The approval expectation of ETFs drives prices to surge, where will the ETH ecosystem head in the future?

Original Title: “Exploring the Impacts of ETH ETF Approvals”

Author: Tanay Ved

Translated by: Deep Tide TechFlow

Key Points:

• The reversal of the approval odds for Ethereum ETFs led to a 25% increase in ETH prices, as well as a rise in tokens related to the Ethereum ecosystem.

• The discount of Grayscale's Ethereum Trust (ETHE) to its net asset value (NAV) shrank from 50% a year ago to 1.28% at the time of ETF approval.

• The lack of staking participation in ETH ETFs may impact ETH's supply dynamics, the staking ecosystem, and network resilience.

Introduction

In an unexpected turn, the U.S. Securities and Exchange Commission (SEC) approved a spot exchange-traded fund (ETF) for the second-largest digital asset—ETH. On May 23, the 19b-4 proposals from eight issuers were approved, including industry giants like BlackRock, Fidelity, Bitwise, VanEck, and Grayscale. Just four months ago, we witnessed the end of a decade-long pursuit for a spot Bitcoin ETF, with 11 issuers participating in a competition dubbed the "Cointucky Derby." Anticipation built for months prior to the launch, which subsequently attracted a net inflow of $12B, making it the fastest-growing ETF launch in history.

However, the situation for Ethereum has been different. The security status of Ethereum and its proof-of-stake (PoS) consensus mechanism remains unclear, with the SEC taking action against well-known industry participants like Coinbase and Consensys. Nevertheless, the odds of a spot Ethereum ETF approval have shifted from unlikely in January to a reality in May, marking a significant turning point in the regulatory landscape of the digital asset industry. In this issue, we assess the market response and network impact following the SEC's approval of a spot Ether ETF in the U.S.

Market Response

Given the short time window for pricing this development, the market reacted swiftly, with the increased approval odds of 75% triggering an immediate response in the market prices of ETH and other Ethereum ecosystem tokens. PEPE (+80%) is the largest meme on Ethereum, LDO (+44%) is the governance token of liquidity staking provider Lido, and UNI (+44%) is the token of the decentralized exchange (DEX) Uniswap, providing the highest returns, while ETH rose by (+27%).

Source: Coin Metrics Reference Rates

Since September 2022, Ethereum (ETH) has been on a downward trend relative to Bitcoin (BTC) (ETH/BTC ratio), but this news provided a much-needed boost. Although it rose to 0.056 before the ETF approval, it needs to break through key resistance levels to regain an upward trend and make up for its underperformance relative to other large crypto assets like BTC and SOL. While the approval of the 19b-4 did not accelerate gains, the anticipated approval of the S-1 registration statement and the subsequent launch of the Ethereum ETF should serve as a strong catalyst for broader acceptance of ETH as an investable "commodity" and mainstream adoption of the Ethereum network.

Source: Coin Metrics Reference Rates

Investor Sentiment and Market Positioning

The market sentiment surrounding the approval of the spot Ethereum ETF is reflected in the narrowing discount of Grayscale's Ethereum Trust (ETHE) to its net asset value (NAV). Compared to a discount of about 50% a year ago, ETHE's market price has narrowed to within 1.28% of its NAV, with 20% of the narrowing occurring within five days.

While this is reminiscent of the situation with Grayscale's Bitcoin Trust (GBTC) before its conversion to an ETF in January, the speed of ETHE's discount compression is more rapid, highlighting that this change caught market participants by surprise. Nevertheless, investors have begun to strategically position themselves, anticipating that ETHE will convert to an exchange-traded product after its public offering.

Source: Coin Metrics Institutional Metrics, Grayscale

The open interest (OI) of ETH futures contracts reached a record $13.8 billion, indicating increased speculation around the Ether ETF. Although this figure is still below the level of open contracts for BTC before the launch of the spot Bitcoin ETF, the growth in the value of outstanding ETH futures contracts on Binance, OKX, and the Chicago Mercantile Exchange (CME) suggests that both retail and institutional investor activity is becoming more active.

Source: Coin Metrics Market Data

How Will the ETH ETF Affect Staking?

An important development regarding the approval of the spot Ethereum ETF is that they will not include staking functionality. Issuers will not be able to stake ETH, which may have potential impacts on ETH's supply dynamics, the health of the Ethereum consensus layer, and the overall staking ecosystem.

Impact on Ethereum's Supply Dynamics

As the native asset of the Ethereum ecosystem, ETH is central to its operation and security. ETH can serve as a unit of account, a store of value, or collateral, upon which a diverse economic system is built. This includes using ETH for staking to secure the network through the proof-of-stake (PoS) consensus mechanism, depositing ETH into smart contracts to support decentralized finance (DeFi) services, paying transaction fees, or holding it as an asset for investment and value storage in users' accounts.

Source: Coin Metrics Network Data

Currently, of the total supply of 120M ETH, 27% is staked in the consensus layer, 11% is held in smart contracts (unstaked), and 61% is held by external accounts (EOA). As ETF issuers absorb more circulating ETH, it is expected that a significant portion of the supply will be locked, potentially reducing the available supply in the market. The decrease in circulating supply, coupled with strong demand, may increase the likelihood of ETH price appreciation.

Impact on Ethereum's Consensus Layer

Currently, 32 million ETH (27% of the total supply) is staked on the Ethereum beacon chain through individual staking, staking pools like Lido, or custodial staking providers like Coinbase. However, excluding ETH ETF staking, the ratio of 27% staked to 73% unstaked is unlikely to change significantly. Staking yield is a key component of the returns for holding ETH. Therefore, excluding the ETF from staking may benefit existing stakers, as it can prevent dilution of staking returns when institutional capital enters the staking ecosystem.

Source: Coin Metrics Network Data

The potential impact of consensus rewards (excluding tips and MEV) on validator yield can be seen in the above chart. Assuming that Ethereum ETF issuers acquire 10% of the ETH supply (approximately 12 million ETH) and stake 30% of that, the number of active validators in the consensus layer would increase by 11.25%, from the current 1 million to 1.125 million. Due to the inverse relationship, more validators and staked ETH would lead to a decrease in the annual percentage yield (APY) for stakers from about 2.9% to 2.7%. While this is not a precise measure, it illustrates the potential impact on staking yields if ETF issuers stake additional ETH.

Equally important is the consideration that the maximum effective balance per validator (currently set at 32 ETH) will be increased to 2048 ETH in the upcoming Electra upgrade, which may alter the dynamics of validators and network security.

Furthermore, the lack of staking functionality in the ETH ETF may positively impact Ethereum's staking ratio and decentralization. Currently, with the rapid growth of staking rates, Lido and Coinbase hold 28% and 13% of the staked ETH market share, respectively. If institutional capital participates in staking, Coinbase, as the primary ETF custodian, may become a major beneficiary of staked ETH, thereby exacerbating centralization risks.

These concerns have sparked discussions within the Ethereum community about adjusting the issuance rate of ETH to mitigate negative impacts such as staking centralization, decreased competitiveness of independent stakers, and inflationary pressures faced by non-stakers. In the long run, it remains to be seen whether the SEC will allow Ether ETFs to participate in staking. However, by not staking ETH, ETFs can help maintain a balanced staking ratio to some extent, promoting a healthier distribution of staking.

Source: Coin Metrics Network Data

The participation rate of the Ethereum consensus layer is 99.5%, indicating that the majority of validators maintain network security through voting and proposing blocks. This also means that staking rewards are being distributed to a larger pool of validators, ensuring decentralization. In the future, proposed changes to issuance and effective balances, along with the SEC's stance on ETFs that include staking, will shape the future of the Ethereum staking ecosystem.

Conclusion

The past week marks a significant shift in the regulatory landscape for digital assets in the U.S., including the passage of the FIT21 Crypto Market Structure Bill and the approval of the Ethereum ETF. However, many questions remain unanswered: Will the Ethereum ETF attract investment flows comparable to the Bitcoin ETF? How will the staking dynamics evolve in this context? And what are the broader implications for other crypto markets? While these remain to be seen, regulatory clarity and greater accessibility are expected to attract broader demand into ETH and its ecosystem.

Network Data Insights

Summary Highlights

Source: Coin Metrics Network Data

The market capitalization of Ethereum (ETH) rose by 25% over the past week, while the adjusted transfer value increased by 132%, reaching $8 billion. With the approval of the ETH ETF, the activity and valuations of some ERC-20 tokens have also risen.