Ether ETFs Could Threaten Ethereum’s Decentralization and Security
The US Securities and Exchange Commission (SEC) is currently reviewing eight applications for spot Ether exchange-traded funds (ETFs), which could be approved as early as May 2024. However, some of these proposed ETFs could pose a threat to the security and decentralization of the Ethereum network, according to a report by S&P Global.
Spot Ether ETFs are funds that track the price of Ether, the native cryptocurrency of the Ethereum blockchain, by holding the actual tokens in custody. Some of the applicants, such as Ark Investment Management and Franklin Templeton, have indicated that they plan to stake a portion of their Ether holdings to the Ethereum network, in order to earn additional rewards and support the network’s transition to a proof-of-stake (PoS) consensus mechanism.
Staking is a process where Ether holders lock up their tokens to the network and act as validators, who are responsible for verifying and securing transactions on the blockchain. Staking allows validators to earn passive income from transaction fees and block rewards, while also reducing the energy consumption and environmental impact of the network.
However, staking also comes with some risks, such as the possibility of losing staked tokens due to network downtime, slashing penalties, or hacking attacks. Moreover, staking could also increase the concentration of Ether among a few large validators, who could potentially collude or compromise the network’s integrity and performance.
According to S&P analysts Andrew O’Neill and Alexandre Birry, who co-chair S&P Global’s digital assets research lab, the approval of spot Ether ETFs that include staking could exacerbate this concentration risk, especially if they attract significant inflows from investors.
The analysts cited the example of Coinbase Global Inc., the largest US cryptocurrency exchange and custodian, which is already the second-largest validator on the Ethereum network, controlling about 14% of the staked Ether. Coinbase also serves as a custodian for eight out of the 11 recently approved US spot Bitcoin ETFs, and for three out of the four largest Ether staking ETFs outside the US.
The analysts suggested that US institutions issuing Ether staking ETFs are more likely to choose an institutional digital asset custodian like Coinbase, rather than a decentralized protocol like Lido, which is the top validator on the Ethereum network with a 31.7% share of the staked Ether. This could result in a further increase in Coinbase’s dominance and influence over the Ethereum network, as well as a reduction in the network’s diversity and resilience.
The analysts also noted that the emergence of new digital asset custodians could help mitigate this concentration risk, by enabling ETF issuers to spread their stakes across different entities. They also pointed out that the Ethereum network is expected to implement some changes in the future, such as the merge of the current proof-of-work (PoW) chain with the PoS chain, and the introduction of sharding, which could improve the network’s scalability and security.
The analysts concluded that the approval of spot Ether ETFs could have both positive and negative implications for the Ethereum network, and that investors should be aware of the potential risks and rewards of staking Ether through ETFs.