A Spot Bitcoin ETF Is Easy. What Comes Next Could Get Dangerous.

A Spot Bitcoin ETF Is Easy. What Comes Next Could Get Dangerous.
A Spot Bitcoin ETF Is Easy. What Comes Next Could Get Dangerous.

Summary

The crypto rally has broadened beyond bitcoin, but a flood of institutional money into markets like ether could come with unexpected risks.

Giving fund managers easier access to bitcoin is already a contentious topic for regulators. It is nothing next to the Pandora’s box that could be opened with its crypto peer ether.

The price of bitcoin has surged roughly 14% this past month to around $42,000. Investors believe U.S. regulators will soon green light exchange-traded funds, or ETFs, that hold spot bitcoins, bringing billions of dollars into the market.

Ether has gained 10% over the same period. Though officials last week delayed the decision whether to allow spot ether ETFs, whose prospective providers include BlackRock and Invesco, traders increasingly think it inevitable that whatever goes for bitcoin will go for the second-most-popular cryptocurrency. One sign of this is that Grayscale’s bitcoin and ether trusts now trade at 11% and 14% respective discounts to the cryptocurrency they own, implying fairly similar chances of getting converted into an ETF.

The problem is that bitcoin and ether aren’t two peas in the same pod.

Bitcoin validates transactions by having computer servers, known as “miners," solve complex problems. This uses up massive amounts of energy and more water than all of New York City. To solve this conundrum, ether’s Ethereum network switched last year to a “proof-of-stake" system. Anyone who owns ether can vouch for the accuracy of transactions and get rewards. The only requirement is to lock up or “stake" their holdings, as one would do with currency in a bank time deposit.

This is a key difference. A spot bitcoin ETF can simply own bitcoin and leave mining to miners, just like a spot gold ETF owns bullion and doesn’t care about digging up new metal. An ether ETF, on the other hand, needs to decide how to deal with the yield that comes from the right to validate. Crypto developers liken this yield to the “benchmark rate" paid by the Federal Reserve on U.S. dollars.

Reality is more complicated. Verifying transactions oneself is a pain, so many prefer to stake through exchanges. Shares in Coinbase have shot up since the start of November in part because of expectations that prospective ETF managers will run their portfolios this way. Also, the rewards the Ethereum network offers for staking fall as more ether is staked. A massive influx of funds would push them lower and, because validating has some fixed costs, force many small players out of the market.

There is a big potential risk here for a network that allocates power to those who hold more currency: A few exchanges could gain outsize control over the entire ether market. Even if they did nothing nefarious, Ethereum penalizes validators who make mistakes when checking transactions. This has happened 406 times now and last month affected Bitcoin Suisse, a firm that caters to institutional investors.

Any snafu from a big player would imply a huge payout. If the ether was held for an ETF that got devalued as a result, “confidence would drop through the floor and regulators would step in," said Jim McDonald, chief technology officer of staking company Attestant.

Alternatively, funds could give their ether to platforms that would allocate it to different validators using “smart contracts," without taking custody themselves. Owners get a “liquid-staking token" that can, as of last April, be redeemed for the real thing.

But smart contracts involve hacking risks, and redemption times can vary. Also, different tokens have different features, with some being far more liquid than others. This is why investors have gravitated toward using only a few liquid-staking protocols, with Lido now holding a whopping 32% market share. One way or another, institutional money seems likely to centralize power in the ether network—an ironic but common pattern in the supposedly decentralized crypto economy.

To be sure, regulators might set certain terms for spot ether ETFs if they approve them. Still, there seems likely to be an ecosystem of products that look alike but have different, hard-to-understand yields and risks. This is the case with the funds allowed in Canada, such as CI Galaxy Ethereum ETF, Purpose Ether ETF and 3iQ Ether Staking ETF.

Jumping on the bitcoin train is one thing. The following ones have very uncertain destinations.

Write to Jon Sindreu at jon.sindreu@wsj.com

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