ETHE: May Still Be Interesting, Even If Near Term ETF Approval Prospects Are Low (Rating Upgrade)

Summary Grayscale Ethereum Trust currently trades at a 25% discount to NAV, indicating a potential buying opportunity. The SEC's limited interest in engaging on Ethereum ETF products suggests low near-term approval odds, but a legal challenge could still lead to approval on a multi-year view. Lack of ETF approval in May would likely have a negative impact on the Grayscale Ethereum Fund, but there is potential for upside if an ETF is ultimately approved. For much of 2023 into 2024 there was an interesting opportunity to purchase the Grayscale Bitcoin Trust ( GBTC ) which traded at a discount to its asset value because it ultimately was approved by the SEC to convert into an Exchange Traded Fund. That conversion caused that NAV valuation gap to effectively close. I wrote about that process here after a favorable legal decision in August 2023, effectively paved with way to ETF conversion. Some risk remained (such as the SEC disputing the legal verdict, or delaying Bitcoin ETF approval further, or finding another route to block Bitcoin ETFs), but the SEC did ultimately follow the court's ruling and approved a range of Bitcoin ETF products. Data by YCharts Please note that looking at NAV discounts alone is only part of the story because the price of crypto assets has been extremely volatile. Nonetheless, it is argued that the ETF conversion also helped broaden mainstream adoption of Bitcoin and helped support demand, too. Furthermore, the recent Bitcoin 'halving' (where supply is reduced every 4 years according to Bitcoin protocols) may have played into price trends too. I'm not going to explore those important topics in any detail here, but rather remain focused on the NAV discount and ETF approval prospects, which is itself quite a complex topic. A Similar Story For An Ethereum ETF? There is a similar narrative for the Grayscale Ethereum Trust ( OTCQX:ETHE ) to the Bitcoin ETF approval process. Today, ETHE trades at approximately a 25% discount to NAV. That's down substantially from earlier in 2024, when there was greater confidence ETF conversion would be approved by the SEC in a similar vein to Bitcoin ETF approval. I wrote here and here that the logic of the Bitcoin legal ruling likely had a positive read-across for Ethereum ETF chances. However, on January 12 of this year, I argued that the NAV discount for ETHE had become a bit too narrow compared to the risks and potential delays inherent in Ethereum ETF approval. I now think we're getting back to a point where the risk/reward is looking more favorable for investors. Data by YCharts Rumors Of Low Approval Odds A decision on Ethereum ETFs is expected to come from the SEC in late May, and so far, the SEC has apparently had limited interest in engaging on the specifics of the ETF products. That implies approval is not coming, according to Reuters . This does make sense, ahead of Bitcoin ETF approval these same media outlets were reporting constructive engagement with the SEC, this time for ETHE it apparently feels different. In this sense, you can argue that the recent widening of the discount to NAV for the Grayscale Ethereum Trust is rational, without approval there's no mechanism for the discount to close, and you're stuck paying a 2.5% management fee while you wait . But Legal Precedent Could Ultimately Lead To Approval However, even if the SEC decides not to approve the Ethereum ETFs, they may face a legal challenge along similar lines to the Bitcoin ETF case. The ruling in the Bitcoin ETF case is here , I'm not a lawyer, but essentially the court found that the SEC could not block a spot Bitcoin ETF and approve a Bitcoin futures ETF. That's because spot and futures markets for the same underlying instrument are strongly correlated and hence to block one and approve the other is evidence of "arbitrariness and caprice," which is something regulators should not do, according to the law. Now, the read-across for Ethereum is quite powerful. Once again, the SEC has approved Ethereum futures ETFs. For example, there is the ProShares Ether Strategy ETF, which holds CME Ether Futures contracts. Hence, unless the SEC is able to find a different way to block an Ethereum spot ETF, there is some chance that a legal ruling once again finds that the SEC cannot approve a futures ETF for a financial product but block a spot version of the same product. The Details Now let's get into the details. First off, there is still some chance the SEC approves spot Ethereum ETFs in May, perhaps 20% or so. I believe market rumors that this is on course not to occur, but there's always a chance things change. Here my view is probably around consensus. But then I think there is quite a good chance of a legal challenge that does enable an Ethereum ETF. However, like all legal processes, if it happens it will take time. The SEC rejected Grayscales spot Bitcoin ETF application in June 2022 . Bitcoin ETFs then first started trading in January 2024 . That's a lag of 19 months. Hence, if the same were to occur again, then we'd be looking at spot Ethereum ETFs starting to trade around December 2025. We should also consider the maximum discount for the Grayscale Ethereum Trust. In recent history, that's about 60%, though at that point a path to ETF conversion based on Grayscale Bitcoin Trust's legal challenge was not evident, and we were in something of a 'crypto winter' with depressed pricing. Data by YCharts The Model Here's how I think about the value of the Grayscale Ethereum Trust today. Scenario Probability Logic Discounted return based on NAV (current discount 24%) May surprise approval 20% Unlikely based on market chatter, but not impossible +31% No legal challenge 10% Discount would widen to perhaps 50% with no prospect of closure -34% Failed legal challenge 10% Discount would widen to perhaps 50% with no prospect of closure -34% Successful legal challenge 60% Seems likely based on GBTC precedent, but discounted for 19 months +20% Expected value (probabilities x returns) +11.4% In summary, there's about an 11% expected return if you believe the values above. A Potential Kicker From Approval One thing that we saw from Bitcoin ETF approval, was that ETF approval may have supported the value of the cryptocurrency itself, as ease of access through the ETF structure improved for many retail and institutional investors. A similar process could play out if an Ethereum ETF were approved, that could improve the upside scenario. For example, an investment manager holding a small Bitcoin ETF allocation for their clients, might theoretically add in some Ethereum exposure to diversify, hence bidding up the Ethereum price. That may suggest that upsides based on NAV discounts are understated in the upside scenarios. Risks Regardless of what happens subsequently, lack of Ethereum ETF approval in May (should that occur) will likely be a negative for the Grayscale Ethereum Fund. My main concern is that no legal challenge is mounted. That's in part because Grayscale would be who you would expect to take the SEC to court based on previous experience, but I'm not sure that converting Bitcoin to an ETF was net profitable for them. That's because even though the Bitcoin ETF AuM has grown, they have lost significant market share and pricing power from the ETF conversion process and now have to compete more directly with the likes of BlackRock and Fidelity. Grayscale are perhaps something of a maverick firm and are hence 'happy' to take on the SEC. Would a company like BlackRock or Fidelity want to risk its relationship with the SEC by taking them on in court? I'm not sure. Clearly, if ETF conversion happens, Grayscale will want to participate in a "prisoners' dilemma" sense, but I'm not convinced they'll want to drive the process once again. The price of Ether is very volatile. There's some risk that attempting to 'arbitrage' NAV discounts on crypto instruments is like picking up nickels in front of a steamroller. It's possible the value of Ether could fall to zero at any point if the technology were found to be flawed or for some other reason. Many smart people believe crypto is fundamentally worthless, and even if it's not, historic crypto drawdowns have been extreme. Grayscale Ethereum Fund is a relatively high-cost fund given its 2.5% fee that creates material costs for investors in the product and creates a cost in addition to the time value of money waiting for any conversion. Even if conversion does ultimately occur, with an estimated 19-month window to conversion (should that forecast hold) even if everything plays out relatively well and positively there will almost certainly be better entry points along the way for Grayscale Ethereum Fund investors to achieve greater upside.