The Mother of All ETFs
A look at the incredible value an ETH Spot ETF can provide to issuers
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Hey everyone! Hope y’all had a great week! Although I’ve been saying it in these intros over the last few blogs, with the NFL seasons officially underway, I can truly say FOOTBALL IS BACK! I always forget how excited and time-consuming I get during this time of year, and I hope that it does not impact my ability to write and publish these blogs in an efficient manner (it most certainly will). While there’s tons of football-related content I could get into, I’ll just leave you with some Mic’ed Up clips from Saints new QB Derek Carr, a player I’m still waiting to see if he’ll be a good fit for the Saints (Sike, I’m 100% bought in and love him to death).
Annoying that this won’t load, but it’s worth watching on Youtube
Publishing this a little late, (especially for all my East Coast peeps who will be receiving this deep into the AM), so let’s not waste any more time. This blog is one of the first in a while where the finance major in me comes out (although my sleep schedule makes me look as if I work in finance) and hopefully brings some insight in clarity about a topic I am extremely excited about. Hopefully, my terrible jokes make this blog not too financey (if that’s a word). Let’s dig in.
What is an Exchange Traded Fund (ETF)?
Before getting into a specific Spot ETH ETF, let’s dial it back and start at the basics so that the people who aren’t finance bros (which is most people who read these blogs) can truly grasp the concept here. At a high level, an ETF is a basket of securities that trades on an exchange similar to how a stock does. To simplify it, think of it like a regular stock you can buy on Robinhood, but instead of being invested in a single company, you are investing in a group of companies.
ETFs are a great way to get overall exposure to a specific industry, sector, or even the stock market in general, and utilizing ETFs makes it incredibly easy to diversify one’s portfolio, which anyone in finance would probably recommend you do (probably don’t listen to me here; I am the opposite of diversified right now, lol). The is almost an endless amount of ETFs to choose from such as stock ETFs, bond ETFs, commodity ETFs (i.e. gold), sector ETFs (i.e. consumer goods), international ETFs (i.e. Japanese market), thematic ETFs (i.e. high growth tech companies), and more.
For an ETF to be created, a financial institution becomes the ETF “sponsor” or “issuer” and proceeds to file a plan with regulatory bodies (i.e. SEC; no…not the football one…the one that sucks a lot more). This filing will include everything from the investment objective, strategy, risks, fees, etc. Next, Authorized Participants (or APs), typically comprised of banks or market makers, are selected and given the authority to create and redeem ETF shares. These APs then gather the underlying assets that the ETF is designed to track and then place these assets in a “basket” and then give that basket to the original ETF issuer.
In exchange for the financial institution issuing these products, they take a management fee, a recurring charge, expressed as a percentage of assets under management, from the investor. These fees can typically range from anywhere as small as .03% to as large as 1.5% depending on the complexity and focus of the ETF. Now, I know these percentages don’t sound like a huge cash generator, but when you look at the .09% that SPY, the largest S&P 500 tracking ETF holding ~ $400b of AUM, is charging, that equates to $360 million. Not too shabby if you ask me.
Synthetic vs. Spot ETFs
Now that you have a general idea of what an ETF is (I hope at least), I want to go through the main two ways these ETly track the underlying asset they are meant to represent: Synthetic & Spot ETFs.
Spot (or physical) ETFs directly own the assets they are designed to track. For example, an ETF tracking the overall stock index (i.e. S&P 500) would involve holding all (or a representative sample) of the stocks in that index in the same proportions. Another example would be an ETF issuer purchasing and holding actual, physical, bars of gold to issue a gold ETF. The benefits of Spot ETFs are that they’re straightforward, transparent, and closely track the Net Asset Value (NAV) of the underlying asset. However, they do force the ETF issue to have greater costs to store and secure physical commodities (if they issue a commodity ETF).
Synthetic (or Derivative-Based) ETFs don’t actually hold the asset the ETF is meant to represent and instead use derivatives (usually swaps) to replicate the performance of the underlying asset. For this specific blog, we’ll focus on futures ETFs (which fall under the Synthetic category). These ETFs specifically use futures contracts (promise delivery of an asset at a future date) to track the underlying value of the asset the ETF is meant to reflect. However, given that these contracts have an expiration date, the ETF issuers are required to sell these contracts before the expiration date and then purchase new futures contracts that expire at a later date. This complication can cause the ETF issuer to either make or lose money depending on the price of the further-dated contracts they are looking to buy vs. the near-dated ones they’re looking to sell (these scenarios have sick names: Contago & Backwardation).
Although these synthetic and more specifically futures-based ETFs have much fewer requirements in terms of storage of certain assets (i.e. commodities like oil), they are much more loosely tied to the actual asset they are meant to track as they follow the price of the futures contracts and not the assets themselves. As seen during the peak of the pandemic with oil prices going negative, futures contracts can sometimes create financial anomalies that are risky. Furthermore, utilizing futures contracts introduces counterparty risk of the future contract issuer, which may trickle down to the ETF itself.
Crypto ETFs Thus Far
Now, let’s dive into the world of crypto ETFs. It all started back in 2013 when the Facebook famous Winklevoss twins submitted the first Bitcoin ETF filing, promptly titled the Winklevoss Bitcoin Trust. Given the deemed risky nature of the nascent crypto industry, this ETF was denied not once, but twice by our financial overlords.
As the industry began making more traction and mainstream news headlines due to the 2017 ICO boom, more ETFs were soon filed. However, given the pump-and-dump schemes created in 2017, the SEC wasn’t too keen on giving the space much legitimacy. This explains why in a single day in 2018, the SEC rejected nine Bitcoin ETF applications, making it seem like the day would never come.
Eventually, in October of 2021, the first Bitcoin ETF was launched by ProShares which tracked Bitcoin prices through futures contracts traded at the Chicago Mercantile Exchange (CME). This was followed up by a bunch of other futures-based Bitcoin ETF applications as well as ETH-futures ETF, which have only recently been expected to be approved. However, the recent craze that is causing a lot of ruckus in DC is the Bitcoin Spot ETFs.
The Bitcoin Spot ETFs have become the biggest talk in institutional crypto adoption, with major financial powerhouses filing applications, such as BlackRock, Invesco, Ark Invest, Van Eck, Fidelity, and more. However, these applications have been met with tons of regulatory scrutiny by the SEC, which has been continually denying or delaying a decision until as late as early 2024. It does seem as if the ETFs are on their way to getting approved after these delays, as the DC Court of Appeals recently stated that the SEC failed to fully explain its reasoning for denying Grayscale’s Bitcoin Spot ETF product in a recent case.
As mentioned earlier in the explanation of spot vs. futures ETFs, these are such a big deal because it would mean these major financial players would not only be allowed to, but permitted to hold large amounts of cryptocurrency on their books to create the spot ETF. Furthermore, a spot ETF would also provide the crypto industry with much more legitimacy amongst the everyday person as calling crypto a scam would imply that the financial institutions that they put their wealth and faith in would be implicit in such nonsense.
The Mother of All ETFs
In my personal opinion, I believe the Bitcoin Spot ETF will be an incredible boon to the cryptocurrency space, and my family may finally start taking my work and blogs seriously for once. I also believe that when we look back in a few years, the launch of these ETFs will be the catalyst for the next bull market in crypto (disclaimer time: this is my personal opinion and not that of the NEAR Foundation. This is also not financial advice. I did that correctly, right?).
However, while this is getting plenty of media attention, my eyes were immediately focused on another headline that went under most people’s radar.
Now, if you’re a crypto native, you might be thinking,
“This is just the Bitcoin ETF 2.0 but using Ethereum, the 2nd biggest crypto instead.”
If you’re new to the crypto space, you may instead be thinking
“This is just the Scam ETF 2.0 but using Ethereum, the 2nd biggest scam instead.”
However, if I were a financial institution that is knowledgeable about this industry and is looking to make a ton of money (which every financial institution loves doing), I would be chomping at the bit to file and get this ETF approved, because the economic model behind this ETF could become a cash cow for their business. Let’s get into why.
The first thing to discuss is the differences (and in this case advantages) that an ETH ETF has over a BTC one. The first thing to note is that Bitcoin and Ethereum have different consensus mechanisms. While you can read more about the differences here, all you need to know is unlike proof-of-work, holders of the ETH coin is that you can earn a yield with it by staking the ETH coin to validate transactions happening on the Ethereum network. Since spot ETFs would require the financial institutions to hold the ETH on their books anyway, they may as well earn some yield while they’re at it.
So, instead of a crypto Spot ETF that simply tracks the price of a cryptocurrency, you have one that not only tracks the price but also offers a yield that can be paid out to ETF investors. The big catch with all of this is that most people buying these ETFs (institutional and retail crypto newcomers) have absolutely no clue about how any of this “magic money” stuff works. Thus, financial institutions would be able to take a large cut on management fees and/or staking yields from investors and be able to pocket that themselves. How much could this be exactly? Let’s do some mental math (that is definitely not very accurate).
Let’s just assume for the moment that all of these applicants of a BTC Spot ETF eventually do the same for ETH and decide to allocate .1% of assets towards this ETF (conservative estimate I think?). That would equate to $17.7 billion in AUM in these ETFs. Given the “complexity” it would take to store these assets on their books, these issuers could charge probably upwards of a 0.5% management fee on these ETFs, which would generate $88.5m for these firms (again…very rough math and doesn’t account for potential future growth of ETH).
Now, let’s look at the staking side of the equation. The current APR (basically yearly yield) for staking on a validator is around 4%. These financial institutions will most likely turn to 3rd parties to conduct staking activities (i.e. Coinbase, Figment, etc.), and let’s assume these 3rd parties get a 15% cut for staking, leaving the financial institutions with a 3.4% annual yield. Let’s also assume that they would pay their ETF investors 50% of this yield (tough to assume how greedy they’ll be), leaving the ETF issuers with 1.7% yearly earnings on their ETH. Assuming the $17.7 billion AUM figure doesn’t change, this would provide the ETF issuers with an additional $300m yearly revenue in additional ETH, not USD.
The total figure that would be paid out to these ETF issuers yearly (again, napkin math here and does not account for wild ETH volatility) would be roughly $388.5m. Looking at it side by side with the SPY ETF I mentioned earlier, the two ETFs generate a similar amount of revenue ($360m for SPY). Thus, the SPY ETF needs to hold about 2260% more in AUM than an ETH Spot Eto to achieve similar revenues for the financial institutions issuing these ETFs. These figures could wildly change for better or worse depending on how the price of ETH changes over the next few years. However, if VanEck’s Ethereum price target of $11.8k by 2030 happens to be correct, then institutions would be smart to begin accumulating and earning as many ETH staking rewards through the issuance of an ETH Spot ETF as they can in my humble, struggling blogger, finance major (and nothing more) opinion.
Thanks for reading! Very glad that I decided to start writing this blog a lot earlier than normal because I had no time to write the majority of this week being in Austin, TX for the Permissionless conference. Was super fun seeing faces I haven’t seen in a while, and also meeting a few of my fellow co-workers. Have so many blog ideas I wish I could just have completed and ready to publish at the moment, so I’ll have to decide which one to give y’all for next week. Stay tuned to find out!
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I love all the self-deprecation. Some interesting ideas here but with so many unknown factors, it is difficult to decide what is actionable.
I am not as familiar with crypto as you, bud. Unlike a stock ETF, which holds several different stocks, do crytpo ETFs only hold shares of a single currency? Is there potential for a crypto ETF that holds multiple currencies?