Galaxy predicts ETH ETF: estimated net inflows of $1 billion per month, one third of BTC ETF

Author: Charles Yu

Compiled by DeepTechFlow

Key Points

• BTC ETF net inflows reached 15.1 billion US dollars from January 11, 2024 to June 15, 2024.
• There are nine issuers competing to launch 10 Ethereum Spot ETFs in the United States.
• After approving all 19b-4 applications on May 23, the SEC is expected to allow these instruments to begin trading in July 2024.
• Just like BTC ETF, we believe that the main new accessible market is independent investment advisors, or those associated with banks or broker/dealers.
• We expect net inflows of ETH ETF to reach 20-50% of net inflows of BTC ETF in the first five months, with a target of 30%, which means a net inflow of $1 billion per month.
• Overall, we believe that due to the majority of ETH total supply being locked in stake, bridge, and Smart Contract, and the smaller amount on Centralized Exchange, the price sensitivity of ETHUSD to ETF inflows is higher than BTC.

Introduction

For months, observers and analysts have underestimated the likelihood of Securities and Exchange Commission (SEC) approving an Ethereum (ETH) exchange-traded product (ETP) based on Spot. The pessimism stemmed from reports of SEC’s hesitation to explicitly declare ETH as a commodity, lack of contact with potential issuers, and news of SEC investigations and pending enforcement actions against the ETH ecosystem. Bloomberg analysts Eric Balchunas and James Seyffart pegged the likelihood of approval at 25% in May (when some potential issuers’ first final approval/rejection deadlines were approaching). However, on Monday, May 20, Bloomberg analysts suddenly raised the approval odds to 75% after reporting SEC had contacted securities exchanges. In fact, all SpotETH ETP applications were approved by SEC later that week. While we are still waiting for these tools to actually launch after S-1 applications become effective—we expect this to happen at some point in the summer of 2024—this report draws on the performance of BTCSpot ETP to predict demand for ETH ETP after launch. We estimate that SpotETH ETP will see net inflows of around $5 billion in the first five months of trading (about 30% of net inflows for BTC ETP).

Background

Currently, nine issuers are competing to launch exchange-traded products (ETPs) holding Spot ETH. In the past few weeks, some issuers have withdrawn. ARK chose not to collaborate with 21Shares to launch an Ethereum ETP, while Valkyrie, Hashdex, and WisdomTree have completely withdrawn their applications. The table below shows the current application status sorted by 19b-4 application date:

Grayscale is seeking to convert the Grayscale Ethereum Trust (ETHE) into an ETP, just as the company did with the Grayscale Bitcoin Investment Trust (GBTC), but has also applied for a ‘mini’ version of the product.

On May 23, the SEC approved all 19b-4 applications, which allow securities exchanges to list Spot ETH ETPs, but now each individual issuer needs to communicate repeatedly with regulators about their registration statements. These products cannot truly begin trading themselves until the SEC allows these S-1s (or S-3s in the case of ETHE) to take effect. Based on our research and Bloomberg Intelligence’s reports, we believe that ETH Spot ETPs may start trading as early as the week of July 11, 2024.

Experience of BTC ETF

BTC ETF has been online for less than 6 months, which can serve as a useful basis for researching the acceptance of ETH Spot ETF.

Source: Bloomberg

Here are some observations on BTCSpot ETP trading in the past few months:

• So far, the inflow has exceeded expectations. As of June 15, the net inflow of the US SpotBTC ETF since its inception exceeded 15.1 billion US dollars, with an average daily net inflow of 136 million US dollars. These ETFs hold approximately 870,000 BTC, accounting for 4.4% of the current BTC supply. With BTC trading at approximately $66,000, the total assets under management of all US Spot ETFs are approximately 58 billion US dollars (Note: before the ETF started, GBTC held approximately 619,000 BTC).
• The inflow of ETF partially drove the price pump of BTC. By regressing the weekly changes in BTC price and ETF net inflows, we calculated an r-squared of 0.55, indicating a high correlation between these two variables. Interestingly, we also found that price changes are more effective as a leading indicator of inflows than inflows themselves.
• The unwind of GBTC trading has impacted overall ETF inflows. Since the trust was converted to an ETF, GBTC has experienced significant outflows in the first few months. The daily outflows of GBTC reached a peak in mid-March, with an outflow of $642 million on March 18th. Since then, the outflows have eased, and GBTC has even seen a few days of net inflows starting in May (78 days of outflows before the first net inflow on May 3rd). As of June 15th, since the ETF launch, the BTC balance held by GBTC has decreased from 619,000 BTC to 278,000 BTC (a decrease of 55%).

• ETF demand is mainly driven by retail investors; institutional demand is increasing. 13F filings show that as of March 31, over 900 US investment firms hold BTC ETFs with a total value of approximately $11 billion, accounting for about 20% of the total BTC ETF holdings, indicating that the majority of demand comes from retail investors. The list of institutional buyers includes some well-known banks (such as JP Morgan, Morgan Stanley, Wells Fargo), hedging funds (such as Millennium, Point72, Citadel), and even pension funds (such as the Wisconsin Investment Board).
• The wealth management platform has not yet started to provide access to BTC ETF. The largest wealth platform has not yet allowed its brokers to recommend BTC ETF, although it is reported that Morgan Stanley is exploring allowing its brokers to advise clients to purchase. In our report “BTC ETF Market Size”, we wrote that access to BTC ETF by wealth platforms (including brokerage firms, banks, and independent registered investment advisors) is expected to continue for several years. So far, the sales-driven inflow from institutional platform access has been minimal, but we believe it will become an important catalyst for BTC adoption in the medium term.

Estimated potential ETH ETF inflows

Using BTC ETP as a reference, we can estimate the potential demand for similar Ethereum-based products.

To estimate the potential inflow of ETH ETF, we applied the BTC/ETH multiple based on the relative asset size of BTC and ETH in the long market to estimate the inflow of BTC US Spot ETF. As of May 31st:

• The Market Cap of BTC is 2.9 times that of ETH.
• Among all exchanges, based on the level of unclosed position contracts and volume, the futures market for BTC is about 2 times that of ETH. Specifically, on CME, the level of unclosed position contracts for BTC is 8.4 times that of ETH, and the daily volume is 4.2 times that of ETH.
• The total assets under management of various existing funds (divided into Grayscale trusts and products (such as futures, Spot) and selected global markets) show that the size of the BTC fund is about 2.6 to 5.3 times that of the ETH fund.

Based on the above data, we believe that the inflow of ETH Spot ETF will be about 3 times less than that of the US Spot BTC ETF (consistent with the market capitalization multiple), ranging from 2 times to 5 times. In other words, we believe that the inflow of ETH Spot ETF may be 33% of the inflow of the US Spot BTC ETF, ranging from 20% to 50%.

Applying this multiplier to the $15.1 billion BTCSpot ETF inflows as of June 15, means that the monthly ETH ETF inflows in the first five months after the approval and launch of the ETH ETF will be approximately $1 billion (estimated range: $600 million to $1.5 billion per month).

We see several estimates lower than our forecast, which is due to several factors. That is, we predicted in the previous report that the first year BTC ETF inflow would be $14 billion, based on the entry of wealth management platforms, but significant inflows into BTC ETF were seen before the arrival of these platforms. Therefore, we recommend caution when predicting the demand for ETH ETF when it is insufficient.

Structural/market differences between BTC and ETH will impact the inflow of ETFs:

Due to the lack of stake rewards, the demand for Spot Ethereum ETF may be limited. Non-stake ETH is foregoing the opportunity cost of:

(i) Inflation rewards paid to validators (which also have a negative dilution effect),

(ii) The priority fee paid to validators and MEV income paid to validators through relayers. Using post-merge data (> September 15, 2022) to June 15, 2024, we estimate that the annual opportunity cost of forgoing stake rewards is 5.6 percentage points, which is significant for Spot ETH holders (or 4.4 percentage points using year-to-date data). This will make the Spot ETH ETF less attractive to potential buyers. Please note that ETPs offered outside the United States (e.g., Canada) provide additional income for holders through stake.

Grayscale’s ETHE may drag down the inflow of ETH-based ETF. Just as GBTC Grayscale Trust experienced significant outflows when it was converted into ETF, ETHE Grayscale Trust’s conversion into ETF will also result in outflows. Assuming that the outflow rate of ETHE matches that of GBTC in the first 150 days (i.e., 54.2% of the trust’s supply is withdrawn), we estimate that ETHE’s monthly outflow is about 319,000 ETH, which is approximately $1.1 billion at current prices or an average daily outflow of $36 million. Note that the supply held by these trusts accounts for 3.2% of BTC supply and 2.4% of ETH supply, indicating that the drag on ETH prices from ETHE ETF conversion is relatively smaller than that from GBTC conversion. In addition, unlike GBTC, ETHE does not face forced selling due to bankruptcy (e.g., 3AC or Genesis), which further supports the view that the selling pressure of Grayscale trusts related to ETH is relatively smaller.

The spread trading may drive the demand for BTC ETF by Hedging funds. Hedging funds look to arbitrage the price difference between BTC spot and futures, and spread trading is likely to drive Hedging funds to adopt ETFs. As mentioned earlier, 13F filings show that as of 3/31/24, over 900 U.S. investment companies hold BTC ETFs, including some well-known Hedging funds such as Millennium and Schonfeld. Throughout 2024, the funding rate for ETH on various exchanges has been higher than that of BTC on average, indicating: (i) relatively greater demand for Long ETH; (ii) SpotETH ETF may attract greater demand from Hedging funds looking to enter spread trading.

Factors Affecting the Price Sensitivity of ETH and BTC

Since we estimate that the Market Cap of the ETF inflow of Ethereum (ETH) is roughly equivalent to the inflow of BTC, we expect the impact of Ethereum (ETH) on price to be roughly similar under similar conditions. However, these two assets have some key differences in supply and demand, which may result in Ether being more sensitive to ETF inflows.

• Supply of exchange: Currently, the proportion of BTC supply held by exchange is higher than that of ETH (11.7% vs 10.3%), which indicates that the supply of ETH may be more tight. Assuming that the inflow is proportional to the Market Cap, the price of ETH will be more sensitive (Note: This indicator is largely dependent on exchangeAddressvesting and there is a big difference in data from different data providers).
• Inflation and Destruction: After the latest Halving on 4/20/24, the annual inflation rate of BTC is about 0.8%. After the merger (>9/15/22), the net issuance of Ethereum is negative (annual issuance -0.19%), as the new issuance paid to depositors (+0.63%) is offset by the basic cost (-0.83%) that is destroyed. In the recent month, the basic cost of Ethereum is relatively low (annualized -0.34%), which failed to offset the new issuance (annualized +0.76%), resulting in an annualized net positive inflation rate of +0.42%.
• ETF holdings: Since its launch, the net amount of BTC entering the US Spot ETF (excluding the initial balance of GBTC) has totaled 251k BTC, accounting for 1.3% of the current supply. If this pace continues annually, the ETF will absorb 583k BTC or 3.0% of the current BTC supply, far exceeding the dilution of Miner rewards (0.81% inflation rate).

However, the actual market liquidity available for ETF purchases is much lower than the reported current supply. We believe that in order to better reflect the available market supply of each asset in the ETF, various factors such as collateralized supply, dormant/lost supply, and supply held in bridges and smart contracts must be adjusted:

• stake Supply (Discount: 30%): The ETH staked reduces the Liquidity in the market. Currently, there is no stake option for BTC. The staked ETH is used to secure the network, but stakers can unstake a portion of the ETH for other purposes. Currently, staked ETH accounts for approximately 27% of the total supply, and we apply a 30% discount to estimate the available supply in the market, resulting in an 8.2% supply discount.
• Dormant/Lost Supply (Discount: 50%): Some BTC and ETH are considered unrecoverable (e.g., lost Secret Key), reducing the supply in the market; we use BTC that has been inactive for over 10 years and ETH with a last active time of over 7 years, accounting for 16.6% and 6.7% of the current supply, respectively. We apply a 50% discount to this supply because the supply in these assumed dormant Addresses may come back online at any time.
• The supply in bridge and Smart Contract (discount: 25%): These supplies are locked in bridge and Smart Contract for productive purposes. For BTC, the wrapped BTC (wBTC) custodied by BitGo is approximately 153k BTC, and we estimate a similar amount of BTC locked in other bridges, totaling about 1.6% of the supply. The ETH locked in Smart Contract accounts for approximately 11.4% of the current supply. We apply a 25% discount to these supplies because we believe they have more Liquidity than stake supplies (i.e., less likely to be affected by the same locking requirements and withdrawal queues).

After applying discount weights for these factors to calculate the adjusted supply of BTC and ETH, we estimate that the available supply of BTC and ETH is 8.7% and 14.4% less than the reported current supply.

Overall, for the following reasons, ETH should be more price-sensitive than BTC: (i) lower available market supply based on adjusted supply factors, (ii) lower supply ratio on exchanges, (iii) lower net issuance. Each of these factors should have a multiplier effect on price sensitivity (rather than additive) as prices tend to be more responsive to changes in market supply and liquidity.

Looking to the Future

Looking ahead, we have several issues in adopting and secondary effects.

• How should product managers and allocators view BTC and ETH? Will existing holders move from BTC ETF to ETH? For allocators, some rebalancing is expected. Will SpotETH ETF attract new marginal buyers who have not yet purchased BTC? What will be the proportion of potential buyers holding only BTC, only ETH, or a mix of both?
• When will stake (if any) be added? Will the lack of stake rewards affect the adoption of SpotETH ETF? Will the investment demand for Decentralized Finance, tokenization, Non-fungible Token, and other encryption-related applications drive greater adoption of ETH ETF compared to BTC, considering the lack of alternative investment products?
• What is the potential impact on other alternatives? After ETH, are we more likely to see other alternatives like ETF approved?

Overall, we believe that the potential launch of the SpotETH ETF should have a positive impact on the Ethereum and the broader encryption market adoption for two main reasons: (i) expanded accessibility within the wealth segment, and (ii) greater acceptance through formal recognition by regulatory bodies and trusted Financial Service brands. ETFs can provide greater coverage for both retail and institutional investors, offering a wider distribution through longer investment channels, and can support Ether for longer investment strategies in portfolios. Additionally, a better understanding of Ethereum by financial professionals ideally leads to accelerated investment and adoption of the technology.