S&P Global: Spot Ethereum ETFs Could Increase Concentration Risk for ETH
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S&P Global: Spot Ethereum ETFs Could Increase Concentration Risk for ETH
The approval of spot Ethereum ETFs could impact validator composition and decentralized staking protocols, increasing centralization risks, while also highlighting the importance of monitoring such risks.
Navigating Web3 tides with focused insightsBy: Andrew O'Neill
Translation: Baic Blockchain
The U.S. may approve a spot Ethereum exchange-traded fund (ETF) as early as May this year, which would give investors direct exposure to the current market price of Ethereum. The addition of staking-enabled Ethereum ETFs could affect the composition of validators participating in Ethereum's consensus mechanism. Institutional custodians' involvement might reduce concentration risk associated with the Lido decentralized staking protocol. However, it could also introduce new concentration risks—especially if a single entity is chosen to stake most of the Ethereum held within these ETFs. The impact of U.S. spot Ethereum ETFs on concentration risk, whether positive or negative, could be significant, making ongoing monitoring of such risks even more important.
1. The U.S. Is Poised to Launch Spot Ethereum Exchange-Traded Funds (ETFs)
Following the U.S. Securities and Exchange Commission’s (SEC) approval of Ethereum futures ETFs in 2023 and spot Bitcoin ETFs on January 10, 2024, market participants expect spot Ethereum ETFs to be next. Currently, the SEC is reviewing eight applications for spot Ethereum ETFs, with an official decision deadline of May 23, 2024.
Canada, Switzerland, and other European countries have already approved spot Ethereum ETFs. According to cryptocurrency data aggregator CoinGecko, global assets under management (AUM) in spot Ethereum ETFs totaled approximately $2 billion as of February 2024.
2. Staking Risks and Rewards
In staking, cryptocurrency holders lock up their tokens in a blockchain network to help validate transactions. Validators can earn staking rewards but face slashing risks—meaning their staked holdings may be reduced if they are inactive or validate invalid transactions. Ether holders can directly stake their ETH into the Ethereum network and participate as validators. Alternatively, they can stake via digital asset custodians or decentralized staking protocols. Custodians and decentralized staking protocols manage staked positions across multiple validators.
3. But Could Affect Concentration Risk Within the Ethereum Network
Spot Ethereum ETFs that simply hold ether would not affect the validator composition within Ethereum's consensus mechanism. However, if spot Ethereum ETFs include staking features, they would influence the validator mix—particularly if inflows are substantial. Based on trading volumes of U.S. spot Bitcoin ETFs one month after approval (approximately $12 billion as of February 14, 2024), U.S. spot Ethereum ETFs with staking capabilities, if large enough, could significantly alter validator concentration on the Ethereum network, for better or worse. Therefore, understanding how ETF issuers’ choices shape concentration risk is crucial.
4. Ethereum's Consensus Mechanism and Concentration Risk
To finalize a block, Ethereum’s proof-of-stake consensus mechanism requires at least two-thirds of validators to confirm each new block as valid. Block finalization is critical for settling financial transactions on Ethereum. If more than one-third of validators become simultaneously inactive or act maliciously, new blocks cannot be finalized. Therefore, monitoring concentration risks that could expose large portions of the network to simultaneous downtime or collusion is essential. Key risks include:
- The proportion of validators controlled by a single entity or decentralized staking protocol;
- The proportion of validators running the same client software package for network validation (client concentration risk), as bugs in this software could cause validators to go offline. This risk is mitigated through diversity and redundancy, since multiple client software packages developed by different companies are available.
For further details, see “What Can You Trust In A Trustless System: Public Blockchains For Financial Applications,” published October 11, 2023.
The largest validator in the Ethereum network is the decentralized staking protocol Lido, whose staked ether concentration is slightly below the 33% threshold (see “Is Lido’s Ethereum Concentration Concerning?” in “What Can You Trust In A Trustless System: Public Blockchains For Financial Applications,” published October 11, 2023). In our view, U.S. institutions launching staked ether ETFs are unlikely to partner directly with decentralized protocols like Lido. Instead, they may opt for institutional-grade digital asset custodians, thereby reducing Lido-related validator concentration risk. However, the overall impact of ETFs on concentration will depend on whether they distribute staked positions across multiple custodians.
Coinbase Global Inc. (Coinbase) controls the second-largest share of validators on the Ethereum network, at 15% (see Chart 1). If Coinbase receives a large volume of newly staked ether from ETFs, it could pose a growing concentration risk to Ethereum. Coinbase serves as custodian for 11 recently approved U.S. Bitcoin ETFs and is listed as a staking provider for three of the largest Ethereum staking ETFs outside the U.S. The emergence of new digital asset custodians could allow ETF issuers to spread staking allocations across different entities, helping mitigate this risk.
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