The Hidden Risks of Crypto Banking: Lessons Learned from Silvergate Bank Failure

Why did Silvergate Bank fail in the crypto market? This is the inside story of Silvergate Bank demise in the world of cryptocurrency.

The Hidden Risks of Crypto Banking: Lessons Learned from Silvergate Bank Failure

Described as the ‘Tech Bank Collapse of 2023’, the three biggest friends of tech startups failed within a week. Seized, liquidated, closed down, to some the losses were personal. Legacies were destroyed and the future was shaken.

Some say that the tech industry moved too fast and broke its prestigious bank. But you and I both know that there were hidden risks. Risks that today have marked the failure of decades old banking institutions. Not one, but three!

What caused it? What EXACTLY happened?

Read on to find out.

Key Factor 1 for Silvergate Bank Failure : Silvergate Exchange Network

Silvergate Bank’s Silvergate Exchange Network (SEN) was one of the key factors that propelled the bank’s growth in the cryptocurrency space.

SEN was a unique service that allowed clients to transfer US dollars instantly between different cryptocurrency exchanges.

This service was a game-changer.

It helped traders and investors avoid the lengthy and uneasy process of transferring funds between banks and exchanges.

Many of the biggest trading entities in the cryptocurrency space used SEN, making it a significant selling point for Silvergate.

However, the service was also a potential regulatory risk for the bank.

It was not an approved product!

The company’s CEO only described it as a “non-disapproved product.” This meant that the bank was operating in a legal grey area and could face regulatory action if the service was found to be non-compliant.

Furthermore, the SEN service opened up the bank to significant anti-money laundering risks. Since its inception in 2017, it facilitated “over $1 trillion in payments,” which could attract unwanted attention from regulators.

The bank had to implement robust AML and KYC (know your customer) processes to minimize the risk of money laundering and other illicit activities.

Despite these risks, the SEN service was a significant contributor to Silvergate’s growth and success in the cryptocurrency space.

The bank continued to innovate and improve the service, making it one of the most popular services among cryptocurrency traders and investors. However, the regulatory risks associated with the service remained a concern for the bank, and it had to tread carefully to avoid any regulatory action. image.png

Key Factor 2 for Silvergate Bank Failure : Money Laundering Controls

To combat the risk of money laundering, Silvergate implemented robust anti-money laundering (AML) controls.

It hired a team of experienced compliance professionals and invested heavily in technology to monitor transactions and identify suspicious activity.

The bank also partnered with Chainalysis, a blockchain analysis firm, to help it detect and investigate potential money laundering activity on the SEN platform.

However, despite these measures, the sheer volume and speed of transactions on the SEN network made it **difficult for Silvergate to detect and prevent all instances of money laundering. **

In 2019, for example, Silvergate filed a Suspicious Activity Report (SAR) with the Financial Crimes Enforcement Network (FinCEN) regarding a customer who had deposited more than $100 million in cash into its account, despite claiming to operate a cryptocurrency mining operation with a revenue of only $35,000 per month.

Silvergate’s SAR filing highlights the bank’s commitment to combating money laundering, but also underscores the **challenges **that it faces in **policing its fast-growing customer base. **

The incident also led to increased regulatory scrutiny of Silvergate’s AML controls, with the bank ultimately agreeing to pay a $450,000 penalty to settle allegations of inadequate AML controls.

Key Factor 3 for Silvergate Bank Failure : TradFi Failure

Silvergate’s attempt to become the leading bank for the cryptocurrency industry came to a screeching halt in 2022. What happened? Its stock prices collapsed and exposed its systemic risks.

The company had relied heavily on traditional financial analysts and their recommendations to attract institutional investors, which resulted in a mismatch between management’s skills and the new business model.

Despite the significant balance sheet risk that came with its cryptocurrency-related business, analysts had failed to take this into account when recommending the stock.

They used traditional investment techniques and metrics to assess the value of a nontraditional company, missing the embedded crypto risks that ultimately caused the company’s failure.

As a result, Silvergate’s decision to offer “non disapproved” products and services, such as the Silvergate Exchange Network (SEN), opened up the bank to significant anti-money laundering risks.

Although the bank employed twice as many compliance staff as comparable banks of its size, the volume and velocity of transactions overwhelmed Silvergate’s compliance apparatus, leading to customers using SEN for illicit purposes, including money laundering.

Final Thoughts

Silvergate Bank’s failure is a warning for businesses that want to profit from the cryptocurrency trend.

The bank’s collapse wasn’t only because of the unpredictable cryptocurrency market. It was also because they didn’t manage risks like anti-money laundering, following regulations, and traditional finance methods that aren’t appropriate for a non-traditional business.

Businesses that want to work with cryptocurrency should take a DeFi approach and use controls and frameworks to lower the risks that come with this new field.

Subscribe to our monthly newsletter

Stay up-to-date about latest tech and new world. Unsubscribe at anytime!