Ever wondered how an ether ETF works? You’re not alone. We get this question a lot, and it makes total sense. Any responsible investor should want to understand how and why certain financial instruments work so that they can make educated decisions on how best to allocate their hard-earned money.
Purpose launched the first-ever spot ether ETF, so we’ve got first-hand knowledge about how ether ETFS work. And we want to give you an inside look at how a spot crypto fund functions. We'll use ether as our example, but the same ideas apply to other cryptocurrencies too.
So, let’s dive into spot ether funds together, and hopefully shine a light on these new and exciting investment vehicles.
Key takeaways
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Spot ether ETF units represent actual underlying ether held in custody on behalf of the ETF fund unitholders.
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The ether bought by the fund is held in trust by institutional-grade custodians, who are regulated entities that specialize in safeguarding crypto assets.
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Ether funds benefit from institutional trading relationships, which allow them to purchase ether at tighter spreads and with lower commissions than retail investors (i.e., similar to the advantages of purchasing goods in bulk—you get economies of scale and typically better pricing).
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Spot crypto ETF units comply with securities regulations. They can be traded using traditional brokerage accounts (including in registered vehicles, such as RRSPs/401ks), making them a user-friendly, low-risk method to access crypto.
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Ether staking funds also exist and offer investors the chance to earn yield while exposing themselves to the growth potential of the Ethereum network.
The components of a spot ether ETF
At the highest level, this is how a spot ether ETF works:
- A buyer purchases units of the ETF on a publicly traded exchange.
- The ETF provider uses the money received to purchase actual ether.
- This ether is held safely in trust by regulated custodians on behalf of the fund provider, usually in cold storage wallets (akin to storing gold in a vault).
- When a seller wants to redeem their ETF units, the ETF provider sells a corresponding amount of ether to fund that redemption.
Some nuances exist of course, but that’s the general gist. As we explore this more deeply, here are some terms and components/players within the ETF buying and selling process that are important to define and understand:
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ETF Provider/Fund Provider: This is the company that operates and manages the ETF.
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Buyers/Sellers: Individuals, family offices, or institutions that would like to buy or sell units of an ETF.
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Exchanges: Where units of a spot ether ETF are publicly traded. Examples of exchanges include the New York Stock Exchange, the Toronto Stock Exchange and the NASDAQ.
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Fund Administrator: A third-party organization to whom the ETF provider outsources some of its back-office tasks. Some of the most important things the fund administrator is responsible for are fund accounting, financial reporting, and net asset value calculations.
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Market Makers: Institutions that function as wholesaler buyers/sellers of ETF units. They will agree to buy or sell ETF units in bulk and at specific prices (by way of exchanges). This helps guarantee the liquidity of an ETF. Unlike regular buyers/sellers, Market Makers have also been authorized by the Fund Provider to create and redeem units of the ETF on their behalf. The partnership between a Market Maker and a Fund Provider ensures ETF units are liquid and always available to trade.
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Custodians: A third-party entity that holds the fund's assets in trust. Custodians will also perform integral functions for the Fund Provider, including clearing and settlement of money transfers, managing compliance with Crypto Trading Counterparties, and providing an additional layer of security. Custodians are usually subject to regulatory standards; for example, any publicly traded fund in Canada must use a qualified custodian. There are a number of specific requirements, including being a regulated trust company, meeting certain operating and compliance standards, and holding a certain amount of capital on their balance sheet.
Part of the complexity of crypto ETFs is that in Canada, funds need a custodian that is domiciled in Canada. Currently, few firms meet all the requirements to be qualified custodians and also have the capability to store crypto assets safely. To solve this challenge, firms have partnered to meet these requirements. In Canada, this has resulted in a structure where, in most cases, there is a Primary Custodian, which is a Canadian trust entity that meets all requirements to be a qualified custodian but that doesn’t have the technical infrastructure to store crypto assets, and a Sub-Custodian, which is typically a US-based entity that does have the infrastructure to store crypto assets.
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Crypto Trading Counterparties: Entities that trade bitcoin. These entities often only trade with institutional clients and are not available to retail investors. They can be considered wholesalers for buying/selling bitcoin.
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Hot/Cold Wallets: A hot wallet is a cryptocurrency wallet that is connected to the internet. A cold wallet is a cryptocurrency wallet that is not connected to the internet. The former is more convenient but less safe; the opposite is true for the latter. Think of a hot wallet as the cash you keep in your pocket. Think of a cold wallet as the gold you keep in your safe.
Right. We’ve got these definitions out of the way. Now, let’s map out the life cycle of a spot ether ETF unit.
What happens when you buy a spot ether ETF unit?
The inner workings of an ETF can be complicated, even for industry professionals. With this in mind, we are going to break down what happens behind the scenes in parts. Note: we said “parts” and not “steps” here. Although we are linearly presenting this information for ease of understanding, in practice, some parts of the unit-buying process are executed simultaneously or out of sequence.
Although this outline doesn’t go into every detail and nuance, it does provide a solid overview of the most important elements that occur when you buy an ether ETF unit.
Part one
Buyers looking to purchase a unit of an ether ETF will do so through an exchange.
Part two
The units that are bought and sold on exchanges are provided by Market Makers. Market Makers will determine the price they are willing to buy/sell to investors for. They will also work with the Fund Administrator and the ETF Provider to identify the number of units to be created or redeemed. This is based on the net trading flow of the day. For example, if three investors buy a total of 10,000 shares, and two investors sell a total of 5,000 shares, then the net flow would be 5,000 shares that are bought. Thus, the ETF Provider needs to create 5000 new shares for the fund.
Part three
Because the objective of the spot crypto ETF is to have each unit represent a real asset (in this case, ether), it is necessary for the Fund Provider to take the money they have received from buyers and use it to purchase actual ether, which they will then hold in trust.
For this to happen, the Fund Provider will communicate to Crypto Trading Counterparties about how much ether they need to buy. When the Fund Provider and a Crypto Trading Counterparty have agreed to an ether purchase price, the Fund Provider will execute the trade with the Crypto Trading Counterparty. This trade will be cleared and settled through the Sub-Custodian and the Primary Custodian (more on clearing and settlement in the segment below).
There. That’s it. That is a bird’s eye view of how fund units, cash, and ether flow through a spot ether ETF. We’ll now dedicate a bit more time to going deeper into a selection of important topics.
How spot ether ETFs benefit from volume
Though nobody gets excited about the prospect of paying fees, it’s important to remember that because ether ETFs have institutional relationships, they are able to benefit from wholesale pricing, which is driven by tighter trading spreads and lower trading commissions. These savings can be passed on to investors, acting as an offset to fees.
For example, here is a snapshot of how much ether you would have received using some of Canada’s most popular crypto exchanges compared to how much ether you would have received buying units of the Purpose Ether ETF (ETHH).
Newton (no fees):
10 000 CAD= 2.430322 ETH
Bitbuy (after fees):
10 000 CAD= 2.420025
ETHH:
10 000 CAD worth of shares= 2.47 worth of ether
All numbers as at July 07, 2024. Source: Newton.com, Bitbuy.com, Purposeinvest.com
Though these savings are not guaranteed every time units of a spot ether ETF are bought and sold, any investor needs to understand the full implications of dealing with an investment vehicle that can effectively leverage volume when compared to an individual.
A closer look at ether transactions and storage
There are a few essential things to understand when we look at the flow of ether in and out of an ether ETF. First, virtually all of the ether that is held by Crypto Custodians on behalf of the fund is held in offline crypto cold wallets (the safest way to store digital assets). Second, Crypto Custodians are regulated entities that hold the fund’s ether in trust, meaning they cannot use the fund’s ether for any other purpose. Third, ether is only moved to online hot wallets in order to execute trades, thereby mitigating the risks of hacking.
If we zoom in further on the ether trading, settlement, and storage components of a spot ether ETF, we would see the breakdown as follows:
Understanding spot ether ETF fees
All ETFs have fees, and spot ether ETFs are no different. But let’s shine some more light on the fee structure of this type of ETF so you understand what’s going on behind the scenes.
First, let’s get familiar with two terms: 1) Management fee and 2) Management Expense Ratio (MER).
The former refers to the administrative fee the Fund Provider charges for operating the ETF. The MER refers to the combined cost of the management fee and operational costs associated with running the fund.
We can outline some of the most common costs incurred when operating a Bitcoin ETF. Here are some examples:
- Sales taxes
- Accounting, auditing, and legal fees (A Fund Provider must pay fees for services that make sure finances are where they should be and do what they should be doing)
- Custodial services (Custodians charge a fee for storing and safekeeping the fund’s bitcoin)
- Investor servicing costs (Think of this as the infrastructure needed by a Fund Provider to offer client-facing services like support, informational content, sales, etc.)
The Fund Provider does not bill an investor for these fees, nor do they interact directly with an investor’s units to charge these fees. They deduct the fees from the assets held in the fund. In the case of a spot ether ETF, some of the fund’s ether will be sold to cover operating costs and management fees. This means that over time, and very incrementally, an investor’s unit will hold slightly less ether than when they first bought it.
Demystifying clearing and settlement
We mentioned clearing and settlement a couple of times above. And while most people have a vague idea of what that means, breaking it down further is a worthwhile exercise if you really want to understand how a spot ether ETF works.
So, let’s peel back the layers a bit more.
First, let’s make sure we understand what clearing and settlement mean. Clearing is the process of reconciling daily transactions.
Settlement is the finalization of these transactions. In the context of a spot ether ETF, settlement occurs when ether is titled to the buyer and money is transferred to the seller.
Clearing and settlement for ether/cash looks something like this:
- The ETF Provider will agree upon terms to buy/sell crypto in bulk quantities with Crypto Trading Counterparties.
- The Sub-Custodian will be informed about the trades and will proceed to settle and clear these trades. This involves receiving the cash and crypto from each party, verifying that each party provided the appropriate amounts and then releasing the cash/crypto to the other party.
- This settlement and clearing process can take between minutes and one business day to occur.
- When the settlement process is complete, the transactions are final and irreversible.
The role of a trusted intermediary (Sub-Custodian in this case) in the clearing and settlements process ensures that no one pays for something and does not receive what they’ve bought.
How ether staking works in an ether ETF
The Ethereum network employs something called Proof of Stake to validate and secure its network. We won’t go into great detail on how this works here, but the infographic below should act as a handy high-level review to get you up to speed:
On a practical investment level, staking effectively amounts to earning interest or yield on an investor's cryptocurrency. In staking, you lock up cryptocurrencies to help maintain the network's security and operations, and in return, you receive rewards, much like earning interest by depositing money in a savings account or investing in interest-bearing instruments.
The catch is that the barrier to entry for staking on the Ethereum network is quite high:
- You need a minimum of 32 ETH to become a validator, and
- A high degree of technical know-how.
The solution for many investors who want to stake their ETH is to stake through large crypto exchanges that run staking programs. Or to get the benefits of staking yield by buying units in an ether staking ETF, like the Purpose Ether Staking Corp ETF we launched in June 2024.
It is important to know that not all ether ETFs stake their ether. This is for various reasons, including regulatory restrictions or limits in the Fund Provider’s technical capabilities or crypto savoir-faire.
That said, it’s important to understand that the benefit of investing in an ether-staking ETF is that you are not only investing in the potential growth of the Ethereum network as you would in a spot ether ETF, but you do so while simultaneously earning yield.
Summing up
Spot ether ETFs can be a great way to get exposure to ether. They’re safe, regulated, accessible, and benefit from institutional-level buying power. And for many, they can be the right choice when deciding how to increase your portfolio’s exposure to digital assets. But that doesn’t mean understanding them isn’t important. Educating yourselves thoroughly on any given financial product is key to making the choices that most make sense for you and your financial goals.
—Purpose Investments
Commissions, trailing commissions, management fees and expenses all may be associated with investment fund investments. The prospectus contains important detailed information about the investment fund. Please read the prospectus before investing. There is no assurance that any fund will achieve its investment objective, and its net asset value, yield, and investment return will fluctuate from time to time with market conditions. Investment funds are not guaranteed, their values change frequently, and past performance may not be repeated.
If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.
This information is provided for illustrative and discussion purposes only. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. Historical trends do not imply, forecast or guarantee future results. Information is as of the date indicated and subject to change without notice. Nothing herein constitutes a prediction or projection of future events or future market behavior.