Understanding Spot Ethereum ETFs: A Comprehensive Guide

After the January 2024 U.S. Securities and Exchange Commission’s (SEC’s) approval of spot Bitcoin exchange-traded funds (ETFs) spurred a massive rally in the digital currency, interest in a proposed spot Ethereum exchange-traded fund (ETF) surged along with the prices of these two major cryptocurrencies.

The SEC, which scuttled 20 spot Bitcoin ETF proposals from 2018 to 2023, has shown itself even more hesitant since the rise in Bitcoin prices in early 2024 to approve similar funds for Ethereum.

The regulator is still concerned that cryptocurrencies are often involved in fraud, could introduce their speculative bubbles into the heart of Wall Street, and could lead less sophisticated investors to infer that SEC approval means these currencies are any safer than before. The SEC only approved spot Bitcoin ETFs on the heels of a ruling against it by a U.S. federal appeals court in August 2023 that essentially forced its hand.

As we reported in March 2024, the SEC has followed up the spot Bitcoin ETF approval by focusing on the difference between Ethereum and Bitcoin’s cryptocurrency models. This has made analysts skeptical about the near- to middle-term prospects of the regulator approving spot Ethereum ETFs. While this process is ongoing, investors and industry observers are closely monitoring developments.

The SEC’s decision, whichever way it falls, will have significant implications for the future of cryptocurrencies and their role in mainstream finance.

Below, we guide you through the travails and controversies surrounding spot Ethereum ETFs in the lead-up to potential approval, how they differ from futures ETFs already valued in relation to the cryptocurrency’s price moves, and what the approval of spot Ethereum ETFs would mean for everyday investors.

Prelude to Spot Ethereum ETFs

Before discussing the specifics of spot Ethereum ETFs, it’s crucial to underline that they are not yet approved for trading in the United States or elsewhere. The approval of spot Bitcoin ETFs, such as the ProShares Bitcoin Strategy ETF (BITO) and the Valkyrie Bitcoin and Ether Strategy ETF (BTF), was significant for the mainstream acceptance of cryptocurrencies. These ETFs have had rapid inflows and strong investor demand, suggesting an appetite for regulated, easily accessible exposure to cryptocurrencies.

Proponents of cryptocurrencies argue that early price increases in spot Bitcoin ETFs bolster the case for spot Ethereum ETFs. They believe that investors are seeking diversification through exposure to Ethereum, the second-largest cryptocurrency by market capitalization. For them, Ethereum’s thriving ecosystem of decentralized applications (dApps) and smart contracts makes it an attractive investment, even before considering the value of its real-world applications as it gains wider acceptance.

However, critics caution against the rush to embrace spot Ethereum ETFs. They argue that the volatile nature of cryptocurrencies makes them unsuitable for many investors. Concerns about regulatory uncertainty, potential market manipulation, and the environmental impact of cryptocurrency mining (even if mitigated by Ethereum’s model) are all cited as reasons for caution. Skeptics worry that the push for ETFs might be driven more by the financial industry’s interest in new products than by a genuine need for investor access to cryptocurrencies.

If approved, spot Ethereum ETFs would hold ether tokens in their portfolios. Their objective would be to track the price of Ethereum as closely as possible, providing investors with direct exposure to the cryptocurrency without the need to purchase and store it themselves.

Spot Ethereum ETFs would offer a more straightforward and transparent approach than ETFs that invest in derivatives or a diversified portfolio of cryptocurrencies. By holding the ether tokens, these ETFs aim to give investors a more accurate representation of the cryptocurrency’s performance.

Spot ETFs vs. Futures ETFs

Investors have two main options for crypto-based exchange-traded funds: spot ETFs and futures-based ETFs. While both types aim to provide exposure to the price movement of an underlying crypto-asset, they differ in how they do this.

Spot ETFs hold actual crypto tokens in their underlying portfolios and are designed to track the price as closely as possible—offering investors direct exposure to the cryptocurrency. When investors buy shares in a spot ETF, they own a portion of the fund’s crypto holdings.

Meanwhile, futures-based ETFs invest in crypto futures contracts rather than hold the cryptocurrency directly. Futures contracts are agreements to buy or sell an asset at a predetermined price on a specific future date. These ETFs track the price of crypto-assets by rolling over futures contracts as they approach expiration.

While spot ETFs should be more cost-effective and provide more direct access than their futures-based alternatives, they have more significant regulatory burdens and are subject to custody risks (e.g., the ETF provider gets hacked or loses their private keys). Futures-based ETFs don’t have regulatory or custody risks, but they typically have tracking errors between the ETF price and the underlying asset and carry higher management fees because of the active trading of futures contracts.

Investing in Ethereum

While Ethereum, the second-largest cryptocurrency by market capitalization, has often been overshadowed by Bitcoin, it has potential applications that could make it attractive to investors. Ethereum is a decentralized, open-source blockchain platform that enables the creation and execution of smart contracts and dApps. Launched in 2015 by Vitalik Buterin, Ethereum has grown into a prominent platform for various blockchain-based applications and services.

Ethereum grew due to the demand for non-fungible tokens, tokenized equity, decentralized finance (DeFi) applications, and Ethereum’s native cryptocurrency, ether (ETH). Because of network effects, as more developers and users have adopted Ethereum—the cryptocurrency has outlasted many others launched at about the same time—the platform has attracted even more participants.

However, investing in Ethereum has risks. The cryptocurrency market is known for its volatility, and the price of ETH can fluctuate significantly over short periods. Regulatory uncertainties, security concerns, and competition from other blockchain platforms are also issues that investors should consider. In addition, Ethereum faces questions about its scalability and has high transaction fees. Transaction costs have risen as the network has become more congested, which could impact its adoption.

The Ethereum community has tried to solve some of these issues, most prominently through its September 2022 “merge,” which was its shift to a proof-of-stake (PoS) consensus mechanism. Under its previous proof-of-work (PoW) system, which Bitcoin still relies upon, powerful computers compete to solve complex mathematical problems to validate transactions and add new blocks to the Ethereum system. Known as mining, this work requires significant computational power and consumes a mammoth amount of energy.

By contrast, the PoS relies on users staking their ether—that is, locking up a part of their ETH as collateral to validate transactions and create new blocks. The more ether that a user stakes, the better their chances of being selected to validate transactions and earn rewards. Ethereum says changes to this model have led to a 99.988% cut in its energy usage. PoS is also designed to improve network security by making it more costly for attackers to gain control of the network. Ethereum has also introduced sharding to reduce latency.

How Ethereum Works

Ethereum operates on a blockchain, a decentralized, distributed ledger technology that records transactions across a network of computers. The Ethereum blockchain is powered by its native cryptocurrency token, ether, which serves as payment for transaction fees and computational services within the network.

One of Ethereum’s key features is its support for smart contracts. These are self-executing agreements with their terms directly written into code. They automatically enforce the rules and penalties surrounding an agreement, eliminating the need for intermediaries and reducing the risk of fraud or manipulation.

Ethereum vs. Bitcoin

While Ethereum and Bitcoin have obvious similarities—most prominently, being based on decentralized blockchain technology—they have differences that are important for investors to note:

1. Purpose: Bitcoin was primarily designed as a digital currency and a store of value to provide an alternative to traditional fiat currencies. Ethereum, meanwhile, was created as a platform for building dApps and enabling smart contracts.
2. Capabilities: Bitcoin primarily facilitates peer-to-peer transactions without the need for intermediaries. Ethereum goes beyond simple transactions and allows developers to build and deploy complex applications on its blockchain.
3. Supply: Bitcoin has a fixed maximum supply of 21 million coins, which makes it scarce and potentially supports its value. Ethereum, by contrast, does not have a fixed supply cap, although its consensus mechanism could limit the issuing of new ETH.
4. Transaction speed: Ethereum’s blockchain processes transactions faster than Bitcoin’s 10-minute target interval between blocks, although both networks have faced scalability issues as their use increased.
5. Consensus mechanism: Bitcoin uses a PoW consensus mechanism, where miners compete to solve complex mathematical problems to validate transactions and create new blocks. Ethereum, meanwhile, has transitioned to a PoS consensus mechanism, where validators stake their ETH holdings to participate in the validation process.
6. Market profile: While Bitcoin remains the dominant cryptocurrency by market capitalization, Ethereum has a strong developer community and a growing ecosystem of dApps and tokenized assets, which could drive future demand for ETH.
   

How Spot Ethereum ETFs Would Work

A spot Ethereum ETF would involve “creation and redemption,” just like other ETFs. Authorized participants, typically large institutional investors, play a crucial role in this process.

To create new shares of the ETF, authorized participants would deposit a corresponding amount of ether with the ETF issuer. In exchange, they receive newly minted shares of the ETF. Conversely, when authorized participants want to redeem shares of the ETF, they return the shares to the issuer and receive an equal amount of ether in return.

This keeps an ETF’s price in line with the value of the underlying ether. As demand for the ETF shares increases, authorized participants can create more shares by depositing additional ether. Similarly, they can redeem shares and receive ether back if demand decreases.

Investors can buy and sell shares of spot Ethereum ETFs on stock exchanges throughout the trading day, as they do with any other ETF or stock. This would make the cryptocurrency fund easy to trade and likely give it abundant liquidity, enabling investors to enter or exit positions throughout the trading day without interacting directly with cryptocurrency exchanges.

Benefits of Spot Ethereum ETFs

If approved, a spot Ethereum ETF could offer these potential advantages for investors:

• Accessibility: Spot Ethereum ETFs provide a convenient way for investors to gain exposure to Ethereum. By investing in an ETF, individuals can avoid the complexities of navigating cryptocurrency exchanges, setting up digital wallets, and worrying about the security and storage of their Ethereum holdings.
• Regulated: ETFs are regulated investments supervised by financial watchdogs. This regulatory framework offers investors more protection and transparency than directly holding cryptocurrencies.
• Diversification: By allocating a part of their portfolio to Ethereum through an ETF, investors might benefit from the cryptocurrency’s growth and diversify their exposure to different asset classes.
• Liquidity: A major advantage of spot Ethereum ETFs would be their liquidity. With the ability to trade ETF shares on stock exchanges throughout the trading day, investors could quickly enter or exit positions based on their investment strategies and market conditions.

Risks of Spot Ethereum ETFs

Investors should also be aware of the potential risks associated with these investments:

1. Volatility: Ethereum, like other cryptocurrencies, is known for its high volatility. The price of ether can fluctuate significantly in short periods, directly impacting the value of spot Ethereum ETFs. Investors should be prepared for potential price swings.
2. Regulatory uncertainty: The legal landscape for cryptocurrencies and related investment products is evolving. In particular, should the SEC classify ether as a security, that would vastly change its market overnight.
3. Regulatory limits: While proponents often note the safety that comes with investing in ETFs under the SEC’s oversight, only the ETFs, not the cryptocurrency, would face the SEC’s full and rigorous oversight. In fact, backers of the spot ETH ETFs have fought against the SEC’s attempts to bring the currency under its purview, namely by treating ether as a security.
4. Counterparty risk: Investors in spot Ethereum ETFs are exposed to counterparty risk arising from the entities involved in the ETF’s operations. Any issues, defaults, or security breaches experienced by these parties could affect the value and integrity of the ETF.
5. Tracking error: While spot Ethereum ETFs will track the price of ether, there might be slight discrepancies or tracking errors. ETF expenses, market inefficiencies, or the timing of ether transactions can contribute to these.

Investing in ETH Directly vs. ETH ETFs and Futures

Investors can purchase ETH on cryptocurrency exchanges and hold it in a digital wallet. This approach offers direct ownership of the cryptocurrency but also involves securely storing and managing the private keys. While now easier to use and more robust in terms of security, crypto exchanges still face challenges such as lack of regulatory oversight, the threat of hacks and theft, and the potential for bad actors to scam users.

Alternatively, investing in spot Ethereum ETFs offers a more accessible and regulated route. ETFs provide investors with exposure to the price movement of ETH without needing to hold the cryptocurrency directly. As of the first half of 2024, only futures-based Ethereum ETFs exist.

Investors can forgo futures-based ETFs and trade Ethereum derivatives themselves, such as futures and options contracts, on a cryptocurrency exchange. These instruments allow for leveraged trading and can be used for hedging or speculative purposes. However, trading derivatives on one’s own comes with many risks and complexities. These contracts are often highly leveraged and may not be fully regulated.

Liquidity is another factor to consider when trading Ethereum derivatives. While major exchanges generally offer enough liquidity for Ethereum futures and options, the market depth may be lower than ETF or spot trading. This can lead to wider bid-ask spreads and challenges in executing large trades.

The Outlook for Spot Ethereum ETFs

The prospects of spot Ethereum ETFs are tied to regulatory developments and the overall acceptance of cryptocurrencies as a legitimate asset class. While the SEC has approved spot Bitcoin ETFs, it has yet to do so with applications for spot Ethereum ETFs.

In May 2024, the SEC is expected to decide on Ethereum ETF applications by major players like Fidelity, BlackRock, and Grayscale. Analysts have become less optimistic about the approval of Ethereum ETFs in 2024.

One sticking point is the practice of staking, where Ethereum holders lock up their funds as collateral to support the operations of the Ethereum blockchain in exchange for rewards. The SEC has cracked down on staking in the past, fining cryptocurrency exchange Kraken and suing Coinbase over their staking offerings. The SEC is also concerned about protecting investors from potentially losing control of their tokens and taking on the risks associated with staking platforms. Adding staking amendments to Ethereum ETF proposals by Fidelity and Grayscale further complicated an already difficult approval process.

Another issue is whether the SEC will classify ether tokens as securities. If this occurs, the asset itself, not just ETFs whose value is tied to it, would fall under the jurisdiction of the SEC and be subject to many of the same securities laws and regulations as stocks. This could change how ether is traded, held, and taxed for investors. It could also impact the development and operation of dApps on Ethereum since these, too, might come under U.S. securities laws.

While SEC Chair Gary Gensler and other regulators have been consistent crypto sceptics, the approval of several spot Bitcoin ETFs in early 2024 set a precedent that could ultimately pave the way for Ethereum ETFs. If the SEC finds the issues it faces with ETH ETFs the same as in the Bitcoin ETF approval process, it should be more inclined to grant its approval.

ETH ETF proponents, such as Coinbase chief legal officer Paul Grewal and Grayscale chief legal officer Craig Salm, have argued that the SEC has no good reason to deny Ethereum ETF applications given its earlier approval of Bitcoin ETFs. They believe that the SEC can’t fairly distinguish between the approved Bitcoin ETFs and the proposed Ethereum ETFs—the only difference is the underlying asset.

However, the specific asset might be the sticking point for the SEC, which could label it a security given the different trading mechanisms it has on its platform from Bitcoin and how certain traders have far greater holdings of ETH than was the case with Bitcoin.

The Bottom Line

If approved by regulators, spot Ethereum ETFs would offer investors a means of gaining exposure to the ETH cryptocurrency market through a regulated and accessible fund. By providing accessibility, simplicity, and regulatory oversight, at least of the ETFs themselves, these investments could attract a broader range of investors to the cryptocurrency market. Unlike futures-based Ethereum ETFs, a spot ETF would directly hold ETH tokens and be more cost-effective.

However, as with any investment, it is crucial to understand the risks and considerations involved. By carefully evaluating the options available and staying informed about market developments, investors can make well-informed decisions when considering these and other ETFs as part of their investment strategy.