Spot ETH ETFs without staking miss the mark

While the recent approval of the spot bitcoin ETF in the US marks a positive step towards the institutionalization of the digital asset industry, the imminent approval of spot ether ETFs raises some concerns. 

These ETFs do not offer staking rewards to investors (unlike European ether crypto ETPs), reflecting a lack of understanding by regulators and certain traditional finance asset managers of the key features that distinguish ether from bitcoin. 

Despite both being leading cryptocurrencies, ETH and BTC differ significantly in their functionality and role within the blockchain ecosystem. It’s therefore essential for the industry and regulators to tailor financial products to their specific characteristics, benefiting both investors and the underlying networks.

Understanding staking and Ethereum 2.0

Before delving into the specifics of ether ETFs, it’s important to understand what staking entails and why it is integral to Ethereum’s project. 

The Ethereum blockchain transitioned from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) model with the launch of Ethereum 2.0 in September 2020.

Staking involves locking up a certain amount of cryptocurrency in a wallet to support the network’s operations, such as block validation, network security and governance. In return, stakers receive rewards in the form of additional cryptocurrency.

To illustrate the importance of staking, consider that over 32 million ETH is currently locked up for staking. This represents 27% of Ethereum’s total supply. At current prices, this equates to more than $121 billion. This significant portion of ETH being staked underscores the critical role staking plays in securing and maintaining the Ethereum network.

BTC vs ETH: Different natures, different functions, different benefits

To fully appreciate the significance of staking in Ethereum, it’s important to understand the fundamental differences between ETH and BTC. While both are leading cryptocurrencies, they serve different purposes and have different technological underpinnings.

Bitcoin is primarily designed as a digital store of value and a medium of exchange. Its blockchain operates on a proof-of-work (PoW) consensus mechanism, which relies on miners to secure the network and validate transactions. 

Moreover, bitcoin’s supply is predetermined, and the issuance rate of new bitcoins is halved approximately every four years. This predictable supply schedule further enhances its appeal as a deflationary asset, in stark contrast to the unpredictable monetary policies governing traditional currencies. These characteristics make bitcoin a unique and attractive asset for investors seeking to hedge against inflation, benefit from its potential decorrelation with traditional financial assets and diversify their portfolios.

Given these attributes, it makes a lot of sense to offer a spot bitcoin ETF. As a digital commodity, bitcoin provides specific benefits for an investor portfolio, similar to those of gold but with the added advantages of digital assets. Our CoinShares Research demonstrates that including just 4% of bitcoin in a traditional 40/60 portfolio significantly enhances its performance. This improved the quality of diversification and potential for higher returns underscore the value of integrating bitcoin into mainstream investment vehicles like ETFs.

Ether, on the other hand, is much more than a digital currency. The Ethereum blockchain is a decentralized, Turing-complete platform that enables developers to build and deploy smart contracts and decentralized applications (dapps). ETH serves multiple roles, from facilitating transactions to staking and securing the network.

In addition to these roles, ETH plays a critical role in decentralized finance (DeFi) and Web3. 

Web3, the potential next evolution of the internet, aims to create a decentralized web where users have control over their data and digital identities. Ethereum is at the forefront of this movement, providing the infrastructure for dapps that give users ownership and governance over their digital interactions. NFTs, which represent unique digital assets, are another significant innovation enabled by Ethereum. They could revolutionize digital art, collectibles and virtual goods, creating new economic models and markets.

Given Ethereum’s versatile nature as a platform that facilitates network usage, dapps, DeFi and NFTs, it raises questions about the relevance of launching a spot ETH ETF without a staking feature. 

Without staking rewards, a spot ETH ETF fails to fully leverage the unique advantages that Ethereum offers, both as an investment and a foundational technology for the future of decentralized applications and digital finance.

The benefits of staking ETH ETFs for investors

One of the most compelling reasons for including staking in an Ethereum ETF is the potential for additional returns through staking rewards. 

When investors stake their ETH, they earn a percentage of newly created ETH as a reward, significantly enhancing the overall return on investment (ROI) compared to simply holding ETH in a non-staking ETF. The annual percentage yield (APY) for staking ether typically ranges between 1% and 4%, which is attractive to investors seeking both capital appreciation and income generation.

By staking ether, investors are directly contributing to the security and stability of the Ethereum network. This alignment of interests ensures that stakeholders are incentivized to act in the network’s best interests, promoting a healthier and more secure ecosystem. This, in turn, can enhance the value of their holdings, creating a virtuous cycle of growth and security.

Additionally, staking-enabled ETH ETFs can foster a more informed and educated investor base. Engaging in staking helps investors better understand the different types of blockchain and stay updated with the evolution of the Ethereum blockchain.

The inclusion of staking rewards in an ether ETF can lead to significantly higher total returns compared to a non-staking ETF. Staking can also help mitigate some of the inherent volatility associated with cryptocurrencies by providing a steady stream of income. 

However, it is important to note that the daily volatility of ether can exceed the annualized staking reward, meaning the notion that staking provides a cushion against price swings might be perceived as somewhat far-fetched. Nevertheless, this regular income can still offer a more predictable return profile, which is particularly important for institutional investors who may be more risk-averse and seek steady income streams in addition to capital appreciation.

Staking-enabled ETFs encourage greater investor engagement with the Ethereum network. By participating in staking, investors are not just passive holders but active contributors to the network’s security and governance. This deeper level of involvement can foster a stronger, more informed investor community, ultimately benefiting the ecosystem as a whole.

Regulatory considerations and challenges

The primary concern for regulators with staking ETH is the security and custody of staked assets. 

Ensuring that staked ETH is safely and transparently managed is crucial for gaining regulatory approval and investor trust. Fortunately, the staking and custody ecosystem for Ethereum is now well-developed, with robust solutions in place to address these concerns. This maturity in infrastructure and technology ensures that investors can participate in staking with confidence, knowing their assets are secure and well-managed.

Additionally, there are fund structure considerations that present significant hurdles. For example, the US SEC has shown itself unwilling to allow staking in the traditional spot ETF structures. This is further complicated by the fact that the spot ETF structure (a 1933 Act grantor trust) generally does not hold securities. Because regulators in the US could consider staking a securities activity, this complicates the inclusion of staking rewards in the currently contemplated US spot ETF structure. Navigating these regulatory and structural challenges is essential to bring a staking-enabled ether ETF to market successfully.

Moreover, the tax implications of staking rewards need to be clearly defined. 

In many jurisdictions, staking rewards are considered taxable income, which could complicate the tax reporting process for ETF investors. Clear guidance from regulatory bodies will be essential to address these concerns and facilitate the adoption of staking-enabled ETFs. Additionally, depending on how staking is integrated into the product, it could generate additional revenue for the IRS, which is a positive aspect for the government to consider.

But the overall case for staking-enabled ether ETFs is compelling. 

By integrating staking into the ETF structure, investors can enjoy additional income through staking rewards, benefit from compounding growth and contribute to the security and stability of the Ethereum network. This alignment of interests between investors and the network fosters a healthier, more secure, informed, and sustainable ecosystem.

Without the inclusion of staking, a spot ETH ETF may struggle to attract investors, who might instead opt for crypto-native solutions which already offer staking and network participation.