What is the "in-kind" vs "cash-create" model for ETH ETFs?

Understanding the ETH ETF Structure

Exchange-traded funds (ETFs) for Ethereum (ETH) are structured to provide investors with exposure to ETH price movements without directly owning the cryptocurrency. Two primary models dominate the design of these ETFs: in-kind and cash-create. Each approach has distinct operational mechanisms, regulatory implications, and investor impacts.

In-kind creation and redemption involves authorized participants (APs) exchanging actual ETH for ETF shares. This method ensures that the fund's holdings mirror the underlying asset supply and demand dynamics.

Cash-create, on the other hand, allows APs to use fiat currency or other financial instruments to create or redeem ETF shares. The fund manager then uses this cash to purchase ETH or synthetic equivalents like futures contracts or swaps.

How In-Kind Creation Works for ETH ETFs

The in-kind model relies on a direct exchange between the AP and the ETF issuer. Here’s how it typically unfolds:

• The AP deposits a specific amount of ETH into the ETF in exchange for a basket of ETF shares.
• This basket is usually large, often representing tens of thousands of ETH, depending on the fund's requirements.
• When redeeming, the AP returns ETF shares and receives an equivalent value in ETH.
• The process is facilitated by custodians who securely store the ETH and ensure its accurate accounting.

This mechanism helps maintain the ETF’s net asset value (NAV) closely aligned with the spot price of ETH. It also reduces counterparty risk because the fund holds real ETH rather than derivatives.

Operational Details of Cash-Creation Models

The cash-create model is more flexible but introduces additional layers of complexity:

• Authorized participants deposit cash instead of ETH to generate new ETF shares.
• Fund managers use the cash to buy ETH on exchanges or enter into derivative contracts that replicate ETH exposure.
• Derivatives such as futures, options, or swap agreements can be used to track ETH prices without holding the physical asset.
• Redemption works similarly—APs return ETF shares and receive cash proportional to the fund’s holdings.

This model may appeal to traditional financial institutions already familiar with cash-based transactions and derivative instruments. However, it increases tracking error and exposes investors to potential credit risks from counterparties.

Regulatory Implications of Both Models

Regulators scrutinize both structures differently due to their inherent risks and transparency levels.

For the in-kind model:

• It aligns well with traditional commodity ETF structures, which are widely accepted by regulators like the U.S. Securities and Exchange Commission (SEC).
• Direct ownership of ETH provides greater transparency, making it easier for auditors and compliance teams to verify holdings.
• However, custody solutions must meet stringent security standards to prevent theft or mismanagement.

For the cash-create model:

• It often involves synthetic exposure through derivatives, which may raise concerns about speculative behavior and market manipulation.
• Regulators may require additional disclosures regarding counterparty risk, liquidity, and the fund’s hedging strategies.
• In some jurisdictions, this model might face higher barriers to approval due to the lack of direct asset backing.

Liquidity and Market Efficiency Considerations

Both models impact the liquidity and efficiency of ETH ETF trading in different ways.

With the in-kind model:

• Liquidity is maintained through the continuous creation and redemption of ETF shares based on ETH inflows and outflows.
• Since the fund holds actual ETH, arbitrage opportunities are minimized, helping keep the ETF price close to the spot ETH value.
• However, during periods of high volatility or low ETH availability, APs might hesitate to engage in creation/redemption activities, potentially affecting liquidity.

With the cash-create model:

• Market makers can more easily adjust positions using cash flows, which can enhance short-term liquidity.
• However, reliance on derivatives may introduce timing lags and basis risk, especially when futures contracts expire or swap rates fluctuate.
• If the fund lacks sufficient cash reserves or fails to roll over derivatives effectively, it may underperform the actual ETH price movement.

Investor Experience and Risk Profiles

From an investor standpoint, understanding the differences in risk and performance is crucial.

In the in-kind model:

• Investors benefit from a transparent structure where each ETF share corresponds to a known quantity of ETH.
• There’s minimal exposure to counterparty default since no third-party contracts are involved.
• Tracking errors are generally lower, offering more predictable returns relative to ETH price changes.

In the cash-create model:

• Investors gain access to ETH exposure even if they cannot transact directly on crypto exchanges.
• However, they face indirect risks from the fund’s derivative positions and potential slippage in replication accuracy.
• Management fees may also be higher due to the complexity of maintaining synthetic exposure.

Frequently Asked Questions

Q: Can retail investors participate in the creation or redemption process of ETH ETFs?A: No, only authorized participants—typically large institutional entities—are allowed to create or redeem ETF shares directly with the fund provider.

Q: How do I know whether an ETH ETF uses an in-kind or cash-create model?A: This information is disclosed in the fund’s prospectus and related regulatory filings. Investors should review these documents before purchasing shares.

Q: Which model is better for tax efficiency?A: The in-kind model may offer better tax advantages in certain jurisdictions, as it avoids triggering taxable events during the creation/redemption process.

Q: Are there any hybrid ETH ETF structures combining both models?A: Some funds explore hybrid approaches, though most opt for one primary model to simplify operations and regulatory compliance.