Because Coinbase already plays a custodial role and has the ability to obtain substantial control through ETFs, the research focuses more on Coinbase as a potential risk factor.
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According to recent research from S&P Global, spot Ethereum exchange-traded funds (ETFs) could increase validator concentration risks within the Ethereum network if approved.
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The study, “U.S. Ether ETFs Could Exacerbate Concentration Risk,” clarifies how spot Ethereum funds—especially those that involve staking—may affect the concentration of validators on the Ethereum network.
“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.
The main purpose of traditional spot traded products, such as spot Bitcoin ETFs, is to mirror the asset’s market price while safeguarding their holdings in digital vaults. But what makes Ethereum special is its staking feature, which rewards users by locking up cryptocurrency to support network functions and safe transactions. Staking entails a risk of “slashing” in the event that validators perform poorly or behave maliciously, despite the possible rewards.
The study indicates that while spot Ethereum ETFs are unlikely to impact the composition of validators, staking-enabled Ethereum ETFs, like those proposed by Ark Invest and Franklin Templeton, have the potential to grow sufficiently large to notably affect validator dominance.
“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.”
The research from S&P Global also draws attention to particular issues with Coinbase and Lido. Though for somewhat different reasons, both entities pose a risk to validator concentration.
Although Lido owns almost 33% of staked Ethereum, the research indicates that due to regulatory and risk concerns, US institutions launching Ethereum staking ETFs are unlikely to work directly with Lido. These ETFs may choose to stake their investments with regulated digital asset custodians instead, which could lessen Lido’s hegemony. But this change begs questions about Coinbase’s involvement.
According to the research, there is a risk that Coinbase, a large exchange with substantial control over validators, will use ETFs to increase its Ethereum stake and thus increase concentration. Furthermore, concentration may be made worse by Coinbase’s dual responsibilities as custodian for several Bitcoin ETFs and possible participation in Ethereum ETFs.
However, the way that ETFs stake their investments determines how they affect concentration overall. According to the research, ETF issuers may be able to reduce concentration risk by diversifying their holdings across a range of companies with the arrival of new digital asset custodians.
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