TL;DR
Shortly after Bitcoin hit new all-time highs back in March, we previewed our expectations for heightened volatility over the coming months while pointing to a few major catalysts on the horizon that would serve to hopefully shepherd some of that volatility into a stronger market moving forward.
Specifically, we highlighted expectations around improved legal clarity for digital assets in the U.S., potential approvals of spot Ethereum ETFs on May 23, core improvements to the Ethereum ecosystem in the form of EIP-4844 alongside Eigenlayer going live, and an increasingly moderating US macro environment. Much of this has come to a head over the past few days.
The big news of the week: spot Ethereum ETF approvals in the U.S.
While most in the market were quite confident that US regulators would approve the spot Bitcoin ETFs earlier this year, there was far more uncertainty around whether Ethereum ETFs would get the greenlight on May 23. Though internally optimistic at the time, we had tagged the market’s odds of approval by this first deadline at roughly 30% back in March, and given the absence of discussion among the SEC and filers throughout April and May, many grew doubtful any approval would come in May, or even in 2024 at all:
But true to form with digital asset markets, things change in a hurry. Bloomberg’s ETF analysts (specifically James Seyffart and Eric Balchunas) have historically been on the money with their expectations around digital asset ETFs but they, along with the issuers themselves, were caught off guard by the sudden about-face by the SEC. The market was largely offside too, and once news of the SEC requesting exchanges to update their 19b-4 filings on May 20 (just 3 days before the expected deadline) broke, ETH spiked from ~$3000 to ~$3800. Though these ETFs will not start trading next week, (the SEC still must approve S-1 registrations for each), the market now sees a condensed window during which they can front-run Wall Street. Expect the ETFs to go live several weeks from now.
So, what changed? Political winds seemed to have shifted in DC, with strong support shown in the House and Senate for overturning SAB121 on May 8 as well as the bipartisan passing of FIT21 on May 22. While neither of these legislative actions are in and of themselves singularly momentous for the industry, they both auger a definite softening in the current administration’s stance against digital assets in the country and help move things forward in terms of badly needed clarity around oversight of digital assets by the SEC and CFTC. Against that backdrop, the sudden movement around the ETFs and the reported lack of internal coordination at the SEC seems to suggest a change in political directive more broadly. Whether this is sustained or just short-lived in the run-up to the November election remains to be seen, but we are optimistic this bodes well for the industry’s outlook in the US writ large.
One negative of this approval is that it still seems the SEC is wary of Ethereum and its staking mechanics. As such, issuers were forced to remove any potential staking within the ETF products in their updated S-1 registrations. This unfortunately shears off the key functionality of ETH the asset in the first place: helping to secure and validate the Ethereum network. Many issuers had signaled their intent to stake a portion of their holdings, thus contributing to the network in exchange for roughly 3-4% ETH-on-ETH yields. Notably, issuers in other jurisdictions, such as Canada’s 3IQ and Sweden’s 21Shares, have long embedded staking in their Ether ETFs. This decision unfortunately puts the US on a different footing from most other regulatory jurisdictions for the foreseeable future and removes a significant value proposition for US-based buyers.
Currently, 10 issuers have filed for ETFs – largely the same as those with BTC ETFs, as would be expected. Much like with Bitcoin, a driving dynamic of net new adoption of these ETFs will be the flows from Grayscale’s existing ETHE Trust. Specifically, the outflows. Over the past year, one of the more crowded trades has been the ETHE discount reversion. This time last year, one could buy shares of ETHE at a roughly 50% discount to the ETH spot due to the lack of clarity around liquidity and carrying costs (2.5%). As of May 1, 2023, ETH was trading at $1700 and ETHE shares at ~$8.00 (now ~$34.00). With the ~50% discount to NAV, one could essentially get exposure to ETH at ~$850. As such, once redemptions are allowed from ETHE, expect mass outflows into either a) other ETF products or b) cashing out completely.
For comparison, the below charts show 1) the discount to NAV for Grayscale’s GBTC in the year leading up to conversion to a spot Bitcoin ETF, 2) the individual spot ETF flows across all funds since going live in January, and 3) the daily net flows for all of those in aggregate. The negative bright green bars in the second chart signify the outflows from GBTC – in essence, the net selling pressure all other ETF inflows had to overcome to turn net flows positive. By and large, daily inflows to these ETFs have been positive in aggregate, but this is a strong dampening effect on any net capital into these new products.
Given that shares in spot, ETH ETFs reflect actual ETH held in custody, the significant capital rotation between funds may trigger some interesting market movements in the near term. We expect heightened volatility around ETH Spot and spikes in gas fees/net ETH burned in the weeks following these ETFs going live until flows balance out into equilibrium. With BTC, this took ~3 months (excluding the Ordinals and Runes-driven spike in April).
An interesting dynamic of ETH being a fundamentally productive asset for Ethereum, L2s, and most of DeFi, is that the net circulating supply of ETH is relatively low. Whereas Bitcoin is unique in that holders do not want to sell their BTC (e.g. 30%+ has not been moved in 5 years), ETH circulating supply is unique in that it is structurally designed to become increasingly scarce. Roughly 32M ETH is staked to participate in consensus, up 159% YoY. Among the top 100 smart contracts, excluding staking and restaking contracts, there is another almost 17M ETH locked. In aggregate, that is almost 49M ETH ‘off the market’, or roughly 41% of all ETH in circulation. This does not account for all the other ETH held in cold storage or other addresses that are not in ‘active’ circulation. This is likely substantial – the balance of ETH on exchanges is at an all-time low of just 13.6M ETH (11%), typically indicative of reduced sell-side supply. It is not unreasonable to estimate that just 15-30% of ETH is being freely traded in the market right now.
Further, ETH’s fee and staking mechanisms work such that net new ETH issuance is a transfer from simple holders/users of ETH to stakers of ETH in order to incentivize network participation. That is, there is structural pressure to continually decrease the share of circulating ‘free’ ETH through fee burns and DeFi growth while increasing the share of ‘locked’ (e.g. staked) ETH through validator rewards. Any new US ETF flows will go into this long-term dilutive bucket at the expense of ETF purchasers and to the benefit of ETH stakers.
Given the relative market cap of Ethereum to that of Bitcoin (~1/3), there will naturally be far fewer flows into these ETFs than seen for the BTC ETFs ($12.0B net new inflows since January). We expect ETH demand to be slightly lower proportionally to that of BTC (e.g. 15-20%) but see a realistic range anywhere from $1.5B to $4B of net new flows over the first 6 months of these ETFs being live. This is a sizeable level of structural spot buying into the limited free floating ETH supply in a relatively short window of time. Though there likely remains some more ‘sell the news’ pressure and profit-taking, new ETH all-time highs in 2024 appear highly probable.
So, what comes next?
The biggest takeaway from all of this is that Ethereum, and PoS networks more broadly, are somewhat derisked in the near term, and with an increasingly clear path towards true clarity in the coming 12-24 months. BTC has always broadly been accepted as a commodity and thus under CFTC oversight, but since its move to Proof of Stake, Ethereum’s status in the eyes of the SEC has been unclear. These approvals, along with the movement in Congress, clarify that ETH itself is a commodity.
Attention is already turning to which assets may be next in line to receive the ETF treatment. Based on size, decentralization, and adoption to date, the next largest chain would likely be Solana. But Solana is far smaller (just $75B market cap) and its futures markets are far from the same stage of maturity as the BTC and ETH markets were at the time of approval (e.g. SOLs is largely non-existent). We do not foresee a SOL ETF being a near-term event but do expect increased capital flows to Solana over the coming months as a result of the longer-term outlook.
Further, Grayscale’s GSOL (e.g. their Solana Trust) is trading remarkably different than how BTC and ETH traded, with a massive premium to NAV. Because GSOL is another closed-end vehicle, there is no way for this price discrepancy to be arbitraged away. To date, there has been limited GSOL available to borrow for shorting in a delta-neutral strategy (not to mention the risk given how quickly GSOL prices have moved), so this trade is not yet as popular as the GBTC and ETHE trades before it. While this premium indicates strong demand for the underlying asset from non-crypto-native buyers, it also highlights how underdeveloped the SOL market is broadly. Despite that, we expect to see much more activity here going forward as the network continues to develop and gain traction.
