A Bitcoin ETF Seems To Be On Its Way, Does That Mean An Ethereum ETF Will Follow Shortly?
While for some it may seem that a Bitcoin ETF has appeared out of the blue, the truth is that it has taken more than a decade to get here. It was back in 2013 the Winklevoss twins filed for the first Bitcoin ETF application for Bitcoin. But it was not meant to be. Since then, many other companies have filed applications. And they were all denied by the SEC. The only Bitcoin related funds that were approved by the SEC were two Bitcoin futures products. Before we can discuss an Ethereum ETF, we have to go over the odyssey a Bitcoin ETF has gone through.
After the SEC failed to approve the Wiknlevoss twins’ Bitcoin ETF, no spot price Bitcoin ETF was approved. Momentum began to change in 2023 though. Grayscale has operated a ETF-like trust since 2013. The trust offers investors exposure to Bitcoin. However, whereas a ETF’s price should closely resemble the price of the underlying asset it holds, an open-ended private trust like Grayscale at times traded above the price of Bitcoin or below the price of Bitcoin by substantial amounts. The reasons for the structure of Grayscale’s trust and the reasons why it may trade above or below the price of Bitcoin is beyond the scope of this article. However, what is important is that Grayscale wanted to convert the trust to an ETF. As with the other applications, the SEC said no. Grayscale did not roll over though, it sued and argued that it was not fair that the SEC approved two Bitcoin futures products, but denied a spot price Bitcoin ETF.
The United States Court of Appeals for the District of Columbia agreed with Grayscale and found the SEC’s denial of a Bitcion ETF was arbitrary and capricious when it had approved two Bitcoin futures products. You can read the decision here. While the SEC was not ordered to approve Grayscale’s application, a new denial would require that the SEC come up with new reasons to deny the application.
Recent events suggest the SEC decided that it would rather approve a Bitcoin ETF (or a few at the same time) rather than come up with new reasons to deny applications. So, the news that has slowly come out is that the multiple entities seeking a Bitcoin ETF have amended their applications multiple times. The assumption is that these amendments are based on recommendations from the SEC. And, unless something unexpected happens, a Bitcoin spot price ETF should be approved this week.
In the meantime speculation has now risen that an Ethereum ETF will be approved as well in short order. However, there are some unique issues as to why an Ethereum ETF might not follow closely on the heels of a Bitcoin ETF.
There are at least 3 reasons why the SEC may take as much time as possible before approving an Ethereum ETF and, like with Grayscale, a lawsuit may be necessary if the SEC ultimately decides against an ETF. These issues are unique to Ethereum, and therefore provide an alternative basis for the SEC’s denial. These reasons are: staking presents a wrinkle; slashing may need to be addressed if ETFs decide to stake their Ethereum; and the SEC’s concerns that tokens on Ethereum may violate securities laws.
One, staking is a unique issue to Ethereum as compared to Bitcoin. Bitcoin uses a Proof of Work (“PoW”) consensus mechanism. When a Bitcoin user creates a transaction that transaction is broadcasted to all Bitcoin nodes. Miners are specialized nodes in the Bitcoin network. They collect multiple transactions into blocks, they verify the validity of each transaction, ensuring that the sender has the required balance and that the transaction adheres to the Bitcoin’s rules. Miners compete to solve a complex mathematical puzzle known as the “hash puzzle” or “proof of work problem.” Finding the correct hash takes a lot of computational power today. The first miner to solve the hash puzzle broadcasts the solution to the Bitcoin network. Other nodes verify that the solution is correct. Once confirmed, the new block is added to the blockchain (the miner is then rewarded with a block reward and transaction fees in the new block, though block rewards decrease over time to 0).
Ethereum uses a Proof of Stake consensus mechanism (“PoS”). In a PoS system, as opposed to a PoW system, the creation of new blocks requires that a user lock up a certain amount of the underlying token. In Bitcoin, a miner may or may not hold any Bitcoin (and if they receive a block reward, they may sell their Bitcoin immediately, what is important is that they contribute hashing power). Validators must hold Ethereum and lock it up in a smart contract. Validators take turns being chosen (based on numerous factors, including, the amount staked, the amount of time tokens have been staked, etc.). Validators when chosen, create a new block, verify transactions, and add them to the blockchain. Validators are incentivized to act honestly because if they validate fraudulent transactions or act maliciously, they risk losing their staked coins as a form of penalty or “slashing.” Like in PoW systems, validators are rewarded for their work in maintaining the network and validating transactions. The rewards typically come from transaction fees and newly created coins as an incentive for securing the network.
Whereas anyone can compete in providing hashing power to mine Bitcoin, only holders of Ethereum can become validators. Meaning, a large ETF runs the issue of having to decide whether to stake its Ethereum. The upside, is that they may be able to earn fees and block rewards. But, that raises the issue of who is entitled to those fees, the owners of the ETF shares or the fund itself? Further, not staking the tokens carries its own risks, because the security of Ethereum is based on users staking. If large holders are not staking, it risks destabilizing the safety of the overall network. These issues will have be addressed to the SEC’s satisfaction.
The second issue is slashing. Should an ETF fund decide to stake, it has to make sure it is not at material risk of slashing. Slashing is an action that results in the forceful removal of a validator from the Ethereum network and an associated loss of their staked ether. There are three ways a validator can be slashed: by proposing and signing two different blocks for the same slot; by attesting to a block that “surrounds” another one (effectively changing history); by “double voting” by attesting to two candidates for the same block. (See Ethereum Foundation’s description here.) So while an ETF may look favorably on staking its Ethereum and perhaps sharing some of the rewards with the shareholders of the ETF, it would have to consider the risks of slashing whether it outsources the staking to a third-party validator (assuming the SEC even allowed that) and validating in-house and putting processes in place to avoid slashing.
The last issue is whether the SEC is comfortable with tokens existing on Ethereum that may be considered securities by the SEC. One of the advantages of Ethereum over Bitcoin is its ability to run smart contracts on the blockchain and that means the creation of things like decentralized apps to new tokens. If one has not noticed the current SEC believes practically ever token besides Bitcoin is a security. In the SEC’s lawsuits against Coinbase and Binance, it has listed a number of tokens as potential securities, some of which exits on the Ethereum network. And even if the SEC were to say that Ethereum itself was not a security, the SEC might not agree that every token on Ethereum, whether it was CRV, MANA, Sushi, would therefore be safe.
While it is not possible to discuss every possible concern the SEC may have, let along correctly rank them in the same order of importance as the SEC might, I have tried to point out three unique issues I think an Ethereum ETF might have that are different from a Bitcoin ETF. That does not mean these issues are insurmountable, but rather, these issues may slow down an Ethereum ETF. Therefore, one should not expect an Ethereum ETF to follow on the heels of a Bitcoin ETF should one be approved this week.
