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors. With approval of the Treasury Secretary, the Department of the Treasury will make available up to $25 billion from the Exchange Stabilization Fund as a backstop for the new Bank Term Funding Program (BTFP). This fully protects all depositors, both insured and uninsured, and depositors will have access to all of their money on Monday.
Also on March 13, HSBC acquired Silicon Valley Bank UK in a last minute deal, for a symbolic £1.
Also, the Department of the Treasury, FDIC and Federal Reserve issued a joint statement announcing decisive actions to protect the U.S. economy by strengthening public confidence in the TradFi system, also covering the public Signature Bank shutdown.
Analyzing the Intersection Between TradFi and DeFi.
To better understand if this presents exposure from TradFi to DeFi, or vice versa, it is key to understand how TradFi and DeFi and interact today. These integrations, asset classes, and hybrid and shared components can help identify if this event, and future events, will pose any additional risk to either dimension of the system based on what we have seen transpire over the past few days.
FinTech has evolved significantly over the last five decades, and the latest wave of developments suggests that more change than ever before is coming for 2022 and beyond as Traditional Finance (TradFi) and Decentralized Finance (DeFi) are each on a path of convergence as they tackle similar challenges to modernize the financial services experience and underlying platforms and infrastructure (read more here on the history of what has brought us to today's current trends).
TradFi continues to embrace DeFi, with announcements such as Coinbase and BlackRock partnering to provide institutional access to digital assets, and DeFi continues to drive innovation and prove it can evolve at scale with releases like last year’s Ethereum Merge.
Read more here to understand how the future of finance technology is hybrid
The current landscape of TradFi, DeFi, and some hybrid and shared components:
Figure 2: the TradFi and DeFi reference architecture suggests a hybrid future
... the key crossover point here is at the Infrastructure level, where stablecoins in the DeFi world are backed with reserves held in fiat currency in TradFi deposits with conventional Banks.
Read more here about the hybrid hypothesis for the future of TradFi and DeFi (which provides deep dives into each category.
Assessing the Challenges and Opportunities of Leveraging DeFi to Improve TradFi Efficiency and Lower Costs... And Help Avert Future Failures?
With the advent of DeFi technology, the banking sector has an unprecedented opportunity to utilize the advantages of blockchain technology to increase efficiency and lower costs associated with financial services. This novel development provides innovative options for banks to leverage financial protocols and applications, offering improved access to derivatives, marketplaces and investments. DeFi promises new levels of security, liquidity, scalability and transparency as compared to traditional banking practices. Banks must confront both challenges and opportunities as they assess how the emerging world of DeFi can be integrated into operations in order to provide better customer experiences while reducing risks and costs. To ensure a successful transition, banks must explore methods not just of implementing DeFi applications quickly but also securely. As such, identifying efficient methods for risk management are integral when introducing cutting-edge technologies like DeFi into modern-day banking systems.
This is actually already happening, however, much of it is coming in the form of TradFi "building its own DeFi", rather than embracing true, pure play DeFi protocols, dApps, and Layer 1 blockchains. TradFi is leveraging blockchain technology, asset tokenization, and smart contracts to build its own private blockchain platforms and ecosystems.
Whether DeFi survives or not, Web3 tech is here to stay (read more here to better understand how TradFi is embracing this technology);. And whether these underlying technologies can increase transparency, enhance risk management practices, and otherwise optimize the financial technology ecosystem to help prevent events like these in the future, remains to be seen.
How This Situation Is Connected to Web3 and DeFi.
Most notably, Circle’s USDC stablecoin broke its dollar peg after the firm revealed it has $3.3 billion in SVB exposure. Circle is fully backed 1:1 dollar for dollar with every stablecoin issued, and thus has TradFi accounts with deposits.
Circle has nearly 8% of its $40 billion in reserves tied up at the collapsed SVB. USDC is designed to trade consistently at $1, but it fell below 87 cents on Saturday, after concerned investors redeemed over $1 billion of USDC tokens on Friday, March 10:
Figure 3: Circle valuation has depegged from $1 USD
Furthermore, this article from TechCrunch details how SVB’s mess could become a problem for stablecoins, as the depegging event exposed a 'crucial flaw' with existing fiat-backed stablecoin design. According to TechCrunch and Nevin Freeman, co-founder and CEO of Reserve:
“If any one of the banks that the stablecoin issuer relies on fails without a bailout, and the issuer can’t fill the hole with their own capital or a new capital injection, that would either force a bank run on the stablecoin and leave the last to redeem with nothing, or the issuer would have to close down and go into bankruptcy to prevent such a run,” Freeman told TechCrunch+. “This isn’t the fault of stablecoin issuers; they have no choice but to rely on fractional reserve banks when providing liquidity to their users.”
NOTE: Since this post and the U.S. Federal Government’s intervention, Circle quickly reverted on Monday with an announcement that $3.3 billion of USDC reserve risk was removed, and the US Dollar de-peg was closed (and that no cash reserves were held with Signature Bank). As a regulated payment token, USDC remains redeemable 1:1 with the U.S. Dollar. While this is good news and a brief scare, it will be interesting to see if and how Circle changes its strategy for TradFi banking with respect to its stablecoin reserves.
One key finding here is that this appears to only have affected CeFi so far (e.g. centralized, USD-backed stablecoins), rather than DeFi. Centralized constructs such as stablecoin projects, and Web3 projects and crypto customers that rely on TradFi services such as banking and lending seem to be the primary impacted parties.
Going forward, this may significantly alter how tech and Web3 startups leverage TradFi banking and lending services, especially CeFi models that are heavily connected with on ramps, asset reserve requirements for stablecoins, etc.
The Bigger Picture - Is a Hybrid Financial System Here to Stay, or Is It Just a Passing Trend?
The emergence of the hybrid financial system has posed an interesting question to those interested in the future of finance and banking - will it continue to be popular and take a dominant share of the market, or is it simply a passing trend? To answer this question, one must look into the bigger picture - at underlying customer needs, economic trends, technological innovations and regulatory frameworks. It is clear that customer demand for digital and mobile services has been a major driver behind the rise of these hybrid systems. Likewise, advances in technology and connectivity have enabled greater access and convenience while also providing more opportunities to develop specialized solutions tailored to customer’s individual needs. However, with several developing regulatory challenges still unresolved, it remains uncertain whether this type of model can paint the big picture in terms of reshaping the industry for long-term sustainability.
In analyzing the failure of SVB, it is clear that there must be a balanced approach between TradFi and DeFi when looking at the future of banking and financial services. Leveraging DeFi will undoubtedly improve efficiency and reduce costs for banks, but it must be done in a thoughtful, secure and most importantly, compliant manner. DeFi has had its own issues over the last few years with respect to crypto crime, multi- and cross-chain security issues, and lack of regulatory policy that is starting to evolve.
While the hybrid model may be here to stay, the full implications remain to be seen. The strategic integration of these two systems can lead to greater transparency and cost savings - however, caution should be taken to ensure that such measures are implemented in a way that prioritizes security over all other criteria. Going forward, it is certainly possible to learn from Silicon Valley Bank's mistakes while capitalizing on its successes. Working together, banks, fintech companies, governments and businesses can create a more secure environment while also taking advantage of the potential benefits offered by both TradFi and DeFi.
Further recommended reading:
Stratechery: The End Of Silicon Valley (Bank)
Marc Rubinstein: The Demise of Silicon Valley Bank
