Abstract: In this article, we discuss the possibility of approval of an Ethereum ETF in the United States. In particular, we focus on the economics of staking and how the lack of returns may somewhat reduce the attractiveness of non-staking Ethereum ETF products. We also look at the challenges of implementing an Ethereum staking ETF, particularly the interrelationship between ETF withdrawals and the Ethereum staking exit queue system. These issues may be solvable in the long term, but given the competition for product approval, it will likely be some time before they are resolved in the United States.
outline
Bitcoin ETFs were launched in the United States on January 11, 2024, and these products huge success. ETFs have allowed new funds to access Bitcoin, which appears to have driven the price of Bitcoin higher. This leads to the question, “When will an Ethereum ETF be approved?” Similar to Bitcoin, large asset managers such as Blackrock and Fidelity have filed applications for an Ethereum ETF with the Securities and Exchange Commission (SEC). The SEC appears intent on denying or delaying applications whenever possible. As with Bitcoin, courts could eventually force the SEC’s hand, and just like with Bitcoin, the SEC could be accused of hypocrisy for allowing an Ethereum futures ETF. In our view, an Ethereum ETF seems inevitable at some point, it’s just a matter of when.
staking
Ethereum’s staking consensus system and associated returns are important factors to consider when it comes to ETFs. Some argue that because Ethereum staking generates returns or stakers propose blocks, this makes Ethereum a “security” and thus provides a basis for the SEC to reject the Ethereum ETF. This is not a problem for us to analyze. If we had to classify some cryptocurrencies as securities and others as securities, we would probably take a simple Bitcoin max position. In other words, if there is a coin offering, it is a security, and if there is no coin offering, it is not. So in our hypothetical system, Bitcoin and Dogecoin are not classified as securities, but Ethereum is. We will not be introducing staking.
But our views are not relevant here. The SEC and the US courts will do what they do and this is not a matter for us to opine any further. In this report, we will instead be interested in the economics of staking and the impact this may have on all ETFs. Staking and yield issues will, in our view, be very important for ETFs regardless of what regulators decide on staking. This is an important economic issue.
The appeal of staking
Currently, Ethereum’s staking yield is approximately 3.7%. Staking is a core part of Ethereum from both a narrative and economic perspective. This rate of return may be what attracts investors to Ethereum and is a key differentiator between Bitcoin and Ethereum. Not all Ethereum investors care about yield, but for institutional investors and ETF buyers, the issue of yield is likely to be a more important consideration. Although raw Ethereum prices are likely to underperform Bitcoin in the long run, Ethereum stakers can take advantage of staking yields to earn higher returns than Bitcoin holders.
However, the staking system may make Ethereum less attractive or suitable for some ETF investors who are unable to stake. Existing Ethereum holders and stakers may be less willing to stop staking and convert their holdings into ETFs because they do not want to lose out on returns. At the same time, new funds may be reluctant to invest in Ethereum ETFs. Knowing that they might get a worse deal than stakers and therefore lower returns, these investors might choose a Bitcoin ETF instead. Staking directly or purchasing coins like stETH is not something some investors can do who need exchange-listed products for cryptocurrency exposure. It is unclear how important this factor is, but as staking returns increase, missing out on returns may be a major factor for some new investors.
Validator Exit Queue and ETF Redemption
The solution here may seem obvious. ETFs can stake Ethereum. However, this may not be possible for regulatory reasons as well as practical reasons related to product exchange. In the Ethereum staking system, closing a stake requires going through two queues. Entry queues can also be considered, but this is less important from an ETF perspective. This is because delayed equity deployment reduces product returns. In contrast, exit queues may be a consideration during the ETF redemption process. The two exit queues are:
- Standard shutdown queue: It is a first-in, first-out queuing system for the staking termination process. This is considered very important for the stability and security of the staking system as it prevents too many stakers from leaving too quickly. The queue is based on a churn limit, which is a limit on the number of validators that can exit per epoch (6.4 minute period). The current churn limit is 14, which depends on the total number of active validators. A value of 14 represents approximately 100,000 ETH per day. Based on the current Ethereum spot price, it is approximately $400 million. From an ETF perspective, it is certainly possible that daily outflows could be larger than this in some economic circumstances (look at GBTC after January 11, 2024). The nature of this queue is that the more people trying to get out, the longer the wait will be. The line is currently almost empty, so the wait time is about 12 hours. With the turbulent cryptocurrency market, it’s easy to see that potentially, given the specific period of time people want to redeem their Ethereum ETFs, the wait could be much longer, possibly taking several months. This is therefore a potential problem for staking Ethereum ETF providers.
- Validator Sweep Delay: This second wait occurs after the shutdown queue and is more of an implementation detail than an economic constraint on the system. This queue is essentially a random queue rather than a first-in-first-out type of circuit. This delay applies to both validator terminations and general partial withdrawal payments. There is a limit of 16 per slot or 512 per epoch. This waiting time is currently around 9 days and, unlike the first waiting time, this waiting time should not increase significantly during periods of financial stress. However, the nine-day waiting time is much longer than the redemption process for regular ETFs, which typically takes one to two business days.
When validators are cut, additional delays occur, resulting in longer waiting times. Slashing is of course another risk of staking Ethereum ETF products and should be explained to potential investors. Therefore, the exit queue system certainly makes it more difficult to implement an Ethereum staking ETF.
the problem is solvable
Of course, these problems are solvable. First, ETFs can only hold shares in a portion of their Ethereum holdings and withdraw the remaining portion immediately. This lowers yield and increases product complexity, but is certainly possible for sophisticated product providers. You may have a team that specializes in liquidity, which is not entirely different from the situation for large ETFs that hold illiquid securities. An ETF holding stocks equivalent to a 9-day average daily volume would be comparable, but not exactly the same, with a 9-day liquidation wait. Additionally, the terms and conditions of the Ethereum Staking ETF have changed, which may delay the redemption process in certain circumstances. However, given how the exit queuing system works, it is likely that large ETF redemptions will actually lead to more withdrawal delays in a downward spiral scenario, which is not an ideal product structure and creates a type of systemic risk. Of course, from Ethereum’s perspective, these risks exist regardless of whether there is an ETF, but ETFs may make the problem worse. Another idea we like is to avoid the Ethereum Stake ETF entirely and instead issue a stETH ETF. This completely resolves the redemption issue or transfers it to Lido.
It is important to note that ARK/21 Shares is already staking Ethereum ETP with $640 million in assets in Europe. ARK’s application for the U.S. Ethereum ETF also includes a provision allowing staking of a portion of the fund’s assets.
However, as we saw with Bitcoin, the SEC appears eager to put in place any obstacles it can get in the way of ETF providers. So product publishers are desperate to get their products over the line. It appears that issuers do not want to complicate the situation by applying for products with staking features that would require them to explain complex issues related to redemption and exit queues to the SEC and investors. Therefore, in our view, it may be several years before there is a meaningful Ethereum ETF in the United States. But in the long term, these problems certainly seem solvable.
conclusion
This staking ETF issue would actually be quite positive for Ethereum from a security and decentralization perspective. The last thing Ethereum needs is for Blackrock to become its biggest validator. This could potentially be much worse for Ethereum than Blackrock becoming the largest Bitcoin holder. This is because Bitcoin holders have no role in block production or choosing between competing valid chains. Combining the role of consensus agent with that of investors is a centralization risk. Therefore, any barriers that impede Blackrock’s staking capabilities can be considered desirable. Maybe the exit line needs to be made longer for this exact purpose!
In our view, ETF approval is likely to be a less important factor for Ethereum than Bitcoin for a number of reasons.
- Since the Bitcoin ETF launched first, the approval of the Ethereum ETF will likely come with less fanfare.
- Ethereum culture is more focused on usage and technology/DAPS, while Bitcoin is more focused on holdings and financial considerations, with ETFs being more relevant.
- Ethereum has staking yield issues discussed in this article, which may make the ETF less attractive.
Nonetheless, the approval of an Ethereum ETF is another exciting prospect for the cryptocurrency space, and we will be tracking and reporting flow data once approval occurs. We will first report on the extent to which Ethereum ETFs are encroaching on Bitcoin ETFs, Ethereum in staking pools, or Ethereum pegged to indices. Alternatively, ETFs may cause new funds to enter the system, causing prices to rise.