Ethereum ETF: Likelihood of SEC Spot-Based Approvals

We expect the net inflows into ETH ETFs to be 20-50% of the net flows into BTC ETFs over the first 5 months, with 30% as our target, implying $1bn/month of net inflows.

For months, observers and analysts considered it unlikely that the Securities & Exchange Commission (SEC) would approve spot-based Ethereum exchange-traded products (ETPs). This pessimism stemmed from the SEC’s hesitation to classify Ether as a commodity, the absence of engagement between the SEC and potential issuers, and ongoing SEC investigations and enforcement actions related to Ethereum. In May, Bloomberg analysts Eric Balchunas and James Seyffart estimated a mere 25% chance of approval for the initial wave of applications. However, on May 20, the analysts unexpectedly raised the approval odds to 75% following reports of SEC contact with securities exchanges. Indeed, the SEC approved all applications for spot Ether ETPs later that week. We expect the launch of these vehicles in Summer 2024, once the S-1 filings are effective. This report uses the performance of Bitcoin spot ETPs as a basis to predict the demand for Ethereum ETPs. We estimate that spot Ethereum ETPs will attract around $5 billion in net inflows within the first five months of trading, approximately 30% of Bitcoin ETP net flows.

Background

Currently, nine issuers are competing to launch ten exchange-traded products (ETPs) that hold spot-ETH. Recently, some issuers have withdrawn. ARK has opted not to partner with 21Shares on an Ethereum ETP, and Valkyrie, Hashdex, and WisdomTree have fully withdrawn their applications. Below is a chart showing the current state of applicants sorted by their 19b-4 filing dates.

Grayscale aims to convert the Grayscale Ethereum Trust (ETHE) into an ETP, similar to its Grayscale Bitcoin Investment Trust (GBTC), and has also filed for a “mini” version of the product.

The SEC approved all the 19b-4s on May 23, enabling securities exchanges to list eventual spot-ETH ETPs. However, each issuer still needs to finalize its registration statement with the regulator. The products can only start trading once the SEC allows those S-1s (or S-3 in the case of ETHE) to become effective. Based on our research and Bloomberg Intelligence reporting, Ethereum spot ETPs could begin trading as soon as the week of July 11, 2024.

Learnings from Bitcoin ETFs

Bitcoin ETFs have been live for just under six months and can serve as a foundation for examining the likely reception of Ethereum spot-ETFs. Some observations from the initial months of Bitcoin spot ETP trading include:

• Higher-than-expected inflows: As of June 15, US Spot Bitcoin ETFs saw over $15 billion in cumulative net inflows since launch, averaging $136 million in net inflows per trading day. The aggregated amount of BTC held by these ETFs was ~870k BTC, amounting to 4.4% of the current supply of BTC. With BTC trading at ~$66k, AUM across all US spot ETFs totaled ~$58 billion.

• ETF inflows correlated with BTC price appreciation: A regression of 1-week changes in BTC price and 1-week net ETF flows yielded an r-squared of 0.55, indicating a high correlation.

• GBTC trade unwinding as an overhang on overall ETF flows: Since converting to an ETF, GBTC experienced significant outflows in the first few months. Outflows peaked mid-March with $642 million on 3/18/24 but have since moderated.

• Retail-driven ETF demand with growing institutional interest: 13F filings show over 900 US investment firms holding bitcoin ETFs as of 3/31/24, representing ~$11 billion in holdings and accounting for ~20% of total bitcoin ETF ownership. Prominent institutional buyers include banks, hedge funds, and pension funds.

• Limited wealth management platform access: Large wealth platforms have yet to allow their brokers to recommend bitcoin ETFs, though Morgan Stanley is exploring enabling this. Sales-driven inflows from institutional platforms have been minimal but are expected to be significant in the near-to-medium term.

Estimating Potential ETH ETF Inflows

Using Bitcoin ETPs as a proxy, we can estimate potential demand for similar Ethereum products. Based on BTC/ETH multiples and the relative asset sizes across various markets, we estimate that ether spot ETF inflows will be approximately 3x less than US spot bitcoin ETF inflows, with a range of 2x to 5x. This translates to ether spot ETF inflows being about 33% the size of US spot bitcoin ETF inflows, with a range of 20% to 50%.

Applying this multiple to $15 billion of bitcoin spot ETF inflows through June 15, we estimate monthly ETH ETF inflows of ~$1 billion for the first five months following the launch, with a range of $600 million to $1.5 billion per month.

Despite some lower estimates due to various factors, our prediction aligns with our previous forecast of $14 billion in first-year bitcoin ETF inflows, which was based on the anticipated entry of wealth management platforms.

Factors Impacting ETF Flows

Several structural and market differences between BTC and ETH will impact ETF flows:

• Lack of staking rewards for spot ether ETF: Non-staked ETH has an opportunity cost from forgoing staking rewards, which could make a spot ETH ETF less attractive. ETPs in other markets, such as Canada, offer additional yield through staking.

• Grayscale’s ETHE conversion impact: Similar to the GBTC Grayscale Trust, the conversion of ETHE to an ETF will likely result in outflows. We estimate that ETHE outflows will be ~319k ETH per month, which at the current price of ~$3,400 would be $1.1 billion or a daily average outflow of $36 million.

• Basis trade driving hedge fund demand: The basis trade, which involves arbitraging the difference between spot and futures prices, has likely fueled ETF adoption by hedge funds. ETH has had higher funding rates than BTC, suggesting greater demand to go long on ETH and potentially attracting hedge funds to a spot ether ETF.

Price Sensitivity of ETH vs. BTC

We expect the price impact of ETH ETF inflows to be roughly equal to BTC flows relative to market cap. However, key differences in supply and demand could make ether more price-sensitive to ETF flows:

• Supply held on exchanges: A greater proportion of BTC supply is held on exchanges than ETH supply (11.7% vs. 10.3%), suggesting that ETH supply may be tighter.

• Inflation & Burn: Following the latest halving, BTC’s annual inflation rate is ~0.8%. Post-Merge, Ethereum has seen net negative issuance (-0.19% annually), with recent data indicating a net positive annualized inflation rate of +0.42%.

• Supply held in ETFs: Since launch, US spot ETFs have absorbed 1.3% of BTC’s current supply. If this pace continues, ETFs would absorb 3.0% of BTC’s supply, significantly outpacing dilution from miner rewards.

Adjusting for factors such as staked supply, dormant/lost supply, and supply held in bridges & smart contracts, we estimate that the available supply of BTC and ETH is 8.7% and 14.4% less than their reported current supplies, respectively.

Overall, the price sensitivity should be greater for ETH compared to BTC due to lower available market supply, lower supply on exchanges, and lower net emissions.

Looking Ahead

Several questions arise regarding the adoption and effects of ETH ETFs:

• How will portfolio managers and allocators approach BTC & ETH? Some rebalancing is expected. Will a spot ether ETF attract new buyers who have not invested in BTC yet?

• Can staking be added to ETFs? Without staking rewards, will adoption be affected? Could investment demand for exposure to DeFi, tokenization, and other crypto-related applications drive greater adoption of ether ETFs?

• Potential for other alt ETFs: Could the approval of ether ETFs pave the way for ETFs of other altcoins?

The potential launch of spot ether ETFs should positively impact Ethereum and the broader crypto market by expanding accessibility and gaining greater acceptance through regulatory recognition and trusted financial services brands. An ETF enables broader reach for both retail and institutional investors, wider distribution, and supports the case for ether in various investment strategies. Greater understanding of Ethereum by financial professionals could accelerate investments and adoption of the technology.

The Value Accrual for Staked vs. Non-Staked ETH Holders

Changes to ETH supply come from new issuance (paid to validators) and burnt base fees. Post-Merge, net issuance has reduced ETH supply by 0.20%.

If issuers are prohibited from staking ETH in the ETF, then the ETF represents a considerable opportunity cost in terms of lost validator income and dilution. Key considerations for value accrual include:

• Base fees: Burned, benefiting both unstaked & staked ETH holders equally.

• Priority fees and MEV payments: Income collected by validators, with no impact on unstaked ETH holders.

• New issuance from block rewards: Creates a dilutive effect for all ETH holders but serves as income for staked validators, offsetting the dilutive impact.