Cryptofinance: into the ether

Hello and welcome to the FT Cryptofinance newsletter. This week we’re taking a look at a momentous week in Washington.

Sometimes it can feel like a new crypto market structure emerges weekly and the last five days are no exception.

As Monday began, few predicted the US markets regulator would approve exchange traded funds that invest in ether, the currency of the ethereum blockchain. But the Securities and Exchange Commission gave way on Thursday and the main outstanding issue now is the start date.

The SEC was coy on the reasons for its change of heart but the mood around crypto in Washington is shifting fast as the election rolls into view. The arrival of bitcoin ETFs in January received huge attention. Yet this lower key move may be the more consequential for financial markets.

Many expect an influx of money into ether ETFs, providing a short-term boost to the cryptocurrency’s price. Geoff Kendrick, an analyst at Standard Chartered, forecasts that ether will rise to $8,000 from its current $3,700 by the end of the year and $14,000 by the end of 2025, with $15bn-$45bn in inflows into the ETFs in the first 12 months.

Still, ether and ethereum just don’t have the branding of bitcoin. Ethereum has always been pitched as something more revolutionary than its larger rival: a platform or the building blocks of a decentralised world. But it’s never truly caught the wider public’s imagination. The biggest ether fund, the Grayscale Investment Trust, only has $10bn in it, compared with the $28bn in its bitcoin trust in January.

“The knowledge and simplicity of the dominant bitcoin narrative fits neatly into an alternatives bucket for portfolio strategists, perhaps like gold, whereas ethereum is much more literally like an early-stage tech company or platform,” said Alex Thorn, head of research at Galaxy Digital, a crypto investment manager.

Arguably, it’s not that large institutional investors and Wall Street banks haven’t understood the appeal of ethereum, it’s rather that they’ve not had regulatory clarity on what they can touch. Ether is a more problematic cryptocurrency than bitcoin, legally speaking, but this week has gone some way to resolving that.

“It’s a game-changer, it means the SEC doesn’t see ether as a security,” said one senior Wall Street chief executive who has considered setting up a crypto-related business unit.

Unlike bitcoin, ether can earn a return for the holder when it is put up, or staked, in the process of securing and validating transactions on the ethereum network.

How much you earn depends on the amount you stake, the length of time you lock it up for and trading activity on the blockchain. Those staking their coins can currently expect a yield of around 3 per cent a year, paid out as crypto tokens. But the point is that in crypto market it is the closest thing to an interest rate and free money, in other words.

This concept causes problems at the SEC because it can give the appearance that ether is an unregulated digital fixed income security — something the agency very much likes to regulate. 

To resolve this for the ETF decision, the SEC demanded that issuers give up plans to participate in staking. That sidesteps a definitive answer on whether ether is a security and instead suggests it is a commodity.

It’s a neat legal solution but the distinction could have some unintended consequences. For a start, ETF providers are missing out.

As CCData pointed out, purchasing 1,000 ether on January 1 last year would have turned $1.2mn into $3.66mn. Staking the same amount would have netted you $3.87mn, a gain of $217,000 or just under 6 per cent more. If ETF issuers cannot get the yield, then they may have to charge higher fees to customers to compensate.

Moreover, large-scale buying by ETF issuers will remove a lot of ether from the market that will then not be staked.

“What happens if there is $20bn taken out of the market? It could be a tipping point in terms of supply and demand. We haven’t really seen this kind of rapid demand shock in the market before,” said Mara Schmiedt, chief executive of Alluvial, a staking infrastructure provider.

More generally, approval for ether ETFs could also could have the perverse effect of raising the annualised yield, which is dependent on the amount of activity in the market and the amount staked. If large amounts of ether are removed, and there were more transactions on the network, the yield would probably go up. It has fallen steadily from 6 per cent in late 2022; a rise could take it close to US interest rates when the Fed begins cutting.

Against this background it’s not hard to imagine that Wall Street will be lobbying to erase the ban. More than that, it may no longer be in the SEC’s best interest to be defensive on ether.

The other important news from Washington this week was that Congress passed a major bill for crypto legislation, FIT21. Among other things it makes the SEC’s rival agency, the Commodity Futures Trading Commission, the main US regulator for crypto.

However an ETF is an SEC-regulated security and issuers will be holding large amounts of ether to underpin it. If ETF issuers were permitted to stake their currency, the SEC would regulate some of the market’s largest participants and exert some indirect influence on the underlying currency.

Through this lens, the ether market structure could end up not looking that dissimilar to the US Treasury market, the world’s biggest and most important market as it sets the price of money. 

The US Treasury market is, in many ways, the original decentralised market. Trading is not funnelled through a single exchange or clearing house and there are fewer rules that govern Treasuries than other asset classes. It has no single overarching regulator but is split among many. The SEC does not have jurisdiction over the primary market but it is an important player.

The question is really how long the SEC can hold its position on staking. If it wants to stay influential in crypto, things may have to change.

What’s your take? Email me at philip.stafford@ft.com

Weekly highlights

• As mentioned, Congress passed the first framework for crypto regulations in the US. The Financial Innovation and Technology for the 21st Century Act, or FIT21 as it’s become commonly known, is a big deal. It’s not over yet as the Senate and White House have to approve it but the Biden administration has said it won’t stand in its way. This will be worth watching in coming weeks.

• Hong Kong regulators banned Worldcoin from operating in the territory because of privacy and personal data risks.

Soundbite of the week: Wake up, America

At the FT Live crypto conference two weeks ago Congressman Patrick McHenry, chair of the US House Financial Services Committee, was positive he could get FIT 21 through. And he did, by a very clear 279-136 votes. The bill

“..should serve as a wake-up call to the Senate and this Administration. They must come to the table to ensure the Americans who engage with digital assets can do so safely”.

Data mining: risk and reward

The benefits of staking — and compounding — become clear when charted. As a side note, the proportion of ether in circulation that is currently staked is pretty low compared with rivals, as CCData points out. Solana and Cardano have 63 per cent and 66 per cent of their respective supplies staked.

Cryptofinance is edited by Laurence Fletcher. To view previous editions of the newsletter click here.

Your comments are welcome.