Spot Ether ETFs: A Comprehensive Guide

After the January 2024 U.S. Securities and Exchange Commission’s (SEC’s) approval of spot bitcoin exchange-traded funds (ETFs) spurred a massive rally in the digital currency, interest in a proposed spot ether (ETH) exchange-traded fund (ETF) surged along with the prices of these two major cryptocurrencies.

The SEC, which initially scuttled some 20 spot bitcoin ETF proposals between 2018 and 2023, had shown itself to be more hesitant in approving similar funds for ether, the cryptocurrency native to the Ethereum blockchain system. However, in a surprise move in May 2024, the SEC permitted Nasdaq, the Chicago Board Options Exchange, and the NYSE to list ETFs holding ether. Nine spot ether ETFs began trading on those exchanges in July 2024.

The SEC's decision came as a significant surprise win for the ETF issuers and the cryptocurrency industry, which until just days before had expected the SEC to reject the filings. The decision marked a significant step toward getting these products to market.

"The approval of ETH ETFs is transformative, allowing investors who are not comfortable investing directly on-chain to capitalize on Ethereum's growing utility in decentralized finance (DeFi) and strong market presence," Christina Lynn, a behavioral finance researcher and certified financial planner at Mariner Wealth Advisors, told Investopedia. "Although ETH ETFs may not see the same immediate demand as BTC ETFs, they offer valuable diversification and are expected to attract substantial investment inflows."

Not everyone is pleased with the development. "Ether is an extremely volatile asset, and the Ethereum network itself has features that make it vulnerable to fraud and manipulation," said Benjamin Schiffrin, director of securities policy at the Washington D.C.-based policy group Better Markets. "By approving the applications to list and trade spot ether ETPs, the SEC failed to live up to its mission to protect investors and the markets.”

However, Lynn argues there is value to be had in crypto, though she counsels a measured approach. Investors "should approach crypto investing with a long-term perspective. A buy-and-hold strategy is superior for the average investor compared to day trading," Lynn said. Anyone investing in crypto ETFs, she added, "should abandon get-rich-quick schemes and aim for above-average return on investment." She said that about 2% to 5% of a portfolio for the more prepared and risk-tolerant investors could be advisable.

Overall, the cryptocurrency market sees this development and other recent positive regulatory moves in the U.S. and abroad as strong tailwinds in its efforts to further integrate with mainstream finance. Launching spot ether ETFs could attract significant investor inflows, given the $30 billion poured into crypto ETFs in 2024 following the earlier bitcoin ETF approvals.

Prelude to Spot Ether ETFs

Spot ether ETFs were not approved for trading in the U.S. until July 2024, when the SEC officially approved nine spot ether ETFs for trading on U.S. exchanges.

The approval of spot bitcoin ETFs, such as the ProShares Bitcoin Strategy ETF (BITO) and the Valkyrie Bitcoin and Ether Strategy ETF (BTF), was significant for the mainstream acceptance of cryptocurrencies. These ETFs have had rapid inflows and strong investor demand, suggesting an appetite for regulated, easily accessible exposure to cryptocurrencies.

Proponents of cryptocurrencies argue that early price increases in spot bitcoin ETFs bolstered the case for spot ether ETFs. They believe that investors are seeking diversification through exposure to ether, the second-largest cryptocurrency by market capitalization. For them, Ethereum’s thriving ecosystem of decentralized applications (dApps) and smart contracts makes it an attractive investment, even before considering the value of its real-world applications as it gains wider acceptance.

However, critics are still cautious about the rush to embrace spot ether ETFs. They argue that the volatile nature of cryptocurrencies makes them unsuitable for many investors. Concerns about regulatory uncertainty, potential market manipulation, and the environmental impact of cryptocurrency mining (even if mitigated by Ethereum’s model) are all cited as reasons for caution. Skeptics worry that the push for ETFs might be driven more by the financial industry’s interest in new products than by a genuine need for investor access to cryptocurrencies.

Spot ether ETFs hold ether tokens in their portfolios. Their objective is to track the price of ether as closely as possible, providing investors with direct exposure to the cryptocurrency without the need to purchase and store it themselves. Spot ether ETFs offer a more straightforward and transparent approach than ETFs that invest in derivatives or a diversified portfolio of cryptocurrencies, such as ether futures ETFs.

How Spot Ether ETFs Work

A spot ether ETF involves “creation and redemption,” just like other ETFs. Authorized participants, typically large institutional investors, play a crucial role in this process.

To create new shares of the ETF, authorized participants deposit a corresponding amount of ether with the ETF issuer. In exchange, they receive newly minted shares of the ETF. Conversely, when authorized participants want to redeem shares of the ETF, they return the shares to the issuer and receive an equal amount of ether in return.

This keeps an ETF’s price in line with the value of the underlying ether. As demand for the ETF shares increases, authorized participants can create more shares by depositing additional ether. Similarly, they can redeem shares and receive ether back if demand decreases.

Investors can buy and sell shares of spot ether ETFs on stock exchanges throughout the trading day, as they do with any other ETF or stock. This makes the cryptocurrency fund easy to trade and likely gives it abundant liquidity, enabling investors to enter or exit positions throughout the trading day without interacting directly with cryptocurrency exchanges.

How To Invest in Spot Ether ETFs

When considering spot ether ETFs, Lynn offers these prudent pieces of advice:

1. Avoid market timing: Instead of trying to predict market movements, invest when you have the funds available and hold for the long-term.
2. Thoughtful allocation: Consider incorporating ETH ETFs into your portfolio as part of your alternative investments, while maintaining an appropriate risk profile.
3. Choose the right investment for you: ETH ETFs may be better suited for retirement accounts than taxable accounts, due to tax implications.

Lynn notes that while Ethereum ETFs may not see the same immediate demand as bitcoin ETFs, they offer valuable prospects for diversification. Ethereum's role in decentralized finance (DeFi) and its versatility as a technology platform make it an attractive investment option, she said.

How do you decide among similar-looking spot ether ETFs? Lynn said to review the following:

• Fees: Lower fees can help maximize returns
• Liquidity: Higher liquidity is generally preferable
• Provider reputation: Consider ETF providers with strong track records in managing crypto assets

"The simplest way to choose an ETH ETF is to opt for the product with the lowest fees, as this helps maximize returns by minimizing costs," Lynn said. That's "a principle that applies equally to both traditional and crypto ETFs."

Benefits of Spot Ether ETFs

A spot ether ETF could offer these potential advantages for investors:

• Accessibility: Spot ether ETFs provide a convenient way for investors to gain exposure to Ethereum. By investing in an ETF, individuals can avoid the complexities of navigating cryptocurrency exchanges, setting up digital wallets, and worrying about the security and storage of their Ethereum holdings.
• Regulated: ETFs are regulated investments supervised by financial watchdogs. This regulatory framework offers investors more protection and transparency than directly holding cryptocurrencies.
• Diversification: By allocating a part of their portfolio to Ethereum through an ETF, investors might benefit from the cryptocurrency’s growth and diversify their exposure to different asset classes.
• Liquidity: A major advantage of spot ether ETFs is their liquidity. With the ability to trade ETF shares on stock exchanges throughout the trading day, investors can quickly enter or exit positions based on their investment strategies and market conditions.
  

Risks of Spot Ether ETFs

Investors should also be aware of the risks associated with these investments:

1. Volatility: Like other cryptocurrencies, Ether is known for its high volatility. The price of ether can fluctuate significantly in short periods, directly impacting the value of spot ether ETFs. Investors should be prepared for potential price swings.
2. Regulatory uncertainty: The legal landscape for cryptocurrencies and related investments is evolving. In particular, should the SEC classify ether as a security, that would vastly change its market overnight.
3. Regulatory limits: While proponents often note the safety of investing in ETFs under the SEC’s oversight, only the ETFs, not the cryptocurrency, would face the SEC’s oversight. In fact, backers of the spot ETH ETFs have fought against the SEC’s attempts to bring the currency under its purview by treating ether as a security.
4. Counterparty risk: Investors in spot ether ETFs are exposed to counterparty risk from entities involved in the ETF’s operations. Any issues, defaults, or security breaches experienced by these parties could affect the value and integrity of the ETF.
5. Tracking error: While spot ether ETFs track the price of ether, there might be slight discrepancies or tracking errors. ETF expenses, market inefficiencies, or the timing of ether transactions can contribute to these.
   

Spot Crypto ETFs vs. Futures Crypto ETFs

Investors have two main options for crypto-based exchange-traded funds: spot ETFs and futures-based ETFs. While both types aim to provide exposure to the price movement of an underlying crypto-asset, they differ in how they do this.

Spot ETFs hold actual crypto tokens in their underlying portfolios and are designed to track the price as closely as possible—offering investors direct exposure to the cryptocurrency. When investors buy shares in a spot ETF, they own a portion of the fund’s crypto holdings.

Meanwhile, futures-based ETFs invest in crypto futures contracts rather than hold the cryptocurrency directly. Futures contracts are agreements to buy or sell an asset at a preset price on a specific future date. These ETFs track the price of crypto-assets by rolling over futures contracts as they approach expiration.

While spot crypto ETFs should be more cost-effective and provide more direct access than their futures-based alternatives, they have more significant regulatory burdens and are subject to custody risks (e.g., the ETF provider gets hacked or loses their private keys). Futures-based ETFs don’t have the same regulatory or custody risks, but they typically have tracking errors between the ETF price and the underlying asset and carry higher management fees because of the active trading of futures contracts.

Investing in Ethereum

While ether, the second-largest cryptocurrency by market capitalization, has often been overshadowed by bitcoin, it has potential applications that could make it attractive to investors. Ethereum is a decentralized, open-source blockchain platform that enables the creation and execution of smart contracts and dApps. Launched in 2015 by Vitalik Buterin, Ethereum has grown into the most prominent platform for various blockchain-based applications and services.

Ethereum grew due to the demand for non-fungible tokens, tokenized equity, decentralized finance (DeFi) applications, and Ethereum’s native cryptocurrency, ether (ETH). Because of network effects, as more developers and users adopted Ethereum—the cryptocurrency has outlasted many others launched at about the same time—the platform has attracted even more participants.

However, investing in ether has risks. The cryptocurrency market is known for its volatility, and the price of ETH can fluctuate significantly over short periods. In addition, Ethereum faces questions about its scalability and has high transaction fees. Transaction costs have risen as the network has become more congested, which could impact its adoption.

The Ethereum community has tried to solve some of these issues, most prominently through its September 2022 “merge,” which was its shift to a proof-of-stake (PoS) consensus mechanism. Under its previous proof-of-work (PoW) system, which bitcoin still relies upon, powerful computers compete to solve complex mathematical problems to validate transactions and add new blocks to the Ethereum system. Known as mining, this work requires significant computational power and consumes an enormous amount of energy.

By contrast, the PoS relies on users staking their ether—that is, locking up a part of their ETH as collateral to validate transactions and create new blocks. The more ether that a user stakes, the better their chances of being selected to validate transactions and earn rewards. Ethereum has reported changes to this model have led to a 99.988% cut in energy usage. PoS is also designed to improve network security by making it more costly for attackers to gain control of the network. Ethereum also introduced sharding to reduce latency.

How Ethereum Works

Ethereum operates on a blockchain, a decentralized, distributed ledger technology that records transactions across a network of computers. The Ethereum blockchain is powered by its native cryptocurrency token, ether, which serves as payment for transaction fees and computational services within the network.

One of Ethereum’s key features is its support for smart contracts. These are self-executing agreements with their terms directly written into code. They automatically enforce the rules and penalties surrounding an agreement, eliminating the need for intermediaries and reducing the risk of fraud or manipulation.

Ethereum vs. Bitcoin

"While Ethereum and Bitcoin are both significant in the blockchain space, they serve different purposes," Lynn said. "Bitcoin is primarily a store of value, while Ethereum is a versatile technology platform." Here are the important differences for investors to note:

1. Purpose: Bitcoin was primarily designed as a digital currency and a store of value to provide an alternative to traditional fiat currencies. Ethereum, meanwhile, was created as a platform for building dApps and enabling smart contracts.
2. Capabilities: Bitcoin primarily facilitates peer-to-peer transactions without the need for intermediaries. Ethereum goes beyond simple transactions and allows developers to build and deploy complex applications on its blockchain.
3. Supply: Bitcoin has a fixed maximum supply of 21 million coins, which makes it scarce and potentially supports its value. Ethereum, by contrast, doesn't have a fixed supply cap, although its consensus mechanism could limit the issuing of new ETH.
4. Transaction speed: Ethereum’s blockchain processes transactions faster than Bitcoin’s 10-minute target interval between blocks, although both networks have faced scalability issues as their use increased.
5. Consensus mechanism: Bitcoin uses a PoW consensus mechanism, where miners compete to solve complex mathematical problems to validate transactions and create new blocks. Ethereum, meanwhile, has transitioned to a PoS consensus mechanism, where validators stake their ETH holdings to participate in the validation process.
6. Market profile: While bitcoin remains the dominant cryptocurrency by market capitalization, Ethereum has a strong developer community and a growing ecosystem of dApps and tokenized assets, which could drive future demand for ETH.

Investing in ETH Directly vs. ETH ETFs and Futures

Investors can purchase ETH on cryptocurrency exchanges and hold it in a digital wallet. This approach offers direct ownership of the cryptocurrency but also involves securely storing and managing the private keys. While now easier to use and more robust in terms of security, crypto exchanges still face challenges such as lack of regulatory oversight, the threat of hacks and theft, and the potential for bad actors to scam users.

Alternatively, investing in spot ether ETFs offers a more accessible and regulated route. ETFs provide investors with exposure to the price movement of ETH without needing to hold the cryptocurrency directly.

Investors can forgo futures-based ETFs and trade ether derivatives themselves, such as futures and options contracts, on a cryptocurrency exchange. These instruments allow for leveraged trading and can be used for hedging or speculative purposes. However, trading derivatives on one’s own comes with many risks and complexities. These contracts are often highly leveraged and may not be fully regulated.

Liquidity is another factor to consider when trading ether derivatives. While major exchanges generally offer enough liquidity for ether futures and options, the market depth may be lower than ETF or spot trading. This can lead to wider bid-ask spreads and challenges in executing large trades.

The Outlook for Spot Ether ETFs

The prospects of spot ether ETFs are tied to regulatory developments and the overall acceptance of cryptocurrencies as a legitimate asset class. In May 2024, the SEC approved applications from Nasdaq, CBOE, and NYSE to list spot ETFs tied to the price of ether. In July 2024, the SEC approved applications from ETF issuers and allowed spot ether ETFs to begin trading.

One sticking point had been the practice of staking, where ether holders lock up their funds as collateral to support the operations of the Ethereum blockchain in exchange for rewards. The SEC has cracked down on staking in the past, fining cryptocurrency exchange Kraken and suing Coinbase over their staking offerings. The SEC is also concerned about protecting investors from potentially losing control of their tokens and taking on the risks associated with staking platforms. Adding staking amendments to ether ETF proposals by Fidelity and Grayscale further complicated an already difficult approval process.

Another issue has been whether the SEC will classify ether tokens as securities. If this occurs, the asset itself, not just ETFs whose value is tied to it, would fall under the jurisdiction of the SEC and be subject to many of the same securities laws and regulations as stocks. This could change how ether is traded, held, and taxed for investors. It could also impact the development and operation of dApps on Ethereum since these, too, might come under U.S. securities laws.

While SEC Chair Gary Gensler and other regulators have been consistent crypto skeptics, the approval of several spot bitcoin ETFs in early 2024 set a precedent paving the way for ether ETFs.

The Bottom Line

Spot ether ETFs, which began trading in July 2024, offer investors a means of gaining exposure to the ETH cryptocurrency market through a regulated and accessible fund. By providing accessibility, simplicity, and regulatory oversight of the ETFs, these investments could attract a broader range of investors to the cryptocurrency market. Unlike futures-based ether ETFs, a spot ETF directly holds ETH tokens and is more cost-effective.

However, as with any investment, it is crucial to understand the risks and considerations involved. By carefully evaluating the options available and staying informed about market developments, investors can make well-informed decisions when considering these and other ETFs as part of their investment strategy.