How an Ether Futures ETF Works

Financial products like ether futures exchange-traded funds (ETFs) allow you to gain exposure to ether in a regulated market setting. This means knowing two things first: Ether is the cryptocurrency from the Ethereum network, a decentralized platform behind the launch of smart contracts and decentralized finance (DeFi) applications. Second, futures for ether are contracts to trade the underlying at a price and time in the future set when the agreement is made.

Spot markets for ether, which trade the underlying assets, were effectively approved by the U.S. Securities and Exchange Commission in May 2024, five months after spot bitcoin ETFs began trading. Thus, traders have two avenues within the regulated ETF space to speculate on ether's prices without buying the crypto tokens directly. Below, we explore Ethereum further and review how futures ETFs based on ether’s price moves work.

Ether and the Ethereum Network

Ether is the name for the Ethereum blockchain's cryptocurrency. It's used for transaction fees and computational services on the Ethereum network. Ether owners can also contribute to helping secure the blockchain in Ethereum’s proof-of-stake (PoS) consensus model. This method validates entries in a distributed database while securing the data.

Ethereum launched in 2015 and helped introduce smart contracts, self-executing code that runs on the blockchain. This produced new ways to engage in DeFi, decentralized apps (dApps), non-fungible tokens (NFTs), and decentralized autonomous organizations.

The Ethereum blockchain has the second highest market capitalization after Bitcoin. However, Ethereum is programmable, unlike Bitcoin, so that developers can build and deploy various dApps on top of the blockchain.

Ether’s price has been highly volatile, but it grew tremendously amid the increased adoption of DeFi and NFTs. The successful transition of Ethereum to a PoS system has been a key milestone for widening the network’s reach. Its price has gone up significantly since spot bitcoin ETFs began trading in early 2024 and then again after spot ether ETFs were effectively approved in May 2024.

Overall, Ethereum has been aiming to do more than provide a means for peer-to-peer payments. It has been trying to build a decentralized global computing infrastructure that expands the uses of blockchain and cryptocurrency technology.

Futures and Futures-Based ETFs

Futures contracts are financial derivatives that allow investors to speculate on the prospective price moves of certain assets. They are legal agreements to buy or sell the asset at a preset price on a specific future date. Thus, they allow you to hedge risks or bet on the direction you believe an asset’s price will move without owning it. They are commonly used for indexes, commodities like gold and oil, and now cryptocurrencies.

Suppose you enter a three-month ether futures contract to buy ether at $1,500. This locks in the price you will pay in three months, no matter ether’s market price at that time. If ether trades above $1,500 in three months, you profit by getting ether below market price. If it’s below $1,500, you lose more money than if you bought ether on the spot market.

Standard futures contracts have set expiration cycles, requiring investors to roll over their positions into new agreements. For futures, ETFs track their contract prices by spreading out the futures' various expiration dates. This provides continuous investment exposure without manually rolling over positions yourself. This also means that these ETFs hold futures contracts and do not directly hold the underlying assets they track—in this case, ether.

Futures Market and the Contango Effect

The contango effect in futures markets can negatively affect the long-term returns of futures-based ETFs like those tracking ether futures. Here’s a brief explanation of it:

Contango refers to a normal market condition where the futures price for an asset rises as the contract’s expiration date moves further out. For example, one-month ether futures may trade at $1,500, while three-month ether futures trade at $1,600.

When ether futures ETFs roll over their contracts as they near expiration, they have to sell the lower-priced short-term contracts and buy the more expensive long-term ones. This constant roll yield erodes the ETF’s returns over time.

This effect can grow, causing futures-based ETF returns to lag behind the spot prices they track. Contango is a major criticism of futures-based commodity ETFs and applies to ether and bitcoin futures ETFs.

Skilled fund managers minimize this by optimizing roll timing, but contango’s effects are hard to mitigate completely. It highlights the trade-offs of obtaining convenience through futures-based cryptocurrency ETF products.

How Ether Futures ETFs Work

Ether futures ETFs hold a portfolio of ether futures contracts traded on exchanges rather than directly owning ether tokens. Authorized participants (APs), typically large broker-dealers, create shares of the ETF to be listed on a stock exchange. They purchase a basket of ether futures proportional to the ETF’s desired holdings and contribute them to the fund in exchange for new ETF shares.

The process also works in reverse, with the ETF redeeming shares from APs in exchange for a basket of underlying futures contracts. This creation/redemption mechanism helps minimize the difference between the ETF’s share price and net asset value.

For example, if ether futures rally, then the ETF share price on the secondary market will also rise. APs could then buy new ETF shares from the fund at net asset value in exchange for the right amount of ether futures. They can then sell the newly obtained ETF shares on the exchange at a higher market price for a profit.

Market makers are also important in providing liquidity for the ETF shares. They stand ready to buy and sell ETF shares continuously to minimize large spreads between the bid and ask prices. This allows investors trading the ETF to enter and exit positions quickly.

With APs and market makers, ether futures ETFs can offer traders convenient exposure to ether’s futures prices through a fund that trades like stocks.

Example of Ether Futures ETF

Suppose an ether futures ETF, Ethereum Futures Fund (ETHF), is launched. The fund's sponsor partners with an AP, a large broker-dealer. The AP buys ether futures contracts on the Chicago Mercantile Exchange to deposit into the fund as its initial holdings. In return for contributing $10 million worth of ether futures, the AP receives 100,000 shares of ETHF at $100 per share from the fund sponsor to be listed on a stock exchange.

Investors can then buy and sell shares of ETHF on the stock exchange through their brokers. The price will fluctuate depending on the market price of ether futures. If ETHF shares are trading on the exchange at $105, then an arbitrage opportunity exists for the AP. The AP can buy new ETHF shares from the fund at $100 net asset value and immediately sell them on the open market for $105, pocketing the spread of $5 per share. This helps keep the ETF share price in line with its holdings. If needed, the AP can redeem ETHF shares from the fund in exchange for a basket of ether futures.

The ETHF fund managers repeatedly trade new futures contracts close to expiration, using capital from the ETF’s assets to maintain exposure across the futures curve.

Risks and Benefits of Investing in Ether Futures ETFs

The case for investing in ether futures ETFs largely rests on their accessibility and diversification potential. By providing exposure to ether and the broader cryptocurrency space within a regulated fund structure, ether futures ETFs allow a wider range of investors to participate. However, while the funds themselves fall under the purview of the CFTC and SEC, the crypto market does not.

The familiar ETF wrapper makes adding a slice of crypto assets simple enough through regular brokerage accounts. This can offer more diversification for a portfolio and the potential for risk-adjusted returns. Active traders also gain liquidity for acting on ether futures price moves that direct futures contracts may lack. Under the right conditions, these benefits make ether futures ETFs appealing.

However, ether futures ETFs' volatility and regulatory uncertainty are sizable risks. Ether’s frequent and extreme price swings translate into highly volatile ETF values, suitable only for investors with a high risk tolerance.

An unsettled regulatory environment for cryptocurrency ETFs, in general, could shift and reduce the value of these products. Additionally, threats like hacking, theft, and manipulation loom over any fund interfacing with the crypto ecosystem. Given the risky and complex nature of ether futures ETF investing, weighing the pros and cons is imperative. For most, minimal exposure combined with ample due diligence is advisable.

Why Invest in an Ether ETF

Compared with bitcoin ETFs, ether futures ETFs have more exposure to the Ethereum ecosystem and, more broadly, the growth of decentralized finance rather than just cryptocurrency prices. However, bitcoins still represent much of the crypto market’s capitalization.

For those who want ETH exposure, investing in an ether futures ETF offers professional management and a certain degree of diversification, which is particularly appealing for individuals who lack the technical know-how or the time to manage crypto investments. Unlike directly holding ether, where investors need to manage their digital wallets and safeguard their private keys, an ether futures ETF is managed by financial professionals who navigate the complex world of cryptocurrency on behalf of the investors. This also allows you to speculate on future prices of ETH, unlike spot ether ETFs. These funds are traded on traditional stock exchanges, offering a more familiar interface to traditional investors than occasionally shady crypto exchanges.

Moreover, compared with ETH futures contracts, an ether futures ETF provides a less complex exposure. Futures contracts require a good understanding of derivative markets, not to mention a readiness to meet margin calls during volatile market conditions. Meanwhile, an ether futures ETF brings these futures within a fund structure, mitigating the need for investors to negotiate the futures market themselves. This reduces the complexity and potential costs tied to managing margin requirements.

In addition, an ether futures ETF provides a degree of diversification since it can hold futures contracts with various expiration dates or other related assets, spreading the risk. Diversification is particularly beneficial in the highly volatile cryptocurrency market.

Finally, regulatory oversight of ETFs provides a layer of security and transparency that direct ether holdings or ETH futures contracts might not have.

Are Ether Futures ETFs Worth Investing in?

The appeal of ether as a digital asset is undeniable among certain investors, given its role in the burgeoning decentralized finance sector. However, ether is a relatively new and complex financial product with limited regulation and oversight. Thus, potential investors should assess the following before diving in:

• Your understanding of Ethereum and blockchain: A good knowledge of Ethereum and its underlying blockchain technology is critical before making any ether investment. Knowing the fundamentals will equip you to discern market trends and the implications of network upgrades or regulatory developments.
• Risk tolerance: Cryptocurrency investments are notoriously volatile. While an ether futures ETF might mitigate some of the hazards of directly holding crypto, it’s still a high-risk investment. Assessing your risk tolerance and investment horizon is crucial.
• Diversification: Diversification is a staple of investment risk management. While an ether futures ETF offers inherent diversification compared with holding ether directly, you should also consider how this ETF fits into your broader portfolio.
• The regulatory landscape: The legal environs surrounding cryptocurrency and related financial products are still evolving. Understanding this landscape and the implications of any changes for ether futures ETFs is crucial.
• Fund management and fees: Examining an ETF's management, performance, and fees is essential. Lower costs and competent management can significantly impact returns over time.
• Long-term vs. short-term investment: Whether you opt for a long-term or short-term strategy will impact your ETF choice. Futures-based ETFs might be better suited for a buy-and-hold approach, while others might be better for short-term trading.
• Regular monitoring and rebalancing: The crypto market’s volatility requires keeping an eye on and perhaps changing your portfolio to align with your financial goals.
• Dollar-cost averaging: Given the volatility of crypto assets, a dollar-cost averaging strategy—investing a fixed amount in the ETF at regular intervals—could be prudent for mitigating the impact of changes in the crypto market.

The Future of Ether Futures ETFs

Several ether futures ETFs were introduced in 2023. For example, the VanEck Ethereum Strategy ETF (EFUT) seeks capital appreciation by investing in ether futures contracts, with around $30.1 million in assets under management (AUM) and an expense ratio of 0.66% as of April 2024. ProShares has the Ether Strategy ETF (EETH), with $72.5 million in AUM and an expense ratio of 0.95%. The Bitwise Ethereum Strategy ETF (AETH) is another futures-based ETF with around $11.9 million under management and a 0.85% expense ratio.

However, the future popularity of Ether futures ETFs remains uncertain. While a bitcoin futures ETF launched in late 2021 had about $1 billion in inflows within its first two trading days, newer Ether futures ETFs attracted only a few million dollars collectively during their first days. Since then, investors have had even more alternatives, like spot bitcoin and spot ETH ETFs, for crypto investing.

From Futures to Spot

Futures-based ETFs provide investors with indirect exposure to cryptocurrency price movements without directly owning or storing the underlying assets. However, futures-based ETFs may not perfectly track the cryptocurrency's spot price because of factors like rolling costs and contango. A spot ETH ETF, meanwhile, invests directly in the underlying cryptocurrency, providing investors with exposure to the spot price.

Spot ETFs offer a more direct, accurate, and lower-cost way to invest in cryptocurrencies, eliminating the complexities and potential drawbacks of futures-based products. In addition, spot ETFs make it easier for institutional and retail investors to gain exposure to ether through traditional brokerage accounts rather than relying on crypto exchanges and digital wallets.

The SEC approved several spot bitcoin ETFs in January 2024, with spot ETH ETFs getting effective approval five months later. Spot ether ETFs began trading on U.S. exchanges in July 2024.

The Bottom Line

Ether futures ETFs represent an intersection of cryptocurrency and traditional finance—an accessible, regulated way to invest in ether, which is a digital asset. By tracking ether derivative contracts on major exchanges, these ETFs allow everyday investors to speculate on prices of the Ethereum ecosystem’s native cryptocurrency.

However, there are inherent risks, from volatility to regulatory uncertainty. While providing access to a novel asset class, ether futures ETFs are complex instruments unsuitable for casual investors.

Performing due diligence is prudent before any investing, and more so in this case. These funds merit consideration for strategic traders seeking efficient cryptocurrency exposure or diversification. As financial gateways to ether and decentralized networks, ether futures ETFs bear watching as fintech evolves.