What just happened with Silicon Valley Bank (SVB)? The ELI25 version.
SVB was the 17th largest bank in the United States and there is $133b of customer deposits that cannot be withdrawn right now.
So what actually happened? Firstly, some prerequisites:
Modern banking relies on fractional reserves. This means that when you deposit your money, the bank pays you some interest, and tries to lend most of it out at a higher rate. They only keep some cash on hand to honor withdrawals as they come. Banks assume that not all deposits will come at the same time, and that these liabilities will “mature” (e.g. a customer pays off their 30 year mortgage, or a 10 year US government bond reaches maturity), in line with when customers ask for withdrawals.
The present value of a future stream of income is inversely related to interest rates. If I guarantee you $100 in 12 months, how much is that worth today?
If interest rates are 0%, it’s worth $100.
If interest rates are 5%, it’s worth $95.24 today, because I can take $95.24, earn interest on it, and in 12 months it will equal the $100 that I owe you.
If interest rates are 20%, it’s worth $83.34 today, because I can take $83.34, earn interest on it, and in 12 months it will equal the $100 that I owe you.
OK, so what happened?
A bank hopes that the Net Interest Margin (the difference between what they earn from lending money, and what they pay depositors) is positive. Think about the difference between the interest you receive on money in your account versus the interest you pay for your mortgage. Most of the time this holds.
However, in 2021, Silicon Valley Bank “lent out” customer funds to the US government, buying, amongst other things, 10-year Treasury bonds which yield 1.63% on average. In that interest rate environment, this was appealing, because depositors were earning less than 1%.
Fast forward 2 years later, and the Fed had increased rates so rapidly, that now a few things happened:
Short-term depositors at SVB could earn over 4%
The market price of those 10-year Treasuries that yield 1.63% lost value as interest rates rose. This in itself was not an issue for SVB, since they planned to hold them to maturity, and recoup the principal
Then a combination of things:
As deposit inflows to SVB slowed, they had to sell some of their bond portfolio at a loss in order to continue honoring withdrawals
Once they announced this loss, it created a panic, which started a bank run. Once there is panic that perhaps a bank is insolvent, the only thing you can do is try and withdraw. This often becomes a self-fulfilling prophecy
The numbers: SVB had $175.4b in deposits, and processed roughly 25% of that in withdrawals by Friday morning.
What’s happening as I write this? (8pm Sunday night in Israel, 1pm EST):
SVB assets are being sold for cash in order to restore customer funds
Accounts with balances up to $250,000 will be guaranteed by the US government
At the time of writing, the Treasury has not announced a bailout, or that deposits above $250,000 will be guaranteed
Why is this such a tough spot?
There are a few choices now:
Do nothing, let capitalism work this all out. The problem with this approach is that come Monday morning, every American will be withdrawing from small banks to larger banks, inducing multiple bank runs.
Guarantee all deposits. The problem is that somebody has to bear this cost, and it is billions of dollars. It also continues to set a standard that whenever there is a bank run, the government will step in. Just on a practical level - the FDIC has $120b of reserves, and they don’t want to use such a large portion on this.
Something in the middle.
What’s this got to do with USDC? Why did USDC depeg?
USDC is a token minted on the blockchain that trades at $1 because for every USDC token that is minted, there is $1 of cash, or cash equivalents, being held somewhere. If it trades at $0.90 on the blockchain, I can buy it and then go to Circle and receive $1. But herein lies the problem. For $40b of USDC in circulation, there was roughly $3.3b USD sitting with SVB. This technically means that without interventions, there is not enough collateral backing the USDC. If you write that $3.3b to 0, you get 91.75 cents for each USDC. What happens next? Of course, Circle has multiple paths to restore confidence:
The USDC peg can be restored in the interim once banks open on Monday and Circle honors redemptions with cash from other assets
They requested a withdrawal before the FDIC officially took over the SVB books, and there may be legal precedent for them to get all their money because they submitted the withdrawal request
If deposits are back-stopped, then things will be fine
If they receive some of the money, but not all of it, they can close the gap from their own balance sheet, presumably from the lucrative interest that they are earning on the rest of their money. On Monday we will see how much demand there is to redeem USDC for real dollars. Circle has not officially closed redemptions (they don’t want to - redemptions are required to keep the peg).