Abstract: In this piece we discuss the potential approval of Ethereum ETFs in the US. In particular we focus on the economics of staking and how the lack of a yield could diminish the attractiveness of non-staking Ethereum ETF products, to some extent. We also look at the challenges of implementing Staking Ethereum ETFs, in particular the interrelationship between ETF withdrawals and Ethereum staking exits queue system. While these problems are probably solvable in the long run, given the race to get the products approved, it is likely to be a while before these issues are addressed in the US.
Overview
The Bitcoin ETFs launched on 11th January 2024 in the United States and these products have been a tremendous success. The ETFs have enabled new money to access Bitcoin which appears to have boosted the Bitcoin price. This has then led to the question: “When will Ethereum ETFs be approved?” As with Bitcoin, large asset management institutions such as Blackrock and Fidelity have submitted Ethereum ETF applications with the Securities and Exchange Commission (SEC). The SEC appears keen to reject or delay the applications, as much as it is able to do so. As with Bitcoin, the courts may eventually force the SEC’s hands and again as with Bitcoin, the SEC may be accused of hypocrisy for allowing Ethereum Futures ETFs. In our view, it looks like an Ethereum ETF is inevitable at some point, it is just a matter of timing.
Staking
Ethereum’s staking consensus system and the associated yield is a critical factor to consider with respect to the ETFs. Some argue that since Ethereum staking generates a yield or because stakers propose blocks, this makes Ethereum a “security” and therefore this provides a rationale for the SEC to reject Ethereum ETFs. This is not an issue we will analyse. If we were forced to classify some cryptocurrencies as a security and others not, we would probably go with the simple Bitcoin maxi stance, if there was a coin offering, its a security and if there wasn’t, its not. Therefore under our hypothetical system, Bitcoin and Dogecoin would not be classified as securities, while Ethereum would be. We would not bring staking into it.
However, our view here is irrelevant, the SEC and the US courts will do what they do and this is not an issue we will opine on further. In this report we will instead concern ourselves with the economic aspects of staking and the impact this could have on any ETFs. The staking and yield issue will be highly significant for the ETFs in our view, a significant economic issue, regardless of what regulators determine about staking.
Attractiveness of Staking
Ethereum’s staking yield is currently around 3.7%. Staking is a core part of Ethereum, both from a narrative perspective and economic perspective. This yield may well be a factor that entices investors into Ethereum and is a key differentiator between Bitcoin and Ethereum. While not all Ethereum investors care about the yield, it’s possible the yield issue is a more important consideration for institutional investors and ETF buyers. It is certainly possible that the raw Ethereum price underperforms Bitcoin in the long run, yet Ethereum stakers, with the benefit of the staking yield, could earn higher returns than Bitcoin holders.
However, the staking system may make Ethereum less attractive or unsuitable for some ETF investors, where the ETFs would presumably be unable to stake. Existing Ethereum holders and stakers may be less willing to stop staking and switch their holding to the ETF, as they would not want to lose out on the yield. At the same time, new money may be reluctant to invest in an Ethereum ETF, when they know they are getting a worse deal than the stakers and could therefore earn lower returns, maybe these investors might choose a Bitcoin ETF instead. Staking directly or purchasing a coin like stETH is not something some investors, the ones who require exchange listed products for their crypto exposure, are capable of doing. How significant this factor will be is uncertain, however if the staking yield increases, missing out on the yield may be a key factor for some new investors.
Validator Exit Queues and ETF Redemptions
The solution here may seem obvious. The ETFs can just stake their Ethereum. However, this may not be possible, for regulatory reasons, but also practical reasons associated with the redemption of the products. In order to exit your stake from Ethereum’s staking system, one needs to go through two queues. One can also consider the entry queues, but these are less important from an ETF’s perspective, since any delay in deploying the stake will just reduce the yield of the product. In contrast, the exit queue may be a consideration for the ETF redemption process. The two exit queues are as follows:
- Standard exit queue: This is a first in first out type queuing system for the staking exit process. This is considered as critical from the perspective of the stability and security of the staking system, as it prevents too many stakers from exiting too quickly. The queue is based on the churn limit, which is a limit in the number of validators allowed to exit per epoch, which is a 6.4 minute period. The current value of the churn limit is 14 and this varies depending on the total number of active validators, with a value of 14, this represents around 100,000 ETH per day. Based on the current Ethereum spot price, this is around US$400 million. From an ETF perspective, it is certainly possible daily outflows could be larger than this, in some economic conditions (Look at GBTC since 11th January 2024). Due to the nature of this queue, the more people that want to exit, the longer the wait. Currently the line is almost empty, so the wait is only around 12 hours. It is easy to see how in some periods, perhaps during turbulent crypto markets, potentially right when people may want to redeem from Ethereum ETFs, the wait could be much longer, many months long. This is therefore a potential issue for Staking Ethereum ETF providers.
- Validator sweep delay: This second wait occurs after the exit queue and is more of an implementation detail rather than an economic constraint on the system. This queue is basically a random wait, rather than a first in first out type of line. This delay applies to both validator exits and normal partial withdrawal payments. There is a limit here of 16 per slot or 512 per epoch. This wait is currently around 9 days and unlike the first wait, this wait should not increase significantly during times of financial stress. However, a 9 day wait is much longer than the redemption process for a normal ETF, which is typically one or two working days.
There are also additional delays if a validator is slashed, resulting in an even longer wait. Slashing is of course another risk for staking Ethereum ETF products, that would need to be explained to potential investors. Therefore, the exit queue system certainly makes it more challenging to implement an Ethereum Staking ETF.
Problem is Solvable
Of course, these problems are solvable. Firstly, the ETF could only stake with part of the Ethereum holdings, leaving the other portion available for immediate withdrawals. This would lower the yield and increase product complexity, but is certainly doable for sophisticated product providers. There could be teams that specialise in liquidity and this is not totally different to the situation of a large ETF holding illiquid securities. An ETF holding an amount of equities equivalent to 9 days average daily trading volume, can be compared to a 9 day exit wait, although it’s not exactly the same. Additionally the terms and conditions of the Ethereum staking ETFs could be altered, allowing for delays in the redemption process under certain circumstances. However, given how the exit queue system works, it is possible that large ETF redemptions actually cause more withdrawal delays in a downward spiral type scenario, which is not an ideal product structure and can be said to create a form of systemic risk. Of course, from Ethereum’s perspective, this risk exists anyway, whether there are ETFs or not, however ETFs could exacerbate the problem. Another idea, one we like, is to avoid the Ethereum Staking ETFs altogether and instead issue an stETH ETF. With this, the redemption problem is entirely solved or transferred to Lido.
It should be noted that ARK/21 Shares already has a staking Ethereum ETP in Europe, with US$640 million of assets. ARK’s application for an Ethereum ETF in the US also includes a provision to allow staking for a portion of the fund’s assets.
However, as we saw with Bitcoin, the SEC appears keen to put every possible obstacle in the way of the ETF providers. The product issuers are therefore desperate to get the products over the line. It seems likely that the issuers may not want to complicate the situation by applying for products with staking, which require explaining the complicated issues around redemption and exit queues to the SEC and investors. Therefore, in our view, it might be several years until meaningful staking Ethereum ETFs exist in the United States. However, in the long term, these issues definitely seem solvable.
Conclusion
This staking ETF problem is probably actually pretty positive for Ethereum from a security and decentralisation perspective. The last thing Ethereum needs is for Blackrock to be the largest validator. This would potentially be much worse for Ethereum, than if Blackrock became the largest Bitcoin holder, since Bitcoin holders have no role in block production or selecting between competing valid chains. Combining the role of consensus agent with investor is a centralisation risk. Therefore any barriers preventing Blackrock’s ability to stake can be considered as desirable. Maybe the exit lines should be made even longer for this exact purpose!
In our view, ETF approval is likely to be a less critical factor for Ethereum, than for Bitcoin, for several reasons:
- The Bitcoin ETFs were first out the gate, so the approval of the Ethereum ETFs will happen with less fanfare.
- Ethereum culture is more about usage and technology/DAPS, while Bitcoin is more about holding and financial considerations, where ETFs are more relevant.
- Ethereum has the staking yield issue discussed in this article, which can make ETFs less attractive.
Nevertheless, approval of Ethereum ETFs is another exciting prospect for the crypto space and when it happens, we will be keen to track and report on the flow data. We will be first to report on the extent to which the Ethereum ETFs cannibalise the Bitcoin ETFs, the Ethereum in staking pools or the Ethereum in locked in dexes. Or if the ETFs cause new money to enter the system and increase the price.