CRB Monitor Chart of the Month: Embedded Risk in Crypto ETPs - February 2025
James B. Francis, CFA, Chief Research Officer, CRB Monitor
Peter Simcox, Senior Analyst, CRB Monitor
For this edition of CRB Monitor’s Chart of the Month we head back to the world of spot cryptocurrency exchange traded products (ETPs) to discuss some of the embedded risks that we have not covered in previous articles. These are related to, specifically, Staking, Airdrops, and Forking.
To those of us that were born during or around the leisure suit era, we believe that these terms might have something to do with camping, or perhaps dinner. But practitioners in the crypto space know these terms well and treat them as “sweeteners” for their crypto investments, as they exist to motivate investors that hold on to (or maybe add to) their crypto investments.
First, a reminder for investors in crypto ETPs (from CRB Monitor’s July 2024 Chart of the Month):
“Financial institutions that seek exposure to cryptocurrencies via investment in crypto-themed ETPs have become increasingly aware of a number of risks associated with this investment choice. While these ETPs are themselves technically not spot cryptocurrencies, we would argue that they are no less risky, as there are embedded risks in crypto-themed ETPs that investors might not be aware of, and we have written about these in prior articles (see our recent Chart of the Month).
In a nutshell, because cryptocurrencies are not considered “securities” by US regulators, spot crypto ETPs are not covered by the Investment Company Act of 1940. As such, investors in spot crypto ETPs are not afforded the standard protections under the 40 Act. This becomes a very big deal when an ETP faces a significant operating loss due to a break in the create-redeem process, or a settlement failure in the facilitation of a shareholder liquidation. In those cases, shareholders of the ETP could very well face absorbing any losses incurred due to operational breakdowns.”
Staking
Staking is the process of participating in a cryptocurrency network's proof-of-stake (or similar consensus mechanism) by locking up a certain amount of cryptocurrency to help secure the 
network. This is accomplished via a transaction that resembles a lease which provides a yield to the “staker”. For those who have lived in the equity fund management world, staking is very similar to securities lending, where investors pledge their crypto to a counterparty for a premium rather than shares of stock.
To be sure, there are some significant differences and we will attempt to point these out. In the words of the mega-crypto exchange Coinbase.com:
“Staking is a way to earn rewards by putting your crypto to work on a blockchain network. In return for helping the network run smoothly and securely, you receive more of the cryptocurrency you're staking. The rewards come from the network itself—your crypto isn’t being lent out. It’s a safe, simple and popular way to grow your crypto while holding.”
Proof-of-Stake vs. Proof-of-Work
In order to fully understand the concept of staking, one must understand the essential differences between “proof-of-stake” cryptocurrencies and those that are defined as “proof-of-work”. (Only proof-of-stake blockchains accommodate staking.)
With Proof-of-Stake cryptocurrencies, participants are chosen based on the amount of cryptocurrency they hold and have staked as collateral. The more they stake, the higher the chance they have of being selected to validate transactions and add new blocks to the blockchain. This is where the concept of staking comes into play, which we will explain below.
Conversely, Proof-of-Work cryptocurrencies rely on computational power to assign new assets, rather than the amount of currency a participant owns. Miners of proof-of-work crypto are rewarded based on their ability to solve cryptographic puzzles which requires significant computational resources and energy consumption (in other words, brute force). As such, there is no staking of coins required for the mining of new assets.
When you stake your coins or tokens, you essentially lend them to the network, and in return, you are rewarded with additional tokens. The rewards typically come from transaction fees or new tokens minted by the network. Staking helps maintain the integrity and security of the blockchain by making it more expensive to attack the network, as participants have a financial incentive to act honestly. The more coins you stake, the higher your chances of earning rewards, though staking usually involves locking up funds for a certain period, which means you can't easily access or sell them without penalties.
Examples of proof-of-stake cryptocurrencies include Ethereum, Cardano, Polkadot, Solana, Tezos, and Cosmos.
Airdrops
Loosely comparable to stock dividends, Airdrops are a method of distributing free tokens or coins to cryptocurrency holders, typically as a way to promote a new project or reward loyal users of a specific blockchain. Airdrops are often conducted by blockchain projects to increase awareness, engage with the community, or encourage adoption of their platform. To receive an airdrop, users generally need to meet certain criteria, such as holding a particular cryptocurrency at a specific time, or performing certain tasks like following a project's social media account or signing up for their newsletter.
Airdrops are seen as a way to quickly distribute tokens to a wide audience, but they can sometimes be used for marketing purposes or as part of a project's initial distribution strategy. Here are some of the main types of airdrops, courtesy of Investopedia.com:
Risks Related to Airdrops
Airdrops can be a playground for illicit activity. With the increasing popularity of airdrops, hackers are grabbing this opportunity to use major platforms’ names to trick users by sending fake tokens. When clicking on such a token, users can often find themselves on a fraudulent website imitating some famous project’s domain name and interface. Such a phishing source usually asks to connect the wallet, enter the seed phrase or even send some funds to receive more tokens. This explanation is from Investopedia.com:
“Many airdrop scams rely on directing an investor to attach their wallet to a phishing website in order to claim their airdrop. Often, the web3 address will prompt a user to connect their wallet using common and popular wallet services such as MetaMask, Trust Wallet, or Oasis. After a user connects their wallet by providing their secret phrase or keys, the scam is complete. Airdrop scams may also occur by enticing market participants to invest in a specific security in hopes of being airdropped a different item. For example, a project may boast that holding certain NFTs in a wallet will cause owners to receive a rare airdrop. Though the airdrop may be legitimate, the project owners may have enticed market activity of the NFT so they could sell theirs at a higher price.”
Hard Forks
A Hard Fork in cryptocurrency is somewhat akin to a spinoff in the world of conventional investments. While that might be an oversimplification, that is essentially what happens. In technical terms, a hard fork refers to a change in the protocol of a blockchain network which results in a permanent divergence from the original blockchain, creating two separate chains.
[This is in contrast to a Soft Fork, where the changes are backward-compatible. In other words, hard forking is when a group of unhappy investors take their ball and start a new game, whereby they completely abandon their friends indefinitely. What results is a potential devaluation when the new and legacy cryptocurrencies face off in competition for assets.
Why Hard Forks Happen
Example of a Hard Fork: Bitcoin Cash (BCH)
One of the most famous examples of a hard fork is the Bitcoin Cash (BCH) fork from Bitcoin (BTC).
- Reason for the Fork: Bitcoin's block size limit was a point of contention in the community. Some wanted to increase the block size to handle more transactions per block (for scalability), while others were against it to preserve the original principles of decentralization.
- The Split: In August 2017, after much debate, the Bitcoin network experienced a hard fork, where a group of miners and developers decided to create Bitcoin Cash, which increased the block size limit to 8 MB (from Bitcoin's original 1 MB).
- Result: The result was two separate blockchains:
- Bitcoin (BTC): Continued using the original protocol and block size limit.
- Bitcoin Cash (BCH): Operates with the new protocol and larger block size.
Since then, both cryptocurrencies have evolved independently, each with its own community and market value.
Risks to Investors of Hard Forks
As crypto investors begin to dip their toes into this vast sea of operational risk and volatility, there are a number of considerations that will be essential components of compliance and risk management beyond those required for typical ETP investing. Rather, it can be assumed that an investment in a spot cryptocurrency-themed ETP is akin, from a risk perspective, to an investment in the underlying cryptocurrency itself. And it should not be overlooked that these cryptocurrencies are actively traded on global exchanges of varying qualities and degrees of regulation, and as such lend themselves to illicit activity and operational pitfalls. CRB Monitor researches, curates, and maintains a wealth of risk-related data for our institutional partners who need essential information about this emerging investment space.
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