Key Takeaways
- Spot ether exchange-traded funds (ETFs), which give investors direct exposure to the current market price of ether, could get approval in the U.S. by as early as May this year.
- An increase in ether staking ETFs could affect the mix of validators participating in the Ethereum network's consensus mechanism. The participation of institutional custodians could reduce the current concentration on the Lido decentralized staking protocol. However, it may also introduce new concentration risk, particularly if a single entity is chosen to stake the bulk of ether included in these ETFs.
- The effect of U.S. spot ether ETFs on concentration risk, be it positive or negative, could be significant, which makes constant monitoring of concentration risk even more important.
U.S. Spot Ether ETFs Are Coming
Following the U.S. Securities and Exchange Commission's (SEC) approval of ether futures ETFs in 2023 and spot bitcoin ETFs on Jan. 10, 2024, market participants expect spot ether ETFs will be next. The SEC is currently reviewing eight applications for spot ether ETFs and the formal deadline for its first decision is May 23, 2024.
Spot ether ETFs have already been approved in Canada, Switzerland, and other European countries. According to cryptocurrency data aggregator CoinGecko, assets under management (AUM) of spot ether ETFs amounted to approximately $2 billion globally, as of February 2024.
Staking Brings Yield Opportunities To Spot Ether ETFs…
The structure of most spot ether ETFs that are currently being reviewed by the SEC follows that of spot bitcoin ETFs. The latter hold bitcoin in a secure digital vault, which is managed by registered custodians. These ETFs simply track the price of the underlying asset. However, some proposed U.S. spot ether ETFs (to date, the applications from Ark Invest and Franklin Templeton), aim to generate additional yield by "staking" the underlying ether. Some ETFs outside the U.S. already do this--we estimate total AUM of non-U.S. spot ether ETFs that incorporate staking is approximately $800 million.
The Risks And Rewards Of Staking
When staking, cryptocurrency holders lock their tokens to a blockchain network to help validate transactions. Validators earn a staking reward but also face a slashing risk, meaning their stake could reduce if they are inactive or attest to invalid transactions. Ether holders can stake directly to the Ethereum network and participate as validators. Alternatively, they can stake through a digital asset custodian or a decentralized staking protocol. Custodians and decentralized staking protocols control the stake of multiple validators.
…But Could Affect Concentration Risks Within The Ethereum Network
Spot ether ETFs that simply hold ether will not affect the validator mix in Ethereum's consensus mechanism. Spot ether ETFs that include staking, however, will do exactly that--at least if inflows are high enough. Based on the volume of U.S. spot bitcoin ETFs one month after their approval (approximately $12 billion as of Feb. 14, 2024), U.S. spot ether ETFs that incorporate staking could become large enough to change validator concentrations in the Ethereum network, for better or worse. It is therefore critical to understand how ETF issuers' choices will drive concentration risks.
Ethereum's Consensus Mechanism And Concentration Risks
To finalize a block, Ethereum's proof-of-stake consensus mechanism requires at least two-thirds of validators to confirm each new block on the chain is valid. Block finalization is central to the settlement of financial transactions on Ethereum. If more than one-third of validators are inactive simultaneously or act with malicious intent, new blocks cannot be finalized. It is therefore crucial to monitor concentration risks that could expose meaningful portions of the network to simultaneous inactivity or malicious collusion, specifically:
- The portion of validators that are controlled by a single entity or decentralized staking protocol; and
- The portion of validators that run the same client software package to validate the network (client concentration risk) since a bug in this software could render validators inactive. Diversification and redundancy partly mitigate this risk as multiple client software packages that are developed by different companies are available.
For more details, see "What Can You Trust in a Trustless System: Public Blockchains for Financial Applications," published on Oct. 11, 2023.
The largest validator in the Ethereum network is Lido, a decentralized staking protocol, whose staked ether concentration is just below the 33% threshold (see "Is Ethereum's Lido concentration a concern?" in "What Can You Trust in a Trustless System: Public Blockchains for Financial Applications," published on Oct. 11, 2023). In our view, U.S. institutions issuing ether staking ETFs are unlikely to engage directly with decentralized protocols such as Lido. Instead, they will opt for an institutional digital asset custodian, which, in turn, would reduce the Lido validator concentration risk. ETFs' overall effect on concentration, though, will depend on whether they spread their stakes across multiple custodians.
Coinbase Global Inc. (Coinbase) controls the second largest share of validators in the Ethereum network at 15% (see chart 1) and could represent a growing concentration risk for Ethereum if it takes a significant share of newly staked ether from ETFs. Coinbase acts as a custodian in eight of the 11 recently approved U.S. bitcoin ETFs and is named as a staking institution by three of the four largest ether staking ETFs outside the U.S. The emergence of new digital asset custodians may enable ETF issuers to spread their stakes across different entities and mitigate this risk.
Chart 1
Related Research
- What Can You Trust in a Trustless System: Public Blockchains for Financial Applications, Oct. 11, 2023
This report does not constitute a rating action.
Primary Credit Analyst: | Andrew O'Neill, CFA, London + 44 20 7176 3578; andrew.oneill@spglobal.com |
Secondary Contact: | Alexandre Birry, Paris + 44 20 7176 7108; alexandre.birry@spglobal.com |
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