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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM
10-K
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☒
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
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For the fiscal year ended
December 31,
2021
or
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☐
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
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For the transition period from _____ to ______
Commission File Number
000-56193
Grayscale®
Ethereum Trust (ETH)
SPONSORED BY GRAYSCALE INVESTMENTS, LLC
(Exact Name of Registrant as Specified in Its Charter)
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Delaware
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82-6677805
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(State or Other Jurisdiction of
Incorporation or Organization)
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(I.R.S. Employer
Identification No.)
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290 Harbor Drive, 4th
Floor
Stamford,
Connecticut
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06902
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(Address of Principal Executive Offices)
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(Zip Code)
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(212)
668-1427
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
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Title of each class
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Trading Symbol(s)
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Name of each exchange on which registered
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N/A
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N/A
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N/A
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Securities registered pursuant to Section 12(g) of the Act:
Grayscale Ethereum Trust (ETH) Shares
Indicate by check mark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act.
Yes
☒ No ☐
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the Act.
Yes
☐
No
☒
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements
for the past 90 days.
Yes
☒ No ☐
Indicate by check mark whether the registrant has submitted
electronically every Interactive Data File required to be submitted
and posted pursuant to Rule 405 of Regulation S-T during the
preceding 12 months (or for such shorter period that the registrant
was required to submit such files).
Yes
☒ No ☐
Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, a non-accelerated filer, a
smaller reporting company, or an emerging growth company. See the
definitions of “large accelerated filer,” “accelerated filer,”
“smaller reporting company,” and “emerging growth company” in Rule
12b-2 of the Exchange Act. (Check one):
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Large accelerated filer
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☒
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Accelerated filer
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☐
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Non-accelerated filer
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☐
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Smaller reporting company
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☐
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Emerging growth company
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☐
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If an emerging growth company, indicate by check mark if the
registrant has elected not to use the extended transition period
for complying with any new or revised financial accounting
standards provided pursuant to Section 13(a) of the Exchange Act.
☐
Indicate by check mark whether the registrant has filed a report on
and attestation to its management’s assessment of the effectiveness
of its internal control over financial reporting under Section
404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the
registered public accounting firm that prepared or issued its audit
report.
☒
Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No
☒
Aggregate market value of registrant’s Shares held by
non-affiliates of the registrant, based upon the closing price of a
Share on June 30, 2021 as reported by the OTC Markets, Inc. on that
date:
$6,759,448,230.
Number of Shares of the registrant outstanding as of February 22,
2022:
310,158,500.
DOCUMENTS INCORPORATED BY REFERENCE: None
i
Industry and Market Data
Although we are responsible for all disclosure contained in this
Annual Report on Form 10-K, in some cases we have relied on certain
market and industry data obtained from third-party sources that we
believe to be reliable. Market estimates are calculated by using
independent industry publications in conjunction with our
assumptions regarding the Ethereum industry and market. While we
are not aware of any misstatements regarding any market, industry
or similar data presented herein, such data involves risks and
uncertainties and is subject to change based on various factors,
including those discussed under the headings “Forward-Looking
Statements” and “Item 1A. Risk Factors” in this Annual
Report.
Forward-Looking Statements
This Annual Report on Form 10-K contains “forward-looking
statements” with respect to the financial conditions, results of
operations, plans, objectives, future performance and business of
Grayscale Ethereum Trust (ETH) (the “Trust”). Statements preceded
by, followed by or that include words such as “may,” “might,”
“will,” “should,” “expect,” “plan,” “anticipate,” “believe,”
“estimate,” “predict,” “potential” or “continue,” the negative of
these terms and other similar expressions are intended to identify
some of the forward-looking statements. All statements (other than
statements of historical fact) included in this Annual Report that
address activities, events or developments that will or may occur
in the future, including such matters as changes in market prices
and conditions, the Trust’s operations, the plans of Grayscale
Investments, LLC (the “Sponsor”) and references to the Trust’s
future success and other similar matters are forward-looking
statements. These statements are only predictions. Actual events or
results may differ materially from such statements. These
statements are based upon certain assumptions and analyses the
Sponsor made based on its perception of historical trends, current
conditions and expected future developments, as well as other
factors appropriate in the circumstances. Whether or not actual
results and developments will conform to the Sponsor’s expectations
and predictions, however, is subject to a number of risks and
uncertainties, including, but not limited to, those described in
“Item 1A. Risk Factors.” Forward-looking statements are made based
on the Sponsor’s beliefs, estimates and opinions on the date the
statements are made and neither the Trust nor the Sponsor is under
a duty or undertakes an obligation to update forward-looking
statements if these beliefs, estimates and opinions or other
circumstances should change, other than as required by applicable
laws. Investors are therefore cautioned against relying on
forward-looking statements.
Factors which could have a material adverse effect on the Trust’s
business, financial condition or results of operations and future
prospects or which could cause actual results to differ materially
from the Trust’s expectations include, but are not limited
to:
•
the extreme volatility of trading prices that many digital assets,
including Ethereum, have experienced in recent periods and may
continue to experience, which could have a material adverse effect
on the value of the Shares;
•
the recentness of the development of digital assets and the
uncertain medium-to-long term value of the Shares due to a number
of factors relating to the capabilities and development of
blockchain technologies and to the fundamental investment
characteristics of digital assets;
•
the value of the Shares depending on the acceptance of Digital
Assets, such as Ethereum, which represent a new and rapidly
evolving industry;
•
the value of the Shares relating directly to the value of Ethereum
then held by the Trust, the value of which may be highly volatile
and subject to fluctuations due to a number of
factors;
•
the unregulated nature and lack of transparency surrounding the
operations of Digital Asset Exchanges, which may adversely affect
the value of digital assets and, consequently, the value of the
Shares;
•
the limited history of the Index;
•
risks related to the COVID-19 outbreak, which could negatively
impact the value of the Trust’s holdings and significantly disrupt
its operations;
•
the lack of an ongoing redemption program due to the holding period
under Rule 144, and the Trust’s ability to halt creations from time
to time, resulting in the lack of an arbitrage mechanism to keep
the value of the Shares closely linked to the Index
Price;
•
the possibility that the Shares may trade at a price that is at,
above or below the Trust’s Digital Asset Holdings per Share as a
result of the non-current trading hours between OTCQX and the
Digital Asset Exchange Market;
•
regulatory changes or actions by the U.S. Congress or any U.S.
federal or state agencies that may affect the value of the Shares
or restrict the use of one or more digital assets, mining activity
or the operation of their networks or the Digital Asset Exchange
Market in a manner that adversely affects the value of the
Shares;
ii
•
changes in the policies of the U.S. Securities and Exchange
Commission (the “SEC”) that could adversely impact the value of the
Shares;
•
regulatory changes or actions in foreign jurisdictions that may
affect the value of the Shares or restrict the use of one or more
digital assets, mining activity or the operation of their networks
or the Digital Asset Exchange Market in a manner that adversely
affects the value of the Shares;
•
the possibility that an Authorized Participant, the Trust or the
Sponsor could be subject to regulation as a money service business
or money transmitter, which could result in extraordinary expenses
to the Authorized Participant, the Trust or the Sponsor and also
result in decreased liquidity for the Shares;
•
regulatory changes or interpretations that could obligate the Trust
or the Sponsor to register and comply with new regulations,
resulting in potentially extraordinary, nonrecurring expenses to
the Trust;
•
potential delays in mail reaching the Sponsor when sent to the
Trust at its registered office;
•
possible requirements for the Trust to disclose information,
including information relating to investors, to
regulators;
•
potential conflicts of interest that may arise among the Sponsor or
its affiliates and the Trust;
•
the potential discontinuance of the Sponsor’s continued services,
which could be detrimental to the Trust;
•
the Custodian’s possible resignation or removal by the Sponsor,
which would trigger early termination of the Trust;
and;
•
additional risk factors discussed in Part I, Item 1A “Risk Factors”
and Part II, Item 7 “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” of this Annual
Report on Form 10-K, as well as those described from time to time
in our future reports filed with the SEC.
Unless otherwise stated or the context otherwise requires, the
terms “we,” “our” and “us” in this Annual Report refer to the
Sponsor acting on behalf of the Trust.
A glossary of industry and other defined terms is included in this
Annual Report, beginning on page
89.
This Annual Report supplements and where applicable amends the
Memorandum, as defined in the Trust’s Amended and Restated
Declaration of Trust and Trust Agreement, for general
purposes.
iii
Table of Contents
iv
PART
I
Item 1.
Business
Overview of the Trust and the Shares
Grayscale Ethereum Trust (ETH) (formerly known as Ethereum
Investment Trust) (the “Trust”) is a Delaware Statutory Trust that
was formed on December 13, 2017 by the filing of the Certificate of
Trust with the Delaware Secretary of State in accordance with the
provisions of the Delaware Statutory Trust Act.
The Trust’s purpose is to hold Ethereum (“ETH”), which are digital
assets that are created and transmitted through the operations of
the peer-to-peer Ethereum Network, a decentralized network of
computers that operates on cryptographic protocols.
There are several key features of the Ethereum Network.
ETH has an unlimited supply and a circulating supply of 119 million
coins as of December 31, 2021. As of December 31, 2021, the 24-hour
trading volume of ETH was approximately
3.5
billion. As of December 31, 2021, the aggregate market value of ETH
was $438 billion.
On January 11, 2019, the Trust changed its name from Ethereum
Investment Trust to Grayscale Ethereum Trust (ETH) by filing a
Certificate of Amendment to the Certificate of Trust with the
Delaware Secretary of State. The Trust issues common units of
fractional undivided beneficial interest (“Shares”), which
represent ownership in the Trust, on a periodic basis to certain
“accredited investors” within the meaning of Rule 501(a) of
Regulation D under the Securities Act of 1933, as amended (the
“Securities Act”) in exchange for deposits of ETH. The Shares are
quoted on OTC Markets Group Inc.’s OTCQX® Best Marketplace
(“OTCQX”) under the ticker symbol “ETHE.”
Grayscale Investments, LLC is the sponsor and administrator of the
Trust (the “Sponsor”), Delaware Trust Company is the trustee of the
Trust (the “Trustee”), Continental Stock Transfer & Trust
Company is the transfer agent of the Trust (in such capacity, the
“Transfer Agent”) and Coinbase Custody Trust Company, LLC is the
custodian of the Trust (the “Custodian”).
The Trust issues Shares only in one or more blocks of 100 Shares (a
block of 100 Shares is called a “Basket”) to certain authorized
participants (“Authorized Participants”) from time to time. Baskets
are offered in exchange for ETH. At this time, the Sponsor is not
operating a redemption program for the Shares and therefore Shares
are not redeemable by the Trust. Due to the lack of an ongoing
redemption program as well as price volatility, trading volume and
closings of Digital Asset Exchanges due to fraud, failure, security
breaches or otherwise, there can be no assurance that the value of
the Shares will reflect the value of the Trust’s ETH, less the
Trust’s expenses and other liabilities, and the Shares may trade at
a substantial premium over, or a substantial discount to, the value
of the Trust’s ETH, less the Trust’s expenses and other
liabilities.
The U.S. dollar value of a Basket of Shares at 4:00 p.m., New York
time, on the trade date of a creation order is equal to the Basket
Amount, which is the number of ETH required to create a Basket of
Shares, multiplied by the “Index Price,” which is the price of an
ETH calculated by applying a weighting algorithm to the price and
trading volume data for the immediately preceding 24-hour period as
of 4:00 p.m., New York time, derived from the selected Digital
Asset Exchanges that are reflected in the CoinDesk Ether Price
Index (ETX) (the “Index”), on each business day. Prior to February
1, 2022, the Trust valued its ETH for operational purposes by
reference to a volume-weighted average index price (the "Old Index
Price") of an ETH in U.S. dollars calculated by applying a
weighting algorithm to the price and trading volume data for the
immediately preceding 24-hour period as of 4:00 p.m., New York
time, derived from the selected Digital Asset Exchanges reflected
in the Index on such trade date. The Old Index Price was calculated
using the same methodology as the Index Price with an additional
averaging mechanism overlaid to the price produced resulting in the
Old Index Price reflecting an average price for the 24-hour period.
The Index Price is calculated using non-GAAP methodology and is not
used in the Trust’s financial statements. In other words, the Index
Price is the price of an ETH at 4:00 p.m., New York time,
calculated based on the price and trading volume data of the
Digital Asset Exchanges included in the Index over the preceding
24-hour period whereas the Old Index Price was the price of an ETH
at 4:00 p.m., New York time, calculated by taking the average of
each price of an ETH produced by the Index over the preceding
24-hour period. See “—Overview
of the ETH Industry and Market—ETH Value—The Index and the Index
Price.”
The Basket Amount is determined by dividing (x) the number of ETH
owned by the Trust at 4:00 p.m., New York time, on such trade date,
after deducting the number of ETH representing the U.S. dollar
value of accrued but unpaid fees and expenses of the Trust
(converted using the Index Price at such time, and carried to the
eighth decimal place), by (y) the number of Shares outstanding at
such time (with the quotient so obtained calculated to one
one-hundred-millionth of one ETH (i.e., carried to the eighth
decimal place)), and multiplying such quotient by 100.
The Shares are neither interests in nor obligations of the Sponsor
or the Trustee.
The Sponsor maintains an Internet website at
www.grayscale.com/products/grayscale-ethereum-trust/, through which
the registrant’s annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, and amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of
the Securities Exchange Act of 1934, as amended (the “Exchange
Act”), are made available free of charge after they have been filed
or furnished to the SEC. Additional information regarding the Trust
may also be found on the SEC’s EDGAR database at
www.sec.gov.
1
Investment Objective
The Trust’s investment objective is for the value of the Shares
(based on ETH per Share) to reflect the value of ETH held by the
Trust, determined by reference to the Index Price, less the Trust’s
expenses and other liabilities. To date, the Trust has not met its
investment objective and the Shares quoted on OTCQX have not
reflected the value of ETH held by the Trust, less the Trust’s
expenses and other liabilities, but instead have traded at both
premiums and discounts to such value, which at times have been
substantial.
In the event the Shares trade at a substantial premium, investors
who purchase Shares on OTCQX will pay substantially more for their
Shares than investors who purchase Shares in the private placement.
The value of the Shares may not reflect the value of the Trust’s
ETH, less the Trust’s expenses and other liabilities, for a variety
of reasons, including the holding period under Rule 144 for Shares
purchased in the private placement, the lack of an ongoing
redemption program, any halting of creations by the Trust, ETH
price volatility, trading volumes on, or closures of, exchanges
where digital assets trade due to fraud, failure, security breaches
or otherwise, and the non-current trading hours between OTCQX and
the global exchange market for trading ETH. As a result, the Shares
may continue to trade at a substantial premium over, or a
substantial discount to, the value of the Trust’s ETH, less the
Trust’s expenses and other liabilities, and the Trust may be unable
to meet its investment objective for the foreseeable
future.
For example, from June 20, 2019 to December 31, 2021, the maximum
premium of the closing price of the Shares quoted on OTCQX over the
value of the Trust’s Digital Asset Holdings per Share was 956%
(949% based on Old Index Price) and the average premium was 191%
(187% based on Old Index Price), and the maximum discount of the
closing price of the Shares quoted on OTCQX below the value of the
Trust's Digital Asset Holdings per share was 16% (15% based on Old
Index Price) and the average discount was 6% (6% based on Old Index
Price). As of December 31, 2021, the Trust’s Shares were quoted on
OTCQX at a discount of 12% (14% based on Old Index Price) to the
Trust’s Digital Asset Holdings per Share. See “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations—Secondary Market Trading.”
While an investment in the Shares is not a direct investment in
ETH, the Shares are designed to provide investors with a
cost-effective and convenient way to gain investment exposure to
ETH. A substantial direct investment in ETH may require expensive
and sometimes complicated arrangements in connection with the
acquisition, security and safekeeping of the ETH and may involve
the payment of substantial fees to acquire such ETH from
third-party facilitators through cash payments of U.S. dollars.
Because the value of the Shares is correlated with the value of the
ETH held by the Trust, it is important to understand the investment
attributes of, and the market for, ETH.
Shares purchased in the private placement are restricted securities
that may not be resold except in transactions exempt from
registration under the Securities Act and state securities laws and
any such transaction must be approved in advance by the Sponsor. In
determining whether to grant approval, the Sponsor will
specifically look at whether the conditions of Rule 144 under the
Securities Act, including the requisite holding period thereunder,
and any other applicable laws have been met. Any attempt to sell
the Shares without the approval of the Sponsor in its sole
discretion will be void ab initio. See “—Description of the
Shares—Transfer Restrictions” for more information.
Pursuant to Rule 144, the minimum holding period for Shares
purchased in the private placement is six months.
The Trust’s ETH are carried, for financial statement purposes, at
fair value, as required by the U.S. generally accepted accounting
principles (“GAAP”). The Trust determines the fair value of ETH
based on the price provided by the Digital Asset Market that the
Trust considers its principal market as of 4:00 p.m., New York
time, on the valuation date. The net asset value of the Trust
determined on a GAAP basis is referred to in this Annual Report as
“NAV.” See “Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations—Critical Accounting
Policies and Estimates—Principal Market and Fair Value
Determination” for more information on the Trust’s principal market
selection.
As of February 1, 2022, the Trust uses the Index Price to calculate
its “Digital Asset Holdings,” which is the aggregate value,
expressed in U.S. dollars, of the Trust’s assets (other than U.S.
dollars, other fiat currency, Incidental Rights or IR Virtual
Currency), less the U.S. dollar value of the Trust’s expenses and
other liabilities calculated in the manner set forth under
“—Valuation of ETH and Determination of the Trust’s Digital Asset
Holdings.” “Digital Asset Holdings per Share” is calculated by
dividing Digital Asset Holdings by the number of Shares currently
outstanding. Digital Asset Holdings and Digital Asset Holdings per
Share are not measures calculated in accordance with GAAP. Digital
Asset Holdings is not intended to be a substitute for the Trust’s
NAV calculated in accordance with GAAP, and Digital Asset Holdings
per Share is not intended to be a substitute for the Trust’s NAV
per Share calculated in accordance with GAAP.
Prior to February 1, 2022, the Trust calculated its Digital Asset
Holdings and Digital Asset Holdings per Share by reference to the
Old Index Price. All references to the Digital Asset Holdings and
Digital Asset Holdings per Share of the Trust in this report have
been calculated using the Index Price unless otherwise
indicated.
At this time, the Trust is not operating a redemption program for
Shares and therefore Shares are not redeemable by the Trust. In
addition, the Trust may halt creations for extended periods of time
for a variety of
reasons, including in connection with forks, airdrops and other
similar occurrences.
As a result Authorized Participants are not able to take advantage
of arbitrage opportunities
2
created when the market value of the Shares deviates from the value
of the Trust’s Digital Asset Holdings per Share, which may cause
the Shares to trade at a substantial premium over, or a substantial
discount to, the value of the Trust’s Digital Asset Holdings per
Share.
Subject to receipt of regulatory approval from the SEC and approval
by the Sponsor in its sole discretion, the Trust may in the future
operate a redemption program. Because the Trust does not believe
that the SEC would, at this time, entertain an application for the
waiver of rules needed in order to operate an ongoing redemption
program, the Trust currently has no intention of seeking regulatory
approval from the SEC to operate an ongoing redemption program.
Even if such relief is sought in the future, no assurance can be
given as to the timing of such relief or that such relief will be
granted. If such relief is granted and the Sponsor approves a
redemption program, the Shares will be redeemable in accordance
with the provisions of the Trust Agreement and the relevant
Participant Agreement. Although the Sponsor cannot predict with
certainty what effect, if any, the operation of a redemption
program would have on the trading price of the Shares, a redemption
program would allow Authorized Participants to take advantage of
arbitrage opportunities created when the market value of the Shares
deviates from the value of the Trust’s ETH, less the Trust’s
expenses and other liabilities, which may have the effect of
reducing any premium at which the Shares trade on OTCQX over such
value or cause the Shares to trade at a discount to such value from
time to time.
For a discussion of risks relating to the deviation in the trading
price of the Shares from the Digital Asset Holdings per Share, see
“Item 1A. Risk Factors—Risk Factors Related to the Trust and the
Shares—Because of the holding period under Rule 144 and the lack of
an ongoing redemption program and the Trust’s ability to halt
creations from time to time, there is no arbitrage mechanism to
keep the value of the Shares closely linked to the Index Price and
the Shares have historically traded at a substantial premium over,
or a substantial discount to, the Digital Asset Holdings per
Share,” “Item 1A. Risk Factors—Risk Factors Related to the Trust
and the Shares—The Shares may trade at a price that is at, above or
below the Trust’s Digital Asset Holdings per Share as a result of
the non-current trading hours between OTCQX and the Digital Asset
Exchange Market,” “Item 1A. Risk Factors—Risk Factors Related to
the Trust and the Shares—Shareholders who purchase Shares on OTCQX
that are trading at a substantial premium over the Digital Asset
Holdings per Share may suffer a loss on their investment if such
premium decreases” and “Item 1A. Risk Factors—Risk Factors Related
to the Trust and the Shares—The restrictions on transfer and
redemption may result in losses on the value of the
Shares”.
Characteristics of the Shares
The Shares are intended to offer investors an opportunity to
participate in Digital Asset Markets through an investment in
securities. As of
December 31, 2021, each Share represented approximately 0.0100
ETH.
The logistics of accepting, transferring and safekeeping of ETH are
dealt with by the Sponsor and Custodian, and the related expenses
are built into the value of the Shares. Therefore, shareholders do
not have additional tasks or costs over and above those generally
associated with investing in any other privately placed
security.
The Shares have certain other key characteristics, including the
following:
•
Easily Accessible and Relatively Cost Efficient.
Investors in the Shares can also directly access the Digital Asset
Markets. The Sponsor believes that investors will be able to more
effectively implement strategic and tactical asset allocation
strategies that use ETH by using the Shares instead of directly
purchasing and holding ETH, and for many investors, transaction
costs related to the Shares will be lower than those associated
with the direct purchase, storage and safekeeping of
ETH.
•
Market-Traded and Transparent.
The Shares are quoted on OTCQX. Shareholders that purchased Shares
directly from the Trust and have held them for the requisite
holding period under Rule 144 may sell their Shares on OTCQX upon
receiving approval from the Sponsor. Investors may also choose to
purchase Shares on OTCQX. Shares purchased on OTCQX are not
restricted. The Sponsor believes the quotation of the Shares on
OTCQX provides investors with an efficient means to implement
various investment strategies. The Trust will not hold or employ
any derivative securities. Furthermore, the value of the Trust’s
assets will be reported each day on
www.grayscale.com/products/grayscale-ethereum-trust/.
•
Minimal Credit Risk.
The Shares represent an interest in actual ETH owned by the Trust.
The Trust’s ETH are not subject to borrowing arrangements with
third parties or to counterparty or credit risks. This contrasts
with the other financial products such as CoinShares
exchange-traded notes, TeraExchange swaps and futures traded on the
Chicago Mercantile Exchange (“CME”) and the Intercontinental
Exchange (“ICE”) through which investors gain exposure to digital
assets through the use of derivatives that are subject to
counterparty and credit risks.
•
Safekeeping System.
The Custodian has been appointed to control and secure the ETH for
the Trust using offline storage, or “cold storage”, mechanisms to
secure the Trust’s private key “shards”. The hardware, software,
administration and continued technological development that are
used by the Custodian may not be available or cost-effective for
many investors.
3
The Trust differentiates itself from competing digital asset
financial vehicles, to the extent that such digital asset financial
vehicles may develop, in the following ways:
•
Custodian.
The Custodian that holds the private key shards associated with the
Trust’s ETH is Coinbase Custody Trust Company, LLC. Other digital
asset financial vehicles that use cold storage may not use a
custodian to hold their private keys.
•
Cold Storage of Private Keys.
The private key shards associated with the Trust’s ETH are kept in
cold storage, which means that the Trust’s ETH are disconnected
and/or deleted entirely from the internet. See “—Custody
of the Trust’s ETH” for more information relating to the storage
and retrieval of the Trust’s private keys to and from cold storage.
Other digital asset financial vehicles may not utilize cold storage
or may utilize less effective cold storage-related hardware and
security protocols.
•
Location of Private Vaults.
Private key shards associated with the Trust’s ETH are distributed
geographically by the Custodian in secure vaults around the world,
including in the United States. The locations of the secure vaults
may change regularly and are kept confidential by the Custodian for
security purposes.
•
Enhanced Security.
Transfers from the Trust’s Digital Asset Account require certain
security procedures, including but not limited to, multiple
encrypted private key shards, usernames, passwords and 2-step
verification. Multiple private key shards held by the Custodian
must be combined to reconstitute the private key to sign any
transaction in order to transfer the Trust’s ETH. Private key
shards are distributed geographically in secure vaults around the
world, including in the United States. As a result, if any one
secure vault is ever compromised, this event will have no impact on
the ability of the Trust to access its assets, other than a
possible delay in operations, while one or more of the other secure
vaults is used instead. These security procedures are intended to
remove single points of failure in the protection of the Trust’s
ETH.
•
Custodian Audits.
The Custodian has agreed to allow the Trust and the Sponsor to take
any necessary steps to verify that satisfactory internal control
system and procedures are in place, and to visit and inspect the
systems on which the Custodian’s coins are held.
•
Directly Held ETH.
The Trust directly owns actual ETH held through the Custodian. The
direct ownership of ETH is not subject to counterparty or credit
risks. This may differ from other digital asset financial vehicles
that provide ETH exposure through other means, such as the use of
financial or derivative instruments.
•
Sponsor’s Fee.
The Sponsor’s Fee is a competitive factor that may influence the
value of the Shares.
Activities of the Trust
The activities of the Trust are limited to (i) issuing Baskets in
exchange for ETH transferred to the Trust as consideration in
connection with the creations, (ii) transferring or selling ETH,
Incidental Rights and IR Virtual Currency as necessary to cover the
Sponsor’s Fee and/or any Additional Trust Expenses, (iii)
transferring ETH in exchange for Baskets surrendered for redemption
(subject to obtaining regulatory approval from the SEC and approval
from the Sponsor), (iv) causing the Sponsor to sell ETH, Incidental
Rights and IR Virtual Currency on the termination of the Trust, (v)
making distributions of Incidental Rights and/or IR Virtual
Currency or cash from the sale thereof and (vi) engaging in all
administrative and security procedures necessary to accomplish such
activities in accordance with the provisions of the Trust
Agreement, the Custodian Agreement, the Index License Agreement and
the Participant Agreements.
In addition, the Trust may engage in any lawful activity necessary
or desirable in order to facilitate shareholders’ access to
Incidental Rights or IR Virtual Currency, provided that such
activities do not conflict with the terms of the Trust Agreement.
The Trust will not be actively managed. It will not engage in any
activities designed to obtain a profit from, or to ameliorate
losses caused by, changes in the market prices of ETH.
Incidental Rights and IR Virtual Currency
The Trust may from time to time come into possession of Incidental
Rights and/or IR Virtual Currency by virtue of its ownership of
ETH, generally through a fork in the Ethereum Blockchain, an
airdrop offered to holders of ETH or other similar event. Pursuant
to the terms of the Trust Agreement, the Trust may take any lawful
action necessary or desirable in connection with the Trust’s
ownership of Incidental Rights, including the acquisition of IR
Virtual Currency, unless such action would adversely affect the
status of the Trust as a grantor trust for U.S. federal income tax
purposes or otherwise be prohibited by the Trust Agreement. These
actions include (i) selling Incidental Rights and/or IR Virtual
Currency in the Digital Asset Market and distributing the cash
proceeds to shareholders, (ii) distributing Incidental Rights
and/or IR Virtual Currency in-kind to the shareholders or to an
agent acting on behalf of the shareholders for sale by such agent
if an in-kind distribution would otherwise be infeasible and (iii)
irrevocably abandoning Incidental Rights or IR Virtual Currency.
The Trust may also use Incidental Rights and/or IR Virtual Currency
to pay the Sponsor’s Fee and Additional Trust Expenses, if any, as
discussed below under
“—Expenses; Sales of ETH.”
However, the Trust does not expect to take any
Incidental
4
Rights or IR Virtual Currency it may hold into account for purposes
of determining the Trust’s Digital Asset Holdings, the Digital
Asset Holdings per Share, the NAV and the NAV per
Share.
With respect to any fork, airdrop or similar event, the Sponsor
may, in its discretion, decide to cause the Trust to distribute the
Incidental Rights or IR Virtual Currency in-kind to an agent of the
shareholders for resale by such agent, or to irrevocably abandon
the Incidental Rights or IR Virtual Currency. In the case of a
distribution in-kind to an agent acting on behalf of the
shareholders, the shareholders’ agent will attempt to sell the
Incidental Rights or IR Virtual Currency, and if the agent is able
to do so, will remit the cash proceeds to shareholders, net of
expenses and any applicable withholding taxes. There can be no
assurance as to the price or prices for any Incidental Rights or IR
Virtual Currency that the agent may realize, and the value of the
Incidental Rights or IR Virtual Currency may increase or decrease
after any sale by the agent. In the case of abandonment of
Incidental Rights or IR Virtual Currency, the Trust would not
receive any direct or indirect consideration for the Incidental
Rights or IR Virtual Currency and thus the value of the Shares will
not reflect the value of the Incidental Rights or IR Virtual
Currency.
On July 29, 2019, the Sponsor delivered to the Custodian a notice
(the “Pre-Creation Abandonment Notice”) stating that the Trust is
abandoning irrevocably for no direct or indirect consideration,
effective immediately prior to each time at which the Trust creates
Shares (any such time, a “Creation Time”), all Incidental Rights
and IR Virtual Currency to which it would otherwise be entitled as
of such time (any such abandonment, a “Pre-Creation Abandonment”);
provided that a Pre-Creation Abandonment will not apply to any
Incidental Rights and IR Virtual Currency if (i) the Trust has
taken, or is taking at such time, an Affirmative Action to acquire
or abandon such Incidental Rights and IR Virtual Currency at any
time prior to such Creation Time or (ii) such Incidental Rights and
IR Virtual Currency has been subject to a previous Pre-Creation
Abandonment. An Affirmative Action refers to a written notification
from the Sponsor to the Custodian of the Trust’s intention (i) to
acquire and/or retain any Incidental Rights and/or IR Virtual
Currency or (ii) to abandon, with effect prior to the relevant
Creation Time, any Incidental Rights and/or IR Virtual
Currency.
In determining whether to take an Affirmative Action to acquire
and/or retain an Incidental Rights and/or IR Virtual Currency, the
Trust takes into consideration a number of factors,
including:
•
the Custodian’s agreement to provide access to the IR Virtual
Currency;
•
the availability of a safe and practical way to custody the IR
Virtual Currency;
•
the costs of taking possession and/or maintaining ownership of the
IR Virtual Currency and whether such costs exceed the benefits of
owning such IR Virtual Currency;
•
whether there are any legal restrictions on, or tax implications
with respect to, the ownership, sale or disposition of the
Incidental Right or IR Virtual Currency, regardless of whether
there is a safe and practical way to custody and secure such
Incidental Right or IR Virtual Currency;
•
the existence of a suitable market into which the Incidental Right
or IR Virtual Currency may be sold; and
•
whether the Incidental Right or IR Virtual Currency is, or may be,
a security under federal securities laws.
In determining whether the IR Virtual Currency is, or may be, a
security under federal securities laws, the Sponsor takes into
account a number of factors, including the
various definitions of “security” under the federal securities laws
and federal court decisions interpreting elements of these
definitions, such as the U.S. Supreme Court’s decisions in
the
Howey
and
Reves
cases, as well as reports, orders, press releases, public
statements and speeches by the SEC and its staff providing guidance
on when a digital asset may be a security for purposes of the
federal securities laws
As a result of the Pre-Creation Abandonment Notice, since July 29,
2019, the Trust has irrevocably abandoned, prior to the Creation
Time of any Shares, any Incidental Right or IR Virtual Currency
that it may have any right to receive at such time. The Trust has
no right to receive any Incidental Right or IR Virtual Currency
abandoned pursuant to either the Pre-Creation Abandonment Notice or
Affirmative Actions. Furthermore, the Custodian has no authority,
pursuant to the Custodian Agreement or otherwise, to exercise,
obtain or hold, as the case may be, any such abandoned Incidental
Right or IR Virtual Currency on behalf of the Trust or to transfer
any such abandoned Incidental Right or IR Virtual Currency to the
Trust if the Trust terminates its custodial agreement with the
Custodian.
The Sponsor intends to evaluate each fork, airdrop or similar
occurrence on a case-by-case basis in consultation with the Trust’s
legal advisers, tax consultants, and Custodian, and may decide to
abandon any Incidental Rights or IR Virtual Currency resulting from
a hard fork, airdrop or similar occurrence should the Sponsor
conclude, in its discretion, that such abandonment is in the best
interests of the Trust.
In the event the Sponsor decides to sell any Incidental Right or IR
Virtual Currency, it would expect to execute the sale to the
Authorized Participant, as principal, or through the Authorized
Participant, as broker. In either case, the Sponsor expects that
the Authorized Participant would only be willing to transact with
the Sponsor on behalf of the Trust if the Authorized Participant
considered it possible to trade the Incidental Right or IR Virtual
Currency on a Digital Asset Exchange or other venue to which the
Authorized Participant has access. The Authorized Participant has
access only to Digital Asset Exchanges or other venues that the
Authorized
5
Participant reasonably believes are operating in compliance with
applicable law, including federal and state licensing requirements,
based upon information and assurances provided to it by each
venue.
Secondary Market Trading
While the Trust’s investment objective is for the value of the
Shares (based on ETH per Share) to reflect the value of the ETH
held by the Trust, determined by reference to the Index Price, less
the Trust’s expenses and other liabilities, the Shares may trade in
the Secondary Market on OTCQX (or on another Secondary Market in
the future) at prices that are lower or higher than the Digital
Asset Holdings per Share. The amount of the discount or premium in
the trading price relative to the Digital Asset Holdings per Share
may be influenced by non-concurrent trading hours and liquidity
between OTCQX and larger Digital Asset Exchanges. While the Shares
are listed and trade on OTCQX from 6:00 a.m. until 5:00 p.m., New
York time, liquidity in the Digital Asset Markets may fluctuate
depending upon the volume and availability of larger Digital Asset
Exchanges. As a result, during periods in which Digital Asset
Market liquidity is limited or a major Digital Asset Exchange is
off-line, trading spreads, and the resulting premium or discount,
on the Shares may widen.
Overview of the ETH Industry and Market
Ethereum, or ETH, is a digital asset that is created and
transmitted through the operations of the peer-to-peer Ethereum
Network, a decentralized network of computers that operates on
cryptographic protocols. No single entity owns or operates the
Ethereum Network, the infrastructure of which is collectively
maintained by a decentralized user base. The Ethereum Network
allows people to exchange tokens of value, called Ether, which are
recorded on a public transaction ledger known as a blockchain. ETH
can be used to pay for goods and services, including computational
power on the Ethereum network, or it can be converted to fiat
currencies, such as the U.S. dollar, at rates determined on Digital
Asset Exchanges or in individual end-user-to-end-user transactions
under a barter system. Furthermore, the Ethereum Network also
allows users to write and implement smart contracts—that is,
general-purpose code that executes on every computer in the network
and can instruct the transmission of information and value based on
a sophisticated set of logical conditions. Using smart contracts,
users can create markets, store registries of debts or promises,
represent the ownership of property, move funds in accordance with
conditional instructions and create digital assets other than ETH
on the Ethereum Network. Smart contract operations are executed on
the Ethereum Blockchain in exchange for payment of ETH. The
Ethereum Network is one of a number of projects intended to expand
blockchain use beyond just a peer-to-peer money system.
The Ethereum Network was originally described in a 2013 white paper
by Vitalik Buterin, a programmer involved with Bitcoin, with the
goal of creating a global platform for decentralized applications
powered by smart contracts. The formal development of the Ethereum
Network began through a Swiss firm called Ethereum Switzerland GmbH
in conjunction with several other entities. Subsequently, the
Ethereum Foundation, a Swiss non-profit organization, was set up to
oversee the protocol’s development. The Ethereum Network went live
on July 30, 2015. Unlike other digital assets, such as Bitcoin,
which are solely created through a progressive mining process, 72.0
million ETH were created in connection with the launch of the
Ethereum Network. For additional information on the initial
distribution, see “—Creation of New ETH.” Coinciding with the
network launch, it was decided that EthSuisse would be dissolved,
designating the Ethereum Foundation as the sole organization
dedicated to protocol development.
The Ethereum Network is decentralized and does not require
governmental authorities or financial institution intermediaries to
create, transmit or determine the value of ETH. Rather, following
the initial distribution of ETH, ETH is created and allocated by
the Ethereum Network protocol through a “mining” process that it
currently subject to an issuance cap of 16.0 million ETH per year
or 2.0 ETH per block, but there is no aggregate cap on the total
number of ETH outstanding. The value of ETH is determined by the
supply of and demand for ETH on the Digital Asset Exchanges or in
private end-user-to-end-user transactions.
New ETH are created and rewarded to the miners of a block in the
Ethereum Blockchain for verifying transactions. The Ethereum
Blockchain is effectively a decentralized database that includes
all blocks that have been mined by miners and it is updated to
include new blocks as they are mined. Each ETH transaction is
broadcast to the Ethereum Network and, when included in a block,
recorded in the Ethereum Blockchain. As each new block records
outstanding ETH transactions, and outstanding transactions are
settled and validated through such recording, the Ethereum
Blockchain represents a complete, transparent and unbroken history
of all transactions of the Ethereum Network. For further details,
see “—Creation of New ETH.”
Among other things, ETH is used to pay for transaction fees and
computational services (i.e.,
smart contracts) on the Ethereum Network; users of the Ethereum
Network pay for the computational power of the machines executing
the requested operations with ETH. Requiring payment in ETH on the
Ethereum Network incentivizes developers to write quality
applications and increases the efficiency of the Ethereum Network
because wasteful code costs more. It also ensures that the Ethereum
Network remains economically viable by compensating people for
their contributed computational resources.
6
Smart Contracts and Development on the Ethereum Network
Smart contracts are programs that run on a blockchain that can
execute automatically when certain conditions are met. Smart
contracts facilitate the exchange of anything representative of
value, such as money, information, property, or voting rights.
Using smart contracts, users can send or receive digital assets,
create markets, store registries of debts or promises, represent
ownership of property or a company, move funds in accordance with
conditional instructions and create new digital assets.
Development on the Ethereum Network involves building more complex
tools on top of smart contracts, such as decentralized apps (DApps)
and organizations that are autonomous, known as decentralized
autonomous organizations (DAOs). For example, a company that
distributes charitable donations on behalf of users could hold
donated funds in smart contracts that are paid to charities only if
the charity satisfies certain pre-defined conditions.
Moreover, the Ethereum Network has also been used as a platform for
creating new digital assets and conducting their associated initial
coin offerings. As of December 31, 2021, a majority of digital
assets were built on the Ethereum Network, with such assets
representing a significant amount of the total market value of all
digital assets.
More recently, the Ethereum Network has been used for decentralized
finance (DeFi) or open finance platforms, which seek to democratize
access to financial services, such as borrowing, lending, custody,
trading, derivatives and insurance, by removing third-party
intermediaries. DeFi can allow users to lend and earn interest on
their digital assets, exchange one digital asset for another and
create derivative digital assets such as stablecoins, which are
digital assets pegged to a reserve asset such as fiat currency.
Over the course of 2021, between $18 billion and $163 billion worth
of digital assets were locked up as collateral on DeFi platforms on
the Ethereum Network.
In addition, the Ethereum Network and other smart contract
platforms have been used for creating non-fungible tokens, or NFTs.
Unlike digital assets native to smart contract platforms which are
fungible and enable the payment of fees for smart contract
execution, NFTs allow for digital ownership of assets created
within the DApps built on smart contract platforms. This new
paradigm allows users to own their digital assets as NFTs, trade
them with others in the DApp or game, and carry them to other
digital experiences, creating an entirely new free-market
internet-native economy that can be monetized in the physical
world.
The DAO and Ethereum Classic
In July 2016, the Ethereum Network experienced what is referred to
as a permanent hard fork that resulted in two different versions of
its blockchain: Ethereum and Ethereum Classic.
In April 2016, a blockchain solutions company known as Slock.it
announced the launch of a decentralized autonomous organization,
known as “The DAO” on the Ethereum Network. The DAO was designed as
a decentralized crowdfunding model, in which anyone could
contribute ETH tokens to The DAO in order to become a voting member
and equity stakeholder in the organization. Members of The DAO
could then make proposals about different projects to pursue and
put them to a vote. By committing to profitable projects, members
would be rewarded based on the terms of a smart contract and their
proportional interest in The DAO. As of May 27, 2016, $150 million,
or approximately 14% of all ETH outstanding, was contributed to,
and invested in, The DAO.
On June 17, 2016, an anonymous hacker exploited The DAO smart
contract code to syphon approximately $60 million, or 3.6 million
ETH, into a segregated account. Upon the news of the breach, the
price of ETH was quickly cut in half as investors liquidated their
holdings and members of the Ethereum community worked to determine
a solution.
In the days that followed, several attempts were made to retrieve
the stolen funds and secure the Ethereum Network. However, it soon
became apparent that direct interference with the protocol
(i.e.,
a hard fork) would be necessary. The argument for the hard fork was
that it would create an entirely new version of the Ethereum
Blockchain, erasing any record of the theft, and restoring the
stolen funds to their original owners. The counterargument was that
it would be antithetical to the core principle of immutability of
the Ethereum Blockchain.
The decision over whether or not to hard fork the Ethereum
Blockchain was put to a vote of Ethereum community members. A
majority of votes were cast in favor of a hard fork. On July 15,
2016, a hard fork specification was implemented by the Ethereum
Foundation. On July 20, 2016, the Ethereum Network completed the
hard fork, and a new version of the blockchain, without recognition
of the theft, was born.
Many believed that after the hard fork the original version of the
Ethereum Blockchain would dissipate entirely. However, a group of
miners continued to mine the original Ethereum Blockchain for
philosophical and economic reasons. On July 20, 2016, the original
Ethereum protocol was rebranded as Ethereum Classic, and its native
token as ether classic (“ETC”), preserving the
untampered
7
transaction history (including The DAO theft). Following the hard
fork of Ethereum, each holder of ETH automatically received an
equivalent number of ETC tokens.
Overview of the Ethereum Network’s Operations
In order to own, transfer or use ETH directly on the Ethereum
Network (as opposed to through an intermediary, such as a
custodian), a person generally must have internet access to connect
to the Ethereum Network. ETH transactions may be made directly
between end-users without the need for a third-party intermediary.
To prevent the possibility of double-spending ETH, a user must
notify the Ethereum Network of the transaction by broadcasting the
transaction data to its network peers. The Ethereum Network
provides confirmation against double-spending by memorializing
every transaction in the Ethereum Blockchain, which is publicly
accessible and transparent. This memorialization and verification
against double-spending is accomplished through the Ethereum
Network mining process, which adds “blocks” of data, including
recent transaction information, to the Ethereum
Blockchain.
Summary of an ETH Transaction
Prior to engaging in ETH transactions directly on the Ethereum
Network, a user generally must first install on its computer or
mobile device an Ethereum Network software program that will allow
the user to generate a private and public key pair associated with
an ETH address, commonly referred to as a “wallet.” The Ethereum
Network software program and the ETH address also enable the user
to connect to the Ethereum Network and transfer ETH to, and receive
ETH from, other users.
Each Ethereum Network address, or wallet, is associated with a
unique “public key” and “private key” pair. To receive ETH, the ETH
recipient must provide its public key to the party initiating the
transfer. This activity is analogous to a recipient for a
transaction in U.S. dollars providing a routing address in wire
instructions to the payor so that cash may be wired to the
recipient’s account. The payor approves the transfer to the address
provided by the recipient by “signing” a transaction that consists
of the recipient’s public key with the private key of the address
from where the payor is transferring the ETH. The recipient,
however, does not make public or provide to the sender its related
private key.
Neither the recipient nor the sender reveal their private keys in a
transaction, because the private key authorizes transfer of the
funds in that address to other users. Therefore, if a user loses
his private key, the user may permanently lose access to the ETH
contained in the associated address. Likewise, ETH is irretrievably
lost if the private key associated with them is deleted and no
backup has been made. When sending ETH, a user’s Ethereum Network
software program must validate the transaction with the associated
private key. In addition, since every computation on the Ethereum
Network requires processing power, there is a transaction fee
involved with the transfer that is paid by the payor The resulting
digitally validated transaction is sent by the user’s Ethereum
Network software program to the Ethereum Network miners to allow
transaction confirmation.
Ethereum Network miners record and confirm transactions when they
mine and add blocks of information to the Ethereum Blockchain. When
a miner mines a block, it creates that block, which includes data
relating to (i) the satisfaction of the consensus mechanism to mine
the block, (ii) a reference to the prior block in the Ethereum
Blockchain to which the new block is being added and (iii)
transactions that have submitted to the Ethereum Network but have
not yet been added to the Ethereum Blockchain. The miner becomes
aware of outstanding, unrecorded transactions through the data
packet transmission and distribution discussed above.
Upon the addition of a block included in the Ethereum Blockchain,
the Ethereum Network software program of both the spending party
and the receiving party will show confirmation of the transaction
on the Ethereum Blockchain and reflect an adjustment to the ETH
balance in each party’s Ethereum Network public key, completing the
ETH transaction. Once a transaction is confirmed on the Ethereum
Blockchain, it is irreversible.
Some ETH transactions are conducted “off-blockchain” and are
therefore not recorded in the Ethereum Blockchain. Some
“off-blockchain transactions” involve the transfer of control over,
or ownership of, a specific digital wallet holding ETH or the
reallocation of ownership of certain ETH in a pooled-ownership
digital wallet, such as a digital wallet owned by a Digital Asset
Exchange. In contrast to on-blockchain transactions, which are
publicly recorded on the Ethereum Blockchain, information and data
regarding off-blockchain transactions are generally not publicly
available. Therefore, off-blockchain transactions are not truly ETH
transactions in that they do not involve the transfer of
transaction data on the Ethereum Network and do not reflect a
movement of ETH between addresses recorded in the Ethereum
Blockchain. For these reasons, off-blockchain transactions are
subject to risks as any such transfer of ETH ownership is not
protected by the protocol behind the Ethereum Network or recorded
in, and validated through, the blockchain mechanism.
Creation of New ETH
Initial Creation of ETH
8
Unlike other digital assets such as Bitcoin, which are solely
created through a progressive mining process, 72.0 million ETH were
created in connection with the launch of the Ethereum Network. The
initial 72.0 million ETH were distributed as follows:
Initial Distribution:
60.0 million ETH, or 83.33% of the supply, was sold to the public
in a crowd sale conducted between July and August 2014 that raised
approximately $18 million.
Ethereum Foundation:
6.0 million ETH, or 8.33% of the supply, was distributed to the
Ethereum Foundation for operational costs.
Ethereum Developers:
3.0 million ETH, or 4.17% of the supply, was distributed to
developers who contributed to the Ethereum Network.
Developer Purchase Program:
3.0 million ETH, or 4.17% of the supply, was distributed to members
of the Ethereum Foundation to purchase at the initial crowd sale
price.
Following the launch of the Ethereum Network, ETH supply increases
through a progressive mining process.
Proof-of-Work Mining Process
The Ethereum Network is kept running by computers all over the
world. In order to incentivize those who incur the computational
costs of securing the network by validating transactions, there is
a reward that is given to the computer that was able to create the
latest block on the chain. Every 15 seconds, on average, a new
block is added to the Ethereum Blockchain with the latest
transactions processed by the network, and the computer that
generated this block is currently awarded 2.0 ETH. In certain
mining scenarios, ETH are sometimes sent to another miner if they
are also able to find a solution, but their block was not included.
This is referred to as an uncle/aunt reward. Due to the nature of
the algorithm for block generation, this process (generating a
“proof-of-work”) is guaranteed to be random. Over time rewards are
expected to be proportionate to the computational power of each
machine.
The process by which ETH is “mined” results in new blocks being
added to the Ethereum Blockchain and new ETH tokens being issued to
the miners. Computers on the Ethereum Network engage in a set of
prescribed complex mathematical calculations in order to add a
block to the Ethereum Blockchain and thereby confirm ETH
transactions included in that block’s data.
To begin mining, a user can download and run Ethereum Network
mining software, which turns the user’s computer into a “node” on
the Ethereum Network that validates blocks. Each block contains the
details of some or all of the most recent transactions that are not
memorialized in prior blocks, as well as a record of the award of
ETH to the miner who added the new block. Each unique block can
only be mined and added to the Ethereum Blockchain by one miner.
Therefore, all individual miners and mining pools on the Ethereum
Network are engaged in a competitive process of constantly
increasing their computing power to improve their likelihood of
solving for new blocks. As more miners join the Ethereum Network
and its processing power increases, the Ethereum Network adjusts
the complexity of the block-solving equation to maintain a
predetermined pace of adding a new block to the Ethereum Blockchain
approximately every fifteen seconds. A miner’s proposed block is
added to the Ethereum Blockchain once a majority of the nodes on
the Ethereum Network confirms the miner’s work. Miners that are
successful in adding a block to the Ethereum Blockchain are
automatically awarded ETH for their effort and may also receive
transaction fees paid by transferors whose transactions are
recorded in the block. This reward system is the method by which
new ETH enter into circulation to the public.
Proof-of-Stake Mining Process
In the second half of 2020, the Ethereum Network began the first of
several stages of an upgrade called Ethereum 2.0. Ethereum 2.0. is
a new iteration of Ethereum that would include switching from a
proof-of-work consensus mechanism to a proof-of-stake consensus
mechanism. Unlike proof-of-work, in which miners expend
computational resources to compete to validate transactions and are
rewarded coins in proportion to the amount of computational
resources expended, in proof-of-stake, miners (sometimes called
validators) risk or “stake” coins to compete to be randomly
selected to validate transactions and are rewarded coins in
proportion to the amount of coins staked. Any malicious activity,
such as mining multiple blocks, disagreeing with the eventual
consensus or otherwise violating protocol rules, results in the
forfeiture or “slashing” of a portion of the staked coins.
Proof-of-stake is viewed as more energy efficient and scalable than
proof-of-work and is sometimes referred to as “virtual
mining”.
Limits on ETH Supply
The rate at which new ETH are mined and put into circulation is
expected to vary. ETH issuances are currently capped at 16.0
million ETH per year or 2.0 ETH per block, but there is no
aggregate cap on the total number of ETH outstanding. In 2022 or
2023, the Ethereum Network may switch from proof-of-work to a new
proof-of-stake consensus algorithm under development, called
Casper. The attributes of the new consensus algorithm are subject
to change, but the new consensus algorithm will reduce total new
ETH issuances and is expected to turn the ETH supply deflationary
when coupled with the EIP-1559 modification, discussed
below.
9
As of December 31, 2021, approximately 119 million ETH were
outstanding.
Modifications to the ETH Protocol
The Ethereum Network is an open source project with no official
developer or group of developers that controls it. However,
historically the Ethereum Network’s development has been overseen
by the Ethereum Foundation and other core developers. The Ethereum
Foundation and core developers are able to access and alter the
Ethereum Network source code and, as a result, they are responsible
for quasi-official releases of updates and other changes to the
Ethereum Network’s source code.
For example, in 2019 the Ethereum Network completed a network
upgrade called Metropolis that was designed to enhance the
usability of the Ethereum Network and was introduced in two stages.
The first stage, called Byzantium, was implemented in October 2017.
The purpose of Byzantium was to increase the network’s privacy,
security, and scalability and reduce the block reward from 5.0 ETH
to 3.0 ETH. The second stage, called Constantinople, was
implemented in February 2019, along with another upgrade, called
St. Petersburg. The purpose of these upgrades was to prepare the
Ethereum Network for the introduction of a proof-of-stake algorithm
and reduce the block reward from 3.0 ETH to 2.0 ETH. In the second
half of 2020, the Ethereum Network began the first of several
stages of an upgrade called Ethereum 2.0. Ethereum 2.0. is a new
iteration of Ethereum that would amend its consensus mechanism to
include proof-of-stake and sharding. The purpose of sharding is to
increase scalability of a database, such as a blockchain, by
splitting the data processing responsibility among many nodes,
allowing for parallel processing and validation of transactions.
This contrasts with the existing Ethereum Blockchain, which
requires each node to process and validate every transaction. The
current version of the Ethereum Network also contains a “difficulty
bomb,” under which mining will become extraordinarily difficult
over time, encouraging miners to switch to proof-of-stake and join
the Ethereum 2.0 hard fork. In January 2020, a network upgrade
called Muir Glacier was implemented in order to delay this
difficulty bomb as the Ethereum Network prepares to switch to
proof-of-stake. Another recent network upgrade, called Istanbul,
was implemented in December 2019. The purpose of Istanbul was to
make the network more denial of service-resistant, enable greater
ETH and Zcash interoperability as well as other Equihash-based
proof of work digital assets, and to increase the scalability and
performance for solutions on zero-knowledge privacy technology like
SNARKs and STARKs. In 2021, the Ethereum network implemented the
EIP-1559 upgrade. EIP-1559 changed the methodology used to
calculate the fees paid to miners. This new methodology splits fees
into two components: a base cost and priority fee. The base cost is
now burnt and the priority fee is paid to miners. EIP-1559 has
reduced the total net issuance of ETH fees to miners. The release
of updates to the Ethereum Network’s source code does not guarantee
that the updates will be automatically adopted. Users and miners
must accept any changes made to the Ethereum source code by
downloading the proposed modification of the Ethereum Network’s
source code. A modification of the Ethereum Network’s source code
is only effective with respect to the Ethereum users and miners
that download it. If a modification is accepted only by a
percentage of users and miners, a division in the Ethereum Network
will occur such that one network will run the pre-modification
source code and the other network will run the modified source
code. Such a division is known as a “fork.” See “Item 1A. Risk
Factors—Risk Factors Related to Digital Assets—A temporary or
permanent “fork” could adversely affect an investment in the
Shares.” Consequently, as a practical matter, a modification to the
source code becomes part of the Ethereum Network only if accepted
by participants collectively having a majority of the processing
power on the Ethereum Network.
Core development of the Ethereum source code has increasingly
focused on modifications of the Ethereum protocol to increase speed
and scalability and also allow for financial and non-financial next
generation uses. The Trust’s activities will not directly relate to
such projects, though such projects may utilize ETH as tokens for
the facilitation of their non-financial uses, thereby potentially
increasing demand for ETH and the utility of the Ethereum Network
as a whole. Conversely, projects that operate and are built within
the Ethereum Blockchain may increase the data flow on the Ethereum
Network and could either “bloat” the size of the Ethereum
Blockchain or slow confirmation times.
ETH Value
Digital Asset Exchange Valuation
The value of ETH is determined by the value that various market
participants place on ETH through their transactions. The most
common means of determining the value of an ETH is by surveying one
or more Digital Asset Exchanges where ETH is traded publicly and
transparently (e.g., Bitstamp, Coinbase, Kraken and LMAX Digital).
Additionally, there are over-the-counter dealers or market makers
that transact in ETH.
Digital Asset Exchange Public Market Data
On each online Digital Asset Exchange, ETH is traded with publicly
disclosed valuations for each executed trade, measured by one or
more fiat currencies such as the U.S. dollar or euro or by the
widely used cryptocurrency Bitcoin. Over-the-counter dealers or
market makers do not typically disclose their trade
data.
10
As of December 31, 2021, the Digital Asset Exchanges included in
the Index are Coinbase Pro, Bitstamp, Kraken and LMAX Digital. As
further described below, each of these Digital Asset Exchanges are
in compliance with applicable U.S. federal and state licensing
requirements and practices regarding AML and KYC
regulations.
Coinbase Pro:
A U.S.-based exchange registered as a money services business
(“MSB”) with FinCen and licensed as a virtual currency business
under the NYDFS BitLicense as well as money transmitter in various
U.S. states.
Bitstamp:
A U.K.-based exchange registered as an MSB with FinCen and licensed
as a virtual currency business under the NYDFS BitLicense as well
as money transmitter in various U.S. states.
Kraken:
A U.S.-based exchange registered as an MSB with FinCen and licensed
as money transmitter in various U.S. states. Kraken does not hold a
BitLicense.
LMAX Digital:
A U.K.-based exchange registered as a broker with FCA. LMAX Digital
does not hold a BitLicense.
Currently, there are several Digital Asset Exchanges operating
worldwide and online Digital Asset Exchanges represent a
substantial percentage of ETH buying and selling activity and
provide the most data with respect to prevailing valuations of ETH.
These exchanges include established exchanges such as exchanges
included in the Index which provide a number of options for buying
and selling ETH. The below table reflects the trading volume in ETH
and market share of the ETH-U.S. dollar trading pairs of each of
the Digital Asset Exchanges included in the Index as of December
31, 2021, using data reported by the Index Provider since the
inception of the Trust:
|
|
|
|
|
|
|
|
|
Digital Asset Exchanges included in the Index as of December 31,
2021 (1)
|
|
Volume (ETH)
|
|
|
Market Share (2)
|
|
Coinbase Pro
|
|
|
268,608,467
|
|
|
|
29.35
|
%
|
Kraken
|
|
|
111,393,121
|
|
|
|
12.17
|
%
|
Bitstamp
|
|
|
70,334,721
|
|
|
|
7.68
|
%
|
LMAX Digital
|
|
|
47,645,892
|
|
|
|
5.21
|
%
|
Total ETH-U.S. Dollar trading pair
|
|
|
497,982,201
|
|
|
|
54.41
|
%
|
(1)
On January 19, 2020, the Index Provider removed itBit due to a lack
of trading volume and added LMAX Digital to the Index due to the
exchange meeting the liquidity thresholds as part of its scheduled
quarterly review.
(2)
Market share is calculated using trading volume data (in ETH)
provided by the Index Provider for certain Digital Asset Exchanges,
including Coinbase Pro, Kraken, Bitstamp, and LMAX Digital, as well
as certain other large U.S.-dollar denominated Digital Asset
Exchanges that are not currently included in the Index, including
Binance.US (included from April 1, 2020), Bittrex (included from
July 31, 2018), Bitfinex, ErisX (including from October 1, 2020),
Gemini, HitBTC (included from June 13, 2019 through March 31,
2020), itBit (included from December 27, 2018) and OKCoin (included
from December 25, 2018).
The domicile, regulation and legal compliance of the Digital Asset
Exchanges included in the Index varies. Information regarding each
Digital Asset Exchange may be found, where available, on the
websites for such Digital Asset Exchanges, among other
places.
Although the Index is designed to accurately capture the market
price of ETH, third parties may be able to purchase and sell ETH on
public or private markets not included among the constituent
Digital Asset Exchanges of the Index, and such transactions may
take place at prices materially higher or lower than the Index
Price. Moreover, there may be variances in the prices of ETH on the
various Digital Asset Exchanges, including as a result of
differences in fee structures or administrative procedures on
different Digital Asset Exchanges. For example, based on data
provided by the Index Provider, on any given day during the year
ended December 31, 2021, the maximum differential between the 4:00
p.m., New York time spot price of any single Digital Asset Exchange
included in the Index and the Index Price was 0.30% (14.57% based
on Old Index Price) and the average of the maximum differentials of
the 4:00 p.m., New York time, spot price of each Digital Asset
Exchange included in the Index and the Index Price was 0.26%
(14.48% based on Old Index Price). During this same period, the
average differential between the 4:00 p.m., New York time, spot
prices of all the Digital Asset Exchanges included in the Index and
the Index Price was 0.001% (0.48% based on Old Index Price). All
Digital Asset Exchanges that were included in the Index throughout
the period were considered in this analysis. To the extent such
prices differ materially from the Index Price, investors may lose
confidence in the Shares’ ability to track the market price of
ETH.
The Index and the Index Price
The Index is a U.S. dollar-denominated composite reference rate for
the price of ETH. The Index is designed to (1) mitigate the effects
of fraud, manipulation and other anomalous trading activity from
impacting the ETH reference rate, (2) provide a real-time,
volume-weighted fair value of ETH and (3) appropriately handle and
adjust for non-market related events.
11
The Index Price is determined by the Index Provider through a
process in which trade data is cleansed and compiled in such a
manner as to algorithmically reduce the impact of anomalistic or
manipulative trading. This is accomplished by adjusting the weight
of each data input based on price deviation relative to the
observable set, as well as recent and long-term trading volume at
each venue relative to the observable set. The Index Price is
calculated using non-GAAP methodology and is not used in the
Trust's financial statements.
Prior to February 1, 2022, the Trust valued its ETH for operational
purposes by reference to the Old Index Price. The Old Index Price
was calculated by applying a weighting algorithm to the price and
trading volume data for the immediately preceding 24-hour period as
of 4:00 p.m., New York time, derived from the Constituent Exchanges
reflected in the Index on such trade date and overlaid an averaging
mechanism to the price produced resulting in the Old Index Price
reflecting an average price for the 24-hour period. In other words,
the Index Price is the price of an ETH at 4:00 p.m., New York time,
calculated based on the price and trading volume data of the
Digital Asset Exchanges included in the Index over the preceding
24-hour period whereas the Old Index Price was the price of an ETH
at 4:00 p.m., New York time, calculated by taking the average of
each price of an ETH produced by the Index over the preceding
24-hour period. The Index Price uses the same methodology without
the additional averaging mechanism being applied to the Index
Price. There was no change to the Index used to determine the Index
Price or the criteria used to select the Constituent
Exchanges.
Constituent Exchange Selection
The Digital Asset Exchanges that are included in the Index are
selected by the Index Provider utilizing a methodology that is
guided by the International Organization of Securities Commissions
(“IOSCO”) principles for financial benchmarks. For an exchange to
become a Constituent Exchange, it must satisfy the criteria listed
below (the “Inclusion Criteria”):
•
Compliance with applicable U.S. federal and state licensing
requirements and practices regarding anti-money laundering (“AML”)
and know-your-customer (“KYC”) regulations (i.e., a U.S.-Compliant
Exchange), based on a review of the exchanges’ publicly disclosed
policies and guidelines
•
Publicly known ownership
•
No restrictions on deposits and/or withdrawals of ETH
•
No restrictions on deposits and/or withdrawals of U.S.
dollars
•
Reliably displays new trade prices and volumes on a real-time basis
through APIs
•
Programmatic trading of the indexed asset’s spot price
•
Liquid market in the indexed asset
•
Trading volume must represent a minimum of total eligible trading
volumes (5% for U.S. exchanges and 10% non-U.S.
exchanges)
•
Discretion of the Index Provider’s analysts,
which applies to both the inclusion and exclusion of such
exchanges. The Index Provider would only use this discretion to
include or exclude an exchange in order to ensure the integrity of
the Index; to date, the Index Provider has not exercised such
discretion.
A Digital Asset Exchange is removed from the Constituent Exchanges
when it no longer satisfies the Inclusion Criteria. The Index
Provider does not currently include data from over-the-counter
markets or derivatives platforms among the Constituent Exchanges.
Over-the-counter data is not currently included because of the
potential for trades to include a significant premium or discount
paid for larger liquidity, which creates an uneven comparison
relative to more active markets. There is also a higher potential
for over-the-counter transactions to not be arms-length, and thus
not be representative of a true market price. ETH derivative
markets are also not currently included as the markets remain
relatively thin.
While the Index Provider has no plans to include data from
over-the-counter markets or derivative platforms at this time,
the
Index Provider will consider IOSCO principles for financial
benchmarks, the management of trading venues of ETH
derivatives
and the aforementioned Inclusion Criteria
when considering whether to include over-the-counter or derivative
platform data in the future.
The Index Provider and the Sponsor have entered into an index
license agreement, dated as of February 1, 2022 (the “Index License
Agreement”) governing the Sponsor’s use of the Index Price. In
connection with the entry into the Index License Agreement, the
Sponsor and the Index Provider terminated that certain license
agreement, dated as of February 28, 2019, between the Sponsor and
the Index Provider that governed the Sponsor's use of the Old Index
Provider. Pursuant to the terms of the Index License Agreement, the
Index Provider may adjust the calculation methodology for the Index
Price without notice to, or consent of, the Trust or its
shareholders. The Index Provider may decide to change the
calculation methodology to maintain the integrity of the Index
Price calculation should it identify or become aware of previously
unknown variables or issues with the existing methodology that it
believes could materially impact its performance and/or
reliability. The Index Provider has sole discretion over the
determination of Index Price
12
and may change the methodologies for determining the Index Price
from time to time. Shareholders will be notified of any material
changes to the calculation methodology or the Index Price in the
Trust’s current reports and will be notified of all other changes
that the Sponsor considers significant in the Trust’s periodic
reports. The Trust will determine the materiality of any changes to
the Index Price on a case-by-case basis, in consultation with
external counsel.
The Index Provider may change the trading venues that are used to
calculate the Index or otherwise change the way in which the Index
is calculated at any time. For example, the Index Provider has
scheduled quarterly reviews in which it may add or remove
Constituent Exchanges that satisfy or fail the Inclusion Criteria.
The Index Provider does not have any obligation to consider the
interests of the Sponsor, the Trust, the shareholders, or anyone
else in connection with such changes. While the Index Provider is
not required to publicize or explain the changes or to alert the
Sponsor to such changes, it has historically notified the Trust of
any material changes to the Constituent Exchanges, including any
additions or removals of the Constituent Exchanges, in addition to
issuing press releases in connection with the same. The Sponsor
will notify investors of any such material event by filing a
current report on Form 8-K. Although the Index methodology is
designed to operate without any manual intervention, rare events
would justify manual intervention. Intervention of this kind would
be in response to non-market-related events, such as the halting of
deposits or withdrawals of funds on a Digital Asset Exchange, the
unannounced closure of operations on a Digital Asset Exchange,
insolvency or the compromise of user funds. In the event that such
an intervention is necessary, the Index Provider would issue a
public announcement through its website, API and other established
communication channels with its clients.
Determination of the Index Price
The Index applies an algorithm to the price of ETH on the
Constituent Exchanges calculated on a per second basis over a
24-hour period. The Index’s algorithm is expected to reflect a
four-pronged methodology to calculate the Index Price from the
Constituent Exchanges:
•
Volume Weighting:
Constituent Exchanges with greater liquidity receive a higher
weighting in the Index, increasing the ability to execute against
(i.e., replicate) the Index in the underlying spot
markets.
•
Price-Variance Weighting:
The Index Price reflects data points that are discretely weighted
in proportion to their variance from the rest of the
Constituent
Exchanges. As the price at a particular exchange diverges from the
prices at the rest of the Constituent Exchanges, its weight in the
Index Price consequently decreases.
•
Inactivity Adjustment:
The Index Price algorithm penalizes stale activity from any given
Constituent Exchange. When a Constituent Exchange does not have
recent trading data, its weighting in the Index Price is gradually
reduced until it is de-weighted entirely. Similarly, once trading
activity at a Constituent Exchange resumes, the corresponding
weighting for that Constituent Exchange is gradually increased
until it reaches the appropriate level.
•
Manipulation Resistance: In order to mitigate the effects of wash
trading and order book spoofing, the Index only includes executed
trades in its calculation. Additionally, the Index only includes
Constituent Exchanges that charge trading fees to its users in
order to attach a real, quantifiable cost to any manipulation
attempts.
The Index Provider formally re-evaluates the weighting algorithm
quarterly, but maintains discretion to change the way in which an
Index Price is calculated based on its periodic review or in
extreme circumstances.
The exact methodology to calculate the Index Price is not publicly
available. Still, the
Index is designed to limit exposure to trading or price distortion
of any individual Digital Asset Exchange that experiences periods
of unusual activity or limited liquidity by discounting, in
real-time, anomalous price movements at individual Digital Asset
Exchanges.
The Sponsor believes the Index Provider’s selection process for
Constituent Exchanges as well as the methodology of the Index
Price’s algorithm provides a more accurate picture of ETH price
movements than a simple average of Digital Asset Exchange spot
prices, and that the weighting of ETH prices on the Constituent
Exchanges limits the inclusion of data that is influenced by
temporary price dislocations that may result from technical
problems, limited liquidity or fraudulent activity elsewhere in the
ETH spot market. By referencing multiple trading venues and
weighting them based on trade activity, the Sponsor believes that
the impact of any potential fraud, manipulation or anomalous
trading activity occurring on any single venue is
reduced.
If the Index Price becomes unavailable, or if the Sponsor
determines in good faith that such Index Price does not reflect an
accurate price for ETH, then the Sponsor will, on a best efforts
basis, contact the Index Provider to obtain the Index Price
directly from the Index Provider. If after such contact such Index
Price remains unavailable or the Sponsor continues to believe in
good faith that such Index Price does not reflect an accurate price
for the relevant digital asset, then the Sponsor will employ a
cascading set of rules to determine the Index Price, as described
below in “—Determination of the Index Price When Index Price is
Unavailable.”
13
The Trust values its ETH for operational purposes by reference to
the Index Price. The Index Price is the value of an ETH as
represented by the Index, calculated at 4:00 p.m., New York time,
on each business day. The Index Provider develops, calculates and
publishes the Index on a continuous basis using the price at the
Digital Asset Benchmark Exchanges, as selected by the Index
Provider.
Illustrative Example
For the purposes of illustration, outlined below are examples of
how the attributes that impact weighting and adjustments in the
aforementioned methodology may be utilized to generate the Index
Price for a digital asset. For example, the Constituent Exchanges
for the Index Price of the digital asset are Coinbase Pro, Kraken,
LMAX Digital and Bitstamp.
•
Volume Weighting: Each Constituent Exchange will be weighted to
appropriately reflect the trading volume share of the Constituent
Exchange relative to all the Constituent Exchanges during this same
period. For example, an average hourly weighting of 67.07%, 11.88%,
14.57% and 6.49% for Coinbase Pro, Kraken, LMAX Digital and
Bitstamp, respectively, would represent each Constituent Exchange’s
share of trading volume during the same period.
•
Inactivity Adjustment:
Assume that a Constituent Exchange represented a 14% weighting on
the Index Price of digital asset, which is based on the per-second
calculations of its trading volume and price-variance relative to
the cohort of Constituent Exchanges included in such Index, and
then went offline for approximately two hours. The index algorithm
would automatically recognize inactivity and start the Constituent
Exchange at the 3-minute mark and continue to do so over a 7-minute
period until its influence was effectively zero, 10-minutes after
becoming inactive. As soon as trading activity resumed at the
Constituent Exchange, the index algorithm would re-weight it to the
appropriate weighting based on trading volume and price-variance
relative to the cohort of Constituent Exchanges included in the
Index. Due to the period of inactivity, it would re-weight the
Constituent Exchange activity to a weight lower than its original
weighting—for example, to 12%.
•
Price-Variance Weighting:
The price-variance weighting adjustment is a relative measure of
each exchange versus the cohort of exchanges. The further the price
at a constituent exchange is from the mean price of the cohort, the
less influence that exchange’s price will have on the algorithm
that produces the Index Price, as the exchange data is discretely
weighted in proportion to their variance from the rest of the
exchanges on a per-second basis and there is no minimum threshold
the variance must meet for this adjustment to take place. For
example, assume that for a one-hour period, the digital asset’s
execution prices on one Constituent Exchange were trading more than
7% higher than the average execution prices on another Constituent
Exchange. The algorithm will automatically detect the anomaly
(price variance) and reduce that specific Constituent Exchange’s
weighting during that one-hour period, ensuring a reliable spot
reference price that is unaffected by the localized event and that
is reflective of broader market activity.
Determination of the Index Price When Index Price is
Unavailable
On January 11, 2022, the Sponsor changed the cascading set of rules
used to determine the Index Price. The Sponsor will use the
following cascading set of rules to calculate the Index Price. For
the avoidance of doubt, the Sponsor will employ the below rules
sequentially and in the order as presented below, should one or
more specific rule(s) fail:
1.
Index Price = The price set by the Index as of 4:00 p.m., New York
time, on the valuation date. If the Index becomes unavailable, or
if the Sponsor determines in good faith that the Index does not
reflect an accurate price, then the Sponsor will, on a best efforts
basis, contact the Index Provider to obtain the Index Price
directly from the Index Provider. If after such contact the Index
remains unavailable or the Sponsor continues to believe in good
faith that the Index does not reflect an accurate price, then the
Sponsor will employ the next rule to determine the Index Price.
There are no predefined criteria to make a good faith assessment
and it will be made by the Sponsor in its sole
discretion.
2.
Index Price = The price set by Coin Metrics Real-Time Rate (the
“Secondary Index”) as of 4:00 p.m., New York time, on the valuation
date (the “Secondary Index Price”). The Secondary Index Price is a
real-time reference rate price, calculated using trade data from
constituent markets selected by Coin Metrics (the “Secondary Index
Provider”). The Secondary Index Price is calculated by applying
weighted-median techniques to such trade data where half the weight
is derived from the trading volume on each constituent market and
half is derived from inverse price variance, where a constituent
market with high price variance as a result of outliers or market
anomalies compared to other constituent markets is assigned a
smaller weight. If the Secondary Index becomes unavailable, or if
the Sponsor determines in good faith that the Secondary Index does
not reflect an accurate price, then the Sponsor will, on a best
efforts basis, contact the Secondary Index Provider to obtain the
Secondary Index Price directly from the Secondary Index Provider.
If after such contact the Secondary Index remains unavailable or
the Sponsor continues to believe in good faith that the Secondary
Index does not reflect an accurate price, then the Sponsor will
employ the next rule to determine the Index Price. There are no
predefined criteria to make a good faith assessment and it will be
made by the Sponsor in its sole discretion.
14
3.
Index Price = The price set by the Trust's principal market (the
“Tertiary Pricing Option”) as of 4:00 p.m., New York time, on the
valuation date. The Tertiary Pricing Option is a spot price derived
from the principal market's public data feed that is believed to be
consistently publishing pricing information as of 4:00 p.m., New
York time, and is provided to the Sponsor via an application
programming interface. If the Tertiary Pricing Option becomes
unavailable, or if the Sponsor determines in good faith that the
Tertiary Pricing Option does not reflect an accurate price, then
the Sponsor will, on a best efforts basis, contact the Tertiary
Pricing Provider to obtain the Tertiary Pricing Option directly
from the Tertiary Pricing Provider. If after such contact the
Tertiary Pricing Option remains unavailable after such contact or
the Sponsor continues to believe in good faith that the Tertiary
Pricing Option does not reflect an accurate price, then the Sponsor
will employ the next rule to determine the Index Price. There are
no predefined criteria to make a good faith assessment and it will
be made by the Sponsor in its sole discretion.
4.
Index Price = The Sponsor will use its best judgment to determine a
good faith estimate of the Index Price. There are no predefined
criteria to make a good faith assessment and it will be made by the
Sponsor in its sole discretion.
In the event of a fork, the Index Provider may calculate the Index
Price based on a virtual currency that the Sponsor does not believe
to be the appropriate asset that is held by the Trust. In this
event, the Sponsor has full discretion to use a different index
provider or calculate the Index Price itself using its best
judgment.
Forms of Attack Against the Ethereum Network
All networked systems are vulnerable to various kinds of attacks.
As with any computer network, the Ethereum Network contains certain
flaws. For example, the Ethereum Network is currently vulnerable to
a “51% attack” where, if a mining pool were to gain control of more
than 50% of the hash rate for a digital asset, a malicious actor
would be able to gain full control of the network and the ability
to manipulate the Ethereum Blockchain. As of the date of this
Annual Report, the top three largest mining pools controlled over
50% of the hash rate of the Ethereum Network.
In addition, many digital asset networks have been subjected to a
number of denial of service attacks, which has led to temporary
delays in block creation and in the transfer of digital assets. Any
similar attacks on the Ethereum Network that impact the ability to
transfer ETH could have a material adverse effect on the price of
ETH and the value of the Shares.
Market Participants
Miners
Miners range from ETH enthusiasts to professional mining operations
that design and build dedicated machines and data centers,
including mining pools, which are groups of miners that act
cohesively and combine their processing power to solve blocks (in
the case of proof-of-work) or stake coins (in the case of
proof-of-stake). When a pool mines a new block, the pool operator
receives the ETH and, after taking a nominal fee, splits the
resulting reward among the pool participants based on the
processing power each of them contributed to mine such block.
Mining pools provide participants with access to smaller, but
steadier and more frequent, ETH payouts. See “—Creation of New ETH”
above.
Investment and Speculative Sector
This sector includes the investment and trading activities of both
private and professional investors and speculators. Historically,
larger financial services institutions are publicly reported to
have limited involvement in investment and trading in digital
assets, although the participation landscape is beginning to
change. Currently, there is relatively limited use of digital
assets in the retail and commercial marketplace in comparison to
relatively extensive use by speculators, and a significant portion
of demand for digital assets is generated by speculators and
investors seeking to profit from the short- or long-term holding of
digital assets.
Retail Sector
The retail sector includes users transacting in direct peer-to-peer
ETH transactions through the direct sending of ETH over the
Ethereum Network. The retail sector also includes transactions in
which consumers pay for goods or services from commercial or
service businesses through direct transactions or third-party
service providers, although the use of ETH as a means of payment is
still developing and has not been accepted in the same manner as
Bitcoin due to ETH’s relative nascency and because ETH has a
slightly different purpose than Bitcoin.
Service Sector
This sector includes companies that provide a variety of services
including the buying, selling, payment processing and storing of
ETH. Bitstamp, Coinbase Pro, Kraken, and LMAX Digital are some of
the largest Digital Asset Exchanges by volume traded.
Coinbase
15
Custody Trust Company, LLC, the Custodian for the Trust, is a
digital asset custodian that provides custodial accounts that store
ETH for users. As the Ethereum Network continues to grow in
acceptance, it is anticipated that service providers will expand
the currently available range of services and that additional
parties will enter the service sector for the Ethereum
Network.
Competition
More than 16,000 other digital assets, as tracked by
CoinMarketCap.com, have been developed since the inception of
Bitcoin, currently the most developed digital asset because of the
length of time it has been in existence, the investment in the
infrastructure that supports it, and the network of individuals and
entities that are using Bitcoin in transactions. While ETH has
enjoyed some success in its limited history, the aggregate value of
outstanding ETH is smaller than that of Bitcoin and may be eclipsed
by the more rapid development of other digital assets. In addition,
while ETH was the first digital asset with a network that served as
a smart contracts platform, a number of newer digital assets also
function as smart contracts platforms, including Solana, Avalanche,
Terra and Cardano. Some industry groups are also creating private,
permissioned blockchain versions of Ethereum. For example, J.P.
Morgan and others are developing an open source platform called
Quorum, which is described as a version of Ethereum designed for
use by the financial services industry.
Government Oversight
As digital assets have grown in both popularity and market size,
the U.S. Congress and a number of U.S. federal and state agencies
(including FinCEN, SEC, CFTC, FINRA, the Consumer Financial
Protection Bureau (“CFPB”), the Department of Justice, the
Department of Homeland Security, the Federal Bureau of
Investigation, the IRS and state financial institution regulators)
have been examining the operations of digital asset networks,
digital asset users and the Digital Asset Exchange Markets, with
particular focus on the extent to which digital assets can be used
to launder the proceeds of illegal activities or fund criminal or
terrorist enterprises and the safety and soundness of exchanges or
other service providers that hold digital assets for users. Many of
these state and federal agencies have issued consumer advisories
regarding the risks posed by digital assets to investors. In
addition, federal and state agencies, and other countries have
issued rules or guidance about the treatment of digital asset
transactions or requirements for businesses engaged in digital
asset activity.
In addition, the SEC, U.S. state securities regulators and several
foreign governments have issued warnings that digital assets sold
in initial coin offerings may be classified as securities and that
both those digital assets and initial coin offerings may be subject
to securities regulations. Ongoing and future regulatory actions
may alter, perhaps to a materially adverse extent, the nature of an
investment in the Shares or the ability of the Trust to continue to
operate. Additionally, U.S. state and federal, and foreign
regulators and legislatures have taken action against virtual
currency businesses or enacted restrictive regimes in response to
adverse publicity arising from hacks, consumer harm, or criminal
activity stemming from virtual currency activity.
In August 2021, the chair of the SEC stated that he believed
investors using digital asset trading platforms are not adequately
protected, and that activities on the platforms can implicate the
securities laws, commodities laws and banking laws, raising a
number of issues related to protecting investors and consumers,
guarding against illicit activity, and ensuring financial
stability. The chair expressed a need for the SEC to have
additional authorities to prevent transactions, products, and
platforms from “falling between regulatory cracks,” as well as for
more resources to protect investors in “this growing and volatile
sector.” The chair called for federal legislation centering on
digital asset trading, lending, and decentralized finance
platforms, seeking “additional plenary authority” to write rules
for digital asset trading and lending. See “Item 1A. Risk Factors—
Regulatory changes or actions by U.S. Congress or any U.S. federal
or state agencies may affect the value of the Shares or restrict
the use of ETH, mining activity or the operation of the Ethereum
Network or the Digital Asset Exchange Market in a manner that
adversely affects the value of the Shares,” “—A determination that
a digital asset is a “security” may adversely affect the value of
ETH and the value of the Shares” and “—Changes in SEC policy could
adversely impact the value of the Shares.”
Various foreign jurisdictions have, and may continue to, in the
near future, adopt laws, regulations or directives that affect a
digital asset network, the Digital Asset Markets, and their users,
particularly Digital Asset Exchanges and service providers that
fall within such jurisdictions’ regulatory scope. For
example:
•
China has made transacting in cryptocurrencies illegal for Chinese
citizens in mainland China, and additional restrictions may follow.
China has banned initial coin offerings and there have been reports
that Chinese regulators have taken action to shut down a number of
China-based Digital Asset Exchanges. In May 2021, the Chinese
government announced renewed efforts to restrict cryptocurrency
trading and mining activities, citing concerns about high energy
consumption and its desire to promote financial stability.
Regulators in the Inner Mongolia and other regions of China have
proposed regulations that would create penalties for companies
engaged in cryptocurrency mining activities and introduce
heightened energy saving requirements on industrial parks, data
centers and power plants providing electricity to cryptocurrency
miners. In January 2018, a Chinese news organization reported that
the People’s Bank of China had ordered financial institutions to
stop providing banking or funding to “any activity related to
cryptocurrencies.”
16
•
South Korea determined to amend its Financial Information Act in
March 2020 to require virtual asset service providers to register
and comply with its AML and counter-terrorism funding framework.
These measures also provide the government with the authority to
close Digital Asset Exchanges that do not comply with specified
processes. South Korea has also banned initial coin
offerings.
•
The Reserve Bank of India in April 2018 banned the entities it
regulates from providing services to any individuals or business
entities dealing with or settling digital assets. In March 2020,
this ban was overturned in the Indian Supreme Court, although the
Reserve Bank of India is currently challenging this
ruling.
•
The United Kingdom’s Financial Conduct Authority published final
rules in October 2020 banning the sale of derivatives and exchange
traded notes that reference certain types of digital assets,
contending that they are “ill-suited” to retail investors citing
extreme volatility, valuation challenges and association with
financial crime.
There remains significant uncertainty regarding foreign
governments’ future actions with respect to the regulation of
digital assets and Digital Asset Exchanges. Such laws, regulations
or directives may conflict with those of the United States and may
negatively impact the acceptance of ETH by users, merchants and
service providers outside the United States and may therefore
impede the growth or sustainability of the ETH economy in the
United States and globally, or otherwise negatively affect the
value of ETH held by the Trust. The effect of any future regulatory
change on the Trust or the ETH held by the Trust is impossible to
predict, but such change could be substantial and adverse to the
Trust and the value of the Shares.
See “Item 1A. Risk Factors—Risk Factors Related to the Regulation
of the Trust and the Shares—Regulatory changes or actions by U.S.
Congress or any U.S. federal or state agencies may affect the value
of the Shares or restrict the use of ETH, mining activity or the
operation of the Ethereum Network or the Digital Asset Markets in a
manner that adversely affects the value of the Shares.”
Description of the Trust
The Trust is a Delaware Statutory Trust that was formed on December
13, 2017 by the filing of the Certificate of Trust with the
Delaware Secretary of State in accordance with the provisions of
the Delaware Statutory Trust Act (“DSTA”). On January 11, 2019, the
Trust changed its name from Ethereum Investment Trust to Grayscale
Ethereum Trust (ETH) by filing a Certificate of Amendment to the
Certificate of Trust with the Delaware Secretary of State in
accordance with the provisions of the DSTA. The Trust operates
pursuant to the Trust Agreement.
The Shares represent units of fractional undivided beneficial
interest in and ownership of the Trust. The Trust is passive and is
not managed like a corporation or an active investment vehicle. The
Trust’s ETH are held by the Custodian on behalf of the Trust. The
Trust’s ETH will be transferred out of the Digital Asset Account
only in the following circumstances: (i) transferred to pay the
Sponsor’s Fee or any Additional Trust Expenses, (ii) sold on an
as-needed basis to pay Additional Trust Expenses or (iii) sold on
behalf of the Trust in the event the Trust terminates and
liquidates its assets or as otherwise required by law or
regulation. Assuming that the Trust is treated as a grantor trust
for U.S. federal income tax purposes, each delivery or sale of ETH
by the Trust to pay the Sponsor’s Fee or any Additional Trust
Expenses will be a taxable event for shareholders. See “—Certain
U.S. Federal Income Tax Consequences—Tax Consequences to U.S.
Holders.”
The Trust is not a registered investment company under the
Investment Company Act and the Sponsor believes that the Trust is
not required to register under the Investment Company Act. The
Trust will not trade, buy, sell or hold ETH derivatives, including
ETH futures contracts, on any futures exchange. The Trust is
authorized solely to take immediate delivery of actual ETH. The
Sponsor does not believe the Trust’s activities are required to be
regulated by the CFTC under the CEA as a “commodity pool” under
current law, regulation and interpretation. The Trust will not be
operated by a CFTC-regulated commodity pool operator because it
will not trade, buy, sell or hold ETH derivatives, including ETH
futures contracts, on any futures exchange. Investors in the Trust
will not receive the regulatory protections afforded to investors
in regulated commodity pools, nor may the COMEX division of the New
York Mercantile Exchange or any futures exchange enforce its rules
with respect to the Trust’s activities. In addition, investors in
the Trust will not benefit from the protections afforded to
investors in ETH futures contracts on regulated futures
exchanges.
The Trust creates Shares from time to time but only in Baskets. A
Basket equals a block of 100 Shares. The number of outstanding
Shares is expected to increase from time to time as a result of the
creation of Baskets. The creation of Baskets will require the
delivery to the Trust of the number of ETH represented by the
Baskets being created. The creation of a Basket will be made only
in exchange for the delivery to the Trust of the number of whole
and fractional ETH represented by each Basket being created, the
number of which is determined by dividing (x) the number of ETH
owned by the Trust at 4:00 p.m., New York time, on the relevant
trade date, after deducting the number of ETH representing the U.S.
dollar value of accrued but unpaid fees and expenses of the Trust
(converted using the Index Price at such time, and carried to the
eighth decimal place) by (y) the number of Shares outstanding at
such time (with the quotient so obtained calculated to one
one-hundred-millionth of one ETH (i.e., carried to the eighth
decimal place)), and multiplying such quotient by 100.
17
Although the redemption of Shares is provided for in the Trust
Agreement, the redemption of Shares is not currently permitted and
the Trust does not currently operate a redemption program. Subject
to receipt of regulatory approval from the SEC and approval by the
Sponsor in its sole discretion, the Trust may in the future operate
a redemption program. Because the Trust does not believe that the
SEC would, at this time, entertain an application for the waiver of
rules needed in order to operate an ongoing redemption program, the
Trust currently has no intention of seeking regulatory approval
from the SEC to operate an ongoing redemption program. Even if such
relief is sought in the future, no assurance can be given as to the
timing of such relief or that such relief will be granted. If such
relief is granted and the Sponsor approves a redemption program,
the Shares will be redeemable in accordance with the provisions of
the Trust Agreement and the relevant Participant Agreement.
Although the Sponsor cannot predict with certainty what effect, if
any, the operation of a redemption program would have on the
trading price of the Shares, this will allow Authorized
Participants to take advantage of arbitrage opportunities created
when the market value of the Shares deviates from the value of the
Trust’s ETH, less the Trust’s expenses and other liabilities, which
may have the effect of reducing any premium at which the Shares
trade on OTCQX over such value or cause the Shares to trade at a
discount to such value from time to time.
Each Share represented approximately 0.0100 ETH as of December 31,
2021. Each Share in the initial Baskets represented approximately
0.0111 ETH.
The decrease in the number of ETH represented by each Share since
inception is primarily a result of the Share Split and, to a lesser
degree, the periodic withdrawal of ETH to pay the Sponsor’s Fee and
any Additional Trust Expenses.
The number of ETH required to create a Basket is expected to
continue to gradually decrease over time due to the transfer or
sale of the Trust’s ETH to pay the Sponsor’s Fee and any Additional
Trust Expenses. The Trust will not accept or distribute cash in
exchange for Baskets other than upon its dissolution. Authorized
Participants may sell to other investors the Shares they purchase
from the Trust only in transactions exempt from registration under
the Securities Act. For a discussion of risks relating to the
unavailability of a redemption program, see “Item 1A. Risk
Factors—Risk Factors Related to the Trust and the Shares—
Because of the holding period under Rule 144, the lack of an
ongoing redemption program and the Trust’s ability to halt
creations from time to time, there is no arbitrage mechanism to
keep the price of the Shares closely linked to the Index Price and
the Shares have historically traded at a substantial premium, or
substantial discount to, the Digital Asset Holdings per
Share”
and “Item
1A. Risk Factors—Risk
Factors Related to the Trust and the Shares—The restrictions on
transfer and redemption may result in losses on the value of the
Shares.”
The Sponsor will determine the Trust’s Digital Asset Holdings on
each business day as of 4:00 p.m., New York time, or as soon
thereafter as practicable. The Sponsor will also determine the
Digital Asset Holdings per Share, which equals the Digital Asset
Holdings divided by the number of outstanding Shares. Each business
day, the Sponsor will publish the Trust’s Digital Asset Holdings
and Digital Asset Holdings per Share on the Trust’s website,
www.grayscale.com/products/grayscale-ethereum-trust/, as soon as
practicable after the Trust’s Digital Asset Holdings and Digital
Asset Holdings per Share have been determined by the Sponsor. See
“Valuation of ETH and Determination of the Trust’s Digital Asset
Holdings.”
The Trust’s assets consist solely of ETH, Incidental Rights, IR
Virtual Currency, proceeds from the sale of ETH, Incidental Rights
and IR Virtual Currency pending use of such cash for payment of
Additional Trust Expenses or distribution to the shareholders and
any rights of the Trust pursuant to any agreements, other than the
Trust Agreement, to which the Trust is a party. Each Share
represents a proportional interest, based on the total number of
Shares outstanding, in each of the Trust’s assets as determined in
the case of ETH by reference to the Index Price, less the Trust’s
expenses and other liabilities (which include accrued but unpaid
fees and expenses). The Sponsor expects that the market price of
the Shares will fluctuate over time in response to the market
prices of ETH. In addition, because the Shares reflect the
estimated accrued but unpaid expenses of the Trust, the number of
ETH represented by a Share will gradually decrease over time as the
Trust’s ETH are used to pay the Trust’s expenses. The Trust does
not expect to take any Incidental Rights or IR Virtual Currency it
may hold into account for purposes of determining the Trust’s
Digital Asset Holdings or the Digital Asset Holdings per
Share.
ETH pricing information is available on a 24-hour basis from
various financial information service providers or Ethereum Network
information sites such as Tradeblock.com or Bitcoincharts.com. The
spot price and bid/ask spreads may also be available directly from
Digital Asset Exchanges. As of December 31, 2021, the constituent
Digital Asset Exchanges of the Index were Bitstamp, Coinbase Pro,
LMAX Digital and Kraken. On January 19, 2020, the Index Provider
removed itBit and added LMAX Digital to the Index as part of its
scheduled quarterly review. The Index Provider may remove or add
Digital Asset Exchanges to the Index in the future at its
discretion. Market prices for the Shares will be available from a
variety of sources, including brokerage firms, information websites
and other information service providers. In addition, on each
business day the Trust’s website will provide pricing information
for the Shares.
The Trust has no fixed termination date.
Service Providers of the Trust
The Sponsor
The Trust’s Sponsor is Grayscale Investments, LLC, a Delaware
limited liability company formed on May 29, 2013 and a wholly owned
subsidiary of DCG. The Sponsor’s principal place of business is 290
Harbor Drive, 4th
Floor, Stamford, Connecticut 06902 and
18
its telephone number is (212) 668-1427. Under the Delaware Limited
Liability Company Act and the governing documents of the Sponsor,
DCG, the sole member of the Sponsor, is not responsible for the
debts, obligations and liabilities of the Sponsor solely by reason
of being the sole member of the Sponsor.
The Sponsor is neither an investment adviser registered with the
SEC nor a commodity pool operator registered with the CFTC, and
will not be acting in either such capacity with respect to the
Trust, and the Sponsor’s provision of services to the Trust will
not be governed by the Investment Advisers Act or the
CEA.
The Sponsor arranged for the creation of the Trust and quotation of
the Shares on OTCQX. As partial consideration for its receipt of
the Sponsor’s Fee from the Trust, the Sponsor is obligated to pay
the Sponsor-paid Expenses. The Sponsor also paid the costs of the
Trust’s organization and the costs of the initial sale of the
Shares.
The Sponsor is generally responsible for the day-to-day
administration of the Trust under the provisions of the Trust
Agreement. This includes (i) preparing and providing periodic
reports and financial statements on behalf of the Trust for
investors, (ii) processing orders to create Baskets and
coordinating the processing of such orders with the Custodian and
the Transfer Agent, (iii) calculating and publishing the Digital
Asset Holdings and the Digital Asset Holdings per Share of the
Trust each business day as of 4:00 p.m., New York time, or as soon
thereafter as practicable, (iv) selecting and monitoring the
Trust’s service providers and from time to time engaging
additional, successor or replacement service providers, (v)
instructing the Custodian to transfer the Trust’s ETH, as needed to
pay the Sponsor’s Fee and any Additional Trust Expenses, (vi) upon
dissolution of the Trust, distributing the Trust’s remaining ETH,
Incidental Rights and IR Virtual Currency or the cash proceeds of
the sale thereof to the owners of record of the Shares and (vii)
establishing the principal market for GAAP valuation. In addition,
if there is a fork in the Ethereum Network after which there is a
dispute as to which network resulting from the fork is the Ethereum
Network, the Sponsor has the authority to select the network that
it believes in good faith is the Ethereum Network, unless such
selection or authority would otherwise conflict with the Trust
Agreement.
The Sponsor does not store, hold, or maintain custody or control of
the Trust’s ETH but instead has entered into the Custodian
Agreement with the Custodian to facilitate the security of the
Trust’s ETH.
The Sponsor may transfer all or substantially all of its assets to
an entity that carries on the business of the Sponsor if at the
time of the transfer the successor assumes all of the obligations
of the Sponsor under the Trust Agreement. In such an event, the
Sponsor will be relieved of all further liability under the Trust
Agreement.
The Sponsor’s Fee is paid by the Trust to the Sponsor as
compensation for services performed under the Trust Agreement and
as partial consideration for the Sponsor’s agreement to pay the
Sponsor-paid Expenses. See “—Expenses; Sales of ETH.”
The Sponsor may, in its sole discretion, select a different index
provider, select a different reference rate provided by the Index
Provider or calculate the Index Price by using the cascading set of
rules set forth under “Overview
of the ETH Industry and Market—ETH
Value—The Index and the Index Price—Determination of the Index
Price When Index Price is Unavailable”.
Distribution and Marketing Agreement
The Sponsor has entered into a Distribution and Marketing Agreement
with Genesis Global Trading, Inc. (“Genesis”), a related party of
the Trust
to assist the Sponsor in distributing the Shares, developing an
ongoing marketing plan for the Trust, preparing marketing materials
regarding the Shares, including the content on the Trust’s website,
www.grayscale.com/products/grayscale-ethereum-trust/, executing the
marketing plan for the Trust and providing strategic and tactical
research on the Digital Asset Markets.
Index License Agreement
The Index Provider and the Sponsor have entered into the Index
License Agreement governing the Sponsor’s use of the Index for
calculation of the Index Price. The Index Provider may adjust the
calculation methodology for the Index without notice to, or consent
of, the Trust or its shareholders. Under the Index License
Agreement, the Sponsor pays a monthly fee and a fee based on the
Digital Asset Holdings of the Trust to the Index Provider in
consideration of its license to the Sponsor of Index-related
intellectual property. The Index License Agreement will
automatically renew on an annual basis. The Index License Agreement
is terminable by either party upon written notice in the event of a
material breach that remains uncured for thirty days after initial
written notice of such breach. Further, either party may terminate
the Index License Agreement immediately upon notice under certain
circumstances, including with respect to the other party’s (i)
insolvency, bankruptcy or analogous event or (ii) violation of
money transmission, taxation or trading regulations that materially
adversely affect either party’s ability to perform under the Index
License Agreement.
19
The Trustee
Delaware Trust Company serves as Delaware trustee of the Trust
under the Trust Agreement. The Trustee has its principal office at
251 Little Falls Drive, Wilmington, Delaware 19808. The Trustee is
unaffiliated with the Sponsor. A copy of the Trust Agreement is
available for inspection at the Sponsor’s principal office
identified above.
The Trustee is appointed to serve as the trustee of the Trust in
the State of Delaware for the sole purpose of satisfying the
requirement of Section 3807(a) of the DSTA that the Trust have at
least one trustee with a principal place of business in the State
of Delaware. The duties of the Trustee will be limited to (i)
accepting legal process served on the Trust in the State of
Delaware and (ii) the execution of any certificates required to be
filed with the Delaware Secretary of State which the Delaware
Trustee is required to execute under the DSTA. To the extent that,
at law or in equity, the Trustee has duties (including fiduciary
duties) and liabilities relating thereto to the Trust or the
shareholders, such duties and liabilities will be replaced by the
duties and liabilities of the Trustee expressly set forth in the
Trust Agreement. The Trustee will have no obligation to supervise,
nor will it be liable for, the acts or omissions of the Sponsor,
Transfer Agent, Custodian or any other person.
Neither the Trustee, either in its capacity as trustee or in its
individual capacity, nor any director, officer or controlling
person of the Trustee is, or has any liability as, the issuer,
director, officer or controlling person of the issuer of Shares.
The Trustee’s liability in connection with the issuance and sale of
Shares is limited solely to the express obligations of the Trustee
as set forth in the Trust Agreement.
The Trustee has not prepared or verified, and will not be
responsible or liable for, any information, disclosure or other
statement in this Annual Report or in any other document issued or
delivered in connection with the sale or transfer of the Shares.
The Trust Agreement provides that the Trustee will not be
responsible or liable for the genuineness, enforceability,
collectability, value, sufficiency, location or existence of any of
the ETH or other assets of the Trust. See “—Description of the
Trust Agreement.”
The Trustee is permitted to resign upon at least 180 days’ notice
to the Trust. The Trustee will be compensated by the Sponsor and
indemnified by the Sponsor and the Trust against any expenses it
incurs relating to or arising out of the formation, operation or
termination of the Trust, or the performance of its duties pursuant
to the Trust Agreement except to the extent that such expenses
result from gross negligence, willful misconduct or bad faith of
the Trustee. The Sponsor has the discretion to replace the
Trustee.
Fees paid to the Trustee are a Sponsor-paid Expense.
The Transfer Agent
Continental Stock Transfer & Trust Company, a Delaware
corporation, serves as the Transfer Agent of the Trust pursuant to
the terms and provisions of the Transfer Agency and Service
Agreement. The Transfer Agent has its principal office at 1 State
Street, 30th Floor, New York, New York 10004. A copy of the
Transfer Agency and Service Agreement is available for inspection
at the Sponsor’s principal office identified herein.
The Transfer Agent holds the Shares primarily in book-entry form.
The Sponsor directs the Transfer Agent to credit the number of
Creation Baskets to the investor on behalf of which an Authorized
Participant submitted a creation order. The Transfer Agent will
issue Creation Baskets. The Transfer Agent will also assist with
the preparation of shareholders’ account and tax
statements.
The Sponsor will indemnify and hold harmless the Transfer Agent,
and the Transfer Agent will incur no liability for the refusal, in
good faith, to make transfers which it, in its judgment, deems
improper or unauthorized.
Fees paid to the Transfer Agent are a Sponsor-paid
Expense.
Authorized Participants
An Authorized Participant must enter into a “Participant Agreement”
with the Sponsor and the Trust to govern its placement of orders to
create Baskets. The Participant Agreement sets forth the procedures
for the creation of Baskets and for the delivery of ETH required
for creations. A copy of the form of Participant Agreement is
available for inspection at the Sponsor’s principal office
identified herein.
Each Authorized Participant must (i) be a registered broker-dealer,
(ii) enter into a Participant Agreement with the Sponsor and (iii)
own an ETH wallet address that is known to the Custodian as
belonging to the Authorized Participant. A list of the current
Authorized Participants can be obtained from the Sponsor. As of the
date of this Annual Report, Genesis is the only acting Authorized
Participant. The Sponsor intends to engage additional Authorized
Participants that are unaffiliated with the Trust in the
future.
No Authorized Participant has any obligation or responsibility to
the Sponsor or the Trust to effect any sale or resale of
Shares.
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The Custodian
Coinbase Custody Trust Company, LLC is a fiduciary under § 100 of
the New York Banking Law and a qualified custodian for purposes of
Rule 206(4)-2(d)(6) under the Investment Advisers Act of 1940, as
amended. The Custodian is authorized to serve as the Trust’s
custodian under the Trust Agreement and pursuant to the terms and
provisions of the Custodian Agreement. The Custodian has its
principal office at 200 Park Avenue South, Suite 1208, New York, NY
10003. A copy of the Custodian Agreement is available for
inspection at the Sponsor’s principal office identified
herein.
Under the Custodian Agreement, the Custodian controls and secures
the Trust’s “Digital Asset Account,” a segregated custody account
to store private keys, which allow for the transfer of ownership or
control of the Trust’s ETH, on the Trust’s behalf. The Custodian’s
services (i) allow ETH to be deposited from a public blockchain
address to the Trust’s Digital Asset Account and (ii) allow the
Trust or Sponsor to withdraw ETH from the Trust’s Digital Asset
Account to a public blockchain address the Trust or Sponsor
controls (the “Custodial Services”). The Digital Asset Account uses
offline storage, or “cold” storage, mechanisms to secure the
Trust’s private keys. The term cold storage refers to a
safeguarding method by which the private keys corresponding to
digital assets are disconnected and/or deleted entirely from the
internet.
The Custodian will withdraw from the Trust’s Digital Asset Account
the number of ETH necessary to pay the Trust’s expenses.
Fees paid to the Custodian are a Sponsor-paid Expense.
Under the Custodian Agreement, each of the Custodian and the Trust
has agreed to indemnify and hold harmless the other party from any
third-party claim or third-party demand (including reasonable and
documented attorneys’ fees and any fines, fees or penalties imposed
by any regulatory authority) arising out of or related to the
Custodian’s or the Trust’s, as the case may be, breach of the
Custodian Agreement, inaccuracy in any of the Custodian’s or the
Trust’s, as the case may be, representations or warranties in the
Custodian Agreement, or the Trust’s violation, or the Custodian’s
knowing violation, of any law, rule or regulation, or the rights of
any third party, except where such claim directly results from the
gross negligence, fraud or willful misconduct of the other such
party.
The Custodian and its affiliates may from time to time purchase or
sell ETH for their own accounts and as agent for their customers or
Shares for their own accounts. The foregoing notwithstanding, ETH
in the Digital Asset Account are not treated as general assets of
the Custodian and cannot be commingled with any other digital
assets held by the Custodian. The Custodian serves as a fiduciary
and custodian on the Trust’s behalf, and the ETH in the Digital
Asset Account are considered fiduciary assets that remain the
Trust’s property at all times.
Once each calendar year, the Sponsor or the Trust may request that
the Custodian deliver a certificate signed by a duly authorized
officer to certify that the Custodian has complied and is currently
in compliance with the Custodian Agreement and that all
representations and warranties made by the Custodian in the
Custodian Agreement are true and correct on and as of the date of
such certificate, and have been true and correct throughout the
preceding year. In addition, the Custodian has agreed to allow the
Trust and the Sponsor to take any necessary steps to verify that
satisfactory internal control system and procedures are in place,
and to visit and inspect the systems on which the Custodian’s coins
are held.
If the Custodian resigns in its capacity as custodian, the Sponsor
may appoint an additional or replacement custodian and enter into a
custodian agreement on behalf of the Trust with such custodian.
Furthermore, the Sponsor and the Trust may use ETH custody services
or similar services provided by entities other than Coinbase
Custody Trust Company, LLC at any time without prior notice to
Coinbase Custody Trust Company, LLC.
Custody of the Trust’s ETH
Digital assets and digital asset transactions are recorded and
validated on blockchains, the public transaction ledgers of a
digital asset network. Each digital asset blockchain serves as a
record of ownership for all of the units of such digital asset,
even in the case of certain privacy-preserving digital assets,
where the transactions themselves are not publicly viewable. All
digital assets recorded on a blockchain are associated with a
public blockchain address, also referred to as a digital wallet.
Digital assets held at a particular public blockchain address may
be accessed and transferred using a corresponding private
key.
Key Generation
Public addresses and their corresponding private keys are generated
by the Custodian in secret key generation ceremonies at secure
locations inside faraday cages, which are enclosures used to block
electromagnetic fields and thus mitigate against attacks. The
Custodian uses quantum random number generators to generate the
public and private key pairs.
21
Once generated, private keys are encrypted, separated into “shards”
and then further encrypted. After the key generation ceremony, all
materials used to generate private keys, including computers, are
destroyed. All key generation ceremonies are performed offline. No
party other than the Custodian has access to the private key shards
of the Trust.
Key Storage
Private key shards are distributed geographically in secure vaults
around the world, including in the United States. The locations of
the secure vaults may change regularly and are kept confidential by
the Custodian for security purposes.
The Digital Asset Account uses offline storage, or “cold storage”,
mechanisms to secure the Trust’s private keys. The term cold
storage refers to a safeguarding method by which the private keys
corresponding to digital assets are disconnected and/or deleted
entirely from the internet. Cold storage of private keys may
involve keeping such keys on a non-networked (or “air-gapped”)
computer or electronic device or storing the private keys on a
storage device (for example, a USB thumb drive) or printed medium
(for example, papyrus, paper or a metallic object). A digital
wallet may receive deposits of digital assets but may not send
digital assets without use of the digital assets’ corresponding
private keys. In order to send digital assets from a digital wallet
in which the private keys are kept in cold storage, either the
private keys must be retrieved from cold storage and entered into
an online, or “hot”, digital asset software program to sign the
transaction, or the unsigned transaction must be transferred to the
cold server in which the private keys are held for signature by the
private keys and then transferred back to the online digital asset
software program. At that point, the user of the digital wallet can
transfer its digital assets.
Security Procedures
The Custodian is the custodian of the Trust’s private keys in
accordance with the terms and provisions of the Custodian
Agreement. Transfers from the Digital Asset Account requires
certain security procedures, including but not limited to, multiple
encrypted private key shards, usernames, passwords and 2-step
verification. Multiple private key shards held by the Custodian
must be combined to reconstitute the private key to sign any
transaction in order to transfer the Trust’s assets. Private key
shards are distributed geographically in secure vaults around the
world, including in the United States.
As a result, if any one secure vault is ever compromised, this
event will have no impact on the ability of the Trust to access its
assets, other than a possible delay in operations, while one or
more of the other secure vaults is used instead. These security
procedures are intended to remove single points of failure in the
protection of the Trust’s assets.
Transfers of ETH to the Digital Asset Account will be available to
the Trust once processed on the Ethereum Blockchain.
Subject to obtaining regulatory approval to operate a redemption
program and authorization of the Sponsor, the process of accessing
and withdrawing ETH from the Trust to redeem a Basket by an
Authorized Participant will follow the same general procedure as
transferring ETH to the Trust to create a Basket by an Authorized
Participant, only in reverse. See “—Description of Creation of
Shares.”
The Distributor and Marketer
Genesis Global Trading, Inc., a Delaware corporation, is the
distributor and marketer of the Shares. Genesis is a registered
broker-dealer with the SEC and is a member of FINRA.
In its capacity as distributor and marketer, Genesis assists the
Sponsor in developing an ongoing marketing plan for the Trust;
preparing marketing materials regarding the Shares, including the
content on the Trust’s website,
www.grayscale.com/products/grayscale-ethereum-trust/; executing the
marketing plan for the Trust; and providing strategic and tactical
research to the Trust on the Digital Asset Markets. Genesis and the
Sponsor are affiliates of one another.
The Sponsor has entered into a Distribution and Marketing Agreement
with Genesis. The Sponsor may engage additional or successor
distributors and marketers in the future.
Description of the Shares
The Trust is authorized under the Trust Agreement to create and
issue an unlimited number of Shares. Shares will be issued only in
Baskets (a Basket equals a block of 100 Shares) in connection with
creations. The Shares represent units of fractional undivided
beneficial interest in and ownership of the Trust and have no par
value. On December 17, 2020, the Trust completed a 9-for-1 Share
split of the Trust’s issued and outstanding Shares. In connection
with the Share Split, shareholders of record on December 14, 2020
received eight additional Shares of the Trust for each Share held.
The number of outstanding Shares and per-Share amounts disclosed
for periods prior to December 17, 2020 have been retroactively
adjusted to reflect the effects of the Share Split, as
applicable.
22
Description of Limited Rights
The Shares do not represent a traditional investment and should not
be viewed as similar to “shares” of a corporation operating a
business enterprise with management and a board of directors. A
shareholder will not have the statutory rights normally associated
with the ownership of shares of a corporation. Each Share is
transferable, is fully paid and non-assessable and entitles the
holder to vote on the limited matters upon which shareholders may
vote under the Trust Agreement. For example, shareholders do not
have the right to elect or remove directors and will not receive
dividends. The Shares do not entitle their holders to any
conversion or pre-emptive rights or, except as discussed below, any
redemption rights or rights to distributions.
Voting and Approvals
The shareholders take no part in the management or control of the
Trust. Under the Trust Agreement, shareholders have limited voting
rights. For example, in the event that the Sponsor withdraws, a
majority of the shareholders may elect and appoint a successor
sponsor to carry out the affairs of the Trust. In addition, no
amendments to the Trust Agreement that materially adversely affect
the interests of shareholders may be made without the vote of at
least a majority (over 50%) of the Shares (not including any Shares
held by the Sponsor or its affiliates). However, the Sponsor may
make any other amendments to the Trust Agreement in its sole
discretion without shareholder consent provided that the Sponsor
provides 20 days’ notice of any such amendment.
Distributions
Pursuant to the terms of the Trust Agreement, the Trust may make
distributions on the Shares in-cash or in-kind, including in such
form as is necessary or permissible for the Trust to facilitate
shareholders’ access to any Incidental Rights or to IR Virtual
Currency.
In addition, if the Trust is terminated and liquidated, the Sponsor
will distribute to the shareholders any amounts of the cash
proceeds of the liquidation remaining after the satisfaction of all
outstanding liabilities of the Trust and the establishment of
reserves for applicable taxes, other governmental charges and
contingent or future liabilities as the Sponsor will determine. See
“—Description of the Trust Agreement—The Trustee—Termination of the
Trust.” Shareholders of record on the record date fixed by the
Transfer Agent for a distribution will be entitled to receive their
pro rata portions of any distribution.
Appointment of Agent
Pursuant to the terms of the Trust Agreement, by holding the
Shares, shareholders will be deemed to agree that the Sponsor may
cause the Trust to appoint an agent (any person appointed in such
capacity, an “Agent”) to act on their behalf in connection with any
distribution of Incidental Rights and/or IR Virtual Currency if the
Sponsor has determined in good faith that such appointment is
reasonably necessary or in the best interests of the Trust and the
shareholders in order to facilitate the distribution of any
Incidental Rights and/or IR Virtual Currency. The Sponsor may cause
the Trust to appoint Grayscale Investments, LLC (acting other than
in its capacity as Sponsor) or any of its affiliates to act in such
capacity.
Any Agent appointed to facilitate a distribution of Incidental
Rights and/or IR Virtual Currency will receive an in-kind
distribution of Incidental Rights and/or IR Virtual Currency on
behalf of the shareholders of record with respect to such
distribution, and following receipt of such distribution, will
determine, in its sole discretion and without any direction from
the Trust, or the Sponsor, in its capacity as Sponsor of the Trust,
whether and when to sell the distributed Incidental Rights and/or
IR Virtual Currency on behalf of the record date shareholders. If
the Agent is able to do so, it will remit the cash proceeds to the
record date shareholders. There can be no assurance as to the price
or prices for any Incidental Rights and/or IR Virtual Currency that
the Agent may realize, and the value of the Incidental Rights
and/or IR Virtual Currency may increase or decrease after any sale
by the Agent.
Any Agent appointed pursuant to the Trust Agreement will not
receive any compensation in connection with its role as agent.
However, any Agent will be entitled to receive from the record-date
shareholders, out of the distributed Incidental Rights and/or IR
Virtual Currency, an amount of Incidental Rights and/or IR Virtual
Currency with an aggregate fair market value equal to the amount of
administrative and other reasonable expenses incurred by the Agent
in connection with its activities as agent of the record-date
shareholders, including expenses incurred by the Agent in
connection with any post-distribution sale of such Incidental
Rights and/or IR Virtual Currency.
The Sponsor currently expects to cause the Trust to appoint
Grayscale Investments, LLC, acting other than in its capacity as
Sponsor, as Agent to facilitate any distribution of Incidental
Rights and/or IR Virtual Currency to shareholders. The Trust has no
right to receive any information about any distributed Incidental
Rights and/or IR Virtual Currency or the disposition thereof from
the record date shareholders, their Agent or any other
person.
23
Creation of Shares
The Trust creates Shares at such times and for such periods as
determined by the Sponsor, but only in one or more whole Baskets. A
Basket equals 100 Shares. As of December 31, 2021, each Share
represented approximately 0.0100 ETH. See “—Description of Creation
of Shares.” The creation of a Basket requires the delivery to the
Trust of the number of ETH represented by one Share immediately
prior to such creation multiplied by 100. The Trust may from time
to time halt creations for a variety of reasons, including in
connection forks, airdrops and other similar
occurrences.
Redemption of Shares
Redemptions of Shares are currently not permitted and the Trust is
unable to redeem Shares. Subject to receipt of regulatory approval
from the SEC and approval by the Sponsor in its sole discretion,
the Trust may in the future operate a redemption program. Because
the Trust does not believe that the SEC would, at this time,
entertain an application for the waiver of rules needed in order to
operate an ongoing redemption program, the Trust currently has no
intention of seeking regulatory approval from the SEC to operate an
ongoing redemption program.
Even if such relief is sought in the future, no assurance can be
given as to the timing of such relief or that such relief will be
granted. If such relief is granted and the Sponsor approves a
redemption program, the Shares will be redeemable only in
accordance with the provisions of the Trust Agreement and the
relevant Participant Agreement. See “Item 1A. Risk Factors—Risk
Factors Related to the Trust and the Shares—Because of the holding
period under Rule 144, the lack of an ongoing redemption program
and the Trust’s ability to halt creations from time to time, there
is no arbitrage mechanism to keep the price of the Shares closely
linked to the Index Price and the Shares have historically traded
at a substantial premium over, or substantial discount to, the
Digital Asset Holdings per Share,” “Item 1A. Risk Factors—Risk
Factors Related to the Trust and the Shares—The Shares may trade at
a price that is at, above or below the Trust’s Digital Asset
Holdings per Share as a result of the non-current trading hours
between OTCQX and the Digital Asset Exchange Market” and “Item 1A.
Risk Factors—Risk Factors Related to the Trust and the Shares—The
restrictions on transfer and redemption may result in losses on the
value of the Shares.”
Transfer Restrictions
Shares purchased in the private placement are restricted securities
that may not be resold except in transactions exempt from
registration under the Securities Act and state securities laws and
any such transaction must be approved by the Sponsor. In
determining whether to grant approval, the Sponsor will
specifically look at whether the conditions of Rule 144 under the
Securities Act and any other applicable laws have been met. Any
attempt to sell Shares without the approval of the Sponsor in its
sole discretion will be void
ab initio.
Pursuant to Rule 144, a minimum six-month holding period applies to
all Shares purchased from the Trust.
On a bi-weekly basis, the Trust aggregates the Shares that have
been held for the requisite holding period under Rule 144 by
non-affiliates of the Trust to assess whether the Rule 144 transfer
restriction legends may be removed. Any Shares that qualify for the
removal of the Rule 144 transfer restriction legends are presented
to outside counsel, who may instruct the Transfer Agent to remove
the transfer restriction legends from the Shares, allowing the
Shares to then be resold without restriction, including on OTCQX
U.S. Premier marketplace. The outside counsel requires that certain
representations be made, providing that:
•
the Shares subject to each sale have been held for the requisite
holding period under Rule 144 by the selling
shareholder;
•
the shareholder is the sole beneficial owner of the
Shares;
•
the Sponsor is aware of no circumstances in which the shareholder
would be considered an underwriter or engaged in the distribution
of securities for the Trust;
•
none of the Shares are subject to any agreement granting any
pledge, lien, mortgage, hypothecation, security interest, charge,
option or encumbrance;
•
none of the identified selling shareholders is an affiliate of the
Sponsor;
•
the Sponsor consents to the transfer of the Shares;
and
•
outside counsel and the Transfer Agent can rely on the
representations.
In addition, because the Trust Agreement prohibits the transfer or
sale of Shares without the prior written consent of the Sponsor,
the Sponsor must provide a written consent that explicitly states
that it irrevocably consents to the transfer and resale of the
Shares. Once the transfer restriction legends have been removed
from a Share and the Sponsor has provided its written consent to
the transfer of that Share, no consent of the Sponsor is required
for future transfers of that particular Share.
24
Book-Entry Form
Shares are held primarily in book-entry form by the Transfer Agent.
The Sponsor or its delegate will direct the Transfer Agent to
credit the number of Creation Baskets to the applicable Authorized
Participant. The Transfer Agent will issue Creation Baskets.
Transfers will be made in accordance with standard securities
industry practice. The Sponsor may cause the Trust to issue Shares
in certificated form in limited circumstances in its sole
discretion.
Share Splits
In its discretion, the Sponsor may direct the Transfer Agent to
declare a split or reverse split in the number of Shares
outstanding and to make a corresponding change in the number of
Shares constituting a Basket. For example, if the Sponsor believes
that the per Share price in the secondary market for Shares has
risen or fallen outside a desirable trading price range, it may
declare such a split or reverse split.
Description of Creation of Shares
The following is a description of the material terms of the Trust
Documents as they relate to the creation of the Trust’s Shares on a
periodic basis from time to time through sales in private placement
transactions exempt from the registration requirements of the
Securities Act.
The Trust Documents also provide procedures for the redemption of
Shares. However, the Trust does not currently operate a redemption
program and the Shares are not currently redeemable. Subject to
receipt of regulatory approval from the SEC and approval by the
Sponsor in its sole discretion, the Trust may in the future operate
a redemption program.
Because the Trust does not believe that the SEC would, at this
time, entertain an application for the waiver of rules needed in
order to operate an ongoing redemption program, the Trust currently
has no intention of seeking regulatory approval from the SEC to
operate an ongoing redemption program.
The Trust will issue Shares to Authorized Participants from time to
time, but only in one or more Baskets (with a Basket being a block
of 100 Shares). The Trust will not issue fractions of a Basket. The
creation of Baskets will be made only in exchange for the delivery
to the Trust, or the distribution by the Trust, of the number of
whole and fractional ETH represented by each Basket being created,
which is determined by dividing (x) the number of ETH owned by the
Trust at 4:00 p.m., New York time, on the trade date of a creation
order, after deducting the number of ETH representing the U.S.
dollar value of accrued but unpaid fees and expenses of the Trust
(converted using the Index Price at such time, and carried to the
eighth decimal place), by (y) the number of Shares outstanding at
such time (with the quotient so obtained calculated to one
one-hundred-millionth of one ETH (i.e.,
carried to the eighth decimal place)), and multiplying such
quotient by 100 (the “Basket Amount”). All questions as to the
calculation of the Basket Amount will be conclusively determined by
the Sponsor and will be final and binding on all persons interested
in the Trust. The Basket Amount multiplied by the number of Baskets
being created is the “Total Basket Amount.” The number of ETH
represented by a Share will gradually decrease over time as the
Trust’s ETH are used to pay the Trust’s expenses. As of December
31, 2021, each Share represented approximately 0.0100 ETH.
Information regarding the number of ETH represented by each Share
is posted to the Trust’s website daily at
www.grayscale.com/products/grayscale-ethereum-trust/.
Authorized Participants are the only persons that may place orders
to create Baskets. Each Authorized Participant must (i) be a
registered broker-dealer, (ii) enter into a Participant Agreement
with the Sponsor and (iii) own an ETH wallet address that is
recognized by the Custodian as belonging to the Authorized
Participant. An Authorized Participant may act for its own account
or as agent for investors who have entered into a subscription
agreement with the Authorized Participant (each such investor, an
“Investor”). An Investor that enters into a subscription agreement
with an Authorized Participant subscribes for Shares by submitting
a purchase order and paying a subscription amount, either in U.S.
dollars or in ETH, to the Authorized Participant.
An Investor may pay the subscription amount in cash or ETH. In the
event that the Investor pays the subscription amount in cash, the
Authorized Participant
purchases ETH in a Digital Asset Market or, to the extent the
Authorized Participant already holds ETH, the Authorized
Participant may contribute such ETH to the Trust. The Authorized
Participant will receive Shares of the Trust and the Shares will
then be registered in the name of the Investor. Depending on
whether the Investor wires cash to the Authorized Participant
before or after 4:00 p.m. New York time, the Investor’s Shares will
be created based on the same or next Business Day’s Digital Asset
Holdings and the risk of any price volatility in ETH during this
time will be borne by the Authorized Participant. The
Authorized Participant will receive Shares of the Trust on behalf
of the Investor, and the Shares will then be registered in the name
of the Investor. In the event that the Investor pays the
subscription amount in ETH, the Investor will transfer such ETH to
the Authorized Participant, which will contribute such ETH in kind
to the Trust, and receive Shares of the Trust, on behalf of the
Investor, and the Shares will then be registered in the name of the
Investor. For the avoidance of doubt, in either case, the
Authorized Participant will act as the agent of the Investor with
respect to the contribution of cash or ETH to the Trust in exchange
for Shares.
25
The creation of Baskets requires the delivery to the Trust of the
Total Basket Amount.
The Participant Agreement provides the procedures for the creation
of Baskets and for the delivery of the whole and fractional ETH
required for such creations. The Participant Agreement and the
related procedures
attached thereto may be amended by the Sponsor and the relevant
Authorized Participant. Under the Participant Agreement, the
Sponsor has agreed to indemnify each Authorized Participant against
certain liabilities, including liabilities under the Securities
Act.
Authorized Participants do not pay a transaction fee to the Trust
in connection with the creation of Baskets, but there may be
transaction fees associated with the validation of the transfer of
ETH by the Ethereum Network. Authorized Participants who deposit
ETH with the Trust in exchange for Baskets will receive no fees,
commissions or other form of compensation or inducement of any kind
from either the Sponsor or the Trust, and no such person has any
obligation or responsibility to the Sponsor or the Trust to effect
any sale or resale of Shares.
The following description of the procedures for the creation of
Baskets is only a summary and shareholders should refer to the
relevant provisions of the Trust Agreement and the form of
Participant Agreement for more detail.
Creation Procedures
On any business day, an Authorized Participant may order one or
more Creation Baskets from the Trust by placing a creation order
with the Sponsor no later than 4:00 p.m., New York time, which the
Sponsor will accept or reject. By placing a creation order, an
Authorized Participant agrees to transfer the Total Basket Amount
from the ETH wallet address that is known to the Custodian as
belonging to the Authorized Participant to the Digital Asset
Account.
All creation orders are accepted (or rejected) by the Sponsor on
the business day on which the relevant creation order is placed. If
a creation order is accepted, the Sponsor will calculate the Total
Basket Amount on the same business day, which will be the trade
date, and will communicate the Total Basket Amount to the
Authorized Participant. The Authorized Participant must transfer
the Total Basket Amount to the Trust no later than 6:00 p.m., New
York time, on the trade date. The expense and risk of delivery,
ownership and safekeeping of ETH will be borne solely by the
Authorized Participant until such ETH have been received by the
Trust.
Following receipt of the Total Basket Amount by the Custodian, the
Transfer Agent will credit the number of Shares to the account of
the Investor on behalf of which the Authorized Participant placed
the creation order by no later than 6:00 p.m., New York time, on
the trade date. The Authorized Participant may then transfer the
Shares directly to the relevant Investor.
Suspension or Rejection of Orders and Total Basket
Amount
The creation of Shares may be suspended generally, or refused with
respect to particular requested creations, during any period when
the transfer books of the Transfer Agent are closed or if
circumstances outside the control of the Sponsor or its delegates
make it for all practical purposes not feasible to process such
creation orders. The Sponsor may reject an order or, after
accepting an order, may cancel such order by rejecting the Total
Basket Amount if (i) such order is not presented in proper form as
described in the Participant Agreement, (ii) the transfer of the
Total Basket Amount comes from an account other than an ETH wallet
address that is known to the Custodian as belonging to the
Authorized Participant or (iii) the fulfillment of the order, in
the opinion of counsel, might be unlawful, among other reasons.
None of the Sponsor or its delegates will be liable for the
suspension, rejection or acceptance of any creation order or Total
Basket Amount.
In particular, upon the Trust’s receipt of any Incidental Rights
and/or IR Virtual Currency in connection with a fork, airdrop or
similar event, the Sponsor will suspend creations until it is able
to cause the Trust to sell or distribute such Incidental Rights
and/or IR Virtual Currency.
None of the Sponsor or its delegates will be liable for the
suspension, rejection or acceptance of any creation order or Total
Basket Amount.
Tax Responsibility
Authorized Participants are responsible for any transfer tax, sales
or use tax, stamp tax, recording tax, value-added tax or similar
tax or governmental charge applicable to the creation of Baskets,
regardless of whether such tax or charge is imposed directly on the
Authorized Participant, and agree to indemnify the Sponsor and the
Trust if the Sponsor or the Trust is required by law to pay any
such tax, together with any applicable penalties, additions to tax
or interest thereon.
26
Valuation of ETH and Determination of Digital Asset
Holdings
The Sponsor will evaluate the ETH held by the Trust and determine
the Digital Asset Holdings of the Trust in accordance with the
relevant provisions of the Trust Documents. The following is a
description of the material terms of the Trust Documents as they
relate to valuation of the Trust’s ETH and the Digital Asset
Holdings calculations.
On each business day at 4:00 p.m., New York time, or as soon
thereafter as practicable (the “Evaluation Time”), the Sponsor will
evaluate the ETH held by the Trust and calculate and publish the
Digital Asset Holdings of the Trust. To calculate the Digital Asset
Holdings, the Sponsor will:
1.
Determine the Index Price as of such business day.
2.
Multiply the Index Price by the Trust’s aggregate number of ETH
owned by the Trust as of 4:00 p.m., New York time, on the
immediately preceding day, less the aggregate number of ETH payable
as the accrued and unpaid Sponsor’s Fee as of 4:00 p.m., New York
time, on the immediately preceding day.
3.
Add
the U.S. dollar value of ETH, calculated using the Index Price,
receivable under pending creation orders, if any, determined by
multiplying the number of the Creation Baskets represented by such
creation orders by the Basket Amount and then multiplying such
product by the Index Price.
4.
Subtract the U.S. dollar amount of accrued and unpaid Additional
Trust Expenses, if any.
5.
Subtract
the U.S. dollar value of the ETH, calculated using the Index Price,
to be distributed under pending redemption orders, if any,
determined by multiplying the number of Baskets to be redeemed
represented by such redemption orders by the Basket Amount and then
multiplying such product by the Index Price (the amount derived
from steps 1 through 5 above, the “Digital Asset Holdings Fee Basis
Amount”).
6.
Subtract
the U.S. dollar amount of the Sponsor’s Fee that accrues for such
business day, as calculated based on the Digital Asset Holdings Fee
Basis Amount for such business day.
In the event that the Sponsor determines that the primary
methodology used to determine the Index Price is not an appropriate
basis for valuation of the Trust’s ETH, the Sponsor will utilize
the cascading set of rules as described in “—Overview of the ETH
Industry Market—ETH Value—The Index and the Index Price.” In
addition, in the event that the Trust holds any Incidental Rights
and/or IR Virtual Currency, the Sponsor may, at its discretion,
include the value of such Incidental Rights and/or IR Virtual
Currency in the determination of the Digital Asset Holdings,
provided that the Sponsor has determined in good faith a method for
assigning an objective value to such Incidental Rights and/or IR
Virtual Currency. At this time, the Trust does not expect to take
any Incidental Rights or IR Virtual Currency it may hold into
account for the purposes of determining the Digital Asset Holdings
or the Digital Asset Holdings per Share.
The Sponsor will publish the Index Price, the Trust’s Digital Asset
Holdings and the Digital Asset Holdings per Share on the Trust’s
website as soon as practicable after its determination. If the
Digital Asset Holdings and Digital Asset Holdings per Share have
been calculated using a price per ETH other than the Index Price
for such Evaluation Time, the publication on the Trust’s website
will note the valuation methodology used and the price per ETH
resulting from such calculation.
In the event of a hard fork of the Ethereum Network, the Sponsor
will, if permitted by the terms of the Trust Agreement, use its
discretion to determine, in good faith, which peer-to-peer network,
among a group of incompatible forks of the Ethereum Network, is
generally accepted as the network for ETH and should therefore be
considered the appropriate network for the Trust’s purposes. The
Sponsor will base its determination on a variety of then relevant
factors, including (but not limited to) the following: (i) the
Sponsor’s beliefs regarding expectations of the core developers of
ETH, users, services, businesses, miners and other constituencies
and (ii) the actual continued acceptance of, mining power on, and
community engagement with the Ethereum Network.
The shareholders may rely on any evaluation furnished by the
Sponsor. The determinations that the Sponsor makes will be made in
good faith upon the basis of, and the Sponsor will not be liable
for any errors contained in, information reasonably available to
it. The Sponsor will not be liable to the Authorized Participants,
the shareholders or any other person for errors in judgment.
However, the preceding liability exclusion will not protect the
Sponsor against any liability resulting from gross negligence,
willful misconduct or bad faith in the performance of its
duties.
Expenses; Sales of ETH
The Trust’s only ordinary recurring expense is expected to be the
Sponsor’s Fee. The Sponsor’s Fee will accrue daily in U.S. dollars
at an annual rate of 2.5% of the Digital Asset Holdings Fee Basis
Amount of the Trust as of 4:00 p.m., New York time, on each day;
provided that for a day that is not a business day, the calculation
will be based on the Digital Asset Holdings Fee Basis
Amount
27
from the most recent business day, reduced by the accrued and
unpaid Sponsor’s Fee for such most recent business day and for each
day after such most recent business day and prior to the relevant
calculation date. This dollar amount for each daily accrual will
then be converted into ETH by reference to the same Index Price
used to determine such accrual. The Sponsor’s Fee is payable in ETH
to the Sponsor monthly in arrears.
Expenses to Be Paid by the Sponsor
The Trust pays the Sponsor’s Fee to the Sponsor. As partial
consideration for its receipt of the Sponsor’s Fee from the Trust,
the Sponsor is obligated under the Trust Agreement to assume and
pay all fees and other expenses incurred by the Trust in the
ordinary course of its affairs, excluding taxes, but including: (i)
the Marketing Fee; (ii) the Administrator Fee, if any; (iii) the
Custodian Fee and fees for any other security vendor engaged by the
Trust; (iv) the Transfer Agent Fee; (v) the Trustee fee; (vi) fees
and expenses related to the listing, quotation or trading of the
Shares on any Secondary Market (including customary legal,
marketing and audit fees and expenses) in an amount up to $600,000
in any given fiscal year; (vii) ordinary course legal fees and
expenses; (viii) audit fees; (ix) regulatory fees, including, if
applicable, any fees relating to registration of the Shares under
the Securities Act or the Exchange Act; (x) printing and mailing
costs; (xi) the costs of maintaining the Trust’s website; and (xii)
applicable license fees (each a “Sponsor-paid Expense”), provided
that any expense that qualifies as an Additional Trust Expense will
be deemed to be an Additional Trust Expense and not a Sponsor-paid
Expense. The Sponsor, from time to time, may temporarily waive all
or a portion of the Sponsor’s Fee of the Trust in its discretion
for stated periods of time. Presently, the Sponsor does not intend
to waive any of the Sponsor’s Fee for the Trust
and there are no circumstances under which the Sponsor has
determined it will definitely waive the fee.
The Sponsor’s Fee will generally be paid in ETH. However, if the
Trust holds any Incidental Rights and/or IR Virtual Currency at any
time, the Trust may also pay the Sponsor’s Fee, in whole or in
part, with such Incidental Rights and/or IR Virtual Currency by
entering into an agreement with the Sponsor and transferring such
Incidental Rights and/or IR Virtual Currency to the Sponsor at a
value to be determined pursuant to such agreement. However, the
Trust may use Incidental Rights and/or IR Virtual Currency to pay
the Sponsor’s Fee only if such agreement and transfer do not
otherwise conflict with the terms of the Trust Agreement. The value
of any such Incidental Rights and/or IR Virtual Currency will be
determined on an arm’s-length basis. The Trust currently expects
that the value of any such Incidental Rights and/or IR Virtual
Currency would be determined by reference to an index provided by
the Index Provider or, in the absence of such an index, by
reference to the cascading set of rules described in “Overview of
the ETH Industry and Market—ETH Value—The Index and the Index
Price.” If the Trust pays the Sponsor’s Fee in Incidental Rights
and/or IR Virtual Currency, in whole or in part, the amount of the
relevant digital asset that would otherwise have been used to
satisfy such payment will be correspondingly
reduced.
After the Trust’s payment of the Sponsor’s Fee to the Sponsor, the
Sponsor may elect to convert the ETH, Incidental Rights and/or IR
Virtual Currency received as payment of the Sponsor’s Fee into U.S.
dollars. The rate at which the Sponsor converts such ETH,
Incidental Rights and/or IR Virtual Currency to U.S. dollars may
differ from the rate at which the relevant Sponsor’s Fee was
determined. The Trust will not be responsible for any fees and
expenses incurred by the Sponsor to convert ETH, Incidental Rights
and/or IR Virtual Currency received in payment of the Sponsor’s Fee
into U.S. dollars.
Extraordinary and Other Expenses
In certain extraordinary circumstances, the Trust may incur certain
extraordinary, non-recurring expenses that are not Sponsor-paid
Expenses, including, but not limited to: taxes and governmental
charges; expenses and costs of any extraordinary services performed
by the Sponsor (or any other service provider) on behalf of the
Trust to protect the Trust or the interests of shareholders
(including in connection with any Incidental Rights and any IR
Virtual Currency); any indemnification of the Custodian or other
agents, service providers or counterparties of the Trust; the fees
and expenses related to the listing, quotation or trading of the
Shares on any Secondary Market (including legal, marketing and
audit fees and expenses) to the extent exceeding $600,000 in any
given fiscal year; and extraordinary legal fees and expenses,
including any legal fees and expenses incurred in connection with
litigation, regulatory enforcement or investigation matters
(collectively, “Additional Trust Expenses”). If Additional Trust
Expenses are incurred, the Trust will be required to pay these
Additional Trust Expenses by selling or delivering ETH, Incidental
Rights and/or IR Virtual Currency. The value of any such Incidental
Rights and/or IR Virtual Currency will be determined on an
arm’s-length basis. The Trust currently expects that the value of
any such Incidental Rights and/or IR Virtual Currency would be
determined by reference to an index provided by the Index Provider
or, in the absence of such an index, by reference to the cascading
set of rules described in “Overview of the ETH Industry and
Market—ETH Value—The Index and the Index Price.” If the Trust pays
Additional Trust Expenses in Incidental Rights and/or IR Virtual
Currency, in whole or in part, the amount of ETH that would
otherwise have been used to satisfy such payment will be
correspondingly reduced. See “—Disposition of ETH, Incidental
Rights and/or IR Virtual Currency” for further information on sales
or other dispositions of ETH, Incidental Rights and/or IR Virtual
Currency. Although the Sponsor cannot definitively state the
frequency or magnitude of Additional Trust Expenses, the Sponsor
expects that they may occur infrequently.
28
The Sponsor or any of its affiliates may be reimbursed only for the
actual cost to the Sponsor or such affiliate of any expenses that
it advances on behalf of the Trust for payment of which the Trust
is responsible. In addition, the Trust Agreement prohibits the
Trust from paying to the Sponsor or such affiliate for indirect
expenses incurred in performing services for the Trust in its
capacity as the Sponsor (or an affiliate of the Sponsor ) of the
Trust, such as salaries and fringe benefits of officers and
directors, rent or depreciation, utilities and other administrative
items generally falling within the category of the Sponsor’s
“overhead.”
Disposition of ETH, Incidental Rights and/or IR Virtual
Currency
To cause the Trust to pay the Sponsor’s Fee, the Sponsor will
instruct the Custodian to (i) withdraw from the Digital Asset
Account the number of ETH, Incidental Rights and/or IR Virtual
Currency, determined as described above in
“—Expenses; Sales of ETH,”
equal to the accrued but unpaid Sponsor’s Fee and (ii) transfer
such ETH, Incidental Rights and/or IR Virtual Currency to an
account maintained by the Custodian for the Sponsor at such times
as the Sponsor determines in its absolute discretion. In addition,
if the Trust incurs any Additional Trust Expenses, the Sponsor or
its delegates (i) will instruct the Custodian to withdraw from the
Digital Asset Account ETH, Incidental Rights and/or IR Virtual
Currency in such quantity as may be necessary to permit payment of
such Additional Trust Expenses and (ii) may either (x) cause the
Trust to convert such ETH, Incidental Rights and/or IR Virtual
Currency into U.S. dollars or other fiat currencies at the Actual
Exchange Rate or (y) cause the Trust (or its delegate) to deliver
such ETH, Incidental Rights and/or IR Virtual Currency in kind, in
each case in such quantity as may be necessary to permit payment of
such Additional Trust Expenses. The Sponsor’s Fee and Additional
Trust Expenses payable by the Trust will generally be paid in ETH.
Shareholders do not have the option of choosing to pay their
proportionate shares of Additional Trust Expenses in lieu of having
their shares of Additional Trust Expenses paid by the Trust’s
delivery or disposition of ETH, Incidental Rights and/or IR Virtual
Currency. Assuming that the Trust is a grantor trust for U.S.
federal income tax purposes, the transfer or sale of ETH,
Incidental Rights and/or IR Virtual Currency to pay the Trust’s
expenses will be a taxable event for shareholders. See “Certain
U.S. Federal Income Tax Consequences—Tax Consequences to U.S.
Holders.”
Because the number of ETH held by the Trust will decrease as a
consequence of the payment of the Sponsor’s Fee in ETH or the sale
of ETH to pay Additional Trust Expenses (and the Trust will incur
additional fees associated with converting ETH into U.S. dollars),
the number of ETH represented by a Share will decline at such time
and the Trust’s Digital Asset Holdings may also decrease.
Similarly, the number (if any) of Incidental Rights and IR Virtual
Currency represented by a Share will decrease as a consequence of
the use of Incidental Rights and IR Virtual Currency to pay the
Sponsor’s Fee and Additional Trust Expenses. Accordingly, the
shareholders will bear the cost of the Sponsor’s Fee and any
Additional Trust Expenses.
New ETH deposited into the Digital Asset Account in exchange for
additional new Baskets issued by the Trust will not reverse this
trend.
The Sponsor will also cause the sale of the Trust’s ETH, Incidental
Rights and/or IR Virtual Currency if the Sponsor determines that
sale is required by applicable law or regulation or in connection
with the termination and liquidation of the Trust. The Sponsor will
not be liable or responsible in any way for depreciation or loss
incurred by reason of any sale of ETH, Incidental Rights and/or IR
Virtual Currency.
The quantity of ETH, Incidental Rights or IR Virtual Currency to be
delivered to the Sponsor or other relevant payee in payment of the
Sponsor’s Fee or any Additional Trust Expenses, or sold to permit
payment of Additional Trust Expenses, will vary from time to time
depending on the level of the Trust’s expenses and the value of
ETH, Incidental Rights or IR Virtual Currency held by the Trust.
Assuming that the Trust is a grantor trust for U.S. federal income
tax purposes, each delivery or sale of ETH, Incidental Rights and
IR Virtual Currency by the Trust for the payment of expenses will
be a taxable event to shareholders. See “—Certain
U.S. Federal Income Tax Consequences—Tax Consequences to U.S.
Holders.”
29
Hypothetical Expense Example
The following table illustrates the anticipated impact of the
payment of the Trust’s expenses on the number of ETH represented by
each outstanding Share for three years, assuming that the Trust
does not make any payments using any Incidental Rights and/or IR
Virtual Currency. It assumes that the only transfers of ETH will be
those needed to pay the Sponsor’s Fee and that the price of ETH and
the number of Shares remain constant during the three-year period
covered. The table does not show the impact of any Additional Trust
Expenses. Any Additional Trust Expenses, if and when incurred, will
accelerate the decrease in the fractional number of ETH represented
by each Share. In addition, the table does not show the effect of
any waivers of the Sponsor’s Fee that may be in effect from time to
time.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year
|
|
|
|
1
|
|
|
2
|
|
|
3
|
|
Hypothetical price per ETH
|
|
$
|
100.00
|
|
|
$
|
100.00
|
|
|
$
|
100.00
|
|
Sponsor’s Fee
|
|
|
2.50
|
%
|
|
|
2.50
|
%
|
|
|
2.50
|
%
|
Shares of Trust, beginning
|
|
|
100,000.00
|
|
|
|
100,000.00
|
|
|
|
100,000.00
|
|
ETH in Trust, beginning
|
|
|
10,000.00
|
|
|
|
9,750.00
|
|
|
|
9,506.25
|
|
Hypothetical value of ETH in Trust
|
|
$
|
1,000,000.00
|
|
|
$
|
975,000.00
|
|
|
$
|
950,625.00
|
|
Beginning Digital Asset Holdings of the Trust
|
|
$
|
1,000,000.00
|
|
|
$
|
975,000.00
|
|
|
$
|
950,625.00
|
|
ETH to be delivered to cover the Sponsor’s Fee
|
|
|
250.00
|
|
|
|
243.75
|
|
|
|
237.66
|
|
ETH in Trust, ending
|
|
|
9,750.00
|
|
|
|
9,506.25
|
|
|
|
9,268.59
|
|
Ending Digital Asset Holdings of the Trust
|
|
$
|
975,000.00
|
|
|
$
|
950,625.00
|
|
|
$
|
926,859.38
|
|
Ending Digital Asset Holdings per share
|
|
$
|
9.75
|
|
|
$
|
9.51
|
|
|
$
|
9.27
|
|
Hypothetical price per ETH
|
|
$
|
100.00
|
|
|
$
|
100.00
|
|
|
$
|
100.00
|
|
Discretion of the Index Provider
The Index Provider has sole discretion over the determination of
Index Price and may change the methodologies for determining the
Index Price from time to time.
Description of the Trust Agreement
The following is a description of the material terms of the Trust
Agreement. The Trust Agreement establishes the roles, rights and
duties of the Sponsor and the Trustee.
The Sponsor
Liability of the Sponsor and Indemnification
Neither the Sponsor nor the Trust insure the Trust’s ETH.
The Sponsor and its affiliates (each a “Covered Person”) will not
be liable to the Trust or any shareholder for any loss suffered by
the Trust which arises out of any action or inaction of such
Covered Person if such Covered Person determined in good faith that
such course of conduct was in the best interests of the Trust.
However, the preceding liability exclusion will not protect any
Covered Person against any liability resulting from its own willful
misconduct, bad faith or gross negligence in the performance of its
duties.
Each Covered Person will be indemnified by the Trust against any
loss, judgment, liability, expense incurred or amount paid in
settlement of any claim sustained by it in connection with the
Covered Person’s activities for the Trust, provided that (i) the
Covered Person was acting on behalf of, or performing services for,
the Trust and had determined, in good faith, that such course of
conduct was in the best interests of the Trust and such liability
or loss was not the result of fraud, gross negligence, bad faith,
willful misconduct or a material breach of the Trust Agreement on
the part of such Covered Person and (ii) any such indemnification
will be recoverable only from the property of the Trust. Any
amounts payable to an indemnified party will be payable in advance
under certain circumstances.
Fiduciary and Regulatory Duties of the Sponsor
The Sponsor is not effectively subject to the duties and
restrictions imposed on “fiduciaries” under both statutory and
common law. Rather, the general fiduciary duties that would apply
to the Sponsor are defined and limited in scope by the Trust
Agreement.
Under Delaware law, a shareholder may bring a derivative action if
the shareholder is a shareholder at the time the action is brought
and either (i) was a shareholder at the time of the transaction at
issue or (ii) acquired the status of shareholder by operation of
law or the Trust’s governing instrument from a person who was a
shareholder at the time of the transaction at issue. Additionally,
Section 3816(e) of the Delaware Statutory Trust Act specifically
provides that “a beneficial owner’s right to bring a derivative
action may be subject to such additional standards and
restrictions, if any, as are set forth in the governing instrument
of the statutory trust, including, without limitation, the
requirement that beneficial owners owning a specified beneficial
interest in the statutory trust join in the bringing
30
of the derivative action.” In addition to the requirements of
applicable law, the Trust Agreement provides that no shareholder
will have the right, power or authority to bring or maintain a
derivative action, suit or other proceeding on behalf of the Trust
unless two or more shareholders who (i) are not “Affiliates” (as
defined in the Trust Agreement and below) of one another and (ii)
collectively hold at least 10.0% of the outstanding Shares join in
the bringing or maintaining of such action, suit or other
proceeding. The Trust selected the 10.0% ownership threshold
because the Trust believed that this was a threshold that investors
would be comfortable with based on market
precedent.
This provision applies to any derivative action brought in the name
of the Trust other than claims brought under the federal securities
laws or the rules and regulations thereunder, to which Section 7.4
does not apply. Due to this additional requirement, a shareholder
attempting to bring a derivative action in the name of the Trust
will be required to locate other shareholders with which it is not
affiliated and that have sufficient Shares to meet the 10.0%
threshold based on the number of Shares outstanding on the date the
claim is brought and thereafter throughout the duration of the
action, suit or proceeding.
“Affiliate” is defined in the Trust Agreement to mean any natural
person, partnership, limited liability company, statutory trust,
corporation, association or other legal entity (each, a “Person”)
directly or indirectly owning, controlling or holding with power to
vote 10% or more of the outstanding voting securities of such
Person, (ii) any Person 10% or more of whose outstanding voting
securities are directly or indirectly owned, controlled or held
with power to vote by such Person, (iii) any Person, directly or
indirectly, controlling, controlled by or under common control of
such Person, (iv) any employee, officer, director, member, manager
or partner of such Person, or (v) if such Person is an employee,
officer, director, member, manager or partner, any Person for which
such Person acts in any such capacity.
Any shareholders seeking to bring a derivative action may determine
whether the 10.0% ownership threshold required to bring a
derivative action has been met by dividing the number Shares owned
by such shareholders by the total number of Shares outstanding.
shareholders may determine the total number of Shares outstanding
by reviewing the Trust’s annual filings on Form 10-K, quarterly
filings on Form 10-Q and periodic reports on Form 8-K reporting
sales of unregistered securities pursuant to Item 3.02 thereof, or
by requesting the number of Shares outstanding at any time from the
Sponsor pursuant to Sections 7.2 and 8.1 of the Trust Agreement and
Section 3819(a) of the DSTA. Because the Trust is a grantor trust,
it may only issue one class of securities, the
Shares.
The Trust offers Shares on a periodic basis at such times and for
such periods as the Sponsor determines in its sole discretion. As a
result, in order to maintain the 10.0% ownership threshold required
to maintain a derivative action, shareholders may need to increase
their holdings or locate additional shareholders during the
pendency of a claim. The Trust posts the number of Shares
outstanding as of the end of each month on its website and as of
the end of each quarter in its annual and quarterly filings with
the SEC. The Trust additionally reports sales of unregistered
securities on Form 8-K pursuant to Item 3.02 thereof. Shareholders
may monitor the number of Shares outstanding at any time for
purposes of calculating their ownership threshold by reviewing the
Trust’s website and SEC filings and by requesting the number of
Shares outstanding on any date from the Sponsor at any time
pursuant to Sections 7.2 and 8.1 of the Trust Agreement.
Shareholders have the opportunity at any time to increase their
holdings or locate other shareholders to maintain the 10.0%
threshold throughout the duration of a derivative claim.
Shareholders may do so by contacting shareholders that are required
to file Schedule 13Ds or Schedule 13Gs with the SEC or by
requesting from the Sponsor the list of the names and last known
address of all shareholders pursuant to Sections 7.2 and 8.1 of the
Trust Agreement and Section 3819(a) of the DSTA.
The Sponsor is not aware of any reason to believe that Section 7.4
of the Trust Agreement is not enforceable under state or federal
law. The Court of Chancery of Delaware has stated that “[t]he DSTA
is enabling in nature and, as such, permits a trust through its
declarations of trust to delineate additional standards and
requirements with which a stockholder-plaintiff must comply to
proceed derivatively in the name of the trust.” Hartsel v. Vanguard
Group., Inc., Del. Ch. June 15, 2011. However, there is limited
case law addressing the enforceability of provisions like Section
7.4 under state and federal law and it is possible that this
provision would not be enforced by a court in another jurisdiction
or under other circumstances.
Beneficial owners may have the right, subject to certain legal
requirements, to bring class actions in federal court to enforce
their rights under the federal securities laws and the rules and
regulations promulgated thereunder by the SEC. Beneficial owners
who have suffered losses in connection with the purchase or sale of
their beneficial interests may be able to recover such losses from
the Sponsor where the losses result from a violation by the Sponsor
of the anti-fraud provisions of the federal securities
laws.
Actions Taken to Protect the Trust
The Sponsor may prosecute, defend, settle or compromise actions or
claims at law or in equity that it considers necessary or proper to
protect the Trust or the interests of the shareholders. The
expenses incurred by the Sponsor in connection therewith (including
the fees and disbursements of legal counsel) will be expenses of
the Trust and are deemed to be Additional Trust Expenses. The
Sponsor will be entitled to be reimbursed for the Additional Trust
Expenses it pays on behalf of the Trust.
31
Successor Sponsors
If the Sponsor is adjudged
bankrupt
or insolvent, the Trust may dissolve and a Liquidating Trustee may
be appointed to terminate and liquidate the Trust and distribute
its remaining assets. The Trustee will have no obligation to
appoint a successor sponsor or to assume the duties of the Sponsor,
and will have no liability to any person because the Trust is or is
not terminated. However, if a certificate of dissolution or
revocation of the Sponsor’s charter is filed (and ninety (90) days
have passed after the date of notice to the Sponsor of revocation
without a reinstatement of the Sponsor’s charter) or the
withdrawal, removal, adjudication or admission of bankruptcy or
insolvency of the Sponsor has occurred, shareholders holding at
least a majority (over 50%) of the Shares may agree in writing to
continue the affairs of the Trust and to select, effective as of
the date of such event, one or more successor Sponsors within
ninety (90) days of any such event.
The Trustee
The Trustee is a fiduciary under the Trust Agreement and must
satisfy the requirements of Section 3807 of the Delaware Trust
Statute. However, the fiduciary duties, responsibilities and
liabilities of the Trustee are limited by, and are only those
specifically set forth in, the Trust Agreement.
Limitation on Trustee’s Liability
Under the Trust Agreement, the Sponsor has exclusive control of the
management of all aspects of the activities of the Trust and the
Trustee has only nominal duties and liabilities to the Trust. The
Trustee is appointed to serve as the trustee for the sole purpose
of satisfying Section 3807(a) of the DSTA which requires that the
Trust have at least one trustee with a principal place of business
in the State of Delaware. The duties of the Trustee are limited to
(i) accepting legal process served on the Trust in the State of
Delaware and (ii) the execution of any certificates required to be
filed with the Delaware Secretary of State which the Trustee is
required to execute under the DSTA.
To the extent the Trustee has duties (including fiduciary duties)
and liabilities to the Trust or the shareholders under the DSTA,
such duties and liabilities will be replaced by the duties and
liabilities of the Trustee expressly set forth in the Trust
Agreement. The Trustee will have no obligation to supervise, nor
will it be liable for, the acts or omissions of the Sponsor,
Transfer Agent, Custodian or any other person. Neither the Trustee,
either in its capacity as trustee or in its individual capacity,
nor any director, officer or controlling person of the Trustee is,
or has any liability as, the issuer, director, officer or
controlling person of the issuer of Shares. The Trustee’s liability
is limited solely to the express obligations of the Trustee as set
forth in the Trust Agreement.
Under the Trust Agreement, the Sponsor has the exclusive
management, authority and control of all aspects of the activities
of the Trust. The Trustee has no duty or liability to supervise or
monitor the performance of the Sponsor, nor does the Trustee have
any liability for the acts or omissions of the Sponsor. The
existence of a trustee should not be taken as an indication of any
additional level of management or supervision over the Trust. The
Trust Agreement provides that the management authority with respect
to the Trust is vested directly in the Sponsor and that the Trustee
is not responsible or liable for the genuineness, enforceability,
collectability, value, sufficiency, location or existence of any of
the ETH or other assets of the Trust.
Possible Repayment of Distributions Received by Shareholders;
Indemnification by Shareholders
The Shares are limited liability investments. Investors may not
lose more than the amount that they invest plus any profits
recognized on their investment. Although it is unlikely, the
Sponsor may, from time to time,
make distributions to the shareholders. However, shareholders could
be required, as a matter of bankruptcy law, to return to the estate
of the Trust any distribution they received at a time when the
Trust was in fact insolvent or in violation of its Trust Agreement.
In addition, the Trust Agreement provides that shareholders will
indemnify the Trust for any harm suffered by it as a result of
shareholders’ actions unrelated to the activities of the
Trust.
The foregoing repayment of distributions and indemnity provisions
(other than the provision for shareholders indemnifying the Trust
for taxes imposed upon it by a state, local or foreign taxing
authority, which is included only as a formality due to the fact
that many states do not have statutory trust statutes therefore the
tax status of the Trust in such states might, theoretically, be
challenged) are commonplace in statutory trusts and limited
partnerships.
32
Indemnification of the Trustee
The Trustee and any of the officers, directors, employees and
agents of the Trustee will be indemnified by the Trust as primary
obligor and Digital Currency Group, Inc. as secondary obligor and
held harmless against any loss, damage, liability, claim, action,
suit, cost, expense, disbursement (including the reasonable fees
and expenses of counsel), tax or penalty of any kind and nature
whatsoever, arising out of, imposed upon or asserted at any time
against such indemnified person in connection with the performance
of its obligations under the Trust Agreement, the creation,
operation or termination of the Trust or the transactions
contemplated therein; provided, however, that neither the Trust nor
Digital Currency Group, Inc. will be required to indemnify any such
indemnified person for any such expenses which are a result of the
willful misconduct, bad faith or gross negligence of such
indemnified person. If the Trust has insufficient assets or
improperly refuses to pay such an indemnified person within 60 days
of a request for payment owed under the Trust Agreement, Digital
Currency Group, Inc. will, as secondary obligor, compensate or
reimburse the Trustee or indemnify, defend and hold harmless such
an indemnified person as if it were the primary obligor under the
Trust Agreement. Any amount payable to such an indemnified person
under the Trust Agreement may be payable in advance under certain
circumstances and will be secured by a lien on the Trust property.
The obligations of Digital Currency Group, Inc. and the Trust to
indemnify such indemnified persons under the Trust Agreement will
survive the termination of the Trust Agreement.
Holding of Trust Property
The Trust will hold and record the ownership of the Trust’s assets
in a manner such that it will be owned for the benefit of the
shareholders for the purposes of, and subject to and limited by the
terms and conditions set forth in, the Trust Agreement. The Trust
will not create, incur or assume any indebtedness or borrow money
from or loan money to any person. The Trustee may not commingle its
assets with those of any other person.
The Trustee may employ agents, attorneys, accountants, auditors and
nominees and will not be answerable for the conduct or misconduct
of any such custodians, agents, attorneys or nominees if such
custodians, agents, attorneys and nominees have been selected with
reasonable care.
Resignation, Discharge or Removal of Trustee; Successor
Trustees
The Trustee may resign as Trustee by written notice of its election
so to do, delivered to the Sponsor with at least 180 days’ notice.
The Sponsor may remove the Trustee in its discretion. If the
Trustee resigns or is removed, the Sponsor, acting on behalf of the
shareholders, will appoint a successor trustee. The successor
Trustee will become fully vested with all of the rights, powers,
duties and obligations of the outgoing Trustee.
If the Trustee resigns and no successor trustee is appointed within
180 days after the Trustee notifies the Sponsor of its resignation,
the Trustee will terminate and liquidate the Trust and distribute
its remaining assets.
Amendments to the Trust Agreement
In general, the Sponsor may amend the Trust Agreement without the
consent of any shareholder. In particular, the Sponsor may, without
the approval of the shareholders, amend the Trust Agreement if the
Trust is advised at any time by the Trust’s accountants or legal
counsel that the amendments are necessary to permit the Trust to
take the position that it is a grantor trust for U.S. federal
income tax purposes. However, the Sponsor may not make an
amendment, or otherwise supplement the Trust Agreement, if such
amendment or supplement would permit the Sponsor, the Trustee or
any other person to vary the investment of the shareholders (within
the meaning of applicable Treasury Regulations) or would otherwise
adversely affect the status of the Trust as a grantor trust for
U.S. federal income tax purposes. In addition, no amendments to the
Trust Agreement that materially adversely affect the interests of
shareholders may be made without the vote of at least a majority
(over 50%) of the Shares (not including any Shares held by the
Sponsor or its affiliates). A shareholder will be deemed to have
consented to a modification or amendment of the Trust Agreement if
the Sponsor has notified the shareholders in writing of the
proposed modification or amendment and the shareholder has not,
within 20 calendar days of such notice, notified the Sponsor in
writing the shareholder objects to such modification or
amendment.
Termination of the Trust
The Trust will dissolve if any of the following events
occur:
•
a U.S. federal or state regulator requires the Trust to shut down
or forces the Trust to liquidate its ETH or seizes, impounds or
otherwise restricts access to Trust assets;
•
any ongoing event exists that either prevents the Trust from making
or makes impractical the Trust’s reasonable efforts to make a fair
determination of the Index Price;
33
•
any ongoing event exists that either prevents the Trust from
converting or makes impractical the Trust’s reasonable efforts to
convert ETH to U.S. dollars; or
•
a certificate of dissolution or revocation of the Sponsor’s charter
is filed (and 90 days have passed since the date of notice to the
Sponsor of revocation without a reinstatement of its charter) or
the withdrawal, removal, adjudication or admission of bankruptcy or
insolvency of the Sponsor has occurred, unless (i) at the time
there is at least one remaining Sponsor and that remaining Sponsor
carries on the Trust or (ii) within 90 days of any such event
shareholders holding at least a majority (over 50%) of Shares, not
including Shares held by the Sponsor and its affiliates, agree in
writing to continue the activities of the Trust and to select,
effective as of the date of such event, one or more successor
Sponsors.
The Sponsor may, in its sole discretion, dissolve the Trust if any
of the following events occur:
•
the SEC determines that the Trust is an investment company required
to be registered under the Investment Company Act of
1940;
•
the CFTC determines that the Trust is a commodity pool under the
CEA;
•
the Trust is determined to be a “money service business” under the
regulations promulgated by FinCEN under the authority of the U.S.
Bank Secrecy Act and is required to comply with certain FinCEN
regulations thereunder;
•
the Trust is required to obtain a license or make a registration
under any state law regulating money transmitters, money services
businesses, providers of prepaid or stored value or similar
entities, or virtual currency businesses;
•
the Trust becomes insolvent or bankrupt;
•
the Custodian resigns or is removed without
replacement;
•
all of the Trust’s assets are sold;
•
the Sponsor determines that the aggregate net assets of the Trust
in relation to the expenses of the Trust make it unreasonable or
imprudent to continue the affairs of the Trust;
•
the Sponsor receives notice from the IRS or from counsel for the
Trust or the Sponsor that the Trust fails to qualify for treatment,
or will not be treated, as a grantor trust under the
Code;
•
if the Trustee notifies the Sponsor of the Trustee’s election to
resign and the Sponsor does not appoint a successor trustee within
180 days; or
•
the Sponsor determines, in its sole discretion, that it is
desirable or advisable for any reason to discontinue the affairs of
the Trust.
The Sponsor may determine that it is desirable or advisable to
discontinue the affairs of the Trust for a variety of reasons. For
example, the Sponsor may terminate the Trust if the digital asset
held by such Trust were asserted, or ultimately determined, to be a
security under the federal securities laws by the SEC or a federal
court.
The death, legal disability, bankruptcy, insolvency, dissolution,
or withdrawal of any shareholder (as long as such shareholder is
not the sole shareholder of the Trust) will not result in the
termination of the Trust, and such shareholder, his or her estate,
custodian or personal representative will have no right to a
redemption or value such shareholder’s Shares. Each shareholder
(and any assignee thereof) expressly agrees that in the event of
his or her death, he or she waives on behalf of himself or herself
and his or her estate, and he or she directs the legal
representative of his or her estate and any person interested
therein to waive the furnishing of any inventory, accounting or
appraisal of the assets of the Trust and any right to an audit or
examination of the books of account for the Trust, except for such
rights as are set forth in Article VIII of the Trust Agreement
relating to the books of account and reports of the
Trust.
Upon dissolution of the Trust and surrender of Shares by the
shareholders, shareholders will receive a distribution in U.S.
dollars or ETH, Incidental Rights and/or IR Virtual Currency, at
the sole discretion of the Sponsor, after the Sponsor has sold the
Trust’s ETH, Incidental Rights and IR Virtual Currency, if
applicable, and has paid or made provision for the Trust’s claims
and obligations.
If the Trust is forced to liquidate, the Trust will be liquidated
under the Sponsor’s direction. The Sponsor, on behalf of the Trust,
will engage directly with Digital Asset Markets to liquidate the
Trust’s ETH as promptly as possible while obtaining the best fair
value possible. The proceeds therefrom will be applied and
distributed in the following order of priority: (a) to the expenses
of liquidation and termination and to creditors, including
shareholders who are creditors, to the extent otherwise permitted
by law, in satisfaction of liabilities of the Trust other than
liabilities for distributions to shareholders and (b) to the
holders of Shares pro rata in accordance with the respective
percentage of percentages of Shares that they hold. It is expected
that the Sponsor would be subject to the same regulatory
requirements as the Trust, and therefore, the markets available to
the Sponsor will be the same markets available to the
Trust.
34
Governing Law
The Trust Agreement and the rights of the Sponsor, Trustee and
shareholders under the Trust Agreement are governed by the laws of
the State of Delaware.
Description of the Custodian Agreement
The Custodian Agreement establishes the rights and responsibilities
of the Custodian, Sponsor, Trust and Authorized Participants with
respect to the Trust’s ETH in the Digital Asset Account, which is
maintained and operated by the Custodian on behalf of the Trust.
For a general description of the Custodian’s obligations, see
“—Service Providers of the Trust—The Custodian.”
Account; Location of ETH
The Trust’s Digital Asset Account is a segregated custody account
controlled and secured by the Custodian to store private keys,
which allow for the transfer of ownership or control of the Trust’s
ETH, on the Trust’s
behalf. Private key shards associated with the Trust’s ETH are
distributed geographically by the Custodian in secure vaults around
the world, including in the United States. The locations of the
secure vaults may change regularly and are kept confidential by the
Custodian for security purposes. The Custodian requires written
approval of the Trust prior to changing the location of the private
key shards, and therefore the Trust’s ETH, including to a different
state. The Digital Asset Account uses offline storage, or cold
storage, mechanisms to secure the Trust’s private keys. The term
cold storage refers to a safeguarding method by which the private
keys corresponding to digital assets are disconnected and/or
deleted entirely from the internet.
ETH in the Digital Asset Account are not treated as general assets
of the Custodian. Rather, the Custodian serves as a fiduciary and
custodian on the Trust’s behalf, and the ETH in the Digital Asset
Account are considered fiduciary assets that remain the Trust’s
property at all times.
Safekeeping of ETH
The Custodian will use best efforts to keep in safe custody on
behalf of the Trust all ETH received by the Custodian. All ETH
credited to the Digital Asset Account will (i) be held in the
Digital Asset Account at all times, and the Digital Asset Account
will be controlled by the Custodian; (ii) be labeled or otherwise
appropriately identified as being held for the Trust; (iii) be held
in the Digital Asset Account on a non-fungible basis; (iv) not be
commingled with other digital assets held by the Custodian, whether
held for the Custodian’s own account or the account of other
clients other than the Trust; (v) not without the prior written
consent of the Trust be deposited or held with any third-party
depositary, custodian, clearance system or wallet; and (vi) for any
Digital Asset Account maintained by the Custodian on behalf of the
Trust, the Custodian will use best efforts to keep the private key
or keys secure, and will not disclose such keys to the Trust, the
Sponsor or to any other individual or entity except to the extent
that any keys are disclosed consistent with a standard of best
efforts and as part of a multiple signature solution that would not
result in the Trust or the Sponsor “storing, holding, or
maintaining custody or control of” the ETH “on behalf of others”
within the meaning of the New York BitLicense Rule (23 NYCRR Part
200) as in effect as of June 24, 2015 such that it would require
the Trust or the Sponsor to become licensed under such
law.
Insurance
Pursuant to the terms of the Custodian Agreement, the Custodian is
required to have insurance coverage to protect against risks such
as theft of funds.
The Custodian has advised the Sponsor that it has insurance
coverage pursuant to policies held by Coinbase Global, Inc.
(“Coinbase”), which procures fidelity (or crime) insurance coverage
of up to $320 million. This insurance coverage is limited to losses
of the digital assets the Custodian custodies on behalf of its
clients, including the Trust’s ETH, resulting from theft, including
internal theft by employees of Coinbase and its subsidiaries and
theft or fraud by a director of Coinbase if the director is acting
in the capacity of an employee of Coinbase or its
subsidiaries.
Deposits, Withdrawals and Storage; Access to the Digital Asset
Account
The Custodial Services (i) allow ETH to be deposited from a public
blockchain address to the Digital Asset Account and (ii) allow the
Trust or Sponsor to withdraw ETH from the Digital Asset Account to
a public blockchain address the Trust or the Sponsor controls (each
such transaction is a “Custody Transaction”).
The Custodian reserves the right to refuse to process or to cancel
any pending Custody Transaction as required by law or in response
to a subpoena, court order, or other binding government order or to
enforce transaction, threshold, and condition limits, in each case
as communicated to the Trust and the Sponsor as soon as reasonably
practicable where the Custodian is permitted to do so, or if the
Custodian reasonably believes that the Custody Transaction may
violate or facilitate the violation of an applicable law,
regulation
35
or applicable rule of a governmental authority or self-regulatory
organization. The Custodian may suspend or restrict the Trust’s and
Sponsor’s access to the Custodial Services, and/or deactivate,
terminate or cancel the Digital Asset Account if the Trust or
Sponsor has taken certain actions, including any Prohibited Use or
Prohibited Business as set forth in the Custodian
Agreement.
From the time the Custodian has verified the authorization of a
complete set of instructions to withdraw ETH from the Digital Asset
Account, the Custodian will have up to forty-eight (48) hours to
process and complete such withdrawal. The Custodian will ensure
that initiated deposits are processed in a timely manner but the
Custodian makes no representations or warranties regarding the
amount of time needed to complete processing which is dependent
upon many factors outside of the Custodian’s
control.
Subject to certain exceptions in the Custodian Agreement, the
Trust, the Sponsor and their authorized representatives will be
able to access the Digital Asset Account via the Custodian’s
website 99.9% of the time (excluding scheduled maintenance) in
order to check information about the Digital Asset Account, deposit
ETH to the Digital Asset Account or initiate a Custody Transaction
(subject to the timing described above).
The Custodian makes no other representations or warranties with
respect to the availability and/or accessibility of ETH or the
availability and/or accessibility of the Digital Asset Account or
Custodial Services.
Subject to any legal and regulatory requirements, in order to
support the Trust’s ordinary course of deposits and withdrawals,
which involves, or will in the future involve, deposits from and
withdrawals to Digital Asset accounts owned by any Authorized
Participant, the Custodian will use commercially reasonable efforts
to cooperate with the Trust and Sponsor to design and put in place
via the Custodial Services a secure procedure to allow Authorized
Participants to receive an ETH address for deposits by Authorized
Participants, and to initiate withdrawals to ETH addresses
controlled by Authorized Participants.
The Custodian Agreement further provides that the Trust’s and the
Sponsor’s auditors or third-party accountants upon reasonable
notice, have inspection rights to visit and inspect the Digital
Asset Account. Such auditors or third-party accountants are not
obligated under the Custodian Agreement to exercise their
inspection rights.
Security of the Account
The Custodian securely stores all digital asset private keys held
by the Custodian in offline storage. Under the Custodian Agreement,
the Custodian must use best efforts to keep private and public keys
secure, and may not disclose private keys to the Sponsor, Trust or
any other individual or entity.
The Custodian has implemented and will maintain a reasonable
information security program that includes policies and procedures
that are reasonably designed to safeguard the Custodian’s
electronic systems and the Trust’s and the Sponsor’s confidential
information from, among other things, unauthorized access or
misuse. In the event of a Data Security Event (as defined below),
the Custodian will promptly (subject to any legal or regulatory
requirements) notify the Trust and the Sponsor. “Data Security
Event” is defined as any event whereby (a) an unauthorized person
(whether within the Custodian or a third party) acquired or
accessed the Trust’s or the Sponsor’s information, (b) the Trust’s
or the Sponsor’s information is otherwise lost, stolen or
compromised or (c) the Custodian’s Chief Information Security
Officer, or other senior security officer of a similar title, is no
longer employed by the Custodian.
Record Keeping; Inspection and Auditing
The Custodian will keep timely and accurate records of its services
pursuant to the Custodian Agreement, and such records must be
retained by the Custodian for no less than seven years. The
Custodian Agreement also provides that the Custodian will permit,
to the extent it may legally do so, the Trust’s or the Sponsor’s
auditors or third-party accountants, upon reasonable notice, to
inspect, take extracts from and audit the records that it
maintains, take such steps as necessary to verify that satisfactory
internal control system and procedures are in place, and visit and
inspect the systems on which the ETH are held, all at such times as
the Trust or the Sponsor may reasonably request. The Custodian is
obligated to provide a copy of any audit report prepared by its
internal or independent auditors to the Trust or the
Sponsor.
The Trust and the Sponsor obtain and perform a comprehensive review
of the Services Organization Controls (“SOC”) 1 report and SOC 2
each year. For additional information, see “—Description of Trust
Documents—Description of the Custodian Agreement—Annual Certificate
and Report.” In addition to the review of SOC 1 and SOC 2 reports,
the Trust, the Sponsor and/or their respective auditors may inspect
or audit the Custodian’s records in a variety of manners if
considered necessary. Such processes, may include validating the
existence balances as reflected on the Custodian’s user interface
to nodes of the underlying blockchain and confirming that such
digital assets are associated with its public keys to validate the
existence and exclusive ownership of the digital assets. To
validate software functionality of the private keys, the Trust may
transfer a portion of its digital assets from one public key to
another public key of the Trust.
36
The Trust, the Sponsor and their independent auditors may evaluate
the Custodian’s protection of private keys and other customer
information, including review of supporting documentation related
to the processes surrounding key lifecycle management, the key
generation process (hardware, software, and algorithms associated
with generation) the infrastructure used to generate and store
private keys, how private keys are stored (for example, cold
wallets), the segregation of duties in the authorization of digital
asset transactions, and the number of users required to process a
transaction and the monitoring of addresses for any unauthorized
activity. For additional information, see “—Custody of the Trust’s
ETH.”
Annual Certificate and Report
Once each calendar year, the Sponsor or Trust may request that the
Custodian deliver a certificate signed by a duly authorized officer
to certify that the Custodian has complied and is currently in
compliance with the Custodian Agreement and that all
representations and warranties made by the Custodian in the
Custodian Agreement are true and correct on and as of the date of
such certificate, and have been true and correct throughout the
preceding year.
Once each calendar year, the Trust and the Sponsor will be entitled
to request that the Custodian produce or commission a new Services
Organization Controls (“SOC”) 1 report and SOC 2 report, and
promptly deliver to the Trust and the Sponsor a copy thereof by
December 31 of each year. The Custodian reserves the right to
combine the SOC 1 and SOC 2 reports into a comprehensive report. In
the event that the Custodian does not deliver a SOC 1 Report or SOC
2 Report, as applicable, the Sponsor and the Trust will be entitled
to terminate the Agreement.
Standard of Care; Limitations of Liability
The Custodian will use best efforts to keep in safe custody on
behalf of the Trust all ETH received by the Custodian. The
Custodian is liable to the Sponsor and the Trust for the loss of
any ETH to the extent that the Custodian directly caused such loss
(including if the Trust or the Sponsor is not able to timely
withdraw ETH from the Digital Asset Account according to the
Custodian Agreement or as a result of the Custodian’s errors in
executing a transaction on behalf of the Trust), even if the
Custodian meets its duty of exercising best efforts, and the
Custodian is required to return to the Trust a quantity equal to
the quantity of any such lost ETH.
The Custodian’s or Trust’s total liability under the Custodian
Agreement will never exceed the value of the ETH on deposit in the
Digital Asset Account at the time of, and directly relating to, the
events giving rise to the liability occurred, the value of which
will be determined in accordance with the Custodian Agreement. In
addition, for as long as a cold storage address holds ETH with a
value in excess of $100 million (the “Cold Storage Threshold”) for
a period of five consecutive business days or more without being
reduced to the Cold Storage Threshold or lower, the Custodian’s
maximum liability for such cold storage address shall be limited to
the Cold Storage Threshold. The Sponsor monitors the value of ETH
deposited in cold storage addresses for whether the Cold Storage
Threshold has been met by determining the U.S. dollar value of ETH
deposited in each cold storage address on business days.
Although the Cold Storage Threshold has never been met for a given
cold storage address, to the extent it is met and not reduced
within five business days, the Trust would not have a claim against
the Custodian with respect to the digital assets held in such
address to the extent the value exceeds the Cold Storage
Threshold.
The Custodian or Trust are not liable to each other for any lost
profits or any special, incidental, indirect, intangible, or
consequential damages, whether based in contract, tort, negligence,
strict liability or otherwise, and whether or not the Custodian has
been advised of such losses or the Custodian knew or should have
known of the possibility of such damages.
Furthermore, the Custodian is not liable for delays, suspension of
operations, whether temporary or permanent, failure in performance,
or interruption of service which result directly or indirectly from
any cause or condition beyond the reasonable control of the
Custodian, including but not limited to, any delay or failure due
to any act of God, natural disasters, act of civil or military
authorities, act of terrorists, including but not limited to
cyber-related terrorist acts, hacking, government restrictions,
exchange or market rulings, civil disturbance, war, strike or other
labor dispute, fire, interruption in telecommunications or Internet
services or network provider services, failure of equipment and/or
software, other catastrophe or any other occurrence which is beyond
the reasonable control of the Custodian and will not affect the
validity and enforceability of any remaining provisions. For the
avoidance of doubt, a cybersecurity attack, hack or other intrusion
by a third party or by someone associated with the Custodian is not
a circumstance that is beyond the Custodian’s reasonable control,
to the extent due to the Custodian’s failure to comply with its
obligations under the Custodian Agreement.
The Custodian does not bear any liability, whatsoever, for any
damage or interruptions caused by any computer viruses, spyware,
scareware, Trojan horses, worms or other malware that may affect
the Sponsor’s or the Trust’s computer or other equipment, or any
phishing, spoofing or other attack, unless such damage or
interruption originated from the Custodian due to its gross
negligence, fraud, willful misconduct or breach of the Custodian
Agreement.
37
Indemnity
Each of the Custodian and the Trust has agreed to indemnify and
hold harmless the other such parties from any third-party claim or
third-party demand (including reasonable and documented attorneys’
fees and any fines, fees or penalties imposed by any regulatory
authority) arising out of the Custodian’s or the Trust’s, as the
case may be, breach of the Custodian Agreement, inaccuracy in any
of the Custodian’s or the Trust’s, as the case may be,
representations or warranties in the Custodian Agreement, or the
Custodian’s or the Trust’s, as the case may be, knowing, in the
case of the Custodian, violation of any law, rule or regulation, or
the rights of any third party, except where such claim directly
results from the gross negligence, fraud or willful misconduct of
the other such party.
Fees and Expenses
The Custodian Fee is an annualized fee charged monthly that is a
percentage of the Trust’s monthly assets under custody. Following
the third anniversary of the Custodian Agreement, the fee may be
adjusted by the Custodian with at least six months’ advance notice.
Any changes to the fee will be agreed to by the Trust and the
Sponsor and the Custodian in writing. To the extent the parties
cannot reach an agreement regarding any modifications in pricing,
either party may elect to terminate the Custodian Agreement. It is
the Trust’s and the Sponsor’s sole responsibility to determine
whether, and to what extent, any taxes apply to any deposits or
withdrawals conducted through the Custodial
Services.
Term; Renewal
Subject to each party’s termination rights, the Custodian Agreement
is for a term of three years. Thereafter, the Custodian Agreement
automatically renews for successive terms of one year, unless
either party elects not to renew, by providing no less than thirty
days’ written notice to the other party prior to the expiration of
the then-current term, or unless terminated earlier as provided
herein.
Termination
During the Initial Term, either party may terminate the Custodian
Agreement for Cause (as defined below) at any time by written
notice to the other party, effective immediately, or on such later
date as may be specified in the notice. “Cause” is defined as if:
(i) such other party commits any material breach of any of its
obligations under the Custodian Agreement; (ii) such other party is
adjudged bankrupt or insolvent, or there is commenced against such
party a case under any applicable bankruptcy, insolvency or other
similar law now or hereafter in effect, or such party files an
application for an arrangement with its creditors, seeks or
consents to the appointment of a receiver, administrator or other
similar official for all or any substantial part of its property,
admits in writing its inability to pay its debts as they mature, or
takes any corporate action in furtherance of any of the foregoing,
or fails to meet applicable legal minimum capital requirements; or
(iii) with respect to the Trust’s and the Sponsor’s right to
terminate, any applicable law, rule or regulation or any change
therein or in the interpretation or administration thereof has or
may have a material adverse effect on the rights of the Trust, the
Sponsor or any of their respective beneficiaries with respect to
any services covered by the Custodian Agreement.
After the initial term, either party may terminate the Custodian
Agreement (i) upon ninety (90) days’ prior written notice to the
other party and (ii) for Cause at any time by written notice to the
other party, effective immediately, or on such later date as may be
specified in the notice.
Notwithstanding the foregoing, the Sponsor and the Trust may cancel
the Digital Asset Account at any time by withdrawing all balances
and contacting the Custodian. Upon termination of the Custodian
Agreement, the Custodian will promptly upon the Sponsor’s or the
Trust’s order deliver or cause to be delivered all digital assets
held or controlled by the Custodian as of the effective date of
termination, together with such copies of the records maintained
pursuant to the Custodian Agreement and as the Sponsor and the
Trust requests in writing.
Governing Law
The Custodian Agreement is governed by New York law.
Certain U.S. Federal Income Tax Consequences
The following discussion addresses the material U.S. federal income
tax consequences of the ownership of Shares. This discussion does
not describe all of the tax consequences that may be relevant to a
beneficial owner of Shares in light of the beneficial owner’s
particular circumstances, including tax consequences applicable to
beneficial owners subject to special rules, such as:
•
financial institutions;
•
dealers in securities or commodities;
38
•
traders in securities or commodities that have elected to apply a
mark-to-market method of tax accounting in respect
thereof;
•
persons holding Shares as part of a hedge, “straddle,” integrated
transaction or similar transaction;
•
Authorized Participants (as defined below);
•
U.S. Holders (as defined below) whose functional currency is not
the U.S. dollar;
•
entities or arrangements classified as partnerships for U.S.
federal income tax purposes;
•
real estate investment trusts;
•
regulated investment companies; and
•
tax-exempt entities, including individual retirement
accounts.
This discussion applies only to Shares that are held as capital
assets and does not address alternative minimum tax consequences or
consequences of the Medicare contribution tax on net investment
income.
If an entity or arrangement that is classified as a partnership for
U.S. federal income tax purposes holds Shares, the U.S. federal
income tax treatment of a partner will generally depend on the
status of the partner and the activities of the partnership.
Partnerships holding Shares and partners in those partnerships are
urged to consult their tax advisers about the particular U.S.
federal income tax consequences of owning Shares.
This discussion is based on the Code, administrative
pronouncements, judicial decisions and final, temporary and
proposed Treasury regulations as of the date hereof, changes to any
of which subsequent to the date hereof may affect the tax
consequences described herein. For the avoidance of doubt, this
summary does not discuss any tax consequences arising under the
laws of any state, local or foreign taxing jurisdiction.
Shareholders are urged to consult their tax advisers about the
application of the U.S. federal income tax laws to their particular
situations, as well as any tax consequences arising under the laws
of any state, local or foreign taxing
jurisdiction.
Tax Treatment of the Trust
The Sponsor intends to take the position that the Trust is properly
treated as a grantor trust for U.S. federal income tax purposes.
Assuming that the Trust is a grantor trust, the Trust will not be
subject to U.S. federal income tax. Rather, if the Trust is a
grantor trust, each beneficial owner of Shares will be treated as
directly owning its
pro rata
share of the Trust’s assets and a
pro rata
portion of the Trust’s income, gain, losses and deductions will
“flow through” to each beneficial owner of
Shares.
If the IRS were to disagree with, and successfully challenge,
certain positions the Trust may take with respect to Incidental
Rights and IR Virtual Currency, the Trust might not qualify as a
grantor trust. In addition, the Sponsor has delivered the
Pre-Creation Abandonment Notice to the Custodian, stating that the
Trust is irrevocably abandoning, effective immediately prior to
each Creation Time, all Incidental Rights or IR Virtual Currency to
which it would otherwise be entitled as of such time and with
respect to which it has not taken any Affirmative Action at or
prior to such time. There can be no complete assurance that these
abandonments will be treated as effective for U.S. federal income
tax purposes. If the Trust were treated as owning any asset other
than ETH as of any date on which it creates Shares, it would likely
cease to qualify as a grantor trust for U.S. federal income tax
purposes.
Because of the evolving nature of digital currencies, it is not
possible to predict potential future developments that may arise
with respect to digital currencies, including forks, airdrops and
other similar occurrences. Assuming that the Trust is currently a
grantor trust for U.S. federal income tax purposes, certain future
developments could render it impossible, or impracticable, for the
Trust to continue to be treated as a grantor trust for such
purposes.
If the Trust is not properly classified as a grantor trust, the
Trust might be classified as a partnership for U.S. federal income
tax purposes. However, due to the uncertain treatment of digital
currency for U.S. federal income tax purposes, there can be no
assurance in this regard. If the Trust were classified as a
partnership for U.S. federal income tax purposes, the tax
consequences of owning Shares generally would not be materially
different from the tax consequences described herein, although
there might be certain differences, including with respect to
timing of the recognition of taxable income or loss. In addition,
tax information reports provided to beneficial owners of Shares
would be made in a different form. If the Trust were not classified
as either a grantor trust or a partnership for U.S. federal income
tax purposes, it would be classified as a corporation for such
purposes. In that event, the Trust would be subject to entity-level
U.S. federal income tax (currently at the rate of 21%) on its net
taxable income and certain distributions made by the Trust to
shareholders would be treated as taxable dividends to the extent of
the Trust’s current and accumulated earnings and profits. Any such
dividend distributed to a beneficial owner of Shares that is a
non-U.S. person for U.S. federal income tax purposes would be
subject to U.S. federal withholding tax at a rate of 30% (or such
lower rate as provided in an applicable tax
treaty).
39
The remainder of this discussion is based on the assumption that
the Trust will be treated as a grantor trust for U.S. federal
income tax purposes.
Uncertainty Regarding the U.S. Federal Income Tax Treatment of
Digital Currency
Each beneficial owner of Shares will be treated for U.S. federal
income tax purposes as the owner of an undivided interest in the
ETH (and any Incidental Rights and/or IR Virtual Currency) held in
the Trust. Due to the new and evolving nature of digital currencies
and the absence of comprehensive guidance with respect to digital
currencies, many significant aspects of the U.S. federal income tax
treatment of digital currency are uncertain.
In 2014, the Internal Revenue Service (“IRS”) released a notice
(the “Notice”) discussing certain aspects of the treatment of
“convertible virtual currency” (that is, digital currency that has
an equivalent value in fiat currency or that acts as a substitute
for fiat currency) for U.S. federal income tax purposes. In the
Notice, the IRS stated that, for U.S. federal income tax purposes,
such digital currency (i) is “property,” (ii) is not “currency” for
purposes of the provisions of the Code relating to foreign currency
gain or loss and (iii) may be held as a capital asset. In 2019, the
IRS released a revenue ruling and a set of “Frequently Asked
Questions” (the “Ruling & FAQs”) that provide some additional
guidance, including guidance to the effect that, under certain
circumstances, hard forks of digital currencies are taxable events
giving rise to ordinary income and guidance with respect to the
determination of the tax basis of digital currency. However, the
Notice and the Ruling & FAQs do not address other significant
aspects of the U.S. federal income tax treatment of digital
currencies. Moreover, although the Ruling & FAQs address the
treatment of hard forks, there continues to be significant
uncertainty with respect to the timing and amount of the income
inclusions. While the Ruling & FAQs do not address most
situations in which airdrops occur, it is clear from the reasoning
of the Ruling & FAQs that the IRS generally would treat an
airdrop as a taxable event giving rise to ordinary
income.
There can be no assurance that the IRS will not alter its position
with respect to digital currencies in the future or that a court
would uphold the treatment set forth in the Notice and the Ruling
& FAQs. It is also unclear
what additional guidance on the treatment of digital currencies for
U.S. federal income tax purposes may be issued in the future. Any
such alteration of the current IRS positions or additional guidance
could result in adverse tax consequences for shareholders and could
have an adverse effect on the prices of digital currencies,
including the price of ETH in the Digital Asset Market, and
therefore could have an adverse effect on the value of Shares.
Future developments that may arise with respect to digital
currencies may increase the uncertainty with respect to the
treatment of digital currencies for U.S. federal income tax
purposes. For example, the Notice addresses only digital currency
that is “convertible virtual currency,” and it is conceivable that,
as a result of a fork, airdrop or similar occurrence, a Trust will
hold certain types of digital currency that are not within the
scope of the Notice.
The remainder of this discussion assumes that ETH, and any
Incidental Rights or IR Virtual Currency that the Trust may hold,
is properly treated for U.S. federal income tax purposes as
property that may be held as a capital asset and that is not
currency for purposes of the provisions of the Code relating to
foreign currency gain and loss.
Shareholders are urged to consult their tax advisers regarding the
tax consequences of an investment in the Trust and in digital
currencies in general, including, in the case of shareholders that
are generally exempt from U.S. federal income taxation, whether
such shareholders may recognize “unrelated business taxable income”
(“UBTI”) as a consequence of a fork, airdrop or similar
occurrence.
Incidental Rights and IR Virtual Currency
It is possible that, in the future, the Trust will hold Incidental
Rights and/or IR Virtual Currency that it receives in connection
with its investment in ETH. The uncertainties with respect to the
treatment of digital currency for U.S. federal income tax purposes,
described above, apply to Incidental Rights and IR Virtual
Currency, as well as to ETH. As described above, the Notice
addressed only digital currency that is “convertible virtual
currency,” defined as digital currency that has an equivalent value
in fiat currency or that acts as a substitute for fiat currency. It
is conceivable that certain IR Virtual Currency the Trust may
receive in the future would not be within the scope of the
Notice.
In general, it is expected that the Trust would receive Incidental
Rights and IR Virtual Currency as a consequence of a fork, an
airdrop or a similar occurrence related to its ownership of ETH. As
described above, the Ruling & FAQs include guidance to the
effect that, under certain circumstances, forks (and, presumably,
airdrops) of digital currencies are taxable events giving rise to
ordinary income, but there continues to be uncertainty with respect
to the timing and amount of the income inclusions. The Trust’s
receipt of Incidental Rights or IR Virtual Currency may give rise
to other tax issues. The possibility that the Trust will receive
Incidental Rights and/or IR Virtual Currency thus increases the
uncertainties and risks with respect to the U.S. federal income tax
consequences of an investment in Shares.
The Trust may distribute Incidental Rights or IR Virtual Currency,
or cash from the sale of Incidental Rights or IR Virtual Currency,
to the shareholders. Alternatively, the Trust may form a
liquidating trust to which it contributes Incidental Rights or IR
Virtual
40
Currency and distribute interests in the liquidating trust to the
shareholders. Any such distribution will not be a taxable event for
a U.S. Holder (as defined below). A U.S. Holder’s tax basis in the
Incidental Rights or IR Virtual Currency distributed, whether
directly or through the medium of a liquidating trust, will be the
same as the U.S. Holder’s tax basis in the distributed assets
immediately prior to the distribution, and the U.S. Holder’s tax
basis in its
pro rata
share of the Trust’s remaining assets will not include the amount
of such basis. Immediately after any such distribution, the U.S.
Holder’s holding period with respect to the distributed Incidental
Rights or IR Virtual Currency will be the same as the U.S. Holder’s
holding period with respect to the distributed assets immediately
prior to the distribution. A subsequent sale of the distributed
Incidental Rights or IR Virtual Currency will generally be a
taxable event for a U.S. Holder.
For simplicity of presentation, the remainder of this discussion
assumes that the Trust will hold only ETH. However, the principles
set forth in the discussion below apply to all of the assets that
the Trust may hold at any time, including Incidental Rights and IR
Virtual Currency, as well as ETH. Without limiting the generality
of the foregoing, each beneficial owner of Shares generally will be
treated for U.S. federal income tax purposes as owning an undivided
interest in any Incidental Rights and/or IR Virtual Currency held
in the Trust, and any transfers or sales of Incidental Rights
and/or IR Virtual Currency by the Trust (other than distributions
by the Trust, as described in the preceding paragraph) will be
taxable events to shareholders with respect to which shareholders
will generally recognize gain or loss in a manner similar to the
recognition of gain or loss on a taxable disposition of ETH, as
described below.
Tax Consequences to U.S. Holders
As used herein, the term “U.S. Holder” means a beneficial owner of
a Share for U.S. federal income tax purposes that is:
•
an individual who is a citizen or resident of the United States for
U.S. federal income tax purposes;
•
a corporation, or other entity treated as a corporation for U.S.
federal income tax purposes, created or organized in or under the
laws of the United States or of any political subdivision thereof;
or
•
an estate or trust the income of which is subject to U.S. federal
income taxation regardless of its source.
Except as specifically noted, the discussion below assumes that
each U.S. Holder will acquire all of its Shares on the same date
for the same price per Share and either solely for cash or solely
for ETH that were originally acquired by the U.S. Holder for cash
on the same date.
As discussed in the section entitled “Description of Creation of
Shares,” a U.S. Holder may be able to acquire Shares of the Trust
by contributing ETH in-kind to the Trust (either directly or
through an Authorized Participant acting as agent of the U.S.
Holder). Assuming that the Trust is properly treated as a grantor
trust for U.S. federal income tax purposes, such a contribution
should not be a taxable event to the U.S. Holder.
For U.S. federal income tax purposes, each U.S. Holder will be
treated as owning an undivided interest in the ETH held in the
Trust and will be treated as directly realizing its pro rata share
of the Trust’s income, gains, losses and deductions. When a U.S.
Holder purchases Shares solely for cash, (i) the U.S. Holder’s
initial tax basis in its pro rata share of the ETH held in the
Trust will be equal to the amount paid for the Shares and (ii) the
U.S. Holder’s holding period for its pro rata share of such ETH
will begin on the date of such purchase. When a U.S. Holder
acquires Shares in exchange for ETH, (i) the U.S. Holder’s initial
tax basis in its pro rata share of the ETH held in the Trust will
be equal to the U.S. Holder’s tax basis in the ETH that the U.S.
Holder transferred to the Trust and (ii) the U.S. Holder’s holding
period for its pro rata share of such ETH generally will include
the period during which the U.S. Holder held the ETH that the U.S.
Holder transferred to the Trust. The Ruling & FAQs confirm that
if a taxpayer acquires tokens of a digital currency at different
times and for different prices, the taxpayer has a separate tax
basis in each lot of such tokens. Under the Ruling & FAQs, if a
U.S. Holder that owns more than one lot of ETH contributes a
portion of its ETH to the Trust in exchange for Shares, the U.S.
Holder may designate the lot(s) from which such contribution will
be made, provided that the U.S. Holder is able to identify
specifically which ETH it is contributing and to substantiate its
tax basis in those ETH. In general, if a U.S. Holder acquires
Shares (i) solely for cash at different prices, (ii) partly for
cash and partly in exchange for a contribution of ETH or (iii) in
exchange for a contribution of ETH with different tax bases, the
U.S. Holder’s share of the Trust’s ETH will consist of separate
lots with separate tax bases. In addition, in this situation, the
U.S. Holder’s holding period for the separate lots may be
different. In addition, the IR Virtual Currency that the Trust
acquires in a hard fork or airdrop that is treated as a taxable
event will constitute a separate lot with a separate tax basis and
holding period.
When the Trust transfers ETH to the Sponsor as payment of the
Sponsor’s Fee, or sells ETH to fund payment of any Additional Trust
Expenses, each U.S. Holder will be treated as having sold
its
pro rata
share of
those ETH for their fair market value at that time (which, in the
case of ETH sold by the Trust, generally will be equal to the cash
proceeds received by the Trust in respect thereof). As a result,
each U.S. Holder will recognize gain or loss in an amount equal to
the difference between (i) the fair market value of the U.S.
Holder’s
pro rata
share of the ETH transferred and (ii) the U.S. Holder’s tax basis
for its
pro rata
share of the ETH transferred. Any such gain or loss will be
short-term capital gain or loss if the U.S. Holder’s holding period
for its pro rata share of the ETH is one year
41
or less and long-term capital gain or loss if the U.S. Holder’s
holding period for its
pro rata
share of the ETH is more than one year. A U.S. Holder’s tax basis
in its pro rata share of any ETH transferred by the Trust generally
will be determined by multiplying the tax basis of the U.S.
Holder’s pro rata share of all of the ETH held in the Trust
immediately prior to the transfer by a fraction the numerator of
which is the amount of ETH transferred and the denominator of which
is the total amount of ETH held in the Trust immediately prior to
the transfer. Immediately after the transfer, the U.S. Holder’s tax
basis in its pro rata share of the ETH remaining in the Trust will
be equal to the tax basis of its pro rata share of the ETH held in
the Trust immediately prior to the transfer, less the portion of
that tax basis allocable to its pro rata share of the ETH
transferred.
As noted above, the IRS has taken the position in the Ruling &
FAQs that, under certain circumstances, a hard fork of a digital
currency constitutes a taxable event giving rise to ordinary
income, and it is clear from the reasoning of the Ruling & FAQs
that the IRS generally would treat an airdrop as a taxable event
giving rise to ordinary income. Under the Ruling & FAQs, a U.S.
Holder will have a basis in any IR Virtual Currency received in a
fork or airdrop equal to the amount of income the U.S. Holder
recognizes as a result of such fork or airdrop and the U.S.
Holder’s holding period for such IR Virtual Currency will begin as
of the time it recognizes such income.
U.S. Holders’
pro rata
shares of the expenses incurred by the Trust will be treated as
“miscellaneous itemized deductions” for U.S. federal income tax
purposes. As a result, for taxable years beginning after December
31, 2017 and before January 1, 2026, a non-corporate U.S. Holder’s
share of these expenses will not be deductible for U.S. federal
income tax purposes. For taxable years beginning on or after
January 1, 2026, a non-corporate U.S. Holder’s share of these
expenses will be deductible for regular U.S. federal income tax
purposes only to the extent that the U.S. Holder’s share of the
expenses, when combined with other “miscellaneous itemized
deductions,” exceeds 2% of the U.S. Holder’s adjusted gross income
for the particular year, will not be deductible for U.S. federal
alternative minimum tax purposes and will be subject to certain
other limitations on deductibility.
On a sale or other disposition of Shares, a U.S. Holder will be
treated as having sold the ETH underlying such Shares. Accordingly,
the U.S. Holder generally will recognize gain or loss in an amount
equal to the difference between (i) the amount realized on the sale
of the Shares and (ii) the portion of the U.S. Holder’s tax basis
in its pro rata share of the ETH held in the Trust that is
attributable to the Shares that were sold or otherwise subject to a
disposition. Such tax basis generally will be determined by
multiplying the tax basis of the U.S. Holder’s
pro rata
share of all of the ETH held in the Trust immediately prior to such
sale or other disposition by a fraction the numerator of which is
the number of Shares disposed of and the denominator of which is
the total number of Shares held by such U.S. Holder immediately
prior to such sale or other disposition (such fraction, expressed
as a percentage, the “Share Percentage”). If the U.S. Holder’s
share of the Trust’s ETH consists of separate lots with separate
tax bases and/or holding periods, the U.S. Holder will be treated
as having sold the Share Percentage of each such lot. Gain or loss
recognized by a U.S. Holder on a sale or other disposition of
Shares will generally be short-term capital gain or loss if the
U.S. Holder’s holding period for the ETH underlying such Shares is
one year or less and long-term capital gain or loss if the U.S.
Holder’s holding period for the ETH underlying such Shares is more
than one year. The deductibility of capital losses is subject to
significant limitations.
After any sale or other disposition of fewer than all of a U.S.
Holder’s Shares, the U.S. Holder’s tax basis in its
pro rata
share of the ETH held in the Trust immediately after the
disposition will equal the tax basis in its
pro rata
share of the total amount of the ETH held in the Trust immediately
prior to the disposition, less the portion
of that tax basis that is taken into account in determining the
amount of gain or loss recognized by the U.S. Holder on the
disposition.
Any brokerage or other transaction fee incurred by a U.S. Holder in
purchasing Shares generally will be added to the U.S. Holder’s tax
basis in the underlying assets of the Trust. Similarly, any
brokerage fee or other transaction fee incurred by a U.S. Holder in
selling Shares generally will reduce the amount realized by the
U.S. Holder with respect to the sale.
In the absence of guidance to the contrary, it is possible that any
income recognized by a U.S. tax-exempt shareholder as a consequence
of a hard fork, airdrop or similar occurrence would constitute
UBTI. A tax-exempt shareholder should consult its tax adviser
regarding whether such shareholder may recognize some UBTI as a
consequence of an investment in Shares.
Tax Consequences to Non-U.S. Holders
As used herein, the term “non-U.S. Holder” means a beneficial owner
of a Share for U.S. federal income tax purposes that is not a U.S.
Holder. The term “non-U.S. Holder” does not include (i) a
nonresident alien individual who is present in the United States
for 183 days or more in a taxable year, (ii) a former U.S. citizen
or U.S. resident or an entity that has expatriated from the United
States; (iii) a person whose income in respect of Shares is
effectively connected with the conduct of a trade or business in
the United States; or (iv) an entity that is treated as a
partnership for U.S. federal income tax purposes. Shareholders
described in the preceding sentence should consult their tax
advisers regarding the U.S. federal income tax consequences of
owning Shares.
A non-U.S. Holder generally will not be subject to U.S. federal
income or withholding tax with respect to its share of any gain
recognized on the Trust’s transfer of ETH in payment of the
Sponsor’s Fee or any Additional Trust Expense or on the Trust’s
sale or
42
other disposition of ETH. In addition, assuming that the Trust
holds no asset other than ETH, a non-U.S. Holder generally will not
be subject to U.S. federal income or withholding tax with respect
to any gain it recognizes on a sale or other disposition of Shares.
A non-U.S. Holder also will generally not be subject to U.S.
federal income or withholding tax with respect to any distribution
received from the Trust, whether in cash or
in-kind.
Provided that it does not constitute income that is treated as
“effectively connected” with the conduct of a trade or business in
the United States, U.S.-source “fixed or determinable annual or
periodical” (“FDAP”) income received, or treated as received, by a
non-U.S. Holder will generally be subject to U.S. withholding tax
at the rate of 30% (subject to possible reduction or elimination
pursuant to an applicable tax treaty and to statutory exemptions
such as the portfolio interest exemption). Although there is no
guidance on point, it is likely that any ordinary income recognized
by a non-U.S. Holder as a result of a fork, airdrop or similar
occurrence would constitute FDAP income. It is unclear, however,
whether any such FDAP income would be properly treated as
U.S.-source or foreign-source FDAP income. Non-U.S. Holders should
assume that, in the absence of guidance, a withholding agent
(including the Sponsor) is likely to withhold 30% from a non-U.S.
Holder’s
pro rata
share of any such income, including by deducting such withheld
amounts from proceeds that such non-U.S. Holder would otherwise be
entitled to receive in connection with a distribution of Incidental
Rights, IR Virtual Currency or proceeds from the disposition of
Incidental Rights or IR Virtual Currency. A non-U.S. Holder that is
a resident of a country that maintains an income tax treaty with
the United States may be eligible to claim the benefits of that
treaty to reduce or eliminate, or to obtain a partial or full
refund of, the 30% U.S. withholding tax on its share of any such
income, but only if the non-U.S. Holder’s home country treats the
Trust as “fiscally transparent,” as defined in applicable Treasury
regulations.
Although the nature of the Incidental Rights and IR Virtual
Currency that the Trust may hold in the future is uncertain, it is
unlikely that any such asset would give rise to income that is
treated as “effectively connected” with the conduct of a trade or
business in the United States or that any income derived by a
non-U.S. Holder from any such asset would otherwise be subject to
U.S. income or withholding tax, except as discussed above in
connection with the fork, airdrop or similar occurrence giving rise
to Incidental Rights or IR Virtual Currency. There can, however, be
no complete assurance in this regard.
In order to prevent the possible imposition of U.S. “backup”
withholding and (if applicable) to qualify for a reduced rate of
withholding tax at source under a treaty, a non-U.S. Holder must
comply with certain certification requirements (generally, by
delivering a properly executed IRS Form W-8BEN or W-8BEN-E to the
relevant withholding agent).
U.S. Information Reporting and Backup Withholding
The Trust or the appropriate broker will file certain information
returns with the IRS and provide shareholders with information
regarding their annual income (if any) and expenses with respect to
the Trust in accordance with applicable Treasury
regulations.
A U.S. Holder will generally be subject to information reporting
requirements and backup withholding unless (i) the U.S. Holder is a
corporation or other exempt recipient or (ii) in the case of backup
withholding, the U.S. Holder provides a correct taxpayer
identification number and certifies that it is not subject to
backup withholding. In order to avoid the information reporting and
backup withholding requirements, a non-U.S. Holder may have to
comply with certification procedures to establish that it is not a
U.S. person. The amount of any backup withholding will be allowed
as a credit against the shareholder’s U.S. federal income tax
liability and may entitle the holder to a refund, provided that the
required information is furnished to the IRS.
FATCA
As discussed above, it is unclear whether any ordinary income
recognized by a non-U.S. Holder as a result of a fork, airdrop or
similar occurrence would constitute U.S.-source FDAP income.
Provisions of the Code commonly referred to as “FATCA” require
withholding of 30% on payments of U.S.-source FDAP income and,
subject to the discussion of proposed U.S. Treasury regulations
below, of gross proceeds of dispositions of certain types of
property that produce U.S.-source FDAP income to, “foreign
financial institutions” (which is broadly defined for this purpose
and in general includes investment vehicles) and certain other
non-U.S. entities unless various U.S. information reporting and due
diligence requirements (generally relating to ownership by U.S.
persons of interests in or accounts with those entities) have been
satisfied, or an exemption applies. An intergovernmental agreement
between the United States and an applicable foreign country may
modify these requirements. In addition, regulations proposed by the
U.S. Treasury Department (the preamble to which indicates that
taxpayers may rely on the regulations pending their finalization)
would eliminate the requirement under FATCA of withholding on gross
proceeds. If FATCA withholding is imposed, a beneficial owner that
is not a foreign financial institution generally may obtain a
refund of any amounts withheld by filing a U.S. federal income tax
return (which may entail significant administrative burden).
Shareholders should consult their tax advisers regarding the
effects of FATCA on an investment in the Trust.
43
ERISA and Related Considerations
The following section sets forth certain consequences under ERISA
and the Code which a fiduciary of an “employee benefit plan” as
defined in and subject to the fiduciary responsibility provisions
of ERISA, or of a “plan” as defined in and subject to Section 4975
of the Code, who has investment discretion should consider before
deciding to acquire Shares with plan assets (such “employee benefit
plans” and “plans” being referred to herein as “Plans,” and such
fiduciaries with investment discretion being referred to herein as
“Plan Fiduciaries”). The following summary is not intended to be
complete, but only to address certain questions under ERISA and the
Code that are likely to be raised by the Plan Fiduciary’s own
counsel.
* * *
In general, the terms “employee benefit plan” as defined in ERISA
and “plan” as defined in Section 4975 of the Code together refer to
any plan or account of various types which provides retirement
benefits or welfare benefits to an individual or to an employer’s
employees and their beneficiaries. Such plans and accounts include,
but are not limited to, corporate pension and profit sharing plans,
“simplified employee pension plans,” Keogh plans for self-employed
individuals (including partners), individual retirement accounts
described in Section 408 of the Code and medical benefit
plans.
Each Plan Fiduciary must give appropriate consideration to the
facts and circumstances that are relevant to an investment in the
Trust, including the role an investment in the Trust plays in the
Plan’s investment portfolio. Each Plan Fiduciary must be satisfied
that investment in the Trust is a prudent investment for the Plan,
that the investments of the Plan, including the investment in the
Trust, are diversified so as to minimize the risks of large losses
and that an investment in the Trust complies with the documents of
the Plan and related trust and that an investment in the Trust does
not give rise to a transaction prohibited by Section 406 of ERISA
or Section 4975 of the Code.
Governmental plans, non-U.S. plans and certain church plans, while
generally not subject to the fiduciary responsibility or prohibited
transaction provisions of ERISA or Section 4975 of the Code, may be
subject to provisions under other U.S. or non-U.S. federal, state,
local or other laws or regulations that are similar to such
provisions of ERISA or the Code. Fiduciaries of such plans should
consider the consequences of an investment in the Trust under any
such applicable similar laws or regulations before acquiring any
Shares.
EACH PLAN FIDUCIARY CONSIDERING ACQUIRING SHARES MUST CONSULT ITS
OWN LEGAL AND TAX ADVISERS BEFORE DOING SO.
Restrictions on Investments by Benefit Plan Investors
ERISA and a regulation issued thereunder contain rules for
determining when an investment by a Plan in an entity will result
in the underlying assets of the entity being deemed assets of the
Plan for purposes of ERISA and Section 4975 of the Code
(i.e.,
“plan assets”). Those rules provide that the assets of an entity
will not be deemed "plan assets" of a Plan that purchases an
interest therein if the investment in the entity by all “benefit
plan investors” is not “significant” or certain other exceptions
apply. The term “benefit plan investors” includes all Plans
(i.e.,
all “employee benefit plans” as defined in and subject to the
fiduciary responsibility provisions of ERISA and all “plans” as
defined in and subject to Section 4975 of the Code) and all
entities that hold “plan assets” (each, a “Plan Assets Entity”) due
to investments made in such entities by already described benefit
plan investors. ERISA provides that a Plan Assets Entity is
considered to hold plan assets only to the extent of the percentage
of the Plan Assets Entity’s equity interests held by benefit plan
investors. In addition, all or part of an investment made by an
insurance company using assets from its general account may be
treated as a benefit plan investor. Investments by benefit plan
investors will be deemed not significant if benefit plan investors
own, in the aggregate, less than 25% of the total value of each
class of equity interests of the entity (determined by not
including the investments of persons with discretionary authority
or control over the assets of such entity, of any person who
provides investment advice for a fee (direct or indirect) with
respect to such assets, and “affiliates” (as defined in the
regulations issued under ERISA) of such persons; provided, however,
that under no circumstances are investments by benefit plan
investors excluded from such calculation).
In order to avoid causing assets of the Trust to be “plan assets,”
the Sponsor intends to restrict the aggregate investment by
“benefit plan investors” to under 25% of the total value of the
Shares of the Trust (not including
the investments of the Trustee, the Sponsor, the distributor, any
other person who provides investment advice for a fee (direct or
indirect) with respect to the assets of the Trust, any other person
who has discretionary authority or control over the assets of the
Trust, and any entity (other than a benefit plan investor) that is
directly or indirectly through one or more intermediaries
controlling, controlled by or under common control with any of such
entities (including a partnership or other entity for which the
Sponsor is the general partner, managing member, investment adviser
or provides investment advice), and each of the principals,
officers, and employees of any of the foregoing entities who has
the power to exercise a controlling influence over the management
or policies of such entity or the Trust). Furthermore, because the
25% test is ongoing, it not only restricts additional investments
by benefit plan investors, but also can cause the Sponsor to
require that existing benefit plan investors redeem from the Trust
in the event that other investors redeem their Shares. If rejection
of subscriptions or such
44
compulsory redemptions are necessary, as determined by the Sponsor,
to avoid causing the assets of the Trust to be “plan assets,” the
Sponsor will effect such rejections or redemptions in such manner
as the Sponsor, in its sole discretion,
determines.
Ineligible Purchasers
In general, Shares may not be purchased with the assets of a Plan
if the Trustee, the Sponsor, the distributor, any placement agent,
any of their respective affiliates or any of their respective
employees either: (i) has investment discretion with respect to the
investment of such Plan assets; (ii) has authority or
responsibility to give or regularly gives investment advice with
respect to such Plan assets, for a fee, and pursuant to an
agreement or understanding that such advice will serve as a primary
basis for investment decisions with respect to such Plan assets and
that such advice will be based on the particular investment needs
of the Plan; or (iii) is an employer maintaining or contributing to
such Plan. A party that is described in clause (i) or (ii) of the
preceding sentence is a fiduciary under ERISA and the Code with
respect to the Plan, and any such purchase (as described in clause
(i), (ii) or (iii)) could result in a “prohibited transaction”
under ERISA and the Code.
Except as otherwise set forth, the foregoing statements regarding
the consequences under ERISA and the Code of an investment in the
Trust are based on the provisions of ERISA and the Code as
currently in effect, and the existing administrative and judicial
interpretations thereunder. No assurance can be given that
administrative, judicial or legislative changes will not occur that
may make the foregoing statements incorrect or
incomplete.
ACCEPTANCE OF SUBSCRIPTIONS ON BEHALF OF PLANS IS IN NO RESPECT A
REPRESENTATION BY THE SPONSOR OR ANY OTHER PARTY RELATED TO THE
TRUST THAT THIS INVESTMENT MEETS THE RELEVANT LEGAL REQUIREMENTS
WITH RESPECT TO INVESTMENTS BY ANY PARTICULAR PLAN OR PLANS
GENERALLY OR THAT THIS INVESTMENT IS APPROPRIATE FOR ANY PARTICULAR
PLAN. THE PERSON WITH INVESTMENT DISCRETION FOR ANY PLAN SHOULD
CONSULT WITH HIS OR HER OWN COUNSEL AND FINANCIAL ADVISERS AS TO
THE PROPRIETY OF AN INVESTMENT IN THE TRUST, IN LIGHT OF THE
CIRCUMSTANCES OF THE PARTICULAR PLAN.
Item 1A.
Risk
Factors
Summary of Risk Factors
Below is a summary of the principal factors that make an investment
in the Shares speculative or risky. This summary does not address
all of the risks that we face. Additional discussion of the risks
summarized in this risk factor summary, and other risks that we
face, can be found below and
should be read in conjunction with the other information included
in this Annual Report on Form 10-K, including the Trust’s financial
statements and related notes thereto,
and our other filings with the SEC, before making an investment
decision regarding the Shares.
See “Glossary of Defined Terms” for the definition of certain
capitalized terms used in this Annual Report.
All other capitalized terms used, but not defined, herein have the
meanings given to them in the Trust Agreement.
•
Extreme volatility of trading prices that many digital assets,
including Ethereum, have experienced in recent periods and may
continue to experience, could have a material adverse effect on the
value of the Shares;
•
The medium-to-long term value of the Shares is subject to a number
of factors relating to the capabilities and development of
blockchain technologies and to the fundamental investment
characteristics of digital assets;
•
The value of the Shares is dependent on the acceptance of Digital
Assets, such as Ethereum, which represent a new and rapidly
evolving industry;
•
The value of the Shares relates directly to the value of Ethereum
held by the Trust, the value of which may be highly volatile and
subject to fluctuations;
•
The unregulated nature and lack of transparency surrounding the
operations of Digital Asset Exchanges may adversely affect the
value of digital assets and, consequently, the value of the
Shares;
•
Risks related to the COVID-19 outbreak could negatively impact the
value of the Trust’s holdings and significantly disrupt its
operations;
•
The lack of an ongoing redemption program due to the holding period
under Rule 144, and the Trust’s ability to halt creations from time
to time, results in the lack of an arbitrage mechanism to keep the
value of the Shares closely linked to the Index Price;
•
The Shares may trade at a price that is at, above or below the
Trust’s Digital Asset Holdings per Share as a result of the
non-current trading hours between OTCQX and the Digital Asset
Exchange Market;
45
•
Regulatory changes or actions by the U.S. Congress or any U.S.
federal or state agencies may affect the value of the Shares or
restrict the use of one or more digital assets, mining activity or
the operation of their networks or the Digital Asset Exchange
Market in a manner that adversely affects the value of the
Shares;
•
Changes in the policies of the U.S. Securities and Exchange
Commission (the “SEC”) could adversely impact the value of the
Shares;
•
Regulatory changes or actions in foreign jurisdictions may affect
the value of the Shares or restrict the use of one or more digital
assets, mining activity or the operation of their networks or the
Digital Asset Exchange Market in a manner that adversely affects
the value of the Shares;
•
An Authorized Participant, the Trust or the Sponsor could be
subject to regulation as a money service business or money
transmitter, which could result in extraordinary expenses to the
Authorized Participant, the Trust or the Sponsor and also result in
decreased liquidity for the Shares;
•
Regulatory changes or interpretations could obligate the Trust or
the Sponsor to register and comply with new regulations, resulting
in potentially extraordinary, nonrecurring expenses to the
Trust;
•
The Trust may be required to disclose information, including
information relating to investors, to regulators;
•
Conflicts of interest may arise among the Sponsor or its affiliates
and the Trust;
•
The Sponsor’s services may be discontinued, which could be
detrimental to the Trust; and
•
The Custodian may resign or be removed by the Sponsor, which would
trigger early termination of the Trust; and;
The following risks, some of which have occurred and any of which
may occur in the future, can have a material adverse effect on our
business or financial performance, which in turn can affect the
price of the Shares. These are not the only risks we face. There
may be other risks we are not currently aware of or that we
currently deem not to be material but may become material in the
future.
Risk Factors Related to Digital Assets
The trading prices of many digital assets, including ETH, have
experienced extreme volatility in recent periods and may continue
to do so. Extreme volatility in the future, including further
declines in the trading prices of ETH, could have a material
adverse effect on the value of the Shares and the Shares could lose
all or substantially all of their value.
The trading prices of many digital assets, including ETH, have
experienced extreme volatility in recent periods and may continue
to do so. For instance, there were steep increases in the value of
certain digital assets, including ETH, over the course of 2017, and
multiple market observers asserted that digital assets were
experiencing a “bubble.” These increases were followed by steep
drawdowns throughout 2018 in digital asset trading prices,
including for ETH. These drawdowns notwithstanding, digital asset
prices, including ETH, increased significantly again during 2019,
decreased significantly again in the first quarter of 2020 amidst
broader market declines as a result of the novel coronavirus
outbreak and increased significantly again over the remainder of
2020 and the first quarter of 2021. Digital asset prices continued
to experience significant and sudden changes throughout 2021
followed by steep drawdowns in the fourth quarter of 2021 and to
date in 2022. Extreme volatility may persist and the value of the
Shares may significantly decline in the future without recovery.
The Digital Asset Markets may still be experiencing a bubble or may
experience a bubble again in the future. Extreme volatility in the
future, including further declines in the trading prices of ETH,
could have a material adverse effect on the value of the Shares and
the Shares could lose all or substantially all of their value. The
Trust is not actively managed and will not take any actions to take
advantage, or mitigate the impacts, of volatility in the price of
ETH. For additional information that quantifies the volatility of
ETH prices, see “Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations—Historical Digital
Asset Holdings and ETH Prices.”
Digital assets such as ETH were only introduced within the past
decade, and the medium-to-long term value of the Shares is subject
to a number of factors relating to the capabilities and development
of blockchain technologies and to the fundamental investment
characteristics of digital assets.
Digital assets such as ETH were only introduced within the past
decade, and the medium-to-long term value of the Shares is subject
to a number of factors relating to the capabilities and development
of blockchain technologies, such as the recentness of their
development, their dependence on the internet and other
technologies, their dependence on the role played by users,
developers and miners and the potential for malicious activity. For
example, the realization of one or more of the following risks
could materially adversely affect the value of the
Shares:
•
Digital asset networks and the software used to operate them are in
the early stages of development. Given the recentness of the
development of digital asset networks, digital assets may not
function as intended and parties may be unwilling to use digital
assets, which would dampen the growth, if any, of digital asset
networks.
46
•
The loss or destruction of a private key required to access a
digital asset may be irreversible. If a private key is lost,
destroyed or otherwise compromised and no backup of the private key
is accessible, the owner would be unable to access the digital
asset corresponding to that private key and the private key will
not be capable of being restored by the digital asset
network
•
Digital asset networks are dependent upon the internet. A
disruption of the internet or a digital asset network, such as the
Ethereum Network, would affect the ability to transfer digital
assets, including ETH, and, consequently, their value.
•
The acceptance of software patches or upgrades by a significant,
but not overwhelming, percentage of the users and miners in a
digital asset network, such as the Ethereum Network, could result
in a “fork” in such network’s blockchain, resulting in the
operation of multiple separate networks.
•
Governance of the Ethereum Network is by voluntary consensus and
open competition. As a result, there may be a lack of consensus or
clarity on the governance of the Ethereum Network, which may stymie
the Ethereum Network’s utility and ability to grow and face
challenges. In particular, it may be difficult to find solutions or
martial sufficient effort to overcome any future problems on the
Ethereum Network, especially long-term problems.
•
The foregoing notwithstanding, the Ethereum Network’s protocol is
informally managed by a group of core developers that propose
amendments to the Ethereum Network’s source code. The core
developers evolve over time, largely based on self-determined
participation. To the extent that a significant majority of users
and miners adopt amendments to the Ethereum Network, the Ethereum
Network will be subject to new protocols that may adversely affect
the value of ETH.
•
Over the past several years, digital asset mining operations have
evolved from individual users mining with computer processors,
graphics processing units and first generation application specific
integrated circuit machines to “professionalized” mining operations
using proprietary hardware or sophisticated machines. If the profit
margins of digital asset mining operations are not sufficiently
high, including due to an increase in electricity costs, digital
asset miners are more likely to immediately sell tokens earned by
mining, resulting in an increase in liquid supply of that digital
asset, which would generally tend to reduce that digital asset’s
market price.
•
To the extent that any miners cease to record transactions that do
not include the payment of a transaction fee in solved blocks or do
not record a transaction because the transaction fee is too low,
such transactions will not be recorded on the Blockchain until a
block is mined by a miner who does not require the payment of
transaction fees or is willing to accept a lower fee. Any
widespread delays in the recording of transactions could result in
a loss of confidence in a digital asset network.
•
Digital asset mining operations can consume significant amounts of
electricity, which may have a negative environmental impact and
give rise to public opinion against allowing, or government
regulations restricting, the use of electricity for mining
operations. Additionally, miners may be forced to cease operations
during an electricity shortage or power outage.
•
Many digital asset networks face significant scaling challenges and
are being upgraded with various features to increase the speed and
throughput of digital asset transactions. These attempts to
increase the volume of transactions may not be
effective.
•
The open-source structure of many digital asset network protocols,
such as the protocol for the Ethereum Network, means that
developers and other contributors are generally not directly
compensated for their contributions in maintaining and developing
such protocols. As a result, the developers and other contributors
of a particular digital asset may lack a financial incentive to
maintain or develop the network or may lack the resources to
adequately address emerging issues. Alternatively, some developers
may be funded by companies whose interests are at odds with other
participants in a particular digital asset network. A failure to
properly monitor and upgrade the protocol of the Ethereum Network
could damage that network.
•
Moreover, in the past, flaws in the source code for digital assets
have been exposed and exploited, including flaws that disabled some
functionality for users, exposed users’ personal information and/or
resulted in the theft of users’ digital assets. The cryptography
underlying ETH could prove to be flawed or ineffective, or
developments in mathematics and/or technology, including advances
in digital computing, algebraic geometry and quantum computing,
could result in such cryptography becoming ineffective. In any of
these circumstances, a malicious actor may be able to take the
Trust’s ETH, which would adversely affect the value of the Shares.
Moreover, functionality of the Ethereum Network may be negatively
affected such that it is no longer attractive to users, thereby
dampening demand for ETH. Even if another digital asset other than
ETH were affected by similar circumstances, any reduction in
confidence in the source code or cryptography underlying digital
assets generally could negatively affect the demand for digital
assets and therefore adversely affect the value of the
Shares
•
The Ethereum Network is in the process of implementing software
upgrades and other changes to its protocol. For example, in 2022 or
2023, the Ethereum Network may begin the final of several stages of
an upgrade called Ethereum 2.0. Ethereum 2.0. is a new iteration of
Ethereum that would amend its consensus mechanism to include
proof-of-stake and sharding. A
47
digital asset network’s consensus mechanism is a material aspect of
its source code, and any failure to properly implement such a
change could have a material adverse effect on the value of ETH and
the value of the Shares.
•
See “Item
1. Business—Overview
of the ETH Industry and Market—Creation of New ETH” and
“—Modifications to the ETH Protocol” for additional information. In
addition, the acceptance of software patches or upgrades by a
significant, but not overwhelming, percentage of the users and
miners in a digital asset network could result in a “fork” in such
network’s blockchain, resulting in the operation of multiple
separate networks. See “A temporary or permanent “fork” could
adversely affect the value of the Shares” for additional
information
•
The Ethereum Network is still in the process of developing and
making significant decisions that will affect policies that govern
the supply and issuance of ETH as well as other Ethereum Network
protocols. For example, the Ethereum Network has on two separate
occasions reduced the quantity of ETH rewarded per block and may
make additional changes in the future, see “Item
1. Business—Overview
of the ETH Industry and Market—Creation of New ETH” for additional
information. The open-source nature of many digital asset network
protocols, such as the protocol for the Ethereum Network, means
that developers and other contributors are generally not directly
compensated for their contributions in maintaining and developing
such protocols. As a result, the developers and other contributors
of a particular digital asset may lack a financial incentive to
maintain or develop the network, or may lack the resources to
adequately address emerging issues. Alternatively, some developers
may be funded by companies whose interests are at odds with other
participants in a particular digital asset network. If the Ethereum
Network does not successfully develop its policies on supply and
issuance, or does so in a manner that is not attractive to network
participants, there may not be sufficient network level support for
such network, which could lead to a decline in the support and
price of ETH.
Moreover, because digital assets, including ETH, have been in
existence for a short period of time and are continuing to develop,
there may be additional risks in the future that are impossible to
predict as of the date of this Annual Report.
Digital assets represent a new and rapidly evolving industry, and
the value of the Shares depends on the acceptance of
ETH.
The first digital asset, Bitcoin, was launched in 2009. ETH
launched in 2015 and, along with Bitcoin, was one of the first
cryptographic digital assets to gain global adoption and critical
mass. In general, digital asset networks, including the Ethereum
Network and other cryptographic and algorithmic protocols governing
the issuance of digital assets represent a new and rapidly evolving
industry that is subject to a variety of factors that are difficult
to evaluate. For example, the realization of one or more of the
following risks could materially adversely affect the value of the
Shares:
•
ETH has only recently become selectively accepted by retail and
commercial outlets, and use of ETH by consumers remains limited.
Banks and other established financial institutions may refuse to
process funds for ETH transactions; process wire transfers to or
from Digital Asset Exchanges, ETH-related companies or service
providers; or maintain accounts for persons or entities transacting
in ETH. As a result, the prices of ETH are largely determined by
speculators, with miners contributing to price volatility that
makes retailers less likely to accept ETH in the
future.
•
Banks may not provide banking services, or may cut off banking
services, to businesses that provide digital asset-related services
or that accept digital assets as payment, which could dampen
liquidity in the market and damage the public perception of digital
assets generally or any one digital asset in particular, such as
ETH, and their or its utility as a payment system, which could
decrease the price of digital assets generally or
individually.
•
Certain privacy-preserving features have been or are expected to be
introduced to digital asset networks, such as the Ethereum Network,
and exchanges or businesses that facilitate transactions in ETH may
be at an increased risk of having banking services cut off if there
is a concern that these features interfere with the performance of
anti-money laundering duties and economic sanctions
checks.
•
Users, developers and miners may otherwise switch to or adopt
certain digital assets at the expense of their engagement with
other digital asset networks, which may negatively impact those
networks, including the Ethereum Network.
Smart contracts are a new technology and ongoing development may
magnify initial problems, cause volatility on the networks that use
smart contracts and reduce interest in them, which could have an
adverse impact on the value of ETH.
Smart contracts are programs that run on a blockchain that execute
automatically when certain conditions are met. Since smart
contracts typically cannot be stopped or reversed, vulnerabilities
in their programming can have damaging effects. For example, in
June 2016, a vulnerability in the smart contracts underlying The
DAO, a distributed autonomous organization for venture capital
funding, allowed an attack by a hacker to syphon approximately $60
million worth of ETH from The DAO’s accounts into a segregated
account. In the aftermath of the theft, certain developers and core
contributors pursued a “hard fork” of the Ethereum Network in order
to erase any record of the theft. Despite these efforts, the price
of ETH dropped approximately 35% in the aftermath of the attack and
subsequent hard fork. In addition, in July 2017, a vulnerability in
a smart contract for a multi-signature wallet software developed by
Parity led to a $30 million theft of ETH, and in November 2017, a
new vulnerability in Parity’s wallet software led to roughly $160
million worth of
48
ETH being indefinitely frozen in an account. Initial problems and
continued problems with the development and deployment of smart
contracts may have an adverse effect on the value of
ETH.
Changes in the governance of a digital asset network may not
receive sufficient support from users and miners, which may
negatively affect that digital asset network’s ability to grow and
respond to challenges.
The governance of decentralized networks, such as the Ethereum
Network, is by voluntary consensus and open competition. As a
result, there may be a lack of consensus or clarity on the
governance of any particular decentralized digital asset network,
which may stymie such network’s utility and ability to grow and
face challenges. Historically the Ethereum Network’s development
has been overseen by the Ethereum Foundation and other core
developers. The core developers evolve over time, largely based on
self-determined participation. To the extent that a significant
majority of users and miners adopt amendments to the Ethereum
Network, the Ethereum Network will be subject to new protocols that
may adversely affect the value of ETH. If a significant majority of
users and miners adopt amendments to a decentralized network based
on the proposals of such core developers, such network will be
subject to new protocols that may adversely affect the value of the
relevant digital asset.
As a result of the foregoing, it may be difficult to find solutions
or marshal sufficient effort to overcome any future problems,
especially long-term problems, on digital asset
networks.
Digital asset networks face significant scaling challenges and
efforts to increase the volume and speed of transactions may not be
successful.
Many digital asset networks face significant scaling challenges due
to the fact that public blockchains generally face a tradeoff
between security and scalability. One means through which public
blockchains achieve security is decentralization, meaning that no
intermediary is responsible for securing and maintaining these
systems. For example, a greater degree of decentralization
generally means a given digital asset network is less susceptible
to manipulation or capture. In practice, this typically means that
every single node on a given digital asset network is responsible
for securing the system by processing every transaction and
maintaining a copy of the entire state of the network. As a result,
a digital asset network may be limited in the number of
transactions it can process by the capabilities of each single
fully participating node. Many developers are actively researching
and testing scalability solutions for public blockchains that do
not necessarily result in lower levels of security or
decentralization, such as off-chain payment channels and sharding.
Off-chain payment channels would allow parties to transact without
requiring the full processing power of a blockchain. Sharding can
increase the scalability of a database, such as a blockchain, by
splitting the data processing responsibility among many nodes,
allowing for parallel processing and validating of
transactions.
As of December 31, 2021, the Ethereum Network could handle
approximately 14 transactions per second. In an effort to increase
the volume of transactions that can be processed on a given digital
asset network, many digital assets are being upgraded with various
features to increase the speed and throughput of digital asset
transactions. For example, in 2022 or 2023, the Ethereum Network
may begin the final of several stages of an upgrade called Ethereum
2.0. Ethereum 2.0. is a new iteration of Ethereum that would amend
its consensus mechanism to include proof-of-stake and sharding. See
“Item 1. Business—Overview of the ETH Industry and Market—Creation
of New ETH” and “—Modifications to the ETH Protocol” for additional
information.
As corresponding increases in throughput lag behind growth in the
use of digital asset networks, average fees and settlement times
may increase considerably. For example, the Ethereum Network has
been, at times, at capacity, which has led to increased transaction
fees. Since January 1, 2019, ETH transaction fees have increased
from $0.09 per ETH transaction, on average, to a high of $68.30 per
transaction, on average, on May 11, 2021. As of December 31, 2021,
ETH transaction fees stood at $28.28 per transaction, on average.
Increased fees and decreased settlement speeds could preclude
certain uses for ETH (e.g., micropayments), and could reduce demand
for, and the price of, ETH, which could adversely impact the value
of the Shares.
There is no guarantee that any of the mechanisms in place or being
explored for increasing the scale of settlement of the Ethereum
Network transactions will be effective, or how long these
mechanisms will take to become effective, which could adversely
impact the value of the Shares.
Digital assets may have concentrated ownership and large sales or
distributions by holders of such digital assets could have an
adverse effect on the market price of such digital
asset.
As of December 31, 2021, the largest 100 ETH wallets held
approximately 40% of the ETH in circulation. Moreover, it is
possible that other persons or entities control multiple wallets
that collectively hold a significant number of ETH, even if they
individually only hold a small amount, and it is possible that some
of these wallets are controlled by the same person or entity. As a
result of this concentration of ownership, large sales or
distributions by such holders could have an adverse effect on the
market price of ETH.
49
If the digital asset award for mining blocks and transaction fees
for recording transactions on the Ethereum Network are not
sufficiently high to incentivize miners, or if certain
jurisdictions continue to limit mining activities, miners may cease
expanding processing power or demand high transaction fees, which
could negatively impact the value of ETH and the value of the
Shares.
In 2021, the Ethereum network implemented the EIP-1559 upgrade.
EIP-1559 changed the methodology used to calculate transaction fees
paid to ETH miners in such a manner that reduced the total net
issuance of ETH fees paid to miners. If the digital asset awards
for mining blocks or the transaction fees for recording
transactions on the Ethereum Network are not sufficiently high to
incentivize miners,
or if certain jurisdictions continue to limit mining
activities,
miners may cease expending processing power to mine blocks and
confirmations of transactions on the Ethereum Blockchain could be
slowed. For example, the realization of one or more of the
following risks could materially adversely affect the value of the
Shares:
•
Over the past several years, digital asset mining operations have
evolved from individual users mining with computer processors,
graphics processing units and first-generation application specific
integrated circuit machines to “professionalized” mining operations
using proprietary hardware or sophisticated machines. If the profit
margins of digital asset mining operations are not sufficiently,
high
including due to an increase in electricity
costs,
digital asset miners are more likely to immediately sell tokens
earned by mining, resulting in an increase in liquid supply of that
digital asset, which would generally tend to reduce that digital
asset’s market price.
•
A reduction in the processing power expended by miners on the
Ethereum Network could increase the likelihood of a malicious actor
or botnet obtaining control. See “If a malicious actor or botnet
obtains control of more than 50% of the processing power on the
Ethereum Network, or otherwise obtains control over the Ethereum
Network through its influence over core developers or otherwise,
such actor or botnet could manipulate the Blockchain to adversely
affect the value of the Shares or the ability of the Trust to
operate.”
•
Miners have historically accepted relatively low transaction
confirmation fees on most digital asset networks. If miners demand
higher transaction fees for recording transactions in the Ethereum
Blockchain or a software upgrade automatically charges fees for all
transactions on the Ethereum Network, the cost of using ETH may
increase and the marketplace may be reluctant to accept ETH as a
means of payment. Alternatively, miners could collude in an
anti-competitive manner to reject low transaction fees on the
Ethereum Network and force users to pay higher fees, thus reducing
the attractiveness of the Ethereum Network. Higher transaction
confirmation fees resulting through collusion or otherwise may
adversely affect the attractiveness of the Ethereum Network, the
value of ETH and the value of the Shares.
•
To the extent that any miners cease to record transactions that do
not include the payment of a transaction fee in mined blocks or do
not record a transaction because the transaction fee is too low,
such transactions will not be recorded on the Ethereum Blockchain
until a block is mined by a miner who does not require the payment
of transaction fees or is willing to accept a lower fee. Any
widespread delays in the recording of transactions could result in
a loss of confidence in the digital asset network.
•
Digital asset mining operations can consume significant amounts of
electricity, which may have a negative environmental impact and
give rise to public opinion against allowing, or government
regulations restricting, the use of electricity for mining
operations. Additionally, miners may be forced to cease operations
during an electricity shortage or power outage.
If a malicious actor or botnet obtains control of more than 50% of
the processing power on the Ethereum Network, or otherwise obtains
control over the Ethereum Network through its influence over core
developers or otherwise, such actor or botnet could manipulate the
Ethereum Blockchain to adversely affect the value of the Shares or
the ability of the Trust to operate.
If a malicious actor or botnet (a volunteer or hacked collection of
computers controlled by networked software coordinating the actions
of the computers) obtains a majority of the processing power
dedicated to mining on the Ethereum Network, it may be able to
alter the Ethereum Blockchain on which transactions in ETH rely by
constructing fraudulent blocks or preventing certain transactions
from completing in a timely manner, or at all. The malicious actor
or botnet could also control, exclude or modify the ordering of
transactions. Although the malicious actor or botnet would not be
able to generate new tokens or transactions using such control, it
could “double-spend” its own tokens (i.e., spend the same tokens in
more than one transaction) and prevent the confirmation of other
users’ transactions for so long as it maintained control. To the
extent that such malicious actor or botnet did not yield its
control of the processing power on the Ethereum Network or the ETH
community did not reject the fraudulent blocks as malicious,
reversing any changes made to the Ethereum Blockchain may not be
possible. Further, a malicious actor or botnet could create a flood
of transactions in order to slow down the Ethereum
Network.
For example, in August 2020, the Ethereum Classic Network was the
target of two double-spend attacks by an unknown actor or actors
that gained more than 50% of the processing power of the Ethereum
Classic Network. The attack resulted in reorganizations of the
Ethereum Classic Blockchain that allowed the attacker or attackers
to reverse previously recorded transactions in excess of over $5.0
million and $1.0 million. Any similar attacks on the Ethereum
Network could negatively impact the value of ETH and the value of
the Shares.
50
In addition, in May 2019, the Bitcoin Cash network experienced a
51% attack when two large mining pools reversed a series of
transactions in order to stop an unknown miner from taking
advantage of a flaw in a recent Bitcoin Cash protocol upgrade.
Although this particular attack was arguably benevolent, the fact
that such coordinated activity was able to occur may negatively
impact perceptions of the Bitcoin Cash Network. Any similar attacks
on the Ethereum Network could negatively impact the value of ETH
and the value of the Shares.
Although there are no known reports of malicious activity on, or
control of, the Ethereum Network, it is believed that certain
mining pools may have exceeded the 50% threshold on the Ethereum
Network. The possible crossing of the 50% threshold indicates a
greater risk that a single mining pool could exert authority over
the validation of ETH transactions, and this risk is heightened if
over 50% of the processing power on the network falls within the
jurisdiction of a single governmental authority. For example, it is
believed that a significant amount of the processing power on the
Ethereum Network is located in China. Because the Chinese
government has subjected digital assets to heightened levels of
scrutiny recently, reportedly forcing several digital asset
exchanges to shut down, there is a risk that the Chinese government
could also achieve control over a significant amount of the
processing power on the Ethereum Network. If network participants,
including the core developers and the administrators of mining
pools, do not act to ensure greater decentralization of ETH mining
processing power, the feasibility of a malicious actor obtaining
control of the processing power on the Ethereum Network will
increase, which may adversely affect the value of the
Shares.
A malicious actor may also obtain control over the Ethereum Network
through its influence over core developers by gaining direct
control over a core developer or an otherwise influential
programmer. To the extent that the ETH ecosystem does not grow, the
possibility that a malicious actor may be able to obtain control of
the processing power on the Ethereum Network in this manner will
remain heightened.
A temporary or permanent “fork” could adversely affect the value of
the Shares.
The Ethereum Network operates using open-source protocols, meaning
that any user can download the software, modify it and then propose
that the users and miners of ETH adopt the modification. When a
modification is introduced and a substantial majority of users and
miners consent to the modification, the change is implemented and
the network remains uninterrupted. However, if less than a
substantial majority of users and miners consent to the proposed
modification, and the modification is not compatible with the
software prior to its modification, the consequence would be what
is known as a “hard fork” of the Ethereum Network, with one group
running the pre-modified software and the other running the
modified software. The effect of such a fork would be the existence
of two versions of ETH running in parallel, yet lacking
interchangeability. For example, in July 2016, Ethereum “forked”
into Ethereum and a new digital asset, Ethereum Classic, as a
result of the Ethereum network community’s response to a
significant security breach in which an anonymous hacker exploited
a smart contract running on the Ethereum network to syphon
approximately $60 million of ETH held by The DAO, a distributed
autonomous organization, into a segregated account. In response to
the hack, most participants in the Ethereum community elected to
adopt a “fork” that effectively reversed the hack. However, a
minority of users continued to develop the original blockchain, now
referred to as “Ethereum Classic” with the digital asset on that
blockchain now referred to as Ethereum Classic, or ETC. ETC now
trades on several Digital Asset Exchanges. A fork may also occur as
a result of an unintentional or unanticipated software flaw in the
various versions of otherwise compatible software that users run.
Such a fork could lead to users and miners abandoning the digital
asset with the flawed software. It is possible, however, that a
substantial number of users and miners could adopt an incompatible
version of the digital asset while resisting community-led efforts
to merge the two chains. This could result in a permanent fork, as
in the case of Ethereum and Ethereum Classic.
Furthermore, a hard fork can lead to new security concerns. For
example, when the Ethereum and Ethereum Classic networks split in
July 2016, replay attacks, in which transactions from one network
were rebroadcast to nefarious effect on the other network, plagued
Ethereum exchanges through at least October 2016. An Ethereum
exchange announced in July 2016 that it had lost 40,000 Ethereum
Classic, worth about $100,000 at that time, as a result of replay
attacks.
Similar replay attack concerns occurred in connection with the
Bitcoin Cash and Bitcoin SV networks split in November 2018.
Another possible result of a hard fork is an inherent decrease in
the level of security due to significant amounts of mining power
remaining on one network or migrating instead to the new forked
network. After a hard fork, it may become easier for an individual
miner or mining pool’s hashing power to exceed 50% of the
processing power of a digital asset network that retained or
attracted less mining power, thereby making digital assets that
rely on proof-of-work more susceptible to attack.
A hard fork may adversely affect the price of ETH at the time of
announcement or adoption. For example, the announcement of a hard
fork could lead to increased demand for the pre-fork digital asset,
in anticipation that ownership of the pre-fork digital asset would
entitle holders to a new digital asset following the fork. The
increased demand for the pre-fork digital asset may cause the price
of the digital asset to rise. After the hard fork, it is possible
the aggregate price of the two versions of the digital asset
running in parallel would be less than the price of the digital
asset immediately prior to the fork. Furthermore, while the Trust
would be entitled to both versions of the digital asset running in
parallel, the Sponsor will, as permitted by the terms of the Trust
Agreement, determine which version of the digital asset is
generally accepted as the Ethereum Network and should therefore be
considered the appropriate network for the Trust’s purposes, and
there is no guarantee that the Sponsor will choose the digital
asset that is ultimately the most valuable fork. Either
51
of these events could therefore adversely impact the value of the
Shares. For example, on July 15, 2016, holders of ETH voted
on-chain to reverse The DAO hack, effectively causing a hard fork.
For the days following the vote, the price of Ethereum rose from
$11.65 on July 15, 2016 to $14.66 on July 21, 2016, the day after
the first ETC block was mined.
Lastly, in the second half of 2020, the Ethereum Network began the
first of several stages of an upgrade called Ethereum 2.0. Ethereum
2.0. is a new iteration of Ethereum that would amend its consensus
mechanism to include proof-of-stake and sharding. This upgrade may
result in a fork of the Ethereum Network that may adversely affect
the value of the Shares and the ability of the Trust to
operate.
A future fork in the Ethereum Network could adversely affect the
value of the Shares or the ability of the Trust to
operate.
Shareholders may not receive the benefits of any forks or
airdrops.
In addition to forks, a digital asset may become subject to a
similar occurrence known as an “airdrop.” In an airdrop, the
promotors of a new digital asset announce to holders of another
digital asset that such holders will be entitled to claim a certain
amount of the new digital asset for free, based on the fact that
they hold such other digital asset.
Shareholders may not receive the benefits of any forks, the Trust
may not choose, or be able, to participate in an airdrop, and the
timing of receiving any benefits from a fork, airdrop or similar
event is uncertain. We refer to the right to receive any such
benefit as an “Incidental Right” and any such virtual currency
acquired through an Incidental Right as “IR Virtual Currency.”
There are likely to be operational, tax, securities law,
regulatory, legal and practical issues that significantly limit, or
prevent entirely, shareholders’ ability to realize a benefit,
through their Shares in the Trust, from any such Incidental Rights
or IR Virtual Currency. For instance, the Custodian may not agree
to provide access to the IR Virtual Currency. In addition, the
Sponsor may determine that there is no safe or practical way to
custody the IR Virtual Currency, or that trying to do so may pose
an unacceptable risk to the Trust’s holdings in ETH, or that the
costs of taking possession and/or maintaining ownership of the IR
Virtual Currency exceed the benefits of owning the IR Virtual
Currency. Additionally, laws, regulation or other factors may
prevent shareholders from benefitting from the Incidental Right or
IR Virtual Currency even if there is a safe and practical way to
custody and secure the IR Virtual Currency. For example, it may be
illegal to sell or otherwise dispose of the Incidental Right or IR
Virtual Currency, or there may not be a suitable market into which
the Incidental Right or IR Virtual Currency can be sold
(immediately after the fork or airdrop, or ever). The Sponsor may
also determine, in consultation with its legal advisers, that the
Incidental Right or IR Virtual Currency is, or is likely to be
deemed, a security under federal or state securities laws. In such
a case, the Sponsor would irrevocably abandon, as of any date on
which the Trust creates Shares, such Incidental Right or IR Virtual
Currency if holding it would have an adverse effect on the Trust
and it would not be practicable to avoid such effect by disposing
of the Incidental Right or IR Virtual Currency in a manner that
would result in shareholders receiving more than insignificant
value thereof. In making such a determination, the Sponsor expects
to take into account a number of factors, including the various
definitions of a “security” under the federal securities law and
federal court decisions interpreting elements of these definitions,
such as the U.S. Supreme Court’s decisions in the
Howey
and
Reves
cases, as well as reports, orders, press releases, public
statements and speeches by the SEC and its staff providing guidance
on when a digital asset may be a security for purposes of the
federal securities laws.
The Trust has informed the Custodian that it is irrevocably
abandoning, as of any date on which the Trust creates Shares, any
Incidental Rights or IR Virtual Currency to which it would
otherwise be entitled as of such date and with respect to which it
has not taken any Affirmative Action at or prior to such date. In
order to avert abandonment of an Incidental Right or IR Virtual
Currency, the Trust will send a notice to the Custodian of its
intention to retain such Incidental Right or IR Virtual Currency.
The Sponsor intends to evaluate each future fork or airdrop on a
case-by-case basis in consultation with the Trust’s legal advisers,
tax consultants and Custodian. Any inability to recognize the
economic benefit of a hard fork or airdrop could adversely affect
the value of the Shares. See “Item 1. Business—Incidental Rights
and IR Virtual Currency.”
In the event of a hard fork of the Ethereum Network, the Sponsor
will, if permitted by the terms of the Trust Agreement, use its
discretion to determine which network should be considered the
appropriate network for the Trust’s purposes, and in doing so may
adversely affect the value of the Shares.
In the event of a hard fork of the Ethereum Network, the Sponsor
will, as permitted by the terms of the Trust Agreement, use its
discretion to determine, in good faith, which peer-to-peer network,
among a group of incompatible forks of the Ethereum Network, is
generally accepted as the Ethereum Network and should therefore be
considered the appropriate network for the Trust’s purposes. The
Sponsor will base its determination on a variety of then relevant
factors, including, but not limited to, the Sponsor’s beliefs
regarding expectations of the core developers of ETH, users,
services, businesses, miners and other constituencies, as well as
the actual continued acceptance of, mining power on, and community
engagement with, the Ethereum Network. There is no guarantee that
the Sponsor will choose the digital asset that is ultimately the
most valuable fork, and the Sponsor’s decision may adversely affect
the value of the Shares as a result. The Sponsor may also disagree
with shareholders, security vendors and the Index Provider on what
is generally accepted as
52
ETH and should therefore be considered “ETH” for the Trust’s
purposes, which may also adversely affect the value of the Shares
as a result.
Any name change and any associated rebranding initiative by the
core developers of Ethereum may not be favorably received by the
digital asset community, which could negatively impact the value of
Ethereum and the value of the Shares.
From time to time, digital assets may undergo name changes and
associated rebranding initiatives. For example, Bitcoin Cash may
sometimes be referred to as Bitcoin ABC in an effort to
differentiate itself from any Bitcoin Cash hard forks, such as
Bitcoin Satoshi’s Vision, and in the third quarter of 2018, the
team behind Zen rebranded and changed the name of ZenCash to
“Horizen.” We cannot predict the impact of any name change and any
associated rebranding initiative on Ethereum. After a name change
and an associated rebranding initiative, a digital asset may not be
able to achieve or maintain brand name recognition or status that
is comparable to the recognition and status previously enjoyed by
such digital asset. The failure of any name change and any
associated rebranding initiative by a digital asset may result in
such digital asset not realizing some or all of the anticipated
benefits contemplated by the name change and associated rebranding
initiative, and could negatively impact the value of Ethereum and
the value of the Shares.
Risk Factors Related to the Digital Asset Markets
The value of the Shares relates directly to the value of ETH, the
value of which may be highly volatile and subject to fluctuations
due to a number of factors.
The value of the Shares relates directly to the value of the ETH
held by the Trust and fluctuations in the price of ETH could
adversely affect the value of the Shares. The market price of ETH
may be highly volatile, and subject to a number of factors,
including:
•
An increase in the global ETH supply;
•
Manipulative trading activity on Digital Asset Exchanges, which, in
many cases, are largely unregulated;
•
The adoption of ETH as a medium of exchange, store-of-value or
other consumptive asset and the maintenance and development of the
open-source software protocol of the Ethereum Network;
•
Forks in the Ethereum Network;
•
Investors’ expectations with respect to interest rates, the rates
of inflation of fiat currencies or ETH, and digital asset exchange
rates;
•
Consumer preferences and perceptions of ETH specifically and
digital assets generally;
•
Fiat currency withdrawal and deposit policies on Digital Asset
Exchanges;
•
The
liquidity of Digital Asset Markets and any increase or decrease in
trading volume on Digital Asset Markets;
•
Investment and trading activities of large investors that invest
directly or indirectly in ETH;
•
A “short squeeze” resulting from speculation on the price of ETH,
if aggregate short exposure exceeds the number of Shares available
for purchase;
•
An active derivatives market for ETH or for digital assets
generally;
•
Monetary
policies of governments, trade restrictions, currency devaluations
and revaluations and regulatory measures or enforcement actions, if
any, that restrict the use of ETH as a form of payment or the
purchase of ETH on the Digital Asset Markets;
•
Global or regional political, economic or financial conditions,
events and situations, such as the novel coronavirus
outbreak;
•
Fees associated with processing an ETH transaction and the speed at
which ETH transactions are settled;
•
Interruptions in service from or closures or failures of major
Digital Asset Exchanges;
•
Decreased confidence in Digital Asset Exchanges due to the
unregulated nature and lack of transparency surrounding the
operations of Digital Asset Exchanges;
•
Increased competition from other forms of digital assets or payment
services; and
•
The Trust’s own acquisitions or dispositions of ETH, since there is
no limit on the number of ETH that the Trust may
acquire.
53
In addition, there is no assurance that ETH will maintain its value
in the long or intermediate term. In the event that the price of
ETH declines, the Sponsor expects the value of the Shares to
decline proportionately.
The value of an ETH as represented by the Index Price or by the
Trust’s principal market may also be subject to momentum pricing
due to speculation regarding future appreciation in value, leading
to greater volatility that could adversely affect the value of the
Shares. Momentum pricing typically is associated with growth stocks
and other assets whose valuation, as determined by the investing
public, accounts for future appreciation in value, if any. The
Sponsor believes that momentum pricing of ETH has resulted, and may
continue to result, in speculation regarding future appreciation in
the value of ETH, inflating and making the Index Price more
volatile. As a result, ETH may be more likely to fluctuate in value
due to changing investor confidence, which could impact future
appreciation or depreciation in the Index Price and could adversely
affect the value of the Shares.
Due to the unregulated nature and lack of transparency surrounding
the operations of Digital Asset Exchanges, they may experience
fraud, security failures or operational problems, which may
adversely affect the value of ETH and, consequently, the value of
the Shares.
Digital Asset Exchanges are relatively new and, in some cases,
unregulated. Furthermore, while many prominent Digital Asset
Exchanges provide the public with significant information regarding
their ownership structure, management teams, corporate practices
and regulatory compliance, many Digital Asset Exchanges do not
provide this information. Digital Asset Exchanges do not appear to
be subject to regulation in a similar manner as other regulated
trading platforms, such as national securities exchanges or
designated contract markets. As a result, the marketplace may lose
confidence in Digital Asset Exchanges, including prominent
exchanges that handle a significant volume of ETH
trading.
Many Digital Asset Exchanges are unlicensed, unregulated, operate
without extensive supervision by governmental authorities, and do
not provide the public with significant information regarding their
ownership structure, management team, corporate practices,
cybersecurity, and regulatory compliance. In particular, those
located outside the United States may be subject to significantly
less stringent regulatory and compliance requirements in their
local jurisdictions. As a result, trading activity on or reported
by these Digital Asset Exchanges is generally significantly less
regulated than trading in regulated U.S. securities and commodities
markets, and may reflect behavior that would be prohibited in
regulated U.S. trading venues. For example, in 2019 there were
reports claiming that 80-95% of Bitcoin trading volume on Digital
Asset Exchanges was false or non-economic in nature, with specific
focus on unregulated exchanges located outside of the United
States. Such reports may indicate that the Digital Asset Exchange
Market is significantly smaller than expected and that the U.S.
makes up a significantly larger percentage of the Digital Asset
Exchange Market than is commonly understood. Nonetheless, any
actual or perceived false trading in the Digital Asset Exchange
Market, and any other fraudulent or manipulative acts and
practices, could adversely affect the value of ETH and/or
negatively affect the market perception of ETH.
In addition, over the past several years, some Digital Asset
Exchanges have been closed due to fraud and manipulative activity,
business failure or security breaches. In many of these instances,
the customers of such Digital Asset Exchanges were not compensated
or made whole for the partial or complete losses of their account
balances in such Digital Asset Exchanges. While smaller Digital
Asset Exchanges are less likely to have the infrastructure and
capitalization that make larger Digital Asset Exchanges more
stable, larger Digital Asset Exchanges are more likely to be
appealing targets for hackers and malware and may be more likely to
be targets of regulatory enforcement action. For example, the
collapse of Mt. Gox, which filed for bankruptcy protection in Japan
in late February 2014, demonstrated that even the largest Digital
Asset Exchanges could be subject to abrupt failure with
consequences for both users of Digital Asset Exchanges and the
digital asset industry as a whole. In particular, in the two weeks
that followed the February 7, 2014 halt of Bitcoin withdrawals from
Mt. Gox, the value of one Bitcoin fell on other exchanges from
around $795 on February 6, 2014 to $578 on February 20, 2014.
Additionally, in January 2015, Bitstamp announced that
approximately 19,000 Bitcoin had been stolen from its operational
or “hot” wallets. Further, in August 2016, it was reported that
almost 120,000 Bitcoins worth around $78 million were stolen from
Bitfinex, a large Digital Asset Exchange. The value of Bitcoin and
other digital assets immediately decreased over 10% following
reports of the theft at Bitfinex. In July 2017, the Financial
Crimes Enforcement Network (“FinCEN”) assessed a $110 million fine
against BTC-E, a now defunct Digital Asset Exchange, for
facilitating crimes such as drug sales and ransomware attacks. In
addition, in December 2017, Yapian, the operator of Seoul-based
cryptocurrency exchange Youbit, suspended digital asset trading and
filed for bankruptcy following a hack that resulted in a loss of
17% of Yapian’s assets. Following the hack, Youbit users were
allowed to withdraw approximately 75% of the digital assets in
their exchange accounts, with any potential further distributions
to be made following Yapian’s pending bankruptcy proceedings. In
addition, in January 2018, the Japanese digital asset exchange,
Coincheck, was hacked, resulting in losses of approximately $535
million, and in February 2018, the Italian digital asset exchange,
Bitgrail, was hacked, resulting in approximately $170 million in
losses. Most recently in May 2019, one of the world’s largest
Digital Asset Exchanges, Binance, was hacked, resulting in losses
of approximately $40 million.
Negative perception, a lack of stability in the Digital Asset
Markets and the closure or temporary shutdown of Digital Asset
Exchanges due to fraud, failure or security breaches may reduce
confidence in the Ethereum Network and result in greater volatility
in the prices of ETH. Furthermore, the closure or temporary
shutdown of a Digital Asset Exchange used in calculating the Index
Price may
54
result in a loss of confidence in the Trust’s ability to determine
its Digital Asset Holdings on a daily basis. These potential
consequences of such a Digital Asset Exchange’s failure could
adversely affect the value of the Shares.
The Index has a limited history and a failure of the Index Price
could adversely affect the value of the Shares.
The Index has a limited history and the Index Price is a composite
reference rate calculated using volume-weighted trading price data
from various Digital Asset Exchanges chosen by the Index Provider.
The Digital Asset Exchanges chosen by the Index Provider have also
changed over time. For example, on January 19, 2020, the Index
Provider removed itBit and added LMAX Digital to the Index as part
of its scheduled quarterly review. The Index Provider may remove or
add Digital Asset Exchanges to the Index in the future at its
discretion. For more information on the inclusion criteria for
Digital Asset Exchanges in the Index, see “Item 1.
Business—Overview of the ETH Industry and Market—ETH Value—The
Index and the Index Price.”
Although the Index is designed to accurately capture the market
price of ETH, third parties may be able to purchase and sell ETH on
public or private markets not included among the constituent
Digital Asset Exchanges of the Index, and such transactions may
take place at prices materially higher or lower than the Index
Price. Moreover, there may be variances in the prices of ETH on the
various Digital Asset Exchanges, including as a result of
differences in fee structures or administrative procedures on
different Digital Asset Exchanges. For example, based on data
provided by the Index Provider, on any given day during the year
ended December 31, 2021, the maximum differential between the 4:00
p.m., New York time spot price of any single Digital Asset Exchange
included in the Index and the Index Price was 0.30% (14.57% based
on Old Index Price) and the average of the maximum differentials of
the 4:00 p.m., New York time spot price of each Digital Asset
Exchange included in the Index and the Index Price was 0.26%
(14.48% based on Old Index Price). During this same period, the
average differential between the 4:00 p.m., New York time spot
prices of all the Digital Asset Exchanges included in the Index and
the Index Price was 0.001% (0.48% based on Old Index Price). All
Digital Asset Exchanges that were included in the Index throughout
the period were considered in this analysis. To the extent such
prices differ materially from the Index Price, investors may lose
confidence in the Shares’ ability to track the market price of ETH,
which could adversely affect the value of the Shares.
The Index Price used to calculate the value of the Trust’s ETH may
be volatile, and purchasing activity in the Digital Asset Markets
associated with Basket creations may affect the Index Price and
Share trading prices, adversely affecting the value of the
Shares.
The price of ETH on public Digital Asset Exchanges has a very
limited history, and during this history, ETH prices on the Digital
Asset Markets more generally, and on Digital Asset Exchanges
individually, have been volatile and subject to influence by many
factors, including operational interruptions. While the Index is
designed to limit exposure to the interruption of individual
Digital Asset Exchanges, the Index Price, and the price of ETH
generally, remains subject to volatility experienced by Digital
Asset Exchanges, and such volatility could adversely affect the
value of the Shares. For example, since the beginning of the
Trust’s operations, the Index Price ranged from $82.41 to $4,776.32
($84.31 to $4,790.65 based on Old Index Price), with the straight
average being $932.92 ($929.14 based on Old Index Price) through
December 31, 2021. In addition, in the twelve months from December
31, 2021, the Index Price ranged from $731.87 to $4,776.32 ($737.16
to $4,790.65 based on Old Index Price). The Sponsor has not
observed a material difference between the Index Price and average
prices from the constituent Digital Asset Exchanges individually or
as a group. The price of ETH more generally has experienced
volatility similar to the Index Price during these periods. For
additional information on movement of the Index Price and the price
of ETH, see “Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations—Historical Digital
Asset Holdings and ETH Prices.”
Furthermore, because the number of Digital Asset Exchanges is
limited, the Index will necessarily be composed of a limited number
of Digital Asset Exchanges. If a Digital Asset Exchange were
subjected to regulatory, volatility or other pricing issues, the
Index Provider would have limited ability to remove such Digital
Asset Exchange from the Index, which could skew the price of ETH as
represented by the Index. Trading on a limited number of Digital
Asset Exchanges may result in less favorable prices and decreased
liquidity of ETH and, therefore, could have an adverse effect on
the value of the Shares.
Purchasing activity associated with acquiring ETH required for the
creation of Baskets may increase the market price of ETH on the
Digital Asset Markets, which will result in higher prices for the
Shares. Increases in the market price of ETH may also occur as a
result of the purchasing activity of other market participants.
Other market participants may attempt to benefit from an increase
in the market price of ETH that may result from increased
purchasing activity of ETH connected with the issuance of Baskets.
Consequently, the market price of ETH may decline immediately after
Baskets are created. Decreases in the market price of ETH may also
occur as a result of sales in Secondary Markets by other market
participants. If the Index Price declines, the trading price of the
Shares will generally also decline.
Competition from the emergence or growth of other digital assets or
methods of investing in ETH could have a negative impact on the
price of ETH and adversely affect the value of the
Shares.
As of December 31, 2021, ETH was the second largest digital asset
by market capitalization. As of December 31, 2021, there were over
16,000 alternative digital assets tracked by CoinMarketCap.com,
having a total market capitalization of approximately
55
$2,066.4 billion (including the approximately $438 billion market
cap of ETH), as calculated using market prices and total available
supply of each digital asset, excluding tokens pegged to other
assets. In addition, many consortiums and financial institutions
are also researching and investing resources into private or
permissioned smart contracts platforms rather than open platforms
like the Ethereum Network. Competition from the emergence or growth
of alternative digital assets and smart contracts platforms, such
as Solana, Avalanche, Terra or Cardano, could have a negative
impact on the demand for, and price of, ETH and thereby adversely
affect the value of the Shares.
In addition, some digital asset networks, including the Ethereum
Network, may be the target of ill will from users of other digital
asset networks. For example, in July 2016, the Ethereum Network
underwent a contentious hard fork that resulted in the creation of
a new digital asset network called Ethereum Classic. As a result,
some users of the Ethereum Classic network may harbor ill will
toward the Ethereum Network. These users may attempt to negatively
impact the use or adoption of the Ethereum Network. For additional
information on the hard fork that resulted in the creation of
Ethereum Classic, see “Item 1. Business—Overview of the ETH
Industry and Market—Introduction to ETH and the Ethereum
Network—The DAO and Ethereum Classic.”
Investors may invest in ETH through means other than the Shares,
including through direct investments in ETH and other potential
financial vehicles, possibly including securities backed by or
linked to ETH and digital asset financial vehicles similar to the
Trust. Market and financial conditions, and other conditions beyond
the Sponsor’s control, may make it more attractive to invest in
other financial vehicles or to invest in ETH directly, which could
limit the market for, and reduce the liquidity of, the Shares. In
addition, to the extent digital asset financial vehicles other than
the Trust tracking the price of ETH are formed and represent a
significant proportion of the demand for ETH, large purchases or
redemptions of the securities of these digital asset financial
vehicles, or private funds holding ETH, could negatively affect the
Index Price, the Digital Asset Holdings, the value of the Shares,
the NAV and the NAV per Share. Moreover, any reduced demand for
Shares of the Trust may cause the Shares of the Trust to trade at a
discount to the Digital Asset Holdings per Share.
Failure of funds that hold digital assets or that have exposure to
digital assets through derivatives to receive SEC approval to list
their shares on exchanges could adversely affect the value of the
Shares.
There have been a growing a number of attempts to list on national
securities exchanges the shares of funds that hold digital assets
or that have exposures to digital assets through derivatives. These
investment vehicles attempt to provide institutional and retail
investors exposure to markets for digital assets and related
products. The SEC has repeatedly denied such requests. In January
2018, the SEC’s Division of Investment Management outlined several
questions that sponsors would be expected to address before the SEC
will consider granting approval for funds holding “substantial
amounts” of cryptocurrencies or “cryptocurrency-related products.”
The questions, which focus on specific requirements of the
Investment Company Act of 1940 (the “Investment Company Act”),
generally fall into one of five key areas: valuation, liquidity,
custody, arbitrage and potential manipulation. The SEC has not
explicitly stated whether each of the questions set forth would
also need to be addressed by entities with similar products and
investment strategies that instead pursue registered offerings
under the Securities Act, although such entities would need to
comply with the registration and prospectus disclosure requirements
of the Securities Act. Furthermore, NYSE Arca previously withdrew
the Sponsor’s application with the SEC to list an affiliate of the
Trust, Grayscale Bitcoin Trust (BTC), on a national securities
exchange. Requests to list the shares of other funds on national
securities exchanges have also been submitted to the SEC. Although
the SEC approved several futures-based Bitcoin ETFs in October
2021, it has not approved any requests to list the shares of
digital asset funds like the Trust to date. The requests to list
the shares of digital asset funds submitted by the Chicago Board
Options Exchange (“CBOE”) and the NYSE Arca in 2019 were withdrawn
or received disapprovals. Subsequently, NYSE Arca and CBOE filed
several new requests to list shares of various digital asset funds
in 2021. Several of those requests were recently denied by the SEC
in 2021 and to date in 2022. The exchange listing of shares of
digital asset funds would create more opportunities for
institutional and retail investors to invest in the digital asset
market. If exchange-listing requests are not approved by the SEC
and further requests are ultimately denied by the SEC, increased
investment interest by institutional or retail investors could fail
to materialize, which could reduce the demand for digital assets
generally and therefore adversely affect the value of the
Shares.
Risk Factors Related to the Trust and the Shares
The Trust faces risks related to the COVID-19 outbreak, which could
negatively impact the value of the Trust’s holdings and
significantly disrupt its affairs.
An outbreak of infectious respiratory illness caused by a novel
coronavirus known as SARS-CoV-19 (“COVID-19”) was first detected in
China in December 2019 and has now been spread globally. This
outbreak has resulted in travel restrictions, closed international
borders, enhanced health screenings at ports of entry and
elsewhere, disruption of and delays in healthcare service
preparation and delivery, prolonged quarantines, cancellations,
lower consumer demand, layoffs, defaults and other significant
economic impacts, as well as general concern and uncertainty.
COVID-19 has had and will likely continue to have serious adverse
effects on the economies and financial markets of many countries,
resulting in an economic downturn that may adversely affect demand
for digital assets generally and impact the value of, and demand
for, the digital assets held by the Trust. Although the duration
and magnitude of
56
the impact of the COVID-19 outbreak or the occurrence of other
epidemics or pandemics on the digital assets held by the Trust
remains uncertain, the continued spread of COVID-19 and the
imposition of related public health measures and travel and
business restrictions have resulted in, and will continue to result
in, increased volatility and uncertainty in economies and financial
markets of many countries, which may include the Digital Asset
Markets. For example, digital asset prices, including ETH,
decreased significantly in the first quarter of 2020 amidst broader
market declines as a result of the COVID-19 outbreak. Governmental
authorities and regulators throughout the world have, in the past,
responded to major economic disruptions with a variety of fiscal
and monetary policy changes, such as quantitative easing, new
monetary programs and lower interest rates. An unexpected or quick
reversal of these policies, or the ineffectiveness of these
policies, is likely to increase volatility in economies and
financial market generally, and could specifically increase
volatility in the Digital Asset Markets, which could adversely
affect the value of ETH and the value of the Shares.
In addition, the COVID-19 pandemic has disrupted the operations of
many businesses. In response to the COVID-19 pandemic, the Sponsor
has made certain adjustments to its operations, including moving
all of its employees to a remote working situation as of March 31,
2020.While the operations of the Sponsor and the Trust have not
been materially impacted as of the date hereof, there can be no
assurance that further developments with respect to the COVID-19
pandemic will not have such an impact. Moreover, the Trust relies
on third party service providers to perform certain functions
essential to managing the affairs of the Trust. Any disruptions to
the Trust’s service providers’ business operations resulting from
business restrictions, quarantines or restrictions on the ability
of personnel to perform their jobs could have an adverse impact on
the Trust’s ability to access critical services and would be
disruptive to the affairs of the Trust. The COVID-19 outbreak or a
similar pandemic could also cause disruption to Digital Asset
Markets, including the closure of Digital Asset Exchanges, which
could impact the price of ETH and impact the Index or the Index
Provider’s operations, all of which could have a negative impact on
the Trust.
Because of the holding period under Rule 144, the lack of an
ongoing redemption program and the Trust’s ability to halt
creations from time to time, there is no arbitrage mechanism to
keep the value of the Shares closely linked to the Index Price and
the Shares have historically traded at a substantial premium over,
or a substantial discount to, the Digital Asset Holdings per
Share.
Shares purchased in the private placement are subject to a holding
period under Rule 144. Pursuant to Rule 144, the minimum holding
period for Shares purchased in the private placement is six months.
In addition, the Trust does not currently operate an ongoing
redemption program and may halt creations from time to time. As a
result, the Trust cannot rely on arbitrage opportunities resulting
from differences between the value of the Shares and the price of
ETH to keep the value of the Shares closely linked to the Index
Price. As a result, the value of the Shares of the Trust may not
approximate the value of the Trust’s Digital Asset Holdings per
Share or meet the Trust’s investment objective, and may trade at a
substantial premium over, or substantial discount to, the value of
the Trust’s Digital Asset Holdings per Share. For example, in the
past, the price of the Shares as quoted on OTCQX varied
significantly from the Digital Asset Holdings per Share due to
these factors, among others, and has historically traded at a
substantial premium over, or a substantial discount to, the Digital
Asset Holdings per Share.
The Shares may trade at a price that is at, above or below the
Trust’s Digital Asset Holdings per Share as a result of the
non-current trading hours between OTCQX and the Digital Asset
Exchange Market.
The Trust’s Digital Asset Holdings per Share will fluctuate with
changes in the market value of ETH, and the Sponsor expects the
trading price of the Shares to fluctuate in accordance with changes
in the Trust’s Digital Asset Holdings per Share, as well as market
supply and demand. However, the Shares may trade on OTCQX at, above
or below the Trust’s Digital Asset Holdings per Share for a variety
of reasons. For example, OTCQX is open for trading in the Shares
for a limited period each day, but the Digital Asset Exchange
Market is a 24-hour marketplace. During periods when OTCQX is
closed but Digital Asset Exchanges are open, significant changes in
the price of ETH on the Digital Asset Exchange Market could result
in a difference in performance between the value of ETH as measured
by the Index and the most recent Digital Asset Holdings per Share
or closing trading price. For example, if the price of ETH on the
Digital Asset Exchange Market, and the value of ETH as measured by
the Index, moves significantly in a negative direction after the
close of OTCQX, the trading price of the Shares may “gap” down to
the full extent of such negative price shift when OTCQX reopens. If
the price of ETH on the Digital Asset Exchange Market drops
significantly during hours OTCQX is closed, shareholders may not be
able to sell their Shares until after the “gap” down has been fully
realized, resulting in an inability to mitigate losses in a rapidly
negative market. Even during periods when OTCQX is open, large
Digital Asset Exchanges (or a substantial number of smaller Digital
Asset Exchanges) may be lightly traded or closed for any number of
reasons, which could increase trading spreads and widen any premium
or discount on the Shares.
Shareholders may suffer a loss on their investment if the Shares
trade above or below the Trust’s Digital Asset Holdings per
Share.
Historically, the Shares have traded at a substantial premium over
the Digital Asset Holdings per Share. More recently, the Shares
have traded at a substantial discount to the Digital Asset Holdings
per Share. If the Shares trade at a premium, investors who purchase
Shares on OTCQX will pay more for their Shares than investors who
purchase Shares directly from Authorized Participants. In contrast,
if the Shares trade on OTCQX at a discount, investors who purchase
Shares directly from Authorized Participants will pay more for
their Shares than investors who purchase Shares on OTCQX. The
premium or discount at which the Shares have traded has fluctuated
over time. From June 20, 2019 to December 31, 2021, the maximum
premium of the closing price of the Shares quoted on OTCQX
over
57
the value of the Trust’s Digital Asset Holdings per Share was 956%
(949% based on Old Index Price) and the average premium was 191%
(187% based on Old Index Price). Moreover, the closing price of the
Shares, as quoted on OTCQX at 4:00 p.m., New York time, on each
business day, has been quoted at a discount on 210 days (198 days
based on Old Index Price). From June 20, 2019 to December 31,
2021,
the maximum discount of the closing price of the Shares quoted on
OTCQX below the value of the Trust's Digital Asset Holdings per
share was 16% (15% based on Old Index Price) and the average
discount was 6% (6% based on Old Index Price).As
of December 31, 2021, the Trust’s Shares were quoted on OTCQX at a
discount of 12% (14% based on Old Index Price) to the Trust’s
Digital Asset Holdings per Share. As a result, shareholders who
purchase Shares on OTCQX may suffer a loss on their investment if
they sell their Shares at a time when the premium has decreased
from the premium at which they purchased the Shares even if the
Digital Asset Holdings per Share remains the same. Likewise,
shareholders that purchase Shares directly from the Trust may
suffer a loss on their investment if they sell their Shares at a
time when the Shares are trading at a discount on OTCQX.
Furthermore, shareholders may suffer a loss on their investment
even if the Digital Asset Holdings per Share increases because the
decrease in any premium or increase in any discount may offset any
increase in the Digital Asset Holdings per Share.
The amount of the Trust’s assets represented by each Share will
decline over time as the Trust pays the Sponsor’s Fee and
Additional Trust Expenses, and as a result, the value of the Shares
may decrease over time.
The Sponsor’s Fee accrues daily in U.S. dollars at an annual rate
based on the Digital Asset Holdings Fee Basis Amount, which is
based on the Digital Asset Holdings of the Trust, and is paid to
the Sponsor in ETH. See “Item 1. Business—Activities of the
Trust—Disposition of ETH, Incidental Rights and/or IR Virtual
Currency” and “Item 1. Business—Activities of the
Trust—Hypothetical Expense Example.” As a result, the amount of
Trust’s assets represented by each Share declines as the Trust pays
the Sponsor’s Fee (or sells ETH in order to raise cash to pay any
Additional Trust Expenses), which may cause the Shares to decrease
in value over time or dampen any increase in value.
The value of the Shares may be influenced by a variety of factors
unrelated to the value of ETH.
The value of the Shares may be influenced by a variety of factors
unrelated to the price of ETH and the Digital Asset Exchanges
included in the Index that may have an adverse effect on the value
of the Shares. These factors include the following
factors:
•
Unanticipated problems or issues with respect to the mechanics of
the Trust’s operations and the trading of the Shares may arise, in
particular due to the fact that the mechanisms and procedures
governing the creation and offering of the Shares and storage of
ETH have been developed specifically for this
product;
•
The Trust could experience difficulties in operating and
maintaining its technical infrastructure, including in connection
with expansions or updates to such infrastructure, which are likely
to be complex and could lead to unanticipated delays, unforeseen
expenses and security vulnerabilities;
•
The Trust could experience unforeseen issues relating to the
performance and effectiveness of the security procedures used to
protect the Digital Asset Account, or the security procedures may
not protect against all errors, software flaws or other
vulnerabilities in the Trust’s technical infrastructure, which
could result in theft, loss or damage of its assets;
or
•
Service providers may decide to terminate their relationships with
the Trust due to concerns that the introduction of privacy
enhancing features to the Ethereum Network may increase the
potential for ETH to be used to facilitate crime, exposing such
service providers to potential reputational harm.
Any of these factors could affect the value of the Shares, either
directly or indirectly through their effect on the Trust’s
assets.
Shareholders do not have the protections associated with ownership
of shares in an investment company registered under the Investment
Company Act or the protections afforded by the
CEA.
The Investment Company Act is designed to protect investors by
preventing insiders from managing investment companies to their
benefit and to the detriment of public investors, such as: the
issuance of securities having inequitable or discriminatory
provisions; the management of investment companies by irresponsible
persons; the use of unsound or misleading methods of computing
earnings and asset value; changes in the character of investment
companies without the consent of investors; and investment
companies from engaging in excessive leveraging. To accomplish
these ends, the Investment Company Act requires the safekeeping and
proper valuation of fund assets, restricts greatly transactions
with affiliates, limits leveraging, and imposes governance
requirements as a check on fund management.
The Trust is not a registered investment company under the
Investment Company Act, and the Sponsor believes that the Trust is
not required to register under such act. Consequently, shareholders
do not have the regulatory protections provided to investors in
investment companies.
58
The Trust will not hold or trade in commodity interests regulated
by the CEA, as administered by the CFTC. Furthermore, the Sponsor
believes that the Trust is not a commodity pool for purposes of the
CEA, and that neither the Sponsor nor the Trustee is subject to
regulation by the CFTC as a commodity pool operator or a commodity
trading adviser in connection with the operation of the Trust.
Consequently, shareholders will not have the regulatory protections
provided to investors in CEA-regulated instruments or commodity
pools.
The restrictions on transfer and redemption may result in losses on
an investment in the Shares.
Shares purchased in the private placement may not be resold except
in transactions exempt from registration under the Securities Act
and state securities laws, and any such transaction must be
approved in advance by the Sponsor. In determining whether to grant
approval, the Sponsor will specifically look at whether the
conditions of Rule 144 under the Securities Act and any other
applicable laws have been met. Any attempt to sell Shares without
the approval of the Sponsor in its sole discretion will be void ab
initio. See “Item 1. Business—Description of the Shares—Transfer
Restrictions” for more information.
At this time the Sponsor is not accepting redemption requests from
shareholders. Therefore, unless the Trust is permitted to, and
does, establish a Share redemption program, shareholders will be
unable to (or could be significantly impeded in attempting to) sell
or otherwise liquidate investments in the Shares, which could have
a material adverse impact on demand for the Shares and their
value.
Affiliates of the Trust previously entered into a settlement
agreement with the SEC concerning the operation of one such
affiliate’s former redemption programs.
On April 1, 2014, Grayscale Bitcoin Trust (BTC), an affiliate of
the Trust, launched a program pursuant to which its shareholders
could request redemptions from Genesis Global Trading Inc.
(“Genesis”), an affiliate of the Trust and the sole Authorized
Participant of Grayscale Bitcoin Trust (BTC) at that time. On
September 23, 2014, Genesis received a letter from the staff of the
SEC’s Office of Compliance Inspections and Examinations summarizing
the staff’s findings from an onsite review of Genesis’s
broker-dealer activities conducted in June 2014. In its exit
report, the staff stated that it had concluded that Grayscale
Bitcoin Trust (BTC)’s redemption program, in which its shareholders
were permitted to request the redemption of their shares through
Genesis, appeared to violate Regulation M under the Exchange Act
because such redemptions of shares took place at the same time
Grayscale Bitcoin Trust (BTC) was in the process of creating
shares. On July 11, 2016, Genesis and Grayscale Bitcoin Trust (BTC)
entered into a settlement agreement with the SEC whereby they
agreed to a cease-and-desist order against future violations of
Rules 101 and 102 of Regulation M under the Exchange Act. Genesis
also agreed to pay disgorgement of $51,650.11 in redemption fees it
collected, plus prejudgment interest of $2,105.68, for a total of
$53,755.79. The Trust currently has no intention of seeking an
exemption from the SEC under Regulation M in order to instate a
redemption program.
There is no guarantee that an active trading market for the Shares
will continue to develop.
The Shares are qualified for public trading on OTCQX and an active
trading market for the Shares has developed. However, there can be
no assurance that such trading market will be maintained or
continue to develop. In addition, OTCQX can halt the trading of the
Shares for a variety of reasons. To the extent that OTCQX halts
trading in the Shares, whether on a temporary or permanent basis,
investors may not be able to buy or sell Shares, which could
adversely affect the value of the Shares. If an active trading
market for the Shares does not continue to exist, the market prices
and liquidity of the Shares may be adversely affected.
We also intend to seek to list the Shares on NYSE Arca sometime in
the future. NYSE Arca must receive approval from the SEC in order
to list the Shares. During 2016 and 2017, NYSE Arca and other
exchanges filed several requests with the SEC to list the shares of
digital asset funds, including the shares of Grayscale Bitcoin
Trust (BTC). After the SEC issued disapprovals for a number of
these requests, NYSE Arca withdrew its request relating to the
shares of Grayscale Bitcoin Trust (BTC). Although the SEC approved
several futures-based Bitcoin ETFs in October 2021, it has not
approved any requests to list the shares of digital asset funds
like the Trust to date. The requests to list the shares of digital
asset funds submitted by the Chicago Board Options Exchange
(“CBOE”) and the NYSE Arca in 2019 were withdrawn or received
disapprovals. Subsequently,
NYSE Arca and CBOE filed several new requests to list shares of
various digital asset funds in 2021. Several of those requests were
recently denied by the SEC in 2021 and to date in 2022.
As such, there is no guarantee that we will be successful in
listing the Shares on NYSE Arca even once we decide to do
so.
As the Sponsor and its management have limited history of operating
investment vehicles like the Trust, their experience may be
inadequate or unsuitable to manage the Trust.
The past performances of the Sponsor’s management in other
investment vehicles, including their experiences in the digital
asset and venture capital industries, are no indication of their
ability to manage an investment vehicle such as the Trust. If the
experience of the Sponsor and its management is inadequate or
unsuitable to manage an investment vehicle such as the Trust, the
operations of the Trust may be adversely affected.
59
Furthermore, the Sponsor is currently engaged in the management of
other investment vehicles which could divert their attention and
resources. If the Sponsor were to experience difficulties in the
management of such other investment vehicles that damaged the
Sponsor or its reputation, it could have an adverse impact on the
Sponsor’s ability to continue to serve as Sponsor for the
Trust.
Security threats to the Digital Asset Account could result in the
halting of Trust operations and a loss of Trust assets or damage to
the reputation of the Trust, each of which could result in a
reduction in the value of the Shares.
Security breaches, computer malware and computer hacking attacks
have been a prevalent concern in relation to digital assets. The
Sponsor believes that the Trust’s ETH held in the Digital Asset
Account will be an appealing target to hackers or malware
distributors seeking to destroy, damage or steal the Trust’s ETH
and will only become more appealing as the Trust’s assets grow. To
the extent that the Trust, the Sponsor or the Custodian is unable
to identify and mitigate or stop new security threats or otherwise
adapt to technological changes in the digital asset industry, the
Trust’s ETH may be subject to theft, loss, destruction or other
attack.
The Sponsor believes that the security procedures in place for the
Trust, including, but not limited to, offline storage, or “cold
storage”, multiple encrypted private key “shards”, usernames,
passwords and 2-step verification, are reasonably designed to
safeguard the Trust’s ETH. Nevertheless, the security procedures
cannot guarantee the prevention of any loss due to a security
breach, software defect or act of God that may be borne by the
Trust.
The security procedures and operational infrastructure may be
breached due to the actions of outside parties, error or
malfeasance of an employee of the Sponsor, the Custodian, or
otherwise, and, as a result, an unauthorized party may obtain
access to a Digital Asset Account, the relevant private keys (and
therefore ETH) or other data of the Trust. Additionally, outside
parties may attempt to fraudulently induce employees of the Sponsor
or the Custodian to disclose sensitive information in order to gain
access to the Trust’s infrastructure. As the techniques used to
obtain unauthorized access, disable or degrade service, or sabotage
systems change frequently, or may be designed to remain dormant
until a predetermined event and often are not recognized until
launched against a target, the Sponsor and the Custodian may be
unable to anticipate these techniques or implement adequate
preventative measures.
An actual or perceived breach of a Digital Asset Account could harm
the Trust’s operations, result in loss of the Trust’s assets,
damage the Trust’s reputation and negatively affect the market
perception of the effectiveness of the Trust, all of which could in
turn reduce demand for the Shares, resulting in a reduction in the
value of the Shares. The Trust may also cease operations, the
occurrence of which could similarly result in a reduction in the
value of the Shares.
ETH transactions are irrevocable and stolen or incorrectly
transferred ETH may be irretrievable. As a result, any incorrectly
executed ETH transactions could adversely affect the value of the
Shares.
ETH transactions are typically not reversible without the consent
and active participation of the recipient of the transaction. Once
a transaction has been verified and recorded in a block that is
added to the Ethereum Blockchain, an incorrect transfer or theft of
ETH generally will not be reversible and the Trust may not be
capable of seeking compensation for any such transfer or theft.
Although the Trust’s transfers of ETH will regularly be made to or
from the Digital Asset Account, it is possible that, through
computer or human error, or through theft or criminal action, the
Trust’s ETH could be transferred from the Trust’s Digital Asset
Account in incorrect amounts or to unauthorized third parties, or
to uncontrolled accounts.
Such events have occurred in connection with digital assets in the
past. For example, in September 2014, the Chinese Digital Asset
Exchange Huobi announced that it had sent approximately 900
Bitcoins and 8,000 Litecoins (worth approximately $400,000 at the
prevailing market prices at the time) to the wrong customers. To
the extent that the Trust is unable to seek a corrective
transaction with such third party or is incapable of identifying
the third party which has received the Trust’s ETH through error or
theft, the Trust will be unable to revert or otherwise recover
incorrectly transferred ETH. The Trust will also be unable to
convert or recover its ETH transferred to uncontrolled accounts. To
the extent that the Trust is unable to seek redress for such error
or theft, such loss could adversely affect the value of the
Shares.
The Sponsor may need to find and appoint a replacement custodian,
which could pose a challenge to the safekeeping of the Trust’s
ETH.
The Sponsor could decide to replace Coinbase Custody Trust Company,
LLC as the custodian of the Trust’s ETH. Transferring maintenance
responsibilities of the Digital Asset Account to another party will
likely be complex and could subject the Trust’s ETH to the risk of
loss during the transfer, which could have a negative impact on the
performance of the Shares or result in loss of the Trust’s
assets.
The Sponsor may not be able to find a party willing to serve as the
custodian under the same terms as the current Custodian Agreement.
To the extent that Sponsor is not able to find a suitable party
willing to serve as the custodian, the Sponsor may be required to
terminate the Trust and liquidate the Trust’s ETH. In addition, to
the extent that the Sponsor finds a suitable party but must enter
into a modified Custodian Agreement that is less favorable for the
Trust or Sponsor, the value of the Shares could be adversely
affected.
60
The lack of full insurance and shareholders’ limited rights of
legal recourse against the Trust, Trustee, Sponsor, Transfer Agent
and Custodian expose the Trust and its shareholders to the risk of
loss of the Trust’s ETH for which no person or entity is
liable.
The Trust is not a banking institution or otherwise a member of the
Federal Deposit Insurance Corporation (“FDIC”) or Securities
Investor Protection Corporation (“SIPC”) and, therefore, deposits
held with or assets held by the Trust are not subject to the
protections enjoyed by depositors with FDIC or SIPC member
institutions. In addition, neither the Trust nor the Sponsor insure
the Trust’s ETH. While the Custodian has advised the Sponsor that
it has insurance coverage of up to $320 million that covers losses
of the digital assets it custodies on behalf of its clients,
including the Trust’s ETH, resulting from theft, shareholders
cannot be assured that the Custodian will maintain adequate
insurance or that such coverage will cover losses with respect to
the Trust’s ETH. While the Custodian maintains certain capital
reserve requirements depending on the assets under custody, and
such capital reserves may provide additional means to cover client
asset losses, the
Sponsor
does not know the amount of such capital reserves, and neither the
Trust nor the Sponsor have access to such information. The Trust
cannot be assured that the Custodian will maintain capital reserves
sufficient to cover losses with respect to the Trust’s digital
assets.
Furthermore, under the Custodian Agreement, the Custodian’s
liability with respect to the Trust will never exceed the value of
the ETH on deposit in the Digital Asset Account at the time of, and
directly relating to, the events giving rise to the liability
occurred, as determined in accordance with the Custodian Agreement.
In addition, for as long as a cold storage address holds ETH with a
value in excess of $100 million (the “Cold Storage Threshold”) for
a period of five consecutive business days or more without being
reduced to the Cold Storage Threshold or lower, the Custodian’s
maximum liability for such cold storage address shall be limited to
the Cold Storage Threshold. The Sponsor monitors the value of ETH
deposited in cold storage addresses for whether the Cold Storage
Threshold has been met by determining the U.S. dollar value of ETH
deposited in each cold storage address on business days. The
Custodian is not liable for any lost profits or any special,
incidental, indirect, intangible, or consequential damages, whether
based in contract, tort, negligence, strict liability or otherwise,
and whether or not the Custodian has been advised of such losses or
the Custodian knew or should have known of the possibility of such
damages. Notwithstanding the foregoing, the Custodian is liable to
the Sponsor and the Trust for the loss of any ETH to the extent
that the Custodian directly caused such loss (including if the
Trust or the Sponsor is not able to timely withdraw ETH from the
Digital Asset Account according to the Custodian Agreement), even
if the Custodian meets its duty of exercising best efforts, and the
Custodian is required to return to the Trust a quantity equal to
the quantity of any such lost ETH. Although the Cold Storage
Threshold has never been met for a given cold storage address, to
the extent it is met and not reduced within five business days, the
Trust would not have a claim against the Custodian with respect to
the digital assets held in such address to the extent the value
exceeds the Cold Storage Threshold.
The shareholders’ recourse against the Sponsor and the Trust’s
other service providers for the services they provide to the Trust,
including those relating to the provision of instructions relating
to the movement of ETH, is limited. Consequently, a loss may be
suffered with respect to the Trust’s ETH that is not covered by
insurance and for which no person is liable in damages. As a
result, the recourse of the Trust or the shareholders, under New
York law, is limited.
The Trust may be required, or the Sponsor may deem it appropriate,
to terminate and liquidate at a time that is disadvantageous to
shareholders.
Pursuant to the terms of the Trust Agreement, the Trust is required
to dissolve under certain circumstances. In addition, the Sponsor
may, in its sole discretion, dissolve the Trust for a number of
reasons, including if the Sponsor determines, in its sole
discretion, that it is desirable or advisable for any reason to
discontinue the affairs of the Trust. For example, the Sponsor
expects that it may be advisable to discontinue the affairs of the
Trust if the SEC or a federal court were to determine that ETH is a
security under the federal securities laws, among other reasons.
See “Description of the Trust Documents—The Trustee—Termination of
the Trust.”
If the Trust is required to terminate and liquidate, or the Sponsor
determines in accordance with the terms of the Trust Agreement that
it is appropriate to terminate and liquidate the Trust, such
termination and liquidation could occur at a time that is
disadvantageous to shareholders, such as when the Actual Exchange
Rate of ETH is lower than the Index Price was at the time when
shareholders purchased their Shares. In such a case, when the
Trust’s ETH is sold as part of its liquidation, the resulting
proceeds distributed to shareholders will be less than if the
Actual Exchange Rate were higher at the time of sale. See “Item 1.
Business—Description of the Trust Agreement—The Trustee—Termination
of the Trust” for more information about the termination of the
Trust, including when the termination of the Trust may be triggered
by events outside the direct control of the Sponsor, the Trustee or
the shareholders.
The Trust Agreement includes provisions that limit shareholders’
voting rights and restrict shareholders’ right to bring a
derivative action.
Under the Trust Agreement, shareholders have limited voting rights
and the Trust will not have regular shareholder meetings.
Shareholders take no part in the management or control of the
Trust. Accordingly, shareholders do not have the right to authorize
actions, appoint service providers or take other actions as may be
taken by shareholders of other trusts or companies where shares
carry such rights. The shareholders’ limited voting rights give
almost all control under the Trust Agreement to the Sponsor and the
Trustee. The
61
Sponsor may take actions in the operation of the Trust that may be
adverse to the interests of shareholders and may adversely affect
the value of the Shares.
Moreover, pursuant to the terms of the Trust Agreement,
shareholders’ statutory right under Delaware law to bring a
derivative action (i.e., to initiate a lawsuit in the name of the
Trust in order to assert a claim belonging to the Trust against a
fiduciary of the Trust or against a third-party when the Trust’s
management has refused to do so) is restricted. Under Delaware law,
a shareholder may bring a derivative action if the shareholder is a
shareholder at the time the action is brought and either (i) was a
shareholder at the time of the transaction at issue or (ii)
acquired the status of shareholder by operation of law or the
Trust’s governing instrument from a person who was a shareholder at
the time of the transaction at issue. Additionally, Section 3816(e)
of the Delaware Statutory Trust Act specifically provides that a
“beneficial owner’s right to bring a derivative action may be
subject to such additional standards and restrictions, if any, as
are set forth in the governing instrument of the statutory trust,
including, without limitation, the requirement that beneficial
owners owning a specified beneficial interest in the statutory
trust join in the bringing of the derivative action.” In addition
to the requirements of applicable law and in accordance with
Section 3816(e), the Trust Agreement provides that no shareholder
will have the right, power or authority to bring or maintain a
derivative action, suit or other proceeding on behalf of the Trust
unless two or more shareholders who (i) are not “Affiliates” (as
defined in the Trust Agreement and below) of one another and (ii)
collectively hold at least 10.0% of the outstanding Shares join in
the bringing or maintaining of such action, suit or other
proceeding. This provision applies to any derivative actions
brought in the name of the Trust other than claims under the
federal securities laws and the rules and regulations
thereunder.
Due to this additional requirement, a shareholder attempting to
bring or maintain a derivative action in the name of the Trust will
be required to locate other shareholders with which it is not
affiliated and that have sufficient Shares to meet the 10.0%
threshold based on the number of Shares outstanding on the date the
claim is brought and thereafter throughout the duration of the
action, suit or proceeding. This may be difficult and may result in
increased costs to a shareholder attempting to seek redress in the
name of the Trust in court. Moreover, if shareholders bringing a
derivative action, suit or proceeding pursuant to this provision of
the Trust Agreement do not hold 10.0% of the outstanding Shares on
the date such an action, suit or proceeding is brought, or such
shareholders are unable to maintain Share ownership meeting the
10.0% threshold throughout the duration of the action, suit or
proceeding, such shareholders’ derivative action may be subject to
dismissal. As a result, the Trust Agreement limits the likelihood
that a shareholder will be able to successfully assert a derivative
action in the name of the Trust, even if such shareholder believes
that he or she has a valid derivative action, suit or other
proceeding to bring on behalf of the Trust. See “Item 1.
Business—Description of the Trust Agreement—The Sponsor—The
Fiduciary and Regulatory Duties of the Sponsor” for more
detail.
The Sponsor is solely responsible for determining the value of the
Digital Asset Holdings and Digital Asset Holdings per Share
and
any errors, discontinuance or changes in such valuation
calculations may have an adverse effect on the value of the
Shares.
The Sponsor will determine the Trust’s Digital Asset Holdings and
Digital Asset Holdings per Share on a daily basis as soon as
practicable after 4:00 p.m., New York time, on each business day.
The Sponsor’s determination is made utilizing data from the
operations of the Trust and the Index Price, calculated at 4:00
p.m., New York time, on such day.
If the Sponsor determines in good faith that the Index does not
reflect an accurate ETH price, then the Sponsor will employ an
alternative method to determine the Index Price under the cascading
set of rules set forth in “Item
1. Business—Overview of the ETH Industry and
Market—ETH
Value—The Index and the Index Price— Determination of the Index
Price When Index Price is Unavailable.” There are no predefined
criteria to make a good faith assessment as to which of the rules
the Sponsor will apply and the Sponsor may make this determination
in its sole discretion. The Sponsor may calculate the Index Price
in a manner that ultimately inaccurately reflects the price of
ETH.
To the extent that the Digital Asset Holdings, Digital Asset
Holdings per Share or the Index Price are incorrectly calculated,
the Sponsor may not be liable for any error and such misreporting
of valuation data could adversely affect the value of the Shares
and investors could suffer a substantial loss on their investment
in the Trust. Moreover, the terms of the Trust Agreement do not
prohibit the Sponsor from changing the Index Price used to
calculate the Digital Asset Holdings and Digital Asset Holdings per
Share of the Trust. Any such change in the Index Price could affect
the value of the Shares and investors could suffer a substantial
loss on their investment in the Trust.
Extraordinary expenses resulting from unanticipated events may
become payable by the Trust, adversely affecting the value of the
Shares.
In consideration for the Sponsor’s Fee, the Sponsor has
contractually assumed all ordinary-course operational and periodic
expenses of the Trust. See “Item 1. Business—Expenses; Sales of
ETH.” Extraordinary expenses incurred by the Trust, such as taxes
and governmental charges; expenses and costs of any extraordinary
services performed by the Sponsor (or any other service provider)
on behalf of the Trust to protect the Trust or the interests of
shareholders (including in connection with any Incidental Rights
and any IR Virtual Currency); or extraordinary legal fees and
expenses are not assumed by the Sponsor and are borne by the Trust.
The Sponsor will cause the Trust to either (i) sell ETH, Incidental
Rights and/or IR Virtual Currency held by the Trust or (ii) deliver
ETH, Incidental Rights and/or IR Virtual Currency in-kind to pay
Trust expenses not assumed by the Sponsor on an as-needed basis.
Accordingly, the Trust may be required to sell or otherwise dispose
of ETH, Incidental Rights or IR Virtual Currency at a time when the
trading prices for those assets are depressed.
62
The sale or other disposition of assets of the Trust in order to
pay extraordinary expenses could have a negative impact on the
value of the Shares for several reasons. These include the
following factors:
•
The Trust is not actively managed and no attempt will be made to
protect against or to take advantage of fluctuations in the prices
of ETH, Incidental Rights or IR Virtual Currency. Consequently, if
the
Trust incurs expenses in U.S. dollars, the Trust’s ETH, Incidental
Rights or IR Virtual Currency may be sold at a time when the values
of the disposed assets are low, resulting in a negative impact on
the value of the Shares.
•
Because the Trust does not generate any income, every time that the
Trust pays expenses, it will deliver ETH, Incidental Rights or IR
Virtual Currency to the Sponsor or sell ETH, Incidental Rights or
IR Virtual Currency. Any sales of the Trust’s assets in connection
with the payment of expenses will decrease the amount of the
Trust’s assets represented by each Share each time its assets are
sold or transferred to the Sponsor.
•
Assuming that the Trust is a grantor trust for U.S. federal income
tax purposes, each delivery or sale of ETH, Incidental Rights or IR
Virtual Currency by the Trust to pay the Sponsor’s Fee and/or
Additional Trust Expenses will be a taxable event to beneficial
owners of Shares. Thus, the Trust’s payment of expenses could
result in beneficial owners of Shares incurring tax liability
without an associated distribution from the Trust. Any such tax
liability could adversely affect an investment in the Shares.
See
“Item 1. Business—Certain U.S. Federal Income Tax
Consequences.”
The Trust’s delivery or sale of ETH to pay expenses or other
operations of the Trust could result in shareholders’ incurring tax
liability without an associated distribution from the
Trust.
Assuming that the Trust is treated as a grantor trust for U.S.
federal income tax purposes, each delivery of ETH by the Trust to
pay the Sponsor’s Fee or other expenses and each sale of ETH by the
Trust to pay Additional Trust Expenses will be a taxable event to
beneficial owners of Shares. Thus, the Trust’s payment of expenses
could result in beneficial owners of Shares incurring tax liability
without an associated distribution from the Trust. Any such tax
liability could adversely affect an investment in the Shares. See
“Item 1. Business—Certain U.S. Federal Income Tax
Consequences.”
The value of the Shares will be adversely affected if the Trust is
required to indemnify the Sponsor, the Trustee, the Transfer Agent
or the Custodian under the Trust Documents.
Under the Trust Documents, each of the Sponsor, the Trustee, the
Transfer Agent and the Custodian has a right to be indemnified by
the Trust for certain liabilities or expenses that it incurs
without gross negligence, bad faith or willful misconduct on its
part. Therefore, the Sponsor, Trustee, Transfer Agent or the
Custodian may require that the assets of the Trust be sold in order
to cover losses or liability suffered by it. Any sale of that kind
would reduce the Digital Asset Holdings of the Trust and the value
of the Shares.
Intellectual property rights claims may adversely affect the Trust
and the value of the Shares.
The Sponsor is not aware of any intellectual property rights claims
that may prevent the Trust from operating and holding ETH,
Incidental Rights or IR Virtual Currency. However, third parties
may assert intellectual property rights claims relating to the
operation of the Trust and the mechanics instituted for the
investment in, holding of and transfer of ETH, Incidental Rights or
IR Virtual Currency. Regardless of the merit of an intellectual
property or other legal action, any legal expenses to defend or
payments to settle such claims would be extraordinary expenses that
would be borne by the Trust through the sale or transfer of its
ETH, Incidental Rights or IR Virtual Currency. Additionally, a
meritorious intellectual property rights claim could prevent the
Trust from operating and force the Sponsor to terminate the Trust
and liquidate its ETH, Incidental Rights or IR Virtual Currency. As
a result, an intellectual property rights claim against the Trust
could adversely affect the value of the Shares.
Risk Factors Related to the Regulation of the Trust and the
Shares
Regulatory changes or actions by the U.S. Congress or any U.S.
federal or state agencies may affect the value of the Shares or
restrict the use of ETH, mining activity or the operation of the
Ethereum Network or the Digital Asset Markets in a manner that
adversely affects the value of the Shares.
As digital assets have grown in both popularity and market size,
the U.S. Congress and a number of U.S. federal and state agencies
(including FinCEN, SEC, CFTC, FINRA, the Consumer Financial
Protection Bureau, the Department of Justice, The Department of
Homeland Security, the Federal Bureau of Investigation, the IRS and
state financial institution regulators) have been examining the
operations of digital asset networks, digital asset users and the
Digital Asset Markets, with particular focus on the extent to which
digital assets can be used to launder the proceeds of illegal
activities or fund criminal or terrorist enterprises and the safety
and soundness of exchanges and other service providers that hold
digital assets for users. Many of these state and federal agencies
have issued consumer advisories regarding the risks posed by
digital assets to investors. Ongoing and future regulatory actions
with respect to digital assets generally or ETH in particular may
alter, perhaps to a materially adverse extent, the nature of an
investment in the Shares or the ability of the Trust to continue to
operate.
63
In August 2021, the chair of the SEC stated that he believed
investors using digital asset trading platforms are not adequately
protected, and that activities on the platforms can implicate the
securities laws, commodities laws and banking laws, raising a
number of issues related to protecting investors and consumers,
guarding against illicit activity, and ensuring financial
stability. The chair expressed a need for the SEC to have
additional authorities to prevent transactions, products, and
platforms from “falling between regulatory cracks,” as well as for
more resources to protect investors in “this growing and volatile
sector.” The chair called for federal legislation centering on
digital asset trading, lending, and decentralized finance
platforms, seeking “additional plenary authority” to write rules
for digital asset trading and lending. It is not possible to
predict whether Congress will grant additional authorities to the
SEC or other regulators, what the nature of such additional
authorities might be, how they might impact the ability of Digital
Asset Markets to function or how any new regulations that may flow
from such authorities might impact the value of digital assets
generally and ETH held by the Trust specifically. The consequences
of increased federal regulation of digital assets and digital asset
activities could have a material adverse effect on the Trust and
the Shares.
Law enforcement agencies have often relied on the transparency of
blockchains to facilitate investigations. However, certain
privacy-enhancing features have been, or are expected to be,
introduced to a number of digital asset networks. If the Ethereum
Network were to adopt any of these features, these features may
provide law enforcement agencies with less visibility into
transaction- level data. Europol, the European Union’s law
enforcement agency, released a report in October 2017 noting the
increased use of privacy-enhancing digital assets like Zcash and
Monero in criminal activity on the internet. Although no regulatory
action has been taken to treat privacy-enhancing digital assets
differently, this may change in the future.
A determination that ETH or any other digital asset is a “security”
may adversely affect the value of ETH and the value of the Shares,
and result in potentially extraordinary, nonrecurring expenses to,
or termination of, the Trust.
Depending on its characteristics, a digital asset may be considered
a “security” under the federal securities laws. The test for
determining whether a particular digital asset is a “security” is
complex and difficult to apply, and the outcome is difficult to
predict. Public, though non-binding, statements by senior officials
at the SEC indicate that the SEC does not consider Bitcoin or ETH
to be securities, at least currently, and the SEC staff has
provided informal assurances to a handful of promoters that their
digital assets are not securities. On the other hand, the SEC has
brought enforcement actions against the promoters of several other
digital assets on the basis that the digital assets in question are
securities.
Whether a digital asset is a security under the federal securities
laws depends on whether it is included in the lists of instruments
making up the definition of “security” in the Securities Act, the
Exchange Act and the Investment Company Act. Digital assets as such
do not appear in any of these lists, although each list includes
the terms “investment contract” and “note,” and the SEC has
typically analyzed whether a particular digital asset is a security
by reference to whether it meets the tests developed by the federal
courts interpreting these terms, known as the
Howey
and
Reves
tests, respectively. For many digital assets, whether or not
the
Howey
or
Reves
tests are met is difficult to resolve definitively, and substantial
legal arguments can often be made both in favor of and against a
particular digital asset qualifying as a security under one or both
of the
Howey
and
Reves
tests. Adding to the complexity, the SEC staff has indicated that
the security status of a particular digital asset can change over
time as the relevant facts evolve.
As part of determining whether ETH is a security for purposes of
the federal securities laws, the Sponsor takes into account a
number of factors, including the various definitions of “security”
under the federal securities laws and federal court decisions
interpreting elements of these definitions, such as the U.S.
Supreme Court’s decisions in the
Howey
and
Reves
cases, as well as reports, orders, press releases, public
statements and speeches by the SEC and its staff providing guidance
on when a digital asset may be a security for purposes of the
federal securities laws. Finally, the Sponsor discusses the
security status of ETH with its external securities lawyers.
Through this process the Sponsor believes that it is applying the
proper legal standards in determining that ETH is not a security in
light of the uncertainties inherent in the
Howey
and
Reves
tests. However, because of these uncertainties, the Sponsor
acknowledges that ETH may in the future be found by the SEC or a
federal court to be a security notwithstanding the Sponsor’s prior
conclusion; and the Sponsor’s prior conclusion, even if reasonable
under the circumstances, would not preclude legal or regulatory
action based on the presence of a security.
As is the case with ETH, analyses from counsel typically review the
often-complex facts surrounding a particular digital asset’s
underlying technology, creation, use case and usage, distribution
and secondary-market trading characteristics as well as
contributions of the individuals or organizations who appear to be
involved in these activities, among other relevant facts, usually
drawing on publicly available information. This information,
usually found on the Internet, often includes both information that
originated with or is attributed to such individuals or
organizations, as well as information from third party sources and
databases that may or may not have a connection to such individuals
or organizations, and the availability and nature of such
information can change over time. The Sponsor and counsel often
have no independent means of verifying the accuracy or completeness
of such information, and therefore of necessity usually must assume
that such information is materially accurate and complete for
purposes of the
Howey
and
Reves
analyses. After having gathered this information, counsel typically
analyzes it in light of the
Howey
and
Reves
tests, in order to inform a judgment as to whether or not a federal
court would conclude that the digital asset in question is or is
not a security for purposes of the federal securities laws. Often,
certain factors appear to support a conclusion that the digital
asset in question is a security, while other factors appear to
support the opposite conclusion, and in such a case counsel
endeavors to weigh the importance and relevance of the competing
factors.
64
This analytical process is further complicated by the fact that, at
present, federal judicial case law applying the relevant tests to
digital assets is scant, with no federal appellate court having
considered the question on the merits, as well as the fact that
because each digital asset presents its own unique set of relevant
facts, it is not always possible to directly analogize the analysis
of one digital asset to another. Because of this factual complexity
and the current lack of a well-developed body of federal case law
applying the relevant tests to a variety of different fact
patterns, the Sponsor has not in the past received, and currently
does not expect that it would be able to receive, “opinions” of
counsel stating that a particular digital asset is or is not a
security for federal securities law purposes. The Sponsor
understands that as a matter of practice, counsel is generally able
to render a legal “opinion” only when the relevant facts are
substantially ascertainable and the applicable law is both
well-developed and settled. As a result, given the relative novelty
of digital assets, the challenges inherent in fact-gathering for
particular digital assets, and the fact that federal courts have
only recently been tasked with adjudicating the applicability of
federal securities law to digital assets, the Sponsor understands
that at present counsel is generally not in a position to render a
legal “opinion” on the securities-law status of ETH or any other
particular digital asset.
The Sponsor does not intend to permit the Trust to continue holding
ETH (and therefore would dissolve the Trust) if the Sponsor
determines it is a security under the federal securities laws,
whether that determination is initially made by the Sponsor itself,
or because the SEC or a federal court subsequently makes that
determination. Because the legal tests for determining whether a
digital asset is or is not a security often leave room for
interpretation, for so long as the Sponsor believes there to be
good faith grounds to conclude that the Trust’s ETH is not a
security, the Sponsor does not intend to dissolve the Trust on the
basis that ETH could at some future point be determined to be a
security.
Any enforcement action by the SEC or a state securities regulator
asserting that ETH is a security, or a court decision, to that
effect would be expected to have an immediate material adverse
impact on the trading value of ETH, as well as the Shares. This is
because the business models behind most digital assets are
incompatible with regulations applying to transactions in
securities. If a digital asset is determined or asserted to be a
security, it is likely to become difficult or impossible for the
digital asset to be traded, cleared or custodied in the United
States through the same channels used by non-security digital
assets, which in addition to materially and adversely affecting the
trading value of the digital asset is likely to significantly
impact its liquidity and market participants’ ability to convert
the digital asset into U.S. dollars.
For example, in 2020 the SEC filed a complaint against the
promoters of XRP alleging that they raised more than $1.3 billion
through XRP sales that should have been registered under the
federal securities laws, but were not. In the years prior to the
SEC’s action, XRP’s market capitalization at times reached over
$140 billion. However, in the weeks following the SEC’s complaint,
XRP’s market capitalization fell to less than $10 billion, which
was less than half of its market capitalization in the days prior
to the complaint. The SEC’s action against XRP’s promoters
underscores the continuing uncertainty around which digital assets
are securities, and demonstrates that such factors as how long a
digital asset has been in existence, how widely held it is, how
large its market capitalization is and that it has actual
usefulness in commercial transactions, ultimately may have no
bearing on whether the SEC or a court will find it to be a
security.
In addition, if ETH is determined to be a security, the Trust could
be considered an unregistered “investment company” under SEC rules,
which could necessitate the Trust’s liquidation. In this case, the
Trust and the Sponsor may be deemed to have participated in an
illegal offering of securities and there is no guarantee that the
Sponsor will be able to register the Trust under the Investment
Company Act at such time or take such other actions as may be
necessary to ensure the Trust’s activities comply with applicable
law, which could force the Sponsor to liquidate the
Trust.
Moreover, whether or not the Sponsor or the Trust were subject to
additional regulatory requirements as a result of any SEC or
federal court determination that its assets include securities, the
Sponsor may nevertheless decide to terminate the Trust, in order,
if possible, to liquidate the Trust’s assets while a liquid market
still exists. As a result, if the SEC or a federal court were to
determine that ETH is a security, it is likely that the value of
the Shares of the Trust would decline significantly, and that the
Trust itself would be terminated and, if practical, its assets
liquidated.
Changes in SEC policy could adversely impact the value of the
Shares.
The effect of any future regulatory change on the Trust or the
digital assets held by the Trust is impossible to predict, but such
change could be substantial and adverse to the Trust and the value
of the Shares. In particular, the SEC has not yet approved the
listing on a national securities exchange of any non-futures based
digital-asset focused exchange- traded fund (“ETF”). If the SEC
were to approve any such ETF in the future, such an ETF may be
perceived to be a superior investment product offering exposure to
digital assets compared to the Trust because the value of the
shares issued by such an ETF would be expected to more closely
track the ETF’s net asset value than do Shares of the Trust, and
investors may therefore favor investments in such ETFs over
investments in the Trust. Any weakening in demand for the Shares
compared to digital asset ETF shares could cause the value of the
Shares to decline.
65
Competing industries may have more influence with policymakers than
the digital asset industry, which could lead to the adoption of
laws and regulations that are harmful to the digital asset
industry.
The digital asset industry is relatively new and does not have the
same access to policymakers and lobbying organizations in many
jurisdictions compared to industries with which digital assets may
be seen to compete, such as banking, payments and consumer finance.
Competitors from other, more established industries may have
greater access to and influence with governmental officials and
regulators and may be successful in persuading these policymakers
that digital assets require heightened levels of regulation
compared to the regulation of traditional financial services. As a
result, new laws and regulations may be proposed and adopted in the
United States and elsewhere, or existing laws and regulations may
be interpreted in new ways, that disfavor or impose compliance
burdens on the digital asset industry or crypto asset platforms,
which could adversely impact the value of ETH and therefore the
value of the Shares.
Regulatory changes or actions in foreign jurisdictions may affect
the value of the Shares or restrict the use of one or more digital
assets, mining activity or the operation of their networks or the
Digital Asset Exchange Market in a manner that adversely affects
the value of the Shares.
Various foreign jurisdictions have, and may continue to adopt laws,
regulations or directives that affect the digital asset network,
the Digital Asset Markets, and their users, particularly Digital
Asset Exchanges and service providers that fall within such
jurisdictions’ regulatory scope. For example, if China or other
foreign jurisdictions were to ban or otherwise restrict mining
activity, including by regulating or limiting manufacturers’
ability to produce or sell semiconductors or hard drives in
connection with mining, it would have a material adverse effect on
digital asset networks (including the Ethereum Network), the
Digital Asset Market, and as a result, impact the value of the
Shares.
A number of foreign jurisdictions have recently taken regulatory
action aimed at digital asset activities. China has made
transacting in cryptocurrencies illegal for Chinese citizens in
mainland China, and additional restrictions may follow. Both China
and South Korea have banned initial coin offerings entirely and
regulators in other jurisdictions, including Canada, Singapore and
Hong Kong, have opined that initial coin offerings may constitute
securities offerings subject to local securities regulations. In
May 2021, the Chinese government announced renewed efforts to
restrict cryptocurrency trading and mining activities, citing
concerns about high energy consumption and its desire to promote
financial stability. Regulators in the Inner Mongolia and other
regions of China have proposed regulations that would create
penalties for companies engaged in cryptocurrency mining activities
and introduce heightened energy saving requirements on industrial
parks, data centers and power plants providing electricity to
cryptocurrency miners. The United Kingdom’s Financial Conduct
Authority published final rules in October 2020 banning the sale of
derivatives and exchange traded notes that reference certain types
of digital assets, contending that they are “ill-suited” to retail
investors citing extreme volatility, valuation challenges and
association with financial crime. See “Item 1. Business—Overview of
the ETH Industry and Market—Government Oversight.”
Foreign laws, regulations or directives may conflict with those of
the United States and may negatively impact the acceptance of one
or more digital assets by users, merchants and service providers
outside the United States and may therefore impede the growth or
sustainability of the digital asset economy in the European Union,
China, Japan, Russia and the United States and globally, or
otherwise negatively affect the value of ETH. The effect of any
future regulatory change on the Trust or ETH is impossible to
predict, but such change could be substantial and adverse to the
Trust and the value of the Shares.
If regulators or public utilities take actions that restrict or
otherwise impact mining activities, there may be a significant
decline in such activities, which could adversely affect the
Ethereum Network and the value of the Shares.
Concerns have been raised about the electricity required to secure
and maintain digital asset networks.
For example, as of December 31, 2021, over 926 million tera hashes
are performed every second in connection with mining on the
Ethereum Network.
Although measuring the electricity consumed by this process is
difficult because these operations are performed by various
machines with varying levels of efficiency, the process consumes a
significant amount of energy.
The operations of the Ethereum Network and other digital asset
networks may also consume significant amounts of energy.
Further, in addition to the direct energy costs of performing
calculations on any given digital asset network, there are indirect
costs that impact a network’s total energy consumption, including
the costs of cooling the machines that perform these
calculations.
Driven by concerns around energy consumption and the impact on
public utility companies, various states and cities have
implemented, or are considering implementing, moratoriums on mining
activity in their jurisdictions. A significant reduction in mining
activity as a result of such actions could adversely affect the
security of an Ethereum Network by making it easier for a malicious
actor or botnet to manipulate the relevant blockchain. See “—If a
malicious actor or botnet obtains control of more than 50% of the
processing power on the Ethereum Network, or otherwise obtains
control over the Ethereum Network through its influence over core
developers or otherwise, such actor or botnet could manipulate the
relevant blockchain to adversely affect the value of the Shares or
the ability of the Trust to operate.” If regulators or public
utilities take action that restricts or otherwise impacts mining
activities, such actions could result in decreased security of a
digital asset network, including the Ethereum Network, and
consequently adversely impact the value of the Shares.
66
If regulators subject an Authorized Participant, the Trust or the
Sponsor to regulation as a money service business or money
transmitter, this could result in extraordinary expenses to the
Authorized Participant, the Trust or the Sponsor and also result in
decreased liquidity for the Shares.
To the extent that the activities of any Authorized Participant,
the Trust or the Sponsor cause it to be deemed a “money services
business” under the regulations promulgated by FinCEN, such
Authorized Participant, the Trust or the Sponsor may be required to
comply with FinCEN regulations, including those that would mandate
the Authorized Participant to implement anti-money laundering
programs, make certain reports to FinCEN and maintain certain
records. Similarly, the activities of an Authorized Participant,
the Trust or the Sponsor may require it to be licensed as a money
transmitter or as a digital asset business, such as under the New
York State Department of Financial Services’ BitLicense
regulation.
Such additional regulatory obligations may cause the Authorized
Participant, the Trust or the Sponsor to incur extraordinary
expenses. If the Authorized Participant, the Trust or the Sponsor
decided to seek the required licenses, there is no guarantee that
they will timely receive them. An Authorized Participant may
instead decide to terminate its role as Authorized Participant of
the Trust, or the Sponsor may decide to discontinue and wind up the
Trust. An Authorized Participant’s decision to cease acting as such
may decrease the liquidity of the Shares, which could adversely
affect the value of the Shares, and termination of the Trust in
response to the changed regulatory circumstances may be at a time
that is disadvantageous to the shareholders.
Additionally, to the extent an Authorized Participant, the Trust or
the Sponsor is found to have operated with