Silicon Valley Bank goes bankrupt! USDC decouples! Today was truly eye-opening. The incident at Silicon Valley Bank caused a massive panic in the market as USDC decoupled. Some people were so scared that they sold their LP for 0.05U, which was originally worth 2 million. Let's discuss why the interest rate hike in the US can lead to Silicon Valley Bank's downfall. Please note that this explanation is limited to my personal understanding, and I welcome any corrections if there are any mistakes.
First, let's introduce Silicon Valley Bank. It is a publicly listed bank that primarily provides financing and other financial services to technology startups. The bank's clients mainly come from the fields of science and technology, life sciences, healthcare, high-end consumption, private equity, and venture capital (PE/VC). One characteristic of these technology startups is that they rely heavily on liquidity.
During the COVID-19 pandemic, the Federal Reserve initiated unlimited quantitative easing (QE), which means they started printing money without any limits. As a result, liquidity flooded the market, and market sentiment became extremely heated. We witnessed Bitcoin skyrocketing to $60,000 under this flood of liquidity. In this context, technology startups were able to easily obtain large amounts of financing, and most of this money was deposited in Silicon Valley Bank. As a result, the bank accumulated a large amount of deposits.
For a bank, customer deposits are its liabilities because the bank has to pay interest on them. Therefore, banks usually lend out the money to earn interest rate spreads. However, in the context of the excessive liquidity during that time, Silicon Valley Bank couldn't lend out as much money. So, they couldn't just leave all that money idle. As a result, Silicon Valley Bank decided to invest in US Treasury bonds and mortgage-backed securities (MBS). In theory, this allocation shouldn't have been a problem. So, what went wrong?
The problem was that Silicon Valley Bank was reckless. They couldn't even call it asset allocation. They went all-in and didn't leave themselves enough liquidity. As the Federal Reserve began raising interest rates and reducing its balance sheet, the amount of money in the market decreased, and investment enthusiasm started to wane. We also saw the cryptocurrency market enter a bear market. For technology startups, they needed liquidity to survive, and the demand to withdraw funds from the bank increased.
The increased demand for withdrawals led to a liquidity crisis at Silicon Valley Bank. The bank started selling its bonds to obtain liquidity. However, due to the aggressive interest rate hikes by the US, the prices of Silicon Valley Bank's bonds plummeted. They sold the bonds at a loss. If they didn't sell, there would be a liquidity crisis. In the end, Silicon Valley Bank sold $21 billion worth of bonds, resulting in a loss of $1.8 billion.
After Silicon Valley Bank sold its bonds at a low price, investors became extremely sensitive. If you saw a bank willing to sell bonds at a loss of $1.8 billion just to obtain liquidity, what would you do? Of course, you would think that the bank must have some serious problems and quickly sell your stocks to hedge your risks. So, those people fled quickly, and as a result, Silicon Valley Bank's stock price plummeted by 60%.
The subsequent plot was the market panic caused by the plummeting stock price, leading to a bank run and ultimately resulting in Silicon Valley Bank's bankruptcy. Many well-known institutions had money in Silicon Valley Bank, including Circle, the issuer of USDC. This caused USDC to decouple, and pools like Uniswap and Curve were emptied. There were even incidents where LP worth 2 million was exchanged for 0.05U.
So, why does the interest rate hike by the Federal Reserve lead to a decline in bond prices?
To understand this, we need to know how the Federal Reserve controls interest rates. First, if you have knowledge of bonds, you would know the concept of "inverse relationship between bond prices and interest rates." But why? Why do bond prices rise when interest rates fall? Why do bond prices fall when interest rates rise? Why is the market so concerned about the US ten-year Treasury bond yield?
First, we need to understand a few characteristics of interest rates: reference and transmission. What does this mean? We all know that the interest rate for borrowing is related to the borrower's risk. Who is the safest borrower in the world? The answer is the Federal Reserve. Borrowing money from the Federal Reserve is currently the safest option in the world. Therefore, the interest rate on US Treasury bonds can be called the risk-free rate.
If you want to lend money to someone else, you would consider adding some interest on top of the risk-free rate. If the interest you receive from lending money is lower than the interest on US Treasury bonds, would you lend? Everyone would use the risk-free rate as a reference and change their behavior as interest rates fluctuate. This is the concept of reference and transmission.
This means that controlling interest rates can influence market behavior through the transmission of interest rates. Since we know that the risk-free rate is based on the interest rate of US Treasury bonds, the Federal Reserve controls interest rates by manipulating the bond market. They don't just hold a meeting and say, "I want to raise interest rates to 10%, and tomorrow everyone will have a 10% interest rate." So, how do they implement it?
Let's take an example. Suppose I hold a US Treasury bond with a face value of $1,000, a ten-year maturity, and a 10% interest rate. It gives me $100 in interest each year. In theory, if I hold it for ten years, I will receive ten dividends totaling $1,000. However, after one year, my wallet gets stolen, and I'm left with nothing. I urgently need funds to survive, so I decide to sell my bond. At this point, I have already received $100 in dividends.
However, at this time, the interest rate on newly issued bonds in the market has risen to 50%. A $1,000 bond can now earn $500 in interest per year, while my bond only has a 10% interest rate. If I want to sell, I can only do so at a loss, and I have to find a counterparty willing to buy my bond. Let's say someone comes along and wants to buy my bond.
Since the interest rate on new bonds is much higher than my 10% rate, the person offers $200 to buy my $1,000 bond. At this point, my bond will mature in nine years, and I will receive $1,000 + $900 = $1,900. The buyer will earn an actual interest rate return of 85%. Meanwhile, I have no choice but to sell because I'm starving and need to eat.
Do you see what happened here? Although the face value of the bond is $1,000, I can only sell it for around $200 in the market. As the market price of my bond decreases, the buyer's actual interest rate return increases. This is the so-called "inverse relationship between bond prices and interest rates." Please note that here, the price and interest rate refer to market price and actual interest rate (effective rate), not face value and interest rate (nominal rate).
Due to the moderate maturity period and frequent trading of the ten-year US Treasury bond, its yield has become a benchmark for market interest rate changes. So, if the Federal Reserve can influence the market price of Treasury bonds, they can indirectly influence market interest rates, right?
There are many factors that affect bond price changes, such as market supply and demand, maturity period, and credit ratings. Therefore, the main way the Federal Reserve influences interest rates is by affecting market supply and demand. They enter the bond market to buy or sell bonds, thereby influencing prices and interest rates. This is called Open Market Operations.
So, when the Federal Reserve implemented unlimited quantitative easing and printed money, they didn't just give money to people. They went crazy buying bonds in the bond market because, after all, the money was printed. When there was such a big buyer willing to take everything, bond prices went up, and interest rates went down, achieving the goal of lowering interest rates.
Now, in the current market context, as the Federal Reserve continues to raise interest rates, they are actually selling Treasury bonds. The more bonds they sell in the market, the lower the price of the bonds, which leads to an increase in interest rates. Of course, controlling interest rates is not the only method the Federal Reserve uses, but I mainly explained this method. Now, let's take a closer look at what happened to Silicon Valley Bank.
According to reports, before the stock price of Silicon Valley Bank plummeted, the bank actually sold a portfolio of bonds at a low price. In SVB's report, we can see that the interest rate on this $21 billion bond portfolio was 1.79%, with a maturity of 3.6 years. However, the yield on the US three-year Treasury bond has already reached 4.7%, and bonds with non-standard maturities like 3.6 years are not easy to sell. This led to Silicon Valley Bank selling the bonds at a loss of $1.8 billion.
In conclusion, Silicon Valley Bank's bankruptcy was entirely its own doing. They recklessly gambled on bonds, and the US interest rate hike didn't end well. The decoupling of stablecoins also reflects the risks of the stablecoin system. Stablecoins are essentially centralized entities. If USDC collapses, so will DAI and FRAX. We should all seriously consider the meaning of Satoshi Nakamoto's words in the genesis block of Bitcoin.