I started this blog with the purpose of explaining Web3 concepts (and maybe some adjacent topics) in simple terms for the less technical among us. If you've been following - thanks, by the way - you may have noticed I like to post every Thursday and Sunday. For my Sunday post, I was hoping to break down cryptocurrency, but given all that's happened since Friday, I'd feel remiss if I didn't make this post a bit more topical. I appreciate all two of you guys' patience. So, WTF is SVB and USDC?
Silicon Valley Bank
Silicon Valley Bank (SVB) is a financial institution that provides services to technology companies, particularly startups. It was founded in 1983 and has become known as one of the most prominent banks for tech startups. The bank's services include banking, lending, and investment services, all tailored to the needs of tech companies.
In recent years, SVB has been experiencing financial difficulties. In 2020, the bank had to take a $110 million loan loss provision due to the impact of the COVID-19 pandemic on its clients. Additionally, the bank has been struggling to meet regulatory requirements, particularly when it comes to anti-money laundering (AML) compliance. In January 2021, the bank was fined $7.5 million by the US Treasury Department's Office of Foreign Assets Control (OFAC) for violations of AML regulations.
These issues put SVB under increased scrutiny and pressure from regulators, and led to concerns about the bank's financial stability. Some experts have even speculated that the bank could be at risk of failing.
Ultimately, though, it was a run on the bank that caused SVB to collapse.
You may recall from high school economics, we deposit money into bank accounts. The banks then invest or lend out that money to turn a profit. They then share some of that profit with us in the form of interest payments on our deposits. A safe and traditional investment many banks use is Treasury bonds.
Treasury Bonds
Treasury bonds are a type of investment that the US government issues to raise money. When you buy a bond, you're essentially lending money to the government, and in return, they promise to pay you back plus interest at a later date.
The price of a bond is affected by a variety of factors, including the interest rate. When interest rates rise, the price of existing bonds falls because investors can get a higher return elsewhere. Conversely, when interest rates fall, the price of existing bonds rises because they offer a higher return than newly issued bonds.
To understand this, let's use an example. Suppose you buy a $100 Treasury bond that pays 2% interest. The bond will mature in five years. At that time, you can expect to get back your $100 plus interest. But let's say a year goes by and you need that $100 now. You can sell that bond to someone else and likely recoup your $100 investment. But that may only be true if interest rates haven't changed.
Now let's say you still want to sell that bond, but interest rates have gone up to 5%. As an investor I would rather buy a new bond that pays 5% interest rather than your old bond that only pays 2%. So to entice me to buy your bond, you offer to sell it at a discount - say, $60. Now you've got my attention. I can either buy a new bond for $100 and receive that money back plus interest, or I can buy your old bond for $60 and receive $100 back plus interest.
In short, to compete with the new bonds offering higher interest, you need to lower the price of your bond so that it offers a higher effective yield, or rather, the total return you receive on your investment, including both the interest payments and any capital gains or losses.
This is the situation SVB found itself in. As the Federal Reserve has raised interest rates considerably this past year in an effort to reel in inflation, old Treasury bonds paying relatively low interest rates are needing to be sold at a hefty discount.
But if all banks are investing in Treasury bonds, why aren't they all collapsing, too?
When the Fed raises interest rates, they do so in the hopes to discourage, or at least slow down, both borrowing and investing. Many of SVB's customers are tech firms and startups that rely heavily on lending and investment to grow. With banks charging more to borrow and venture capital and private equity groups demanding higher returns (otherwise, they'll just buy Treasury bonds), many of the firms simply started spending money they had in the bank.
One other tidbit to throw in here: in 2020, the Fed also eliminated the need for banks to keep at least ten percent of deposits on hand (or "in reserve"). This requirement was previously in place to ensure banks could always cover customer withdraws.
Now any good finance professor will tell you it's important to diversify your investments. Apparently the good folks at SVB skipped that day of business school because, they were heavily invested in Treasury bonds. So when a bunch of their customers came asking for their money this year, SVB was forced to sell off those low interest bonds at such a discount that they could no longer cover customer withdraws.
This is why SVB was declared insolvent and the FDIC has now taken over.
Circle Internet Financial and USDC
Circle Internet Financial is a fintech company that specializes in digital currency and blockchain technology. The company offers a range of products and services, including a digital wallet and a stablecoin called USD Coin (USDC).
USDC is a cryptocurrency that is pegged to the US dollar, meaning that its value is supposed to remain relatively stable compared to other cryptocurrencies. This stability makes USDC a popular choice for traders and investors who want to avoid the volatility of other cryptocurrencies.
However, USDC's stability is dependent on the backing of US dollars. In order to ensure that there are enough US dollars to back the supply of USDC, Circle works with banks to hold the funds in reserve. One of the banks that Circle worked with was Silicon Valley Bank.
The announcement of SVB's insolvency meant that over $3 billion of Circle's USDC collateral was potentially compromised. At one point this weekend, USDC began trading below 90 cents. Holders of the stablecoin quickly sold $1.6 billion of the token. This of course fueled speculation that Circle itself would suffer its own bank run. Exchanges like Coinbase paused USDC withdraws and exchanges in order to prevent such an event.
The irony of course is that a so-called cryptocurrency, a concept borne out of the 2008 financial crisis when banks were dropping like flies, was threatened by the collapse of a bank itself.
Fortunately for Circle and the rest of SVB's customers, the FDIC and Federal Reserve have said they will ensure customers will have access to their full deposits. And so for the time, Circle and its stablecoin are safe.
Circle's USDC has regained its peg with the dollar. But while the worst was avoided, questions still persist about Circle's future and that of stablecoins. This of course comes on the heels of a year riddled with failures in the crypto space after the collapse of several firms caused by the failures of TerraForm Labs (another stablecoin issuer) and FTX.
Circle is already calling for stricter regulations for stablecoins. But perhaps what's needed is more regulations for banks - reinstating a reserve ratio to cover withdraws, and requiring a diverse mix of assets and investments on their balance sheets. Still, others in the crypto space (especially Bitcoin evangelists) are calling this past weekend a further indictment of both our current financial system and cryptocurrencies and blockchain protocols backed by centralized organizations.
Wild times.
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