Ethereum spot ETFs may intensify validator concentration risk, says S&P Global

The research focuses more on Coinbase as a potential risk factor due to its existing custodial role and potential to gain significant control through ETFs.

Spot Ethereum exchange-traded funds (ETFs), if approved, could intensify validator concentration risks within the Ethereum network, according to recent research from S&P Global.

The research, titled “U.S. Ether ETFs Could Exacerbate Concentration Risk,” sheds light on the potential impact of spot Ethereum funds on validator concentration on the Ethereum network, particularly those that incorporate staking.

“An increase in ether staking ETFs could affect the mix of validators participating in the Ethereum network’s consensus mechanism. The participation of institutional custodians could reduce the current concentration on the Lido decentralized staking protocol. However, it may also introduce new concentration risk, particularly if a single entity is chosen to stake the bulk of ether included in these ETFs,” stated the analysis.

Traditional spot Bitcoin ETFs secure their holdings in digital vaults, with their primary function being to mirror the asset’s market price. However, Ethereum’s unique proposition lies in staking – where crypto is locked up to support network operations and secure transactions, rewarding participants in the process. Despite potential rewards, staking introduces the risk of ‘slashing’ if validators underperform or act maliciously.

According to the research, spot Ethereum ETFs won’t affect the validator mix, but the proposed staking-enabled Ethereum ETFs, such as those of Ark Invest and Franklin Templeton, could become large enough to significantly influence validator power.

“Spot ether ETFs that simply hold ether will not affect the validator mix in Ethereum’s consensus mechanism. Spot ether ETFs that include staking, however, will do exactly that–at least if inflows are high enough,” added the analysis. “U.S. spot ether ETFs that incorporate staking could become large enough to change validator concentrations in the Ethereum network, for better or worse.”

S&P Global’s analysis also highlights specific concerns around Lido and Coinbase. Both entities are potential threats to validator concentration but for slightly different reasons.

The research notes that while Lido holds nearly 33% of staked ETH, it’s unlikely that US institutions launching Ethereum staking ETFs will directly engage with Lido due to regulatory and risk considerations. Instead, these ETFs might opt for regulated digital asset custodians for staking, potentially mitigating Lido’s dominance. However, this shift raises concerns about the role of Coinbase.

The research warns that Coinbase, a major exchange with significant validator control, could increase its Ethereum stake through ETFs, leading to greater concentration. Furthermore, Coinbase’s dual role as custodian for multiple Bitcoin ETFs and potential involvement in Ethereum ETFs could exacerbate concentration.

However, the overall impact of ETFs on concentration depends on their staking practices. The research suggests that the introduction of new digital asset custodians could allow ETF issuers to diversify their stakes across different entities, potentially mitigating concentration risk.

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