ETH ETF: A Welcome Milestone for Digital Assets + Key Takeaways

The recent approval of a series of Ethereum ETFs by the SEC marks a significant milestone in the evolution of digital asset investment products. In this piece, we provide our insights on the event and explore the potential implications for the industry's future direction.

Market Impact

The scale of the inflows into the Bitcoin ETFs dramatically surprised the market. Based on those numbers, we believe capital flows into Ethereum ETFs are likely to be substantial, potentially around $4 billion within the first 3-4 months, given the BTC ETFs have so far garnered approximately $14 billion against a $1.4 trillion market cap. If filings are later amended to permit staking, which would in and of itself be novel and another innovation, this could make the product even more attractive to retail and institutional investors; staking is a strong narrative that the Wall St. Machine can likely get behind further enhancing the flows.  

Beyond Ethereum, other tokens likely to benefit include core DeFi plays like Lido (LDO), Uniswap (UNI), Aave (AAVE), and dYdX (DYDX), along with Ethereum L2s Arbitrum (ARB) and Optimism (OP). We believe the ETF will help Ethereum cement its position as the most institutional quality L1 and as such, projects will want to build on the Ethereum L2s with the most mindshare and TVL, especially with L2 fees down dramatically over the past few months. Additionally, middleware projects like Chainlink (LINK) could perform well as LINK aligns with the narrative of traditional finance migrating to the blockchain and the enormous potential market associated with that. At a higher level, we see the change in regulatory stance implying a far more fertile backdrop for the proliferation of higher quality, institutional grade projects with real world utility. These require years of capital and talent (e.g. the Uber of web3) and are difficult to bootstrap in an uncertain regulatory environment. If this truly is a sea change in government policy we could be at the foothills of a multi-year boom for web3 innovation, capital and talent. Much like trying to predict Uber, Netflix or Facebook in the mid 1990s, it is difficult to comprehend what could be achieved over a decade or two with the right conditions in place.

Lastly, while there has been recent speculation around the approval of ETFs for other tokens (such as SOL or DOGE), we believe this is unlikely any time soon given the lack of history and an existing futures contract (which are important in showing a strong correlation to spot markets to open up the path to a successful spot ETF application) and lower demand from investors and ETF providers.  

Legal Recap

Legally, as with the BTC ETFs, the listings need to be designed such that they meet two major requirements.

• “Prevent fraudulent and manipulative acts and practices” and “in general, to protect investors and the public interest” (Section 6(b)(5) of the Exchange Act).
• Are “in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure the availability to brokers, dealers, and investors for information with respect to quotations for and transactions in securities” (Section 11A(a)(1)(C)(iii) of the Exchange Act).

In respect of point 1 above, in a similar manner to the BTC ETF approvals, the SEC found that the spot ether market and the CME ether futures market are highly correlated (98.6% using an hourly interval over 6 months). Therefore, the SEC was able to conclude that fraud or manipulation that impacts prices in the spot ether markets would likely similarly impact CME futures prices, and because the CME can assist in the surveillance of detecting those impacts, the surveillance-sharing agreement with the CME could be reasonably expected to detect fraudulent/manipulative acts and practices.

In respect of point 2 above, the SEC was satisfied that the proposals for the listings included sufficient information regarding, for example, the availability of pricing information and transparency of portfolio holdings, which are all consistent with other ETPs the SEC has previously approved.

As noted above, ETFs are approved through a two-part process. The first part involves the 19b-4 filing, which requests a rule change to allow for the approval of an ETH spot ETF, which was approved on May 25, 2024. The second part is the S-1 filing, effectively a prospectus for the product. An S-1 approval is still needed before the product can go live. We anticipate a lag of a few weeks, given the accelerated timeframe for the 19b-4 filing, before these products can be freely traded. Nonetheless, the first set of approvals remains a significant milestone.  

Regulatory Landscape – What We Can Infer:

In the approved Ethereum spot-ETF applications, the funds were referred to as “commodity-based trust shares”. The manner and form of these specific Ethereum spot-ETF's approvals would not be possible if Ethereum was considered a security. Though the natural inference would be that the SEC has now classified Ethereum as a commodity and not a security, it is important to note (i) it is possible for something to be deemed a commodity in one transaction, but a security in another transaction – it depends on the specific circumstances; and (ii) the SEC has definitively not made that statement yet. It is not beyond the SEC’s power to bring forth arguments such as staked Ethereum is a security or that the manner and circumstances of offering Ethereum is still a securities offering or another number of various other arguments  While it would be easier to assume the SEC now sees Ethereum as a commodity, at the end of the day, whether a digital asset is a security or not still depends on the facts and circumstances of that transaction, issuance, or offering. We continue to monitor the actions and statements of all regulators in an effort to glean how they view and intend to regulate this nascent class of digital assets. Still, the current approvals indicate a cautious but clear pathway forward for Ethereum-based financial products.

The above findings, although based on a specific analysis of ETH, are very similar to the arguments proposed in the BTC ETFs approval. On that basis, from a strictly legal perspective, so long as the spot ether market and the CME ether futures market proved to be correlated, these ETH ETFs were always going to be approved. However, given the public commentaries, there had been much doubt and speculation about when exactly the ETH ETFs would be approved.

The outcome above came the day after 71 Democrats joined 208 Republicans in the House of Representatives to vote on the Financial Innovation and Technology for the 21st Century Act (FIT21) – this bill seeks to define the responsibilities of authorities like the SEC and CFTC for digital assets. The bill is a positive step for digital assets, and was passed despite vocal opposition from President Biden and SEC Chair Gary Gensler. A week earlier, the Senate voted to overturn a controversial SEC bulletin that would restrict the ability of banks to hold crypto. All laws and regulations start somewhere in politics. Maybe commentators, across X and traditional outlets, are right that we are seeing a shift in the SEC’s position due to political shifts (and an election year). However, we welcome a timely response from the SEC on these ETH ETFs.