ETH ETF Market and Legal Update: Slow Start, Bright Future

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Date

August 2, 2024

Market Analysis

By Steve Goulden, Senior Trader

After much initial hype, week one flows across the Ethereum ETF space have frankly been somewhat tepid. Net outflows have so far been ~$400m (based on data from farside.co.uk), with the Grayscale Ethereum Trust (ETHE) contributing outflows of over $1.8bn. With annual fees at 2.5%, we believe ETHE holders have generally been looking to move into lower fee alternatives, with most ETFs at around 0.25%, or have been switching into native Ethereum - and in fact, we have seen a slight uptick in staking over the past week, with roughly $1bn deposited. Note that staking yields on Lido are currently 2.9% APY, so the net yield compared to holding ETHE is over 5% higher.

Roughly 20% of ETHE's assets have now been withdrawn, and based on the Grayscale Bitcoin Trust experience, outflows began to slow at around 30% of the original NAV (based on data from coinglass.com). It is our opinion that outflows should begin to ease soon based on the experience with GBTC, and in fact, we have seen a reduction in the outflows in the last couple of days. This suggests the ETF launch could soon switch to becoming a meaningful tailwind for the Ethereum price. Of course, there is a high degree of reflexivity here; over the past week, investors have had to contend with Bitcoin 2024 Nashville and a speech from Donald Trump hinting at establishing a strategic reserve for Bitcoin, followed by the US government moving its Bitcoin on-chain, with the latter dampening risk appetites, along with the (ETHE driven) tepid initial headline flow numbers. Similarly, going into the ETF launch and the Bitcoin conference, investors were positioned fairly long across spot, perps, and options, limiting the scope for meaningful near- term upside. 

Going forward, we remain optimistic. Much like the Bitcoin ETF, the Ethereum ETF suite creates a source of significant buying pressure from retail and institutions. The market is looking for around 20-25% of the flows seen for Bitcoin – a target that we believe is reasonable. In that scenario, we would expect to see a meaningful price impact (likely with Ethereum pushing past all-time highs), and we expect that as flows begin to show a continued run of daily net inflows, the price will begin to meaningfully recover both on a stand-alone basis and vs. Bitcoin.

Legal Analysis: Changing Tides?

By Leland Chang, Corporate Counsel

After nearly a decade and over 20 rejected applications, the first spot Bitcoin ETFs were finally launched earlier this year after the U.S. Court of Appeals for the District of Columbia deemed the SEC’s denials as “arbitrary and capricious.” With the unexpected launch of a spot Ethereum ETF following close behind, 2024 might just be shaping up to be Crypto’s redemption arc.

The beginning of 2024 looked bleak for the Crypto industry. The SEC’s decision to approve the spot Bitcoin ETF was a clear disclaimer that they still view “bitcoin [as a] primarily speculative, volatile asset.”¹ Subsequently, the SEC issued subpoenas to a plethora of firms and companies associated with the Ethereum Foundation and the Ethereum ecosystem, signaling that a Well’s notice may be coming. These came against the backdrop of several high-profile cases between the SEC and other key industry players, notably exchanges, such as Coinbase, Binance, and Kraken. The prior two years saw some of the loudest personalities in Crypto quieted by revelations of fraud, misfeasance, and negligence, with the misdeeds or bankruptcy of Celsius Networks, Three Arrows Capital, FTX, Voyager Digital, and BlockFi becoming synonymous with the Crypto industry as a whole.

And how the tides have changed.

There are two different baskets of digital asset-based spot-ETFs trading in the market. While the approval of the spot Bitcoin ETF was historic, it would not be presumptuous to say the launch of the Ethereum spot-ETF could prove to be more impactful. Let’s look at what the launch of an Ethereum spot-ETF means for the Ethereum ecosystem, and the larger crypto industry as a whole.

Crypto is here to stay

To recap, there are already 11 spot Bitcoin ETFs currently trading in the U.S. with over 30 billion in assets. Canada, Europe, Brazil, and Australia have also launched spot Bitcoin ETFs with assets totaling over 6 billion, for a combined total of 32 spot Bitcoin ETFs offered globally. Hong Kong has already launched its spot Bitcoin and Ethereum ETPs, and the FCA in the UK has approved applications for crypto ETPs, a trend that may spread in Asia and Europe respectively.

In the U.S., the launch of an ETF is a 2-step process: first, the approval of a 19b-4 application, and second the approval of a form S-1. Approval of a 19b-4 application is a decision on the merits of the asset itself and whether it meets specific criteria regarding security, liquidity, and investor protection, amongst other factors. They provide details on how the ETF would comply with rules and regulations, and ultimately, the SEC was satisfied that any fraud/manipulation could reasonably be detected, and the listings were in the public interest and appropriate for the maintenance of fair and orderly markets. The S-1 form is a registration form with all the relevant disclosures, ensuring transparency before the products can officially be traded.

As with any new emergent asset class, it must a) stand the test of time, b) pass governmental scrutiny, and c) find an active market. Bitcoin was born over 15 years ago and is a testament to crypto-resilience. Though many exchanges, on-ramps, and applications may have been hacked, the Bitcoin protocol (i.e. the underlying asset) has shown itself to be incredibly robust. Ethereum, and other general-purpose blockchains may be younger but show familiar patterns of resiliency. In fact, the very nature of blockchain technology dictates that any blockchain vulnerable to hacking and manipulation cannot exist for a very long time. Though regulatory ambiguity has hampered adoption, a global trend is moving towards governments realizing that Crypto is an asset class that will not go away and cannot be ignored.

Though uncertainty still surrounds regulation, these ETF products are now an indelible mark of Crypto’s legitimacy as an asset class, especially in the eyes of Wall Street, and an indicator of investor demand. The integration of digital assets into traditional financial markets is just beginning.

Recalibrates the Risk Framework for Fringe TradFi Players

Financial instruments are much like Lego pieces. Traditional finance and institutional advisers are obligated to construct and manage their portfolio with the best combination of “Lego pieces” to achieve maximum returns under specific risk parameters. Before 2024, Crypto wasn’t even a viable Lego piece for many. This was largely due to its extreme risk profile, not just in terms of its price volatility, but its potential existential regulatory risk. Will it still be around 10, 20 or 50 years from now or will this kind of “Lego piece” be left behind as a distant memory, incompatible going forward? Crypto punks saw what made these “Lego pieces” special in the 2010s, others have slowly learned over the years, and U.S. regulators have now caught on… And Wall Street is listening intently.

The approval of a spot Ethereum ETF is more than a new regulated investment product;, it is evidence that the SEC has taken a look at Ethereum as an asset, and signed off on another “Lego piece” fit for investor consumption. Now that major financial institutions have easy, regulated access to the two largest Crypto assets out there, portfolio construction starts to look a lot different. Is it too risky? What if the SEC deems it a security? How does custody work? Is it safe and secure? What about tax compliance? All valid questions, and all questions that can be addressed by an ETF. There are fewer questions gatekeeping a digital asset allocation from becoming a mainstay in many well-diversified portfolios. It is also just easier. The barrier to entry for large institutions and retail investors looking for their first taste of crypto exposure has been dramatically reduced. Depending on one’s risk appetite, this also paves the way for access to other crypto-derivatives, stablecoins, and through Ethereum, staking, and DeFi. Furthermore, the entry of traditional financial powerhouses dabbling with Crypto reduces fear and increases confidence in the Crypto market.

At the end of the day, the launch of spot Ethereum ETFs has increased accessibility and ease across the financial sector. It is an indication of acceptance by U.S. regulators and trusted financial brands, ultimately contributing to accelerated adoption of this ground-breaking technology.

Introduces liquidity and potentially new investors

ETFs provide a regulated and accessible way for institutions, traditional traders, and retail investors to participate in and gain exposure to, the crypto market, potentially attracting more capital, and further increasing liquidity and market participation. The boost in liquidity indirectly creates smoother and less volatile transactions, eventually benefiting everyone from developers to large-scale asset managers. The spot Ethereum ETFs also reduce operational complexities, opening the door for investors who are accustomed to the ease and security of a regulated platform without the need to fuss over custody. The benefits of applying the ease of trading on a traditional US stock exchange and compliant tax reporting to Ethereum cannot be understated. The barrier to entry for retail investors looking for their first exposure to crypto on a Robinhood account or major financial institutions adding a percentage of their portfolio to Ethereum exposure has been greatly reduced.

The Ethereum Ecosystem Gets a Boost

Until the U.S. gets congressional intervention and comprehensive digital asset legislation like the proposed FIT21 bill², these court cases and regulatory decisions are what we can use to glean what the regulatory landscape will look like in the near future. ETFs bring regulatory oversight and investor protection measures, and their approval brings some level of regulatory clarity in the U.S.

First, the SEC no longer sees Ethereum as a security, and the CFTC maintains its classification that Ethereum is a commodity. This determination may even impact the ongoing (and potential future) SEC lawsuits against the likes of Coinbase, Ripple, Kraken, and other large institutions charged with offering unregistered securities. Though the SEC has reserved the right to look at staked Ethereum differently, this is a huge win for the entire space.
Second, Ethereum’s transition from a proof-of-work consensus protocol to a proof-of-stake system in 2021 does not make it a security. Ethereum’s inception from 3 co-founders to a decentralized platform provides a strong precedent.
Third, there is more to Crypto than ‘just’ Bitcoin. The stories of other cryptocurrencies are closer to that of Ethereum than Ethereum’s is to Bitcoin’s. From their inception, to purpose and use case, to consensus protocol, Ethereum has provided a road map (to be clear, not the only road) for other blockchains to get their own spot ETF or earn the nod of approval from the SEC.

Ethereum is more than just a digital asset: it’s a platform, it’s the fuel that runs the biggest decentralized computer in the world, and it is a gateway to a much larger ecosystem, comprising layer-2 solutions, NFTs, DeFi, tokenization, and more.

The spot Ethereum ETF cracked a hole in a dam, and a flood is coming.

¹ https://www.sec.gov/newsroom/speeches-statements/gensler-statement-spot-bitcoin-011023

² Legislation, like the proposed Financial Innovation and Technology for the 21^st Century Act (FIT21), attempted to regulated most crypocurrencies as commodities.

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