Ethereum ETF’s Cash Creation Conundrum: Innovations and Concerns

ARK Invest and 21Shares have detailed a new cash creation and redemption mechanism for their latest filing of an Ethereum spot ETF. They say the new process takes an innovative approach by departing from the traditional processes of ETPs, which represent in-kind creation and redemption.

Revolutionizing the Ethereum Creation Process

The revised filing highlights that authorized participants will create and redeem shares entirely in cash, departing from the typical in-kind creation and redemption of shares. It also mentions the inclusion of staking, where the sponsor may stake a part of the trust’s assets.

The switch to cash transactions raises potential difficulties for the arbitrage mechanism, designed to keep the shares’ prices close to Ethereum’s value. The document warned that such departure could lead to shares trading at a premium or discount to the net asset value (NAV), even wide deviations.

In addition, reliance upon cash transactions would introduce operational complications, presumably causing delays in the execution of trades and the widening of bid/ask spreads in secondary trading. Additional market volatility or turmoil might result in the suspension of creation or redemption, negatively impacting liquidity and increasing costs for investors.

The sponsors stress the efficiency of in-kind transactions with other commodity-based ETFs and recognize that purely cash-based processes are untested. Operational inefficiencies in this novel approach could block the arbitrage mechanism and dislocate prices between shares and underlying assets.

The document also highlights the critical role of authorized participants in supporting the ETF ecosystem. Concerns arise due to potential limitations in participants and associated risks, including industry-wide implications such as operational disruptions or adverse developments, prompting heightened caution.

To reduce the operational risk and for timely transactions, the trust has a Post-Trade Financing Agreement with Coinbase Credit, Inc., according to which there is an ability to borrow as trade credit for short-term periods, either ether or cash.

To make fees and expense payments in a timely manner, this setup will facilitate cash creation and redemptions. However, while the proposed cash creation and redemption process is indeed innovative, it remains under question regarding how it is workable and its market effects.