Grayscale Report: Ethereum spot ETF has less room to rise after approval, Solana may capture market share

Author: Grayscale Research

• The potential launch of spot Ethereum ETF will allow More investors are learning about the concepts of smart contracts and decentralized applications, allowing them to understand the potential of public blockchains to transform digital commerce.
• Ethereum is the largest blockchain network in terms of users and applications and is being expanded with a modular design concept. More activities will be conducted on the Layer2 network in the future. To maintain its dominance in a highly competitive market segment, Ethereum needs to attract more users and increase fee revenue.
• Based on international precedent, U.S. spot Ethereum ETF demand is expected to be approximately 25%-30% of spot Bitcoin ETF demand. It is unlikely that a large portion of the Ethereum supply (e.g. staked ETH) will be available for ETFs.
• Given the higher initial valuations, further price gains may be limited compared to a Bitcoin ETF launching in January 2024, but Grayscale Research remains optimistic about the prospects for both assets.

Last week, the U.S. Securities and Exchange Commission (SEC) approved the filing of Form 19B-4 for spot Ethereum ETFs by several issuers, making significant progress in listing these products on U.S. exchanges. Like the spot Bitcoin ETF that launched in January, these new products will give a wider range of investors exposure to crypto assets. While both assets are based on the same public blockchain technology, Ethereum is a separate network with different use cases (Table 1), while Bitcoin primarily serves as a store of value and a digital alternative to gold. Ethereum is a decentralized computing platform with a rich application ecosystem and is often compared to a decentralized application store. New investors interested in exploring this asset may want to consider Ethereum’s unique fundamentals, competitive positioning, and potential role in the growth of blockchain-based digital commerce.

## Chart 1: Ethereum is a smart contract platform blockchain

Smart Contract Basics

Ethereum expands on the original vision of Bitcoin by adding smart contracts. A smart contract is a pre-programmed and automatically executed computer code. When a user uses a smart contract, predefined actions are performed without any additional input. Just like a vending machine: the user inserts a coin and the vending machine dispenses an item. When using smart contracts, users "insert" digital tokens and the software can perform certain types of operations, such as token transactions, loan issuance, and verifying the user's digital identity.

Smart contracts run through the mechanism of the Ethereum blockchain. In addition to recording ownership of assets, block-by-block updates to the blockchain can also record any changes in "state" (note: a computer science term meaning the state of data in a database). In this way, coupled with smart contracts, public blockchains can actually run like computers (software computers rather than hardware computers). With these, Ethereum and other smart contract platform blockchains can host almost any type of application and serve as the core infrastructure of the emerging digital economy.

Asset Returns and Fundamentals

Since the beginning of 2023, the overall performance of the ETH and smart contract platform token market segments has been broadly consistent (Table 2). However, ETH underperformed BTC and Solana. ETH, like BTC, has outperformed some traditional asset classes on a risk-adjusted basis since the start of 2023. Over the long term, both BTC and ETH have achieved risk-adjusted returns comparable to traditional asset classes, despite significantly higher volatility.

Figure 2: ETH’s performance has been consistent with the cryptocurrency sector

Through Ethereum’s modular design , different types of blockchain infrastructure work together to provide a good experience for end users. In particular, the ecosystem has expanded as activity on the Ethereum Layer 2 network has increased. Layer2 periodically settles and publishes its transaction records to Layer1, benefiting from its network security and decentralization. This approach contrasts with the single-layer design philosophy of blockchains such as Solana, where all key operations (execution, settlement, consensus, and data availability) occur in Layer1.

In March 2024, Ethereum underwent a major upgrade that was expected to facilitate its transition to a modular network architecture. From a blockchain activity perspective, the upgrade was successful: the number of active addresses on the Layer 2 network increased significantly and accounted for approximately two-thirds of the total activity in the Ethereum ecosystem (Figure 3).

Figure 3: Significant growth in Ethereum Layer 2 activity

At the same time, the Layer 2 network’s The transfer also affects ETH’s token economics, at least in the short term. Smart contract platform blockchains accumulate value primarily through transaction fees, which are typically paid to validators or used to shrink the token supply. In the Ethereum network, base transaction fees are burned (removed from circulation), while priority fees ("tips") are paid to validators. When Ethereum's transaction revenue is relatively high, the number of tokens destroyed exceeds the rate of new issuance, and the total ETH supply decreases (deflation). However, as network activity transitioned to Layer 2, fee revenue on the Ethereum mainnet declined and ETH supply began to increase again (Figure 4). Although Layer2 networks also pay fees to publish their data to Layer1 (so-called "blob fees," among other transaction fees), the amounts tend to be relatively low.

Figure 4: ETH supply has increased recently due to lower mainnet fees

In order for ETH to increase in value over time, the Ethereum mainnet will likely need to increase fee revenue. This may be achieved in two ways:

• Moderately increase Layer1 activity, pay higher transaction fees
• Significantly increase Layer2 activity, pay lower transaction fees

Grayscale Research predicts that it is more likely to be a combination of the two methods.

Grayscale believes that growth in Layer 1 activity will most likely come from low-frequency and high-value transactions, as well as any transactions that require a high degree of decentralization (at least until the Layer 2 network is fully decentralized). This may include many types of tokenized projects, where transaction costs may be relatively low compared to the dollar value of the transaction. Currently, approximately 70% of tokenized U.S. Treasury securities are on the Ethereum blockchain (Table 5). In Grayscale’s view, relatively high-value NFTs are also likely to remain on the Ethereum mainnet, as they benefit from its high degree of security and decentralization and change hands less frequently (for similar reasons, Bitcoin NFTs are expected to continue increase).

Figure 5: Ethereum hosts the majority of tokenized Treasury bills

By comparison , relatively high-frequency and/or low-value transactions will occur more frequently on Ethereum’s various Layer2 networks. Consider social media applications, various recent success stories on Ethereum Layer 2, including friend.tech (Base), Farcaster (OP Mainnet), and Fantasy Top (Blast). In Grayscale’s view, both gaming and retail payments are likely to require very low transaction costs and are more likely to migrate to Layer 2 networks. Importantly, however, given the low transaction costs, these applications would need to attract a large number of users to significantly increase fee revenue on the Ethereum mainnet.

Potential Impact of US Spot Ethereum ETF

Over the long term, ETH’s market capitalization should reflect its fee income as well as other fundamentals. But in the short term, the market price of ETH may be affected by changes in supply and demand. While approval of a U.S. spot Ethereum ETF is progressing, the ETF’s issuer will still need to wait for an S-1 registration statement to become effective before it can begin trading. Full approval and the launch of trading in these products will likely create new demand as the assets will be available to a wider range of investors. Given the supply and demand dynamics, Grayscale Research expects that increased access to Ethereum and the Ethereum protocol through ETF wrapping will help drive increased demand and, in turn, the token’s price.

Outside the United States, both Bitcoin and Ethereum exchange-traded products (ETPs) are listed, with assets in Ethereum ETPs accounting for approximately 25%-30% of Bitcoin ETP assets (Table 6). On this basis, Grayscale Research predicts that net inflows into U.S.-listed spot Ethereum ETFs will reach 25%-30% of net inflows into spot Bitcoin ETFs to date; or within the first four months or so, There are approximately $3.5 billion to $4 billion in inflows (25%-30% of the $13.7 billion in net inflows into spot Bitcoin ETFs since January). Ethereum’s market capitalization is about one-third (33%) of Bitcoin’s market capitalization, so Grayscale’s assumptions mean that net inflows to Ethereum may be a slightly smaller share of market capitalization. But this is just hypothetical, and there is uncertainty about higher and lower net inflows into U.S.-listed spot Ethereum ETFs. It is worth mentioning that in the U.S. market, ETH futures ETFs only account for about 5% of BTC futures ETF assets, although this does not represent possible demand for spot ETH ETFs.

Figure 6: Outside the United States, Ethereum ETP asset management scale accounts for 25%-30% of Bitcoin ETP asset management scale

In terms of ETH supply, Grayscale Research believes that approximately 17% of ETH can be classified as idle or relatively illiquid. According to data analysis platform Allium, about 6% of the ETH supply has not moved for more than five years, and about 11% of the ETH supply is "locked" in various smart contracts (e.g., bridges, wrapped ETH and various other applications ). Additionally, 27% of the ETH supply is staked. Recently, issuers of spot Ethereum ETFs, including Grayscale, have removed references to staking from public filings, suggesting the SEC may allow ETFs to trade without collateral. Therefore, this portion of the supply is unlikely to be available for purchase by the ETF.

Outside of these categories, $2.8 billion worth of ETH is used for transactions on the network each year. This represents an additional 0.6% of supply at current ETH prices. There are also protocols that hold large amounts of ETH in their vaults, including the Ethereum Foundation ($1.2 billion worth of ETH), Mantle (about $879 million in ETH), and Golem ($995 million in ETH). Overall, ETH in protocol vaults represents approximately 0.7% of the supply. Finally, approximately 4 million ETH, or 3% of the total supply, is occupied by ETH ETPs.

Collectively, these categories account for approximately 50% of the ETH supply, although there is some overlap (e.g., ETH in protocol libraries may be staked) (Figure 7). Grayscale believes that net purchases of ETH are more likely to come from the remaining circulating supply. Because existing usage limits the available supply of new spot ETF products, any increase in demand is likely to have a larger impact on price.

Figure 7: A significant portion of ETH supply cannot enter new spot ETFs

From Valuation From a perspective, Ethereum’s valuation is arguably higher than Bitcoin’s when the spot Bitcoin ETF was launched in January. For example, a popular valuation metric is the MVRV z-score. This metric is based on the ratio of a token’s total market capitalization to its “realized value”: the market capitalization based on the price at which the token last moved on-chain (as opposed to the price at which it traded on an exchange). When the spot Bitcoin ETF launched in January this year, its MVRV z-score was relatively low, indicating modest valuations and potentially more room for price gains. Since then, the crypto market has appreciated, with both Bitcoin and Ethereum increasing their MVRV ratios (Table 8). This may indicate that there is less room for price upside following the approval of a spot ETH ETF compared to the approval of a U.S. spot Bitcoin ETF in January.

Figure 8: When spot Bitcoin ETF was launched, ETH’s valuation metrics were higher than BTC

Finally, native crypto investors may be concerned about the impact of spot Ethereum ETFs on smart contract platform tokens, specifically the SOL/ETH price ratio. Solana is the second-largest asset in the segment (by market cap). Grayscale Research believes that Solana is currently the most likely to capture market share from Ethereum in the long term. Solana has significantly outperformed Ethereum over the past year, with the SOL/ETH price ratio now close to the peak of the last crypto bull market (Figure 9). Part of the reason may be that, despite Solana being affected by the FTX incident (in terms of token ownership and development activity), the Solana network's user and developer community continues to grow the ecosystem. More importantly, Solana also drives an increase in transaction activity and fee income through a "silky" user experience. In the short term, Grayscale expects the SOL/ETH price ratio to level off as inflows from the Ethereum ETF support the price of ETH. However, in the long term, the SOL/ETH price ratio is likely to be determined by the fee income of both chains.

Figure 9: SOL/ETH price ratio near last cycle high

Looking ahead

While the launch of a spot ETH ETF in the U.S. market may have a direct impact on ETH valuations, the impact of regulatory approval extends far beyond price. Ethereum provides an alternative framework for digital commerce based on a decentralized network. While traditional online experiences are quite good, public blockchains may offer many more possibilities, including near-instant cross-border payments, true digital ownership, and interoperable applications. While other smart contract platforms offer this useful functionality, the Ethereum ecosystem has the most users, the most decentralized applications, and the deepest pool of funds. Grayscale Research expects that the new spot ETF can bring this transformative technology to a wider range of investors and other observers and help accelerate the adoption of public blockchains.

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