Luisa Crawford
Sep 16, 2024 16:07
Delve into the essential distinctions between Ethereum ETPs and ETFs, their effects on the cryptocurrency landscape, and the larger financial market.
After the introduction of Bitcoin exchange-traded products (ETPs) earlier this year, U.S. stock exchanges launched ETPs based on Ether, the native asset of the Ethereum blockchain, for the first time on July 23. Investors can now trade, buy, and invest in shares of products that contain Ether (ETH) on platforms like NASDAQ and the New York Stock Exchange. This development is immensely significant — not only for Ethereum but also for the notion of cryptocurrency as an asset class, as detailed by a16z crypto.
ETH ETP: Significance for Ethereum
The approval of ETPs for Ethereum resolves a long-standing inquiry. At its launch, Ethereum was developed and funded by various founders and investors, raising questions about whether the original distribution of Ether constituted an investment contract and thus a security under federal law. However, the involvement of these early participants has waned over time, making the development of the Ethereum blockchain more decentralized, ultimately placing control in the hands of its user community.
The classification of an asset as a security or non-security shapes its regulatory landscape. If Ether is deemed a non-security, it aligns more closely with other commodities, like oil, which lack a definitive owner or operator. On the contrary, if Ether were classified as a security, it would subject it and ETH transactions to a multitude of compliance and ongoing disclosure mandates. Furthermore, it raises concerns about how a decentralized, open-source project like Ethereum could possibly meet such requirements, putting its potential and innovations at significant risk.
The introduction of ETPs signals that the SEC has reassessed Ether’s status, regardless of the context surrounding its inception. It appears that the SEC utilized its 2019 framework in deciding on ETH ETPs, which outlines how assets involved in potential securities transactions can transition to non-securities. The SEC’s treatment of the ETH ETP indicates its conclusion that ETH is not a security, and that the offers and sales of ETH do not constitute securities transactions, thereby establishing a precedent for others to follow.
ETH ETP: Implications for the Crypto Industry
The SEC’s decisions regarding ETH ETPs hold significant implications that ripple far beyond Ethereum itself. Following considerable delays and regulatory uncertainty prompted by the SEC’s vague stance on ETH, the newly approved ETPs reveal a clear pathway for digital asset securities to evolve into non-securities. Notably, if Ether can be reclassified as a non-security, this potentially opens the door for other digital assets to follow suit. Setting such a consequential precedent for the crypto sector is hard to overstate.
Regardless of whether the SEC intended to grant the crypto market a “victory,” it undeniably has. The SEC’s recognition emphasizes the dynamic nature of cryptocurrency and the need for modernizing securities regulation to align with crypto’s integration into the broader financial and commercial ecosystem. Even if it is incremental, regulatory progress is underway. The approval of ETP listings could greatly enhance investor access to crypto assets, unlock billions in value, and broaden the spectrum of crypto asset investment. In fact, multiple issuers are already looking to launch ETPs for another crypto asset, Solana, with even more anticipated to follow.
Introduction to ETPs
What is an ETP?
ETPs, or exchange-traded products, typically consist of trusts or other entities that possess one or more underlying assets. Shares of ETPs are traded on national securities exchanges, representing interests in the assets safeguarded by the trust. These shares are offered in accordance with a registration statement filed with the SEC and effectively mirror the value of the underlying assets. If you hold any exchange-traded commodity baskets, like SPDR’s well-known gold-tracking product GLD, you are likely using an ETP.
Why utilize an ETP?
Historically, ETPs provide various advantages over direct asset ownership, such as enhanced liquidity, secure and convenient custody, optimal trade execution, and beneficial tax implications, including possible capital gains tax advantages due to the discretion of buyers and sellers regarding when to recognize taxes. The situation with crypto assets, however, is more complex, as elaborated on later.
How do ETPs function?
Fundamentally, ETP shares are maintained in alignment through arbitrage and a process of creation and redemption: When the trading price of the public ETP exceeds the value of the underlying assets, ETP shares are created, and this increase in supply lowers the price to match the asset price. Conversely, when the ETP share price falls below the underlying asset’s market price, ETP shares can be redeemed to elevate the ETP share value. In most cases, this process involves a group of “authorized participants” who can either provide assets or shares to the issuers depending on whether a creation or redemption event is occurring.
What distinguishes an ETP from an ETF?
Though both ETPs and ETFs (exchange-traded funds) are registered with the SEC, they differ substantially in their regulatory structures and requirements. ETFs are primarily trusts that hold securities, while ETPs mainly consist of trusts that hold non-securities. Consequently, ETPs register on SEC Form S-1, typically used for the offers and sales of securities from issuers that do not qualify as “investment companies” under the Investment Company Act of 1940 (the “40 Act”). In contrast, ETFs file under SEC Form N-1A, tailored specifically for investment companies.
In essence, an investment company is an entity that is:
- engaged in the business of investing, owning, holding, or trading in securities; and
- owns “investment securities” with a value that exceeds 40% of the total assets of the entity (excluding U.S. government securities and cash items).
This regulatory distinction carries weight. ETPs are treated similarly to all other public companies and, while they must adhere to the reporting and compliance obligations of the Securities and Exchange Act of 1934, they do not face the additional scrutiny that comes with being classified as a registered investment company. In comparison, ETFs, which invest in securities, must comply with the ’40 Act and its numerous limitations regarding liquidity, affiliated transactions, and other compliance practices.
(In practice, some entities investing in commodities or pools of non-securities have the option to treat themselves as an investment company by placing assets in a subsidiary. This inclusion of securities, i.e., the subsidiary’s shares, makes them subject to the regulations of the ‘40 Act. Occasionally, issuers do this to market their products as funds that fall under the added protections of the ‘40 Act.)
Diving Deeper: Crypto ETPs
Bitcoin vs. Ethereum: What Sets BTC ETPs Apart from ETH ETPs?
While Bitcoin and Ether are two leading digital assets, they fulfill fundamentally different roles. BTC mainly serves as a unit of exchange or account within a distributed ledger, functioning as a decentralized digital currency. Its primary utility lies in facilitating peer-to-peer transactions without intermediaries.
On the other hand, ETH operates as a unit of computation within the Ethereum network, a global virtual computer that supports smart contracts and decentralized applications (dApps), allowing for various functionalities that extend beyond mere value transfer. Therefore, despite both BTC and ETH’s importance in the digital asset ecosystem, their distinct utilities highlight their unique roles and potential applications.
What benefits do ETH ETPs provide?
For crypto assets, some traditional ETP advantages may not apply. For example, ETH holders benefit from 24/7 liquidity in cryptocurrency markets and can directly manage their assets. Some investors, particularly those new to cryptocurrency, may prefer the comfort of owning ETPs rather than managing assets in wallets or via cryptocurrency custodians. While exchanges trading ETP shares might offer deeper liquidity than that of the underlying asset markets, clarity on whether ETH and other crypto-based ETPs will maintain comparable or superior market depth to current crypto trading platforms remains to be seen. Additionally, operational limitations may lead to ETP shares trading at a discount to ETH.
Nonetheless, ETP products for ETH can expand the potential market of buyers and sellers, including fiduciaries that may be restricted by various considerations, such as investment policies or compliance issues. Holding assets through an ETP significantly mitigates the complexities associated with managing and securing those assets. For instance, while holding crypto can be technologically challenging for some, ETPs offer the option for a regulated institution to oversee custody, simplifying access to this asset class.
What drawbacks do BTC and ETH ETPs have?
One limitation imposed on ETH and BTC ETPs is that, unlike most other ETPs, the mechanisms that help keep the trading price of the ETP in line with the underlying asset’s market value are restricted.
According to the SEC orders for ETH ETPs, buyers are not permitted to deliver the underlying ETP assets to the trust in exchange for ETP shares, nor can sellers redeem ETP shares acquired on the market for underlying assets. Creation and redemption processes for ETP shares can only be settled in cash under the SEC’s orders. While this might not concern most individual investors, this restriction on institutional liquidity during buy and sell surges in the arbitrage process could lead to inefficiencies when the issuer needs to acquire or dispose of underlying assets. Given the volatility of crypto prices, this added requirement could cause significant price spreads between the ETP and the underlying asset, potentially diminishing the attractiveness of ETPs for investors seeking exposure to this asset class.
How do ETH ETPs address staking?
ETH ETPs also carry a unique stipulation: the SEC orders sanctioning their approval prohibit “staking,” the process of securing the blockchain which yields rewards. This practice remains available to direct holders of ETH, leaving ETH ETP owners without the ability to earn additional ETH through staking rewards. This prohibition may complicate the previously discussed arbitrage process and could be perceived as a disadvantage of holding ETH ETP instead of directly owning ETH, depending on investors’ perspectives.
On one hand, banning staking could be viewed positively, as it simplifies certain aspects of ETPs, including minimizing technical complexities, liquidity hurdles, and the risk of slashing (loss of ETH due to computational errors). Conversely, direct holders can benefit from staking, providing a source of income and offsetting investment carrying costs. The pricing repercussions on ETH ETPs stemming from the staking ban will be intriguing to observe. If the missed income results in a discount in ETP unit pricing, some investors may prefer ETH ETPs to holding ETH directly, finding the discount more compelling than potential staking rewards which can entail their own complexities.
A secondary implication of the staking prohibition is the potential threat to network security if a substantial portion of ETH remains locked in the ETP, unable to stake. Should this scenario occur, it would create a smaller pool of ETH holders who validate transactions, possibly giving them disproportionate power.
Which is more advantageous: ETH ETPs or direct ETH ownership?
Investors must weigh the convenience and accessibility of ETPs against the benefits of direct asset ownership. While ETPs can provide trading and storage conveniences, direct ownership imparts greater control and potential benefits such as staking rights.
In the end, the approval of ETH ETPs grants investors an additional means to gain exposure to ETH. Their selection will rely on individual assessments of the aforementioned factors and whether they intend to utilize ETH for computational tasks. Regardless of their choice, having diversified options, notably one that acknowledges that decentralized digital assets like ETH are non-securities, represents a positive advancement.
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