Good morning.

Welcome to Deep Flow: our weekly analysis of the hottest issues in digital assets.

This week, we go deep into the Ethereum ETFs.

First, a reminder that this edition of Deep Flow is free to all Flow State subscribers, but it will go behind a paywall for members on June 17.

If you’d like to support us and upgrade your membership today, you’ll receive a 25% discount.

Thanks, and let’s dive in.…🌊🌊🌊

1. Introduction

2. Background to approval

3. Political winds shift

4. SEC Approval (?)

5. TL;DR and commentary

Introduction

In a stunning reversal, the SEC has partially approved applications for spot Ethereum ETFs.

Analysts, journalists, and industry insiders did not expect this to happen. At least not this soon.

So what caused the SEC to change its tune?

In this edition of Deep Flow, we’re going deep into the Ethereum ETF story to explain how we got here, what’s actually happened over the past couple of weeks, and where things go from here.

Background to approval

The Bitcoin ETF approval story

In order to understand why the Ethereum ETFs are on a (likely) path to approval, you need to first understand why the Bitcoin ETFs were approved first.

The spot Bitcoin ETF story is a long one, but the most important elements are this:

• The SEC resisted them for a long time, and in fact only approved them because their hand was forced through litigation.

• The SEC had long argued that the Bitcoin spot market had too high a risk of manipulation, and that surveillance of the market was too challenging.

• However, they had separately approved Bitcoin futures ETFs for trade on the Chicago Mercantile Exchange (CME).

• Grayscale, issuer of GBTC, sued the SEC. It argued that the SEC’s approval of futures-based ETFs but not spot ETFs was arbitrary and inconsistent.

• And they won.

The court ruled in Grayscale’s favor, determining that their proposed spot ETF was “materially similar” to the already-operating futures ETFs; that the SEC’s rejection of Grayscale’s application was “arbitrary and capricious”, and that they had “never explained why Grayscale owning bitcoins rather than bitcoin futures affects the CME’s ability to detect fraud.”

This ruling then set the stage for what was to come for Ethereum.

Ethereum vs. Bitcoin

The Grayscale precedent

So how does the Bitcoin story compare to what’s happening with Ethereum?

First, what’s similar: like Bitcoin, Ethereum already has futures ETFs approved and trading on the CME.

Thus the Grayscale case could serve as a precedent.

Grayscale, in fact, also has an Ethereum trust, which they are seeking to convert to a spot ETF.

Therefore, what is to stop Grayscale from bringing essentially the exact same lawsuit against the SEC for a second time?

If the SEC was “arbitrary and capricious” for rejecting a spot Bitcoin ETF after approval one for futures, then surely the same logic would apply to Ethereum?

The wrinkle: Staking

The major difference between Ethereum and Bitcoin, at least as far as ETF approval is concerned, is mostly likely their different consensus mechanisms.

That is, how they achieve decentralized consensus over the network’s rules and the state of the shared ledger of transactions.

Bitcoin’s consensus is based on Proof of Work (PoW), whereas Ethereum runs on Proof of Stake.

The differences are complex, but the one key point to understand is this:

Under Proof of Stake (PoS), consensus is determined by ‘validators’, who hold a certain amount of the asset (in this case ETH), and ‘stake’ it on the network.

The more ‘stake’ one has, theoretically the more influential one would be in determine network consensus.

Crucially, stakers earn a reward for this work, in the form of a yield that accrues to them. This yield is proportionate to their stake.

In one line: the more you stake, the more you earn.

What’s at … stake?

Why does the PoW vs. PoS comparison matter for ETFs?

The answer boils down to what amounts to a regulatory turf war between the SEC and the Commodity Futures Trading Commission (CFTC)

The SEC has jurisdiction over securities. And the CFTC over commodities.

Therefore, whether or not a digital asset is one or the other, has massive implications for how it’s treated legally.

In short: it’s much harder to get an ETF approved for a security, and then it will be regulated much more tightly.

Okay. So what makes a security?

To find the answer, for any particular asset, we apply something called the Howey Test. It says that a security involves:

1. An investment of money

2. In a common enterprise

3. A reasonable expectation of profit

4. Derived from the efforts of others

Now, back to Ethereum.

It’s arguable that someone who buys ETH and stakes it, is making an investment in a common enterprise (the Ethereum network) with an expectation of profit (staking yield) derived from others (Ethereum contributors).

Therefore, it might be security. Which is no bueno for ETF approval prospects.

In fact, Gary Gensler himself had previously indicated that staked Ethereum could meet the definition of a security.

Furthermore, recent court filings show that the SEC had believed internally that ETH was a security for at least a year.

Case closed then?

Well, not so. As we’ll see, something has caused the SEC to change its mind on all this very quickly.

Political winds shift

So why did this anti-crypto SEC, doing the bidding of an anti-crypto Democrat administration, suddenly reverse course?

After all, SEC Chair Gary Gensler has been quite clear that, in his view, “Everything other than Bitcoin” is a security. To say nothing of Elizabeth Warren’s tireless crusade against all things crypto.

We don’t know for sure at this stage, but it can’t be a coincidence that multiple massive political developments occurred in the couple of weeks prior to the SEC’s decision, which seemed to shift the perceived crypto sentiment in Washington D.C. to a much more friendly one.

Here they are.

1) Trump’s crypto endorsement

First, at an event on May 8, Donald Trump was asked about crypto and said: “I’m fine with it…if you’re in favor of crypto, you better vote Trump.”

Then, just last week, his campaign announced that they would begin accepting campaign contributions in cryptocurrencies.

There’s been a massive groundswell of Trump support among bitcoin and crypto supporters, who previously hadn’t meaningfully formed a political bloc.

While it’s too early to say the degree to which that has changed, it certainly appears (from our point of view) that many in this constituency are voicing their intention to vote now for the most pro-crypto candidate.

Which would be Trump.

This was all but confirmed by Trumps comments on the weekend at the Libertarian National Convention, where he promised to protect the right to self custody, and to protect bitcoin from “Elizabeth Warren and her goons.”

2) SAB 121 overturned

On May 16, SEC guidance SAB 121 was effectively overturned, as the resolution to remove it was passed through Congress (though Biden can still veto it).

This guidance required any digital asset custodian to report its holdings on its own balance sheet.

In practice, this made it prohibitively costly for regulated custodians (i.e. banks) to enter the space.

Really, in this context the details of SAB 121 are less important than the fact that it represented a significant roadblock for the progression of the digital assets industry. The seemingly arbitrary and irrational nature of it meant that it was basically just an ‘anti-crypto’ law.

Congress overturning it, therefore, was a repudiation of the politics behind it. And a big victory for the pro-crypto movement generally.

3) FIT21 bill passed in the House

The third political blow to the anti-crypto wing of the administration was the passage of the FIT21 bill through the House of Representatives on May 22.

FIT21 seeks to define the respective responsibilities of the Commodity Futures Trading Commission (CFTC) and the SEC, when it comes to the regulation of digital assets.

Specifically, commodities are regulated by the CFTC, and securities by the SEC. This isn’t new, but the bill redefines relevant legislation to make it much clearer when a digital asset is one or the other.

In short, “digital commodities” are in the domain of the CFTC. A digital asset is considered to be a digital commodity if it relates to a blockchain that is “certified to be a decentralized system.”

And the definition of ‘decentralized system’ is a five-part test:

1. Control: During the prior 12 months, no single person or entity had unilateral control over it

2. Ownership: During the prior 12 months, no single person entity owned more than 20% of the supply

3. Governance: During the prior 3 months, no material changes to the source were made (other than for maintenance or fixing errors), or were adopted through a decentralized governance system

4. Marketing: Nobody affiliated with the system marketed the asset as an investment during the prior 3 months

5. Supply: All assets issued within the prior 12 months went to end-users

[Note: I think that final point is designed to exclude insider distributions].

Anyway why is FIT21 specifically important regarding the Ethereum ETF approvals?

First: Because the five-part test outlined above clears up a lot of the mess mentioned earlier in the background section. Namely, whether or not Ethereum is a commodity or security, and whose job it is to make that decision.

Second (and maybe more importantly): it was the third blow in very quick succession against the Gensler-Warren faction.

There is a sense in which their control over the destiny of, not just the ETFs but Ethereum itself, is directly proportionate to the regulatory uncertainty that FIT21 seeks to do away with.

SEC Approval (?)

Form 194-b applications approved

So, have the ETFs been approved. You would have seen the headlines presuming this to be the case.

On the one hand, this is effectively true. As we’ve discussed, it appears that ETF issuers have achieved the necessary and final political victory against the Warren-Gensler faction.

However, the process is not yet finished and there’s much we don’t yet know about the precise shape and operations of the ETFs.

And indeed final approval has not yet been granted.

What has happened, is that something called the 19b-4 applications have been approved.

These applications are submitted by the exchanges that propose to list the various ETFs (in this case: NYSE, Nasdaq, and Cboe BZX).

In order to satisfy the requirements for listing under this application, the exchanges must demonstrate to the SEC three things:

1. Surveillance-Sharing Agreement: Exchanges must have a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying asset (i.e. Chicago Mercantile Exchange).

2. Correlation Analysis: The SEC required robust correlation analysis between CME Ether futures and spot Ether markets. High correlation would mean that CME would be able to detect any price manipulation of the spot market.

3. Compliance with Listing Standards: The proposals had to conform to the exchanges' existing listing standards for commodity-based trust shares, ensuring transparency and fair trading practices.

The SEC’s decision found that all three components were satisfied, and therefore the exchanges can list the ETFs.

And the approval covers the ETFs proposed by Grayscale, Bitwise, iShares, VanEck, ARK 21Shares, Invesco Galaxy, Fidelity, and Franklin.

Next: S-1 applications

Now, the ETF issuers will all have to file and have approved their Form S-1 applications.

S-1s must be filed by any company before going public and being listed on exchanges, and this applies to ETFs too. It’s a detailed disclosure document, in which the applicant has to spell out its proposed operations, risk factors, and other stuff.

While S-1 approval from the SEC may just be a formality, the content of those applications could tell us a lot about how Ethereum ETFs will work.

For example, we know that Fidelity has amended their S-1 to remove references to staking.

What does this mean?

As discussed earlier, Ethereum’s Proof-of-Stake consensus is predicated on holders staking their Ethereum and being a validator of the network, for which they earn a yield on the Ether they stake. Like interest on a savings account.

The staking model was (likely) one of the main reasons for the SEC’s designation of ETH as security.

Today, on-chain data shows that 27% of ETH is staked, and the leading staker (Lido) has 28.6% of the supply of all staked ETH. The degree to which these stakers both influence the network, and benefit from security-like characteristics of it, is still fuzzy.

However, not all holders of ETH have to stake it. You can just have it sitting in a Coinbase account, earning no yield. Thus removing the controversy, right?

This is probably what Fidelity (and presumably the issuers) are assuming. Thus, removing staking from the S-1 could be a concession to the SEC, designed to appease the regulator.

We’ll have to wait for more S-1s to be filed - and then eventually the SEC’s comments and decision - to be sure.

TL;DR and commentary

To sum it all up, this is the story of Ethereum ETFs so far:

1. The SEC never wanted to approve anything. But it was forced to approve the spot Bitcoin ETFs.

2. The Bitcoin ETFs cemented a certain frame of analysis: if there’s a futures ETF already approved, the SEC can’t logically deny a spot ETF.

3. Spot Ethereum ETF approval was probably therefore inevitable, but until last week, it looked like the SEC would drag it out.

4. Some surprising developments (Trump, SAB 121 overturning, FIT21 passing) changed the political climate very quickly in a pro-crypto direction.

5. Resultant political pressure (i.e. from the White House) probably forced the SEC into changing its position, and approve the first stage (Form 19b-4) of Ethereum spot ETFs.

6. We’re still waiting on issuers’ S-1 applications. But subject to certain changes (i.e. removing staking), approval is probably a formality.

Finally, here are some unanswered questions:

1. Is staked ETH actually a security?

2. If ETH held in ETFs can’t be staked, what will the institutional demand for it be? Given buyers can earn a yield by for example just buying and staking through Coinbase?

3. Does this open the door for ETFs of other digital assets?

There aren’t any conclusive answers to these question yet. Mostly because the current environment is so politically charged.

Much hangs on the degree to which the bitcoin/crypto constituency exerts its influence between now and the November election, and then which candidate emerges triumphant.

For now, though, it’s a massive win for Ethereum, and likely the whole ecosystem.

That’s the Deep Flow for this week.

I’ll see you back here next Monday.

— Julian