BTC247: Bitcoin's evolution with Traditional Finance w/ Jon Melton (Bitcoin Podcast)

0:00You're listening to TIP. Hey, everyone. Welcome to this Wednesday's release of the Bitcoin Fundamentals podcast. Do you guys remember all the drama with FTX and how numerous traditional banks went under during this period of time, which was the start of this whole choke point 2.0, which was debanking everyone in the Bitcoin and crypto space? Well, today's guest, Jon Melton, had a front row seat at Silvergate Bank. During our conversation, he explains how this entire thing went down, what the solvency actually was. at the bank, and how the company was forced to liquidate despite still being very solvent and actually having solid operations.

0:37This episode also gets into a broad range of topics, which is why I titled it Bitcoin's Evolution with Traditional Finance. And I think the historical context and lessons learned are a great place for many people to study and understand. There's no better teacher than John to tell these stories and the lessons. And with that, I hope you guys enjoy this fun conversation.

1:01Celebrating 10 years, you are listening to Bitcoin Fundamentals by the Investors Podcast Network. Now for your host, Preston Pysh.

1:19Hey, everyone, welcome to the show. I've got John Melton here with me, and we're going to cover a whole host of topics here. And you've got a lot of experience in finance, in the Bitcoin space. And we're going to get into some really interesting topics. So John, welcome to the show. Thanks so much, Preston. Looking forward to it and I appreciate you having me. So I want to start off just kind of covering where you have a lot of experience, which is in currency markets, working at Morgan Stanley for like 13 years before you even came into Bitcoin. I guess my question for you in that, because I've never really had conversations on the show with people with that experience.

1:52I'm just kind of curious, what is that like? Like what's day-to-day, if you were going to describe it to a family member, what's that experience in currency trading like? Well, thanks for the question. And it's really an interesting multidisciplinary area, which I think prime me a little bit for Bitcoin in terms of macro. So it's changed a lot over time as markets have become more electronified, but sometimes it can be a pretty almost kinetic environment in terms of trading activity. But at other times, it's a bit more cerebral in terms of structuring when you think about derivatives and options and how do you create a hedge for a client.

2:28But on a real-time basis, you really have to be abreast of central bank policy, what's going on in different countries. You're not just looking at the currency market, you're interested in the commodities market and equities and risk settlement. So it's a mix of having a conversation about markets all day long, but really intense focus on execution and help clients. I don't remember what interview or when I heard this, but I do remember Stanley Druckenmiller talking about how currencies move in like these seven-year kind of three to seven-year cycles. And I would imagine a lot of the job is just, you got a client, they have some type of exposure through a commodity or whatever in said country, and they then have the currency exposure there as well.

3:14And you're just trying to cover that with some type of derivative if it's being sent here back to the US or whatever to make sure that that's offset. And it's almost looked at like an insurance policy to make sure that you don't have any type of risk there. Is that really how most people in the currency space think about it or are using it in application as opposed to just people speculating on the direction that it's going to go? Yeah, I think there's a lot of both. And sort of which first item that you described, I would consider more a real money application or a risk management tool where you have a structural flow.

3:49You're an importer, but you're based in one country. So you've got to send euros every month somewhere. And you know, you're going to be new on that for months on end, but the euro keeps on going up because Trump's hammering the dollar because we're trying to get exports going here. And that's something you might want to hedge and there's different ways you can do it. But it's also a super liquid, very deep market with a lot of leverage embedded in it. So a guy like Stanley Druckenmiller, who's a very opportunistic global macro oriented investor, could find it a really interesting and convenient way to express a more macro view with a multi-year time horizon, just because there's so much levers with the way things are charged, you can kind of get a specific sort of payout or exposure you're looking for.

4:30Yeah. So you did this for many years, over a decade. And in 2018, you told me that you had this no turning back moment where you came into the Bitcoin space and really just felt like you had to do something in this space. Walk us through what was that. Yeah. Just tell us the story. Yeah. So in September of 2017, I think Bitcoin was$4 ,000 or$5 ,000, but it was the year where went from 1 ,000 at the start of the year. I had no idea if it existed. And then it got up to 19 or 20 ,000 that year. And it's in temper of that year. So I was working at Morgan Stanley. And in the midst of this big run-up in Bitcoin, they had an event focused on crypto.

5:14So they had, I remember Joey Krug was there, Ted Rogers from Zappo, which at the time was probably the biggest Bitcoin custodian in the world, also gave a talk. And that really resonated. And he essentially gave the very well-known Wences Casares framing of Bitcoin as the best money that humans have ever come across, or in this case, engineered. And as somebody who had been sort of grounded in macro investing, that was really, really interesting to me. So I went home and listened to a lot of Andreas, listened to everything I could find from Wences, read every blog post from Zappo, and ultimately quit my job about nine months later in May of 2018 and joined the institutional team at Zappo where I marketed custody and trading, but essentially Bitcoin, to institutional investors.

6:04So some of the largest college endowments in the country, hedge funds, high net worth bulls. And it was a really interesting time just given what was going on in terms of forks in a bad bear market. But to your question, it was absolutely the calculation that if Bitcoin is for real, and it's a once in a 5 ,000 year opportunity, and I had the opportunity to join a great company with somebody like Ted, who I respected immensely, I would kick myself if it all worked out. So yeah, I just left. You mentioned this name, Wences Casares. And for people that I think are casual observers of the space, they may not know who Wences is.

6:42for people that have been in the space, they know he's a very big deal. And somebody that, for instance, it's my understanding that he's the one that orange-pilled Bill Miller back in 2015, you know, is a very high net worth individual and has had a massive impact on the space. You've worked with Wences. Tell us a little bit of his background for the general audience. Just tell them who he is, like what he's built, how he became who he is, and then what key role he kind of plays in the space, and then we'll go from there. Preston Pyshko, Sure. So Wences, I think I would agree with, as you said, some of the people have been here really early on in class of 2017.

7:18So everybody feels like they're late, but there was a lot of history before 17. But a lot of people are coming into Bitcoin, obviously all the time. And I do think that Wences is one of the most important figures in the history of Bitcoin because of what he built and also for the credibility that he brought to the space. So Wences' background, this is a very talented entrepreneur, founding a company called Patagon in Argentina, which has been described as the E-Trade of South America. Previous to that, he had the first internet service provider in Argentina. So somebody that was around and saw the birth and participated in the birth of the internet.

7:55And because of his personal background in Argentina. It's a very different economy, obviously, than the United States, where we take things like a stable and free currency for granted. We really had a deep appreciation for what Bitcoin could mean for the world, and I think most specifically for folks in emerging markets. And that stuck with me. I remember sitting in meetings at Zappo and sharing with folks my view that I think Bitcoin for the first time allowed everybody on the whole planet access to a G7 currency. Whereas if you lived into Virago before and you wanted Swiss franc, that was really hard, but everybody could get Bitcoin.

8:35But back to this, ultimately he found Bitcoin, went deep down the rabbit hole. And with his knowledge of financial markets and technology, brought a lot of credibility, but importantly, he built what at the time was and continues to be an incredibly secure custody solution far ahead of its time called Zappo with multi-state, multi-continent dispersed keys, a really next level custody solution that was very safe that folks, I think, would even have a hard time thinking about. What timeline was this that Zappos came up? I believe it was founded in 2013. 13. Okay. And the way I think of it is the network of people that went to Zappo was connecting with, he really lowered the barriers.

9:18So if you've heard about Bitcoin, you thought it was interesting, your next question is, well, if I want to buy it, where am I going to store it? I don't want to keep it on a thumb drive under my... Self-customies is an important aspect of Bitcoin. But for some of those early institutional type investors, like you mentioned of Bill Miller, the famous Lake Mason money manager, trusting Wences and Zappa to hold their keys was a really big benefit for Bitcoin early on. Yeah. Okay. You also have this interesting background where you were at Silvergate. And for people that experienced this last bear market, they know that Silvergate was like right front and center of that bear market, got very political.

9:59There was a whole lot to unravel here. I've never covered this on the show and I would love to get into as much detail as you're willing to talk about. But I think this is a really core and important point is that Silvergate was instrumental in Coinbase, Kraken, Circle, having liquidity 24-7 that was never there prior to them kind of coming into the scene. And I'm more curious for you to kind of give us the story of Silvergate, kind of the founding of it, how it kind of found itself in this space, the founding of that, in Bitcoin specifically. And then maybe some of the story of what went down as far as there during the bear market.

10:43Yeah. Go ahead. Absolutely. So Silvergate was for a time a small commercial bank in San Diego. It was founded in 1988. And the CEO, really the visionary behind the Bitcoin and ultimately digital asset strategy at Silvergate, there's a gentleman named Alan Lane, who joined Silvergate in 2008 or 2009. And at that time, Silvergate had sidesteped a lot of the pitfalls of the great financial crisis, that it had a clean balance sheet. And Alan was brought in to help the bank with his next chapter. If you fast forward to around 2013, Alan is a very tech curious, non-traditional banker who came across Bitcoin and said, Bitcoin is a way to be your own bank.

11:27And I run a bank, I should look into that. So he did as curious people do. And at that time, it was only Bitcoin and there were only a handful of name brand companies that had raised serious venture money like Zappo, Genesis, Coinbase, just some of their early first-generation service providers. However, it's hard to contemplate now with names like JP Morgan and BlackRock and Fidelity. These companies had a hard time getting a bank account. Bank accounts are your access to the Fed and to the wire system. And the other side of Bitcoin, if you want any liquidity out of it, if you want any productive uses, you need to get access to dollars.

12:06And the credit bar comes later, But early on, it was simply, can we provide an operating account to these first-generation companies, which was interesting as a banker in terms of a source of deposit. Yeah. So that was the first chapter. After it went along for a few years and they had gotten regulators and educated the Fed on Bitcoin and kind of brought everybody up to speed, got a little bit more involved in terms of what problems can we solve. And Bitcoin trades 24-7, but the Fedwire system does not trade 24-7. So because Silvergate ultimately had a critical mass of digital asset clients, they connected the pipes and created a system called the Silvergate Exchange Network, where participants could facilitate trading 24-7.

12:51And I think this was really, as flawed as the fiat system is, it's really important to have access to fiat system for Bitcoin to progress and to mature and to go from being a 10 billion to 100 billion to a trillion,$2 trillion asset. So the SEND was very successful, ultimately transferred over a trillion dollars of value. Silvergate went public in 2019. The ecosystem was growing up. Fidelity came in in 17, 18, Intercontinental Exchange. It was just growing up. And ultimately, Silvergate had 1 ,600 digital asset clients. It had the industry. And it had gone from, can we raise deposits from this niche industry to, we can be a better bank for these clients if we solely focus on this strategy.

13:36So ultimately, the whole deposit base was digital asset clients. It was a very liquid balance sheet. And when I got there in 2020, it was just the start of scaling up a Bitcoin collateralized lending strategy. Only against Bitcoin, all over collateralized, never realized ending loss. But that was sort of the next chapter of the silver gate strategy when I got there. So late 2020, think about Tesla, Saylor, these material allocations from the space that continues to mature. The Bitcoin-backed lending business takes off as well. We ultimately had a billion and a half dollars of commitments. We did multiple hundred million dollar deals with Marathon, a large facility, a large loan to MicroStrategy.

14:24It was a great business. FTX, Luna, 2022 was a very interesting timeline from Luna in May to FTX in November. And there were widespread fears throughout the industry, and the price obviously performed very poorly. There was a run on multiple banks because Silvergate was so liquid in terms of its high-quality securities and pretty low-duration securities on its balance sheet, it survived the biggest bank run in recent memory. I think Continental Illinois had a 40-ish percent drawdown in 84, and Silvergate was far greater than that. Ultimately, in early 2023, Silvergate made the decision to voluntarily wind down, which is, as I understand it, very rare in banking and completely different from receivership, where the executives are replaced and the bank assets are sold.

15:14So Silvergate ultimately gave all the money back to depositors and been in the process of an orderly wind down. Subsequent to that, but in very close proximity in terms of a timeline, the bank term funding program was put in place. So there was a amnesty and lifeline to the banking community only realized after the stress of the banks that serve the digital asset community. We're going to get into that. Or at least I want to get - There's a lot there, but that's sort of the arc of the Silvergate. No, that was from infancy to maturity. That was amazing. Let's take a quick break and hear from today's sponsors.

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18:24NetSuite Next is the next huge leap because now AI is built into everything you do. It surfaces custom insights throughout your day. AI agents work alongside you on the routine stuff. And anytime you've got a question about anything, you just ask, like you're talking to a colleague. And I use it. And really, I think you should too. For the first time ever, you can try NetSuite Next for free. If your revenue is at least in the seven figures, go to netsuite.ai.tip. Built for every industry, ready for every boardroom, netsuite.ai slash tip. All right, back to the show. Okay. The first question I have out of that is now that you have FedNow or FedWire that's basically processing wires within an hour now, do you think that what you guys stood up there at Silvergate was inspirational to the Fed realizing that they're going to have to start processing wires a lot faster and that the liquidity really needs to be there?

19:23Or what do you think was the impetus for this change? Knowing how slow government moves, I wouldn't be surprised that this is something that they've been thinking about for a long time, and it just took them 25 years to do something about it. At the same time, it's absolutely certain that Silvergate pushed the baking envelope. I know that on the credit side, we were far ahead of other bankers and I think put pressure on others to get into Bitcoin collateralized lending in the last cycle. And it wouldn't surprise me at all if sort of the business that we were doing and the technology that the team at Silvergate put together was a bit of a blueprint for others in the market, for upstate the Fed.

20:01Yeah. You had made the comment that you guys have short duration fixed income on the books, on the balance sheet of Silvergate, and that's why you were in a better position than a lot of others like Silicon Valley Bank that had a bunch of long duration. And that was the whole reason that they absolutely blew up. When we're looking at that scenario and you're looking at this idea that it just wound down, I think everybody looking at this from the outside in is kind of raising an eyebrow saying, come on, why was this bank wound down? It seemed like it was politically motivated or that there was almost like a political threat that that's what was going to happen because of how involved they were in this crypto economy.

20:40You seem like you might not be able to comment, but I'm kind of curious if you have an opinion on that. Robert Leonard Yeah. I think from a financial perspective, and I'll get to your question, but you mentioned in terms of high quality, the low duration assets. It's important to note as well, I mentioned the billion and a half dollar loan book by commitment. We had an extremely low loan to deposit ratio. So in addition to not being in the business of extending 30-year residential mortgages, we had a book of highly over collateralized, short term, generally one year, sometimes a few years, but our Bitcoin back loan book, was a very small portion of our balance sheet.

21:14It was very low duration, all over collateralized, super safe. The rest of it was high quality securities that we could pledge as banks do for liquidity that three years in duration was an extremely conservative balance sheet. And why was that? It's because the CEO, Alan Lane, who's a Bitcoiner and has seen this asset grow up and seen the industry grow up, knew that with the inflows and the volatility in the market, you had to be extremely liquid. So it was purpose-built for volatility. Your question about politically motivated and what's come to light, I'm very grateful that Nick Carter has done some excellent reporting on this.

21:51Yes, he has. Because of bankruptcy proceedings and things that have come to light, there's a Wall Street Journal op-ed by our former chairman, Mike Lebris at Silvergate, who's another industry veteran. Ultimately, it's clear to those in the industry that the regulators are not comfortable with above a certain threshold of concentration to this industry. So I mentioned that Silvergate had gone from, let's try to bank some of these companies to, this is a real industry. We can build a business and serve these clients better if we just focus on them. So even though regulators as a Fed regulated bank are meeting with you on an ongoing basis, again, I'm not in all of those, certainly not in all of those meetings, but I do think that there's a sense in the market that allowing a bank totally focused on digital assets one day, and then quickly saying, we're not okay with the business model that has existed with consultation with them.

22:43That was the decision. We couldn't run the business model any further at a high level. Yeah. Like I said, all the cash was just given back to deposit. And this industry still need banks. Yeah. Nick did a fantastic job covering this. We'll find the articles that you're referencing and have them in the show notes so people can read up on it. But it's really quite fascinating. This Silvergate was such an instrumental player there, especially in this timeline that we're talking about in particular for getting liquidity, getting access to traditional fiat rails that would touch the Bitcoin rails. And yeah, what an interesting historical place to work and kind of see that all unfold.

23:23You had mentioned this idea of borrowing and lending and being over collateralized. And that's exactly what you're doing with Unchained now. Let's talk about this a little bit, because I think this is something that I'm super passionate about, because there's been so much pain, so much pain in this space with borrowing and lending and people thinking that they're over collateralized, only to find out that they aren't because they're dealing with a centralized entity that's commingling funds. And some of them are over collateralized. the other ones aren't. So do this for us, John, just give us a borrowing and lending 101 over collateralization.

24:05What does that even mean? Why it's important to really kind of just lay it out there for folks and maybe even throw out what are some things that should make you be almost like a red flag was just raised, like pay attention, you're about to be bamboozled if people would hear certain things. Yeah. And it's an important situation because Bitcoin is this financial asset, and we equate it with other sorts of services that we get in the world of fiat. So everybody's familiar with interest on your dollars in a bank account, if you're lucky enough to find it, or just returns on your portfolio or borrowing against your house.

24:42But if Bitcoin is a still maturing industry, you do have to be careful and you have to diligence who you're working with and the sorts of transactions that you're involved. So the only business that we did at Silvergate, and then we actually do it on chain, is the most conservative style of lending. We lend dollars over collateralized by Bitcoin. And all that means is that if you're looking for a$200 ,000 loan, then you have to post$400 ,000 in Bitcoin. So if you think about that in another more familiar asset like your house, it's the same thing as pledging your$400 ,000 house and getting a$200 ,000 mortgage against it.

25:22No bank is going to give you more money than the asset that you pledge. So that's the structure, lending dollars backed by Bitcoin. I'll tell you why it's an appealing strategy for some. A lot of Bitcoiners ultimately come to the view that Bitcoin is the right investment. And it might not be a 10 % allocation. It might be a 50 or a 60 or more percent allocation in their portfolio. Leo, and they believe that it still has years and years of a really attractive CAGR, compound on your growth rate. Maybe it's going to 10X. I listened to your show with Jeff Booth and HODL. Those guys are really smart, but they also have a long-term constructive outlook that a lot of Bitcoiners do.

26:01But we've all got to live in the fiat world. So as I said, there's only two ways to get liquidity. You can sell it for dollars, pay taxes on it, totally fine. You can also borrow against it. And that has the value of you maintain access to your collateral, it can grow over time and do the work for you if you're conservative and careful with your risk management. Now, you mentioned what should you watch out for? It's really important for us at Unchained to deliver transparency and rehypothecation or re-pledging. These are technical terms, but they're really, really important. And I think it might be helpful to break it down by degrees in terms of what is react publication.