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Are Ethereum ETFs a Threat to Decentralization?

Last Updated June 1, 2024 6:57 PM
Eddie Mitchell
Last Updated June 1, 2024 6:57 PM
Key Takeaways
  • Ethereum ETFs won’t be able to stake tokens, raising concerns over Ethereum’s ability to remain decentralized.
  • Coinbase could be the custodian of six of the 9 proposed ETH ETFs.
  • Concentration risks resulting from U.S. spot ETH ETFs could lead to security and operational risks for the Ethereum network

Ethereum (ETH) exchange-traded funds (ETFs) are expected to begin trading as early as July this year, but they could pose a threat to the network itself.

Looking at over 1 million Bitcoin tokens now in the possession of exchange-traded products (ETPs) around the world, what happens when ETH ETFs accumulate massive portions of the ETH supply that they won’t be allowed to stake?

The Path to Centralization?

Following the launch of Bitcoin (BTC) ETFs, questions over whether or not BTC would become centralized emerged. This was fueled further when U.S. Securities and Exchange Commission (SEC) chair, Gary Gensler, quipped  that there’s a certain “irony” to the Bitcoin ETFs.

Speaking with CNBC shortly after their launch, Gensler noted :

“Think about the irony of those who would say this week is historic,” he said. “Now you can buy [Bitcoin] through this thing called an exchange-traded product that’s, well, centralized.”
Since their launch, U.S. ETFs have hoovered up over 855k BTC tokens, or approximately 8.33% of every BTC token in circulation. Furthermore, ETF issuers are buying up BTC tokens faster than miners can produce them. This compounds the supply shock caused by the Bitcoin halving as fewer BTC tokens will be created or reach the retail market.
With the number of new Bitcoin wallet  addresses in decline, attention is being drawn to the fact that BTC ETFs may be concentrating too much of Bitcoin’s supply within ETF funds, and these same concerns are being echoed in anticipation of U.S. Ethereum ETFs.

No Staking for ETFs

There is the added conundrum of the SEC’s investigation into the Ethereum Foundation’s sale of ETH since the “Merge” in 2022, in which they are trying to determine if Ethereum’s switch to proof-of-stake (PoS) constituted a security offering.

Staking involves locking up crypto to secure and further decentralize the network, as well as validate transactions in exchange for rewards. This is a major part of Ethereum’s PoS mechanism, and as far as the SEC is concerned, staking services may constitute unregistered securities offerings.

This view resulted in the SEC taking action against Coinbase and Kraken, alleging violations of federal securities laws for their staking services. Therefore, the SEC has required ETH ETF applicants to remove staking from their ETF proposals.

Aside from missing out on additional profits provided by staking, there are some broader implications for the Ethereum ecosystem. If staking is removed from ETFs, a large portion of the ETH token supply will be held up in funds. This could impact token supply, network security, and decentralization as there’ll be less staked ETH.

However, if staking was included and such significant portions of Ethereum’s supply poured into funds as we have seen with Bitcoin, would it mean that institutions could gain dominance over Ethereum by centralizing its staked supply into ETFs?

Concentration Risk

Staking-enabled ETH ETFs exist in other countries, they’re not a new concept, but the scale of U.S. markets can have significant impact on market dynamics. The removal of staking from U.S. ETFs is contentious.

As a short-term solution to appease the SEC through the approval process may cause significant long-term pains. As pointed out by S&P Global :

“U.S. spot ether ETFs that incorporate staking could become large enough to change validator concentrations in the Ethereum network, for better or worse,”

If multiple ETF issuers use the same custodian, just as Coinbase is the primary custodian for a majority of BTC ETFs, the increased concentration of ETH could lead to operational risks like market collusion.

Coinbase is expected to be the custodian for six of nine  Ethereum ETF issuers. The exchange is already the second-largest Ethereum validator, and the risk to network security due to a single point of failure will be heightened if a single entity commands a growing number of nodes.

ETFs represent a shift toward centralization, which is at odds with the core ethos of cryptocurrency. In crypto’s quest for legitimacy, the holy grail that ETFs were thought to be were perhaps nothing more than a gift horse.

If interest in ETH ETFs is similar to U.S. BTC ETFs, which currently command over $61 billion  worth of BTC, the power of concentration could certainly pose a threat to Ethereum’s security.

Can Staking Save ETH ETFs?

There’s no telling if ETF issuers will enable staking in the future. Regardless, there is no consensus over whether or not it will have a positive or negative impact on the Ethereum network itself.

Without staking, the Ethereum network could be exposed to security risks. With staking, Ethereum could be exposed to centralization risks. Unfortunately, there doesn’t appear to be a middle ground, especially when there is no clear guidance or regulations when it comes to crypto staking.

Whether or not staking is enabled, what is clear is that new digital asset custodians will need to emerge, which will distribute ETF stakes broadly, which could contribute to mitigating concentration risk.

Ensuring Ethereum remains secure and decentralized is going to require greater concentration risk monitoring, as well as a collective effort to continue mitigating concentration risks. This would include ensuring that no single validator or group gains disproportionate power.

ETFs represent a shift toward centralization, which is at odds with the core ethos of cryptocurrency. In crypto’s quest for legitimacy, the holy grail that ETFs were thought to be were perhaps nothing more than a gift horse.

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