Hurray, the ETF Has Been Approved! But Hold On, What Does It Mean for Ethereum Staking?

Positive for the price, harmful for the network 

I become suspicious when the media shines such a bright spotlight on something that it renders everything else invisible. The crypto ETF saga has spanned a decade, fading away and resurfacing periodically. However, in the past month, this topic has taken a commanding presence in the headlines. The Securities and Exchange Commission (SEC) has contributed to the speculative mood by delaying the final decision for as long as possible. 

This kept the crowd guessing, 'Will they approve? Will they not approve the ETF?' and gave market manipulators a field day, because big hype offers ample opportunities to 'shake the tree' during market rallies and corrections. Finally, on January 11, the approval was granted. Everyone uncorked the champagne, and the market rallied like in the good old days of 2021.

Obviously, my suspicion was triggered by the media's clear desire to present the ETF as entirely positive, much like an old meme – whatever happens, it must be good for Bitcoin. So, I started digging into this topic like an enthusiastic mole, with the sole question in mind: 'What does the ETF mean for Ethereum staking?'

The ETF: not as good as it seems 

And I must say, what I understood did not make me happy. At its core, the ETF is nothing more than just another instrument made for market speculators to do what they do best—making money out of thin air. I'll explain the ETF in a nerdy way a bit later, but for now, you've got to understand: an exchange-traded fund itself doesn't contribute anything to the underlying blockchain network or the usability of the native coin. 

Many of us, staking enthusiasts, lock up our crypto in the Ethereum network because we believe it's an amazing tech that can make a difference—not that we don't want to make some coins along the way. So, why get excited over something that doesn't contribute to this cause? In fact, the approval of an ETF could do a world of harm to the Ethereum blockchain. Paradoxically, by attracting too much capital and too many participants to the network that can't handle such an inflow. 

When did the crypto take the wrong turn? 

Another upsetting aspect of this whole ETF ordeal is that it's yet another example of how crypto has become a plaything for the financial world's sharks and regulators, and everyone seems to be exuberant about it. Call me naive, but the main appeal of crypto was that it had initially put itself in opposition to the decaying traditional finance. It was supposed to serve the people, the community, not investment bankers whose sole purpose is to seek profits and avoid responsibility for losses. 

And now, we see everyone applauding as Grayscale, BlackRock, and other 'players' have finally secured approval from regulators to add Bitcoin (BTC) and soon Ethereum (ETH) to a 'traded' product.Sad to witness the corporatization of crypto, but hey, gotta keep chugging along, right? 

However, cryptocurrency traders, holders, and those who began staking ETH on platforms like CryptoStake a while ago may see the ETF approval as a positive development. I'll explain why shortly, but first, let's get to the promised nerdy explanation: What is an exchange-traded fund (ETF)? 

In case you still don’t know what ETF stands for 

The acronym ETF stands for Exchange-Traded Fund. It is a financial instrument designed to represent a diversified basket of assets, providing investors with exposure to various markets or sectors. Traditionally, ETFs have included a mix of stocks, bonds, or commodities, allowing investors to gain broad market exposure through a single investment vehicle. In recent times, the scope of ETFs has expanded to include cryptocurrencies. Here is how the ETF works:

  • The ETF issuer puts together a mix of assets representing crypto's value. This could be actual BTC or ETH or financial tools linked to the cryptocurrency.
  • Once created, the ETF is listed on a stock exchange. This lets investors buy and sell its shares on the open market, much like stocks.
  • The goal of the ETF is to follow the price changes of Ethereum. If Bitcoin's price rises or falls, the value of the ETF shares should move in sync.
  • To maintain the ETF's price alignment with Bitcoin, authorized participants, usually large institutional investors, can trade or create ETF shares based on the underlying assets.

When investors buy an Ethereum ETF, they aren't getting actual cryptocurrency. Instead, they own shares in the ETF, representing their stake in the fund's underlying assets. This setup lets investors tap into Bitcoin through regular brokerage accounts, avoiding the complications of owning and securing digital assets.Now, you see, those who trade ETFs never come close to the actual crypto. They don't contribute anything to the industry except for the market action. On the other hand, those who stake and earn rewards are actively supporting the network.

Is there anything positive for crypto about the ETF?

Let me be clear that my pessimism towards the crypto exchange-traded fund applies only to the fundamentals. When it comes to the price of ETH in the context of a highly-anticipated bullish cycle, there's hardly anything better that could happen to crypto in this period. The approval of the ETF opens the gateway for conservative investors like pension funds that typically engage only in highly regulated financial products, to jump on the crypto bandwagon and bring their billions along. 

This translates to a larger market capitalization, which, as you probably know, is the primary prerequisite for price growth. In simpler terms, without substantial funds entering the market, the price of ETH would struggle to overcome selling pressure, hindering the end of Crypto Winter 2.0 and the pursuit of new all-time highs. 

About 80% of US wealth is managed by financial advisors and institutions. Their participation, along with approval from regulators and the government, gives crypto a much-need credibility. This increased legitimacy is expected to boost demand for Ether beyond the ETF. Early indications show growing institutional interest. Bitwise is discussing potential allocations rising from 1% to 5%, and Coinbase has doubled the number of institutions onboarded to over 100, according to their Q3 earnings report. 

Many people worldwide may never personally own any physical cryptocurrency. However, they can gain financial exposure through channels like pension allocations or private savings and investments. ETFs play a role in making this asset class more credible,  allowing individuals who might otherwise discard the possibility of investing in crypto to easily explore new exposure within familiar frameworks, such as a bank or brokerage.

All of this will generate heightened demand for ETH. The fundamental principles of economics dictate that when demand rises, prices follow suit. Notably, Ethereum has turned deflationary post-Merge, signifying the shift to the Proof of Stake consensus mechanism. This increased demand is expected to have an even more pronounced impact on the price, ultimately reinstating the bulls in the driver's seat.

How the rising price of ETH may impact staking is a key consideration. For those foresighted enough to have acquired their 32+ ETH when the price was near its lowest, they now find themselves as the fortunate holders of a premier digital asset that generates passive income while appreciating in value—a favorable situation. However, for those who are unable to accumulate sufficient ETH at current prices, meeting the minimum validator demand becomes a more expensive endeavor. This might prompt them to explore liquid staking, which has a significantly lower entry barrier but introduces a substantial threat to the network in the form of centralization.

The ETF issuers could worsen the centralization of the Ethereum network 

While it may not frequently surface in the media, firms that have applied for Bitcoin and Ethereum ETFs have already contemplated ways to incorporate staking solutions into the package. It's evident that ETH generating rewards is more appealing than non-rewarding ETH, yet ETF issuers don't appear too eager to establish a staking infrastructure, operate their own validators, implement new business models, or expose themselves to additional regulatory risks. 

ETF issuers typically opt for easy solutions like making agreements, including loans, with third-party staking providers, who charge a small fee. This approach is already in use with 21Shares' staked Ether ETF, AETH. They keep their ETH with Coinbase Custody and probably lend it to Coinbase Cloud, Blockdaemon, and Figment.The 21Shares Ethereum Staking ETP (AETH) follows ETH's price action and reinvests staking yields to improve its overall performance.

AETH has $240.77 million in assets, equivalent to 121,400 ETH, all staked with centralized providers. These inflows are insensitive to yield changes as a fixed percentage is staked programmatically. It's likely that US-based ETF issuers will adopt similar lending agreements to 21Shares AETH. This automated approach may favor centralized providers over decentralized ones. For example, if ARK filed with 21Shares, they'll likely use the same providers as the AETH product.

Why should it be the cause for concern? Ethereum's value comes from its decentralization and security. When multiple node operators are connected, they can act as a single powerful entity, jeopardizing Ethereum's core principles. Liquid staking providers, like Lido, significantly contribute to staking growth. The top 5 providers control over 50% of Ethereum staking, with Lido alone accounting for almost one-third.

Centralization, whether by a protocol or entity, poses risks to Ethereum. A concentrated number of liquidity providers or node operators could act as a single point of failure, becoming vulnerable to attacks or colluding to create an oligopoly that prioritizes their interests over the community's, potentially censoring transactions or front-running end users.

Another concern arising from the rise of liquid staking is rehypothecation—using liquidity tokens as collateral across multiple DeFi protocols simultaneously. This practice could trigger a series of liquidations if a staked asset sharply declines in value, is hacked, or faces a malicious attack or protocol error.

The emergence of ETH staking ETFs, exemplified by AETH and those that are likely to follow, appears to empower entities that pose a potential threat to the integrity of the Ethereum network. This trend raises concerns as it concentrates power and influence in the hands of a few, contradicting the decentralized principles that underpin the Ethereum ecosystem. The growing reliance on such ETFs may inadvertently contribute to centralization, undermining the very foundations that make Ethereum valuable. In this light, it's challenging to view these developments as a positive force for the Ethereum network, as they risk compromising its core tenets of decentralization and security.

Scalability and ETF: An indirect yet toxic connection 

Ethereum scalability refers to how well the network can manage more transactions and tasks efficiently. It measures the ability of the Ethereum blockchain to handle increased user activity, computational needs, and the execution of smart contracts. ETFs themselves do not directly affect how well Ethereum can handle more transactions. Factors like block size, block time, and the network's consensus mechanism carry much more weight in this regard.

However, the popularity of Ethereum-related ETFs can indirectly impact scalability. If an ETF becomes widely adopted and attracts many investors, particularly those involved in activities like staking or using decentralized finance (DeFi) applications, it can lead to more transactions on the Ethereum blockchain. This increased demand may cause congestion on the network and result in higher gas fees.

The Ethereum Foundation, with Vitalik at its helm, plans to overcome the scalability problem through the Danksharding upgrade. To reach this objective, various protocol upgrades are needed. Proto-Danksharding which should free up more block space for Layer 2 scaling solutions like multiple EVMs, OVMs, and ZkEVMs to efficiently handle additional off-chain transactions. This temporary solution aims to reduce costs and enhance scaling for rollups, making Layer 2 transactions as economical as possible for users.

But as already mentioned, Proto-Danksharding is only a temporary solution, and its rollout isn't due to happen until at least Q2 2024, while full Danksharding implementation remains a distant prospect. At the same time, the new money and participants that will start coming en masse through ETFs will put an even larger strain on the network that sometimes struggles to digest what it already has in the system. 

Bottom line 

The approval of the Ethereum Exchange-Traded Fund (ETF) is a major positive milestone in the cryptocurrency world, the first good thing that happened since the FTX collapse. Social media is buzzing with celebration – "hurray, the ETF has been approved!" Yet, looking beyond the initial excitement, there are potential issues with Ethereum ETFs that might impact the network in the long run. The surge in capital and participants could strain Ethereum's scalability, raising concerns for the future. Despite these considerations, let's enjoy the current celebration on social media, acknowledging the immediate impact and importance of this moment while staying mindful of potential challenges for Ethereum down the road.

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16 january 2024