Galaxy Research Report: Estimated monthly net inflow of $1 billion for Ethereum ETF, one-third of Bitcoin ETF

Original Title: 《Sizing the Market for the Ethereum ETF》

Author: Charles Yu

Translation: Shenchao TechFlow

Key Points

• From January 11, 2024, to June 15, 2024, Bitcoin ETFs saw net inflows of $15.1 billion.

• Nine issuers are competing to launch 10 spot Ethereum ETFs in the U.S.

• After the approval of all 19b-4 applications on May 23, the SEC is expected to allow these instruments to begin trading in July 2024.

• Similar to Bitcoin ETFs, we believe the primary new accessible market is independent investment advisors, or those associated with banks or broker/dealers.

• We expect net inflows for ETH ETFs to reach 20-50% of BTC ETF net inflows in the first five months, targeting 30%, which implies a net inflow of $1 billion per month.

• Overall, we believe that due to a large portion of ETH's total supply being locked in staking, bridging, and smart contracts, and the lower amount on centralized exchanges, ETHUSD is more price-sensitive to ETF inflows than BTC.

Introduction

For months, observers and analysts have underestimated the likelihood that the SEC would approve spot Ethereum exchange-traded products (ETPs). The pessimism stemmed from the SEC's hesitation to clearly state that Ethereum is a commodity, reports of not engaging with potential issuers, and news of investigations and pending enforcement actions regarding the Ethereum ecosystem. Bloomberg analysts Eric Balchunas and James Seyffart assigned a 25% probability of approval in May (as some potential issuers faced their first final approval/rejection deadlines). However, on Monday, May 20, after reports that the SEC had contacted exchanges, Bloomberg analysts suddenly raised the probability of approval to 75%. In fact, all applications for spot Ethereum ETPs were approved later that week. While we are still waiting for these instruments to actually launch after the S-1 applications become effective—expected sometime in the summer of 2024—this report draws on the performance of Bitcoin spot ETPs to predict demand after the launch of Ethereum ETPs. We estimate that spot Ethereum ETPs will see approximately $5 billion in net inflows during the first five months of trading (about 30% of Bitcoin ETP net inflows).

Background

Currently, nine issuers are vying to launch exchange-traded products (ETPs) that hold spot ETH. In recent weeks, some issuers have dropped out. ARK chose not to partner with 21Shares to launch an Ethereum ETP, while Valkyrie, Hashdex, and WisdomTree have completely withdrawn their applications. The table below shows the current application status sorted by 19b-4 application date:

Grayscale is seeking to convert the Grayscale Ethereum Trust (ETHE) into an ETP, similar to what the company did with the Grayscale Bitcoin Investment Trust (GBTC), but has also applied for a "mini" version of the product.

The SEC approved all 19b-4 applications on May 23—these rule changes allow exchanges to eventually list spot ETH ETPs—but now each individual issuer needs to communicate repeatedly with regulators regarding their registration statements. These products cannot truly begin trading until the SEC allows these S-1s (or S-3s in the case of ETHE) to become effective. Based on our research and Bloomberg Intelligence's report, we believe that spot Ethereum ETPs could start trading as early as the week of July 11, 2024.

Experience from Bitcoin ETFs

Bitcoin ETFs have been live for less than six months and can serve as a useful basis for studying the potential acceptance of spot Ethereum ETFs.

Source: Bloomberg

Here are some observations from the first few months of trading for Bitcoin spot ETPs:

• So far, inflows have exceeded expectations. As of June 15, U.S. spot Bitcoin ETFs have seen cumulative net inflows of over $15.1 billion since launch, averaging net inflows of $136 million per day. The total amount of Bitcoin held by these ETFs is approximately 870,000 BTC, accounting for 4.4% of the current BTC supply. With BTC trading at around $66,000, the total assets under management for all U.S. spot ETFs are about $58 billion (note: prior to the launch of the ETF, GBTC held approximately 619,000 BTC).

• ETF inflows have contributed to the rise in BTC prices. By regressing BTC prices against weekly changes in ETF net inflows, we calculated an r-squared of 0.55, indicating a high correlation between the two variables. Interestingly, we also found that price changes serve as a better leading indicator for inflows than inflows themselves.

• The unwinding of GBTC trading has impacted overall ETF inflows. Since the trust converted to an ETF, GBTC has experienced significant outflows in the first few months. Daily outflows peaked in mid-March, with an outflow of $642 million on March 18. Since then, outflows have moderated, and GBTC even saw a few days of net inflows starting in May (after 78 days of outflows prior to the first net inflow on May 3). As of June 15, the BTC balance held by GBTC has decreased from 619,000 BTC to 278,000 BTC (a reduction of 55%).

• ETF demand is primarily driven by retail; institutional demand is increasing. 13F filings show that as of March 31, over 900 U.S. investment firms held Bitcoin ETFs, with holdings of approximately $11 billion, accounting for about 20% of total Bitcoin ETF holdings, indicating that most demand comes from retail. The list of institutional buyers includes some well-known banks (such as JP Morgan, Morgan Stanley, Wells Fargo), hedge funds (such as Millennium, Point72, Citadel), and even pension funds (such as the Wisconsin Investment Board).

• Wealth management platforms have yet to start offering access to Bitcoin ETFs. The largest wealth platforms have not yet allowed their brokers to recommend Bitcoin ETFs, although reports suggest that Morgan Stanley is exploring allowing its brokers to suggest purchases. In our report on the market size for Bitcoin ETFs, we noted that access to Bitcoin ETFs through wealth platforms (including broker-dealers, banks, and independent registered investment advisors) is expected to take years. So far, sales-driven inflows from institutional platform access have been minimal, but we believe it will become an important catalyst for Bitcoin adoption in the medium to short term.

Estimating Potential ETH ETF Inflows

Using Bitcoin ETPs as a reference, we can estimate the potential demand for similar Ethereum products.

To estimate the potential inflows for ETH ETFs, we apply the BTC/ETH multiple based on the relative asset sizes of BTC and ETH across multiple markets to estimate the inflows for U.S. spot Bitcoin ETFs. As of May 31:

• The market cap of BTC is 2.9 times that of ETH.

• Across all exchanges, based on open interest levels and trading volume, the futures market for BTC is about 2 times that of ETH. Specifically, at CME, the open interest level for BTC is 8.4 times that of ETH, while daily trading volume is 4.2 times that of ETH.

• The total assets under management of various existing funds (broken down by Grayscale trusts and products such as futures and spot, as well as selected global markets) show that the size of BTC funds is approximately 2.6 to 5.3 times that of ETH funds.

Based on the above data, we believe that inflows for spot Ethereum ETFs will be approximately 3 times less than those for U.S. spot Bitcoin ETFs (consistent with market cap multiples), ranging from 2 times to 5 times less. In other words, we believe that inflows for spot Ethereum ETFs could be 33% of U.S. spot Bitcoin ETF inflows, ranging from 20% to 50%.

Applying this multiple to the $15.1 billion in Bitcoin spot ETF inflows as of June 15 implies that in the first five months after the approval and launch of the Ethereum ETF, the monthly inflows for the Ethereum ETF would be approximately $1 billion (estimated range: $600 million to $1.5 billion per month).

Several estimates we see are below our predictions due to the following factors. Specifically, our previous report on the estimated first-year inflows for Bitcoin ETFs of $14 billion was based on the entry of wealth management platforms, but Bitcoin ETFs had already seen significant inflows before these platforms arrived. Therefore, we advise caution in underestimating the demand for Ethereum ETFs.

Some structural/market differences between BTC and ETH will affect ETF inflows:

Demand for spot Ethereum ETFs may be limited due to the lack of staking rewards. Non-staked ETH forgoes the following opportunity costs:

(i) Inflation rewards paid to validators (which also have a negative dilution effect),

(ii) Priority fees paid to validators, and MEV income paid to validators through relayers. Using post-merge data (>September 15, 2022) up to June 15, 2024, we estimate the annual opportunity cost of forgoing staking rewards to be 5.6 percentage points for spot ETH holders (or 4.4 percentage points using year-to-date data), which is a significant difference. This will make spot Ethereum ETFs less attractive to potential buyers. Note that ETPs offered outside the U.S. (e.g., Canada) provide additional yield to holders through staking.

Grayscale's ETHE may weigh on inflows for Ethereum ETFs. Just as GBTC experienced significant outflows when converting to an ETF, ETHE's conversion to an ETF will similarly lead to outflows. Assuming ETHE's outflow rate matches GBTC's outflow rate in the first 150 days (i.e., 54.2% of the trust's supply is withdrawn), we estimate ETHE's monthly outflow to be approximately 319,000 ETH, which at the current price of around $3,400 would amount to $1.1 billion or an average daily outflow of $36 million. Note that the supply held by these trusts accounts for 3.2% of BTC supply and 2.4% of ETH supply, indicating that the impact of the ETHE ETF conversion on ETH prices is relatively smaller than that of the GBTC conversion. Additionally, unlike GBTC, ETHE does not face forced sellers due to bankruptcies (e.g., 3AC or Genesis), further supporting the view that selling pressure related to Grayscale trusts for ETH is relatively small.

Basis trading may drive hedge fund demand for Bitcoin ETFs. Hedge funds may seek to arbitrage the price differences between Bitcoin spot and futures, and basis trading is likely to drive hedge fund adoption of ETFs. As previously mentioned, 13F filings show that as of March 31, 2024, over 900 U.S. investment firms held Bitcoin ETFs, including some well-known hedge funds like Millennium and Schonfeld. Throughout 2024, ETH's financing rates across exchanges have averaged higher than BTC's, indicating that: (i) demand to go long on ETH is relatively greater; (ii) spot Ethereum ETFs have the potential to attract greater demand from hedge funds looking to engage in basis trading.

Factors Affecting Price Sensitivity of ETH vs. BTC

Since we estimate that the inflows for Ethereum ETFs will be roughly comparable to those for BTC in terms of market cap, we expect that, all else being equal, the impact on price will also be roughly similar. However, there are some key differences in supply and demand between the two assets that may lead to Ethereum being more price-sensitive to ETF flows:

• Supply on exchanges: Currently, the proportion of BTC supply held on exchanges is higher than that of ETH (11.7% vs. 10.3%), suggesting that ETH supply may be tighter. Assuming inflows are proportional to market cap, ETH's price will be more sensitive (note: this metric largely depends on the attribution of exchange addresses, and there is significant variance among data providers).

• Inflation and burn: Following the latest halving on April 20, 2024, Bitcoin's annual inflation rate is approximately 0.8%. Post-merge (>September 15, 2022), Ethereum's net issuance is negative (annual issuance of -0.19%) because the new issuance paid to stakers (+0.63%) is offset by the base fees burned (-0.83%). In the most recent month, ETH's base fees have been relatively low (annualized -0.34%), failing to offset new issuance (annualized +0.76%), resulting in an annualized net positive inflation rate of +0.42%.

• Supply held in ETFs: Since launch, the net amount of BTC entering U.S. spot ETFs (excluding the initial balance of GBTC) has totaled 251k BTC, accounting for 1.3% of the current supply. If this pace continues on an annualized basis, ETFs will absorb 583k BTC or 3.0% of the current BTC supply, far exceeding the dilution from miner rewards (0.81% inflation rate).

However, the actual market liquidity available for ETFs is far below the reported current supply. We believe that to better reflect the available market supply of each asset in ETFs, various factors must be adjusted for, such as staked supply, dormant/lost supply, and supply held in bridges and smart contracts:

• Staked supply (discount: 30%): Staked ETH reduces liquidity in the market. Currently, there are no staking options for BTC. Staked ETH is used to secure the network, but stakers can unstake some ETH for other purposes. Currently, approximately 27% of the total supply is staked, and we apply a 30% discount to estimate the available supply in the market, resulting in an 8.2% supply discount.

• Dormant/lost supply (discount: 50%): Some BTC and ETH are considered unrecoverable (e.g., lost keys), reducing the supply in the market; we use BTC that has been inactive for over 10 years and ETH that has been inactive for over 7 years, accounting for 16.6% and 6.7% of the current supply, respectively. We apply a 50% discount to these supplies, as the supply in these presumed dormant addresses could come back online at any time.

• Supply in bridges and smart contracts (discount: 25%): These supplies are locked in bridges and smart contracts for productive purposes. For Bitcoin, wrapped BTC (wBTC) held by BitGo is approximately 153k BTC, and we estimate a similar amount of BTC locked in other bridges, totaling about 1.6% of the supply. The ETH locked in smart contracts accounts for approximately 11.4% of the current supply. We apply a 25% discount to these supplies, as we believe they are more liquid than staked supplies (i.e., less likely to be affected by the same locking requirements and withdrawal queues).

After applying these discount weights to calculate the adjusted BTC and ETH supplies, we estimate that the available supplies of BTC and ETH are 8.7% and 14.4% less than the reported current supplies, respectively.

Overall, ETH's price sensitivity relative to BTC should be higher for the following reasons: (i) lower available market supply based on adjusted supply factors, (ii) lower proportion of supply on exchanges, (iii) lower net issuance. Each of these factors should have a multiplicative effect on price sensitivity (rather than additive), as prices tend to be more responsive to changes in market supply and liquidity.

Looking Ahead

Looking ahead, we have several questions regarding adoption and secondary effects:

• How should product managers and allocators view BTC and ETH? Will existing holders shift from Bitcoin ETFs to ETH? Some rebalancing is expected for allocators. Will spot Ethereum ETFs attract new marginal buyers who have not yet purchased BTC? What would be the ratio of potential buyers holding only BTC, only ETH, or a mix of both?

• When (if ever) can staking be added? Will the lack of staking rewards affect the adoption of spot Ethereum ETFs? Will investment demand for DeFi, tokenization, NFTs, and other crypto-related applications drive greater adoption of Ethereum ETFs compared to Bitcoin, given the lack of alternative investment products?

• What are the potential impacts on other alternatives? After Ethereum, are we more likely to see other alternative ETFs approved?

Overall, we believe that the potential launch of spot Ethereum ETFs should have a positive impact on market adoption of Ethereum and the broader crypto market for two main reasons: (i) expanded accessibility in the wealth segment, and (ii) greater acceptance through formal recognition by regulators and trusted financial service brands. ETFs can provide greater coverage for both retail and institutional investors, offering broader distribution through more investment channels, and can support Ethereum's use in portfolios for more investment strategies. Additionally, a greater understanding of Ethereum among financial professionals ideally would lead to accelerated investment and adoption of the technology.