The approval of the Ethereum spot trading fund in the United States may affect the validator composition and decentralized staking protocols, increasing concentration risk, but also highlights the importance of monitoring concentration risk.

Author: Andrew O'Neill

Translation: Plain Blockchain

The United States may approve an Ethereum spot trading fund (ETF) as early as May this year, which will directly expose investors to the current market price of Ethereum. The increase in Ethereum spot staking ETFs may affect the validator composition participating in the Ethereum network's consensus mechanism. The participation of institutional custodians may reduce the concentration of the Lido decentralized staking protocol. However, this may also introduce new concentration risks, especially if a single entity is chosen to stake most of the Ethereum included in these ETFs. The impact of the U.S. Ethereum spot ETF on concentration risk, whether positive or negative, could be significant, making continuous monitoring of concentration risk more important.

1. The United States is about to launch a spot Ethereum trading platform trading fund (ETF)

After the U.S. Securities and Exchange Commission (SEC) approved the Ethereum futures ETF in 2023 and the Bitcoin spot ETF on January 10, 2024, market participants expect the next one to be launched will be the Ethereum spot ETF. Currently, the SEC is reviewing eight applications for permission to obtain an Ethereum spot ETF, with the first formal deadline for a decision being May 23, 2024.

Canada, Switzerland, and other European countries have already approved spot Ethereum ETFs. According to data from the cryptocurrency data aggregator CoinGecko, as of February 2024, the total assets under management of global spot Ethereum ETFs are approximately $2 billion.

2. Risks and returns of staking

When staking, cryptocurrency holders lock their tokens into the blockchain network to help validate transactions. Validators can receive staking rewards but also face the risk of penalties, meaning that if they are inactive or confirm invalid transactions, their staked shares may decrease. Ether holders can stake directly into the Ethereum network and participate as validators. In addition, they can also stake through digital asset custodians or decentralized staking protocols. Custodians and decentralized staking protocols control the staked shares of multiple validators.

3. But may affect concentration risk within the Ethereum network

Holding only spot Ethereum ETFs will not affect the validator composition in the Ethereum consensus mechanism. However, if spot Ethereum ETFs include staking functions, they will indeed have an impact on the validator composition, at least when the inflow of funds is high enough. Based on the trading volume of the U.S. spot Bitcoin ETF one month after approval (approximately $12 billion as of February 14, 2024), if the U.S. spot Ethereum ETFs include staking functions and are of sufficient scale, they may be enough to change the concentration of validators in the Ethereum network, whether positively or negatively. Therefore, it is crucial to understand how the choices of ETF issuers will drive concentration risk.

4. Ethereum's consensus mechanism and concentration risk

To complete a block, Ethereum's proof-of-stake consensus mechanism requires at least two-thirds of validators to confirm that each new block on the chain is valid. Block completion is crucial for financial transaction settlement on Ethereum. If more than one-third of validators are inactive or acting maliciously at the same time, new blocks will not be completed. Therefore, monitoring the concentration risk of most nodes in the network being inactive or colluding maliciously is crucial, including:

The proportion of validators controlled by a single entity or decentralized staking protocol;

The proportion of validators running the same client software package for network validation (client concentration risk), as errors in this software may lead to validators being inactive. This risk is mitigated through diversification and redundancy, as multiple client software packages developed by different companies are available for selection.

For more detailed information, please refer to the article "What Can You Trust in a Trustless System: Public Blockchains for Financial Applications" published on October 11, 2023.

The largest validator in the Ethereum network is the decentralized staking protocol Lido, with the concentration of staked Ether slightly below the 33% threshold (see "Is the Concentration of Lido in Ethereum Concerning?" published on October 11, 2023). In our view, U.S. institutions issuing Ethereum staking ETFs are unlikely to directly cooperate with decentralized protocols such as Lido. Instead, they may choose institutional-grade digital asset custodians to reduce the concentration risk of Lido validators. However, the overall impact of ETFs on concentration will depend on whether they will diversify staked shares among multiple custodians.

Coinbase Global Inc. (Coinbase) controls the second-largest proportion of validators in the Ethereum network, accounting for 15% (see Chart 1). If it receives a large amount of newly staked Ether from ETFs, it may pose an increasingly growing concentration risk to Ethereum. Coinbase serves as a custodian in the recently approved 11 U.S. Bitcoin ETFs and is listed as a staking institution for three of the largest Ethereum staking ETFs outside the United States. The emergence of new digital asset custodians may allow ETF issuers to diversify staked shares among different entities, thereby mitigating this risk.

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