Crypto ETFs: The $85% Freeze Risk You Need To Know

Crypto ETFs: The Looming $85% Custody Risk and What Investors Need to Know

The SEC’s approval of generic listing standards for crypto Exchange Traded Products (ETPs) on September 17th dramatically shortened the launch timeline to just 75 days and unlocked the door for straightforward, “plain-vanilla” investment products. This has sparked predictions of explosive growth, with Bitwise forecasting over 100 crypto-linked ETFs by 2026. However, beneath the surface of this bullish outlook lies a critical vulnerability: an 85% concentration of custody with a single provider, Coinbase. This article delves into the potential risks and opportunities presented by the burgeoning crypto ETF market, examining the plumbing, the players, and the potential for both massive gains and swift liquidations.

The ETF Boom: Growth and the Inevitable Cull

Bloomberg ETF analyst James Seyffart echoes Bitwise’s prediction of a rapid expansion in the number of crypto ETFs, but adds a crucial caveat: “We're going to see a lot of liquidations.” This pairing of explosive growth and swift culling defines the next phase of the market. The new generic standards address the timing of launches, but not the underlying liquidity problems that could plague many of these products. For established cryptocurrencies like Bitcoin, Ethereum, and Solana, the influx of capital will likely reinforce their dominance. However, for altcoins and smaller projects, it represents a significant stress test.

The SEC’s approach mirrors its actions with equity and bond ETFs in 2019, where annual launches jumped from 117 to over 370. This was immediately followed by fee compression and the closure of dozens of smaller funds within two years. The crypto market is poised for a similar experiment, but with even more challenging starting conditions.

The Custody Conundrum: An $85% Freeze Risk

Coinbase currently holds the assets for the vast majority of crypto ETFs, claiming up to an 85% share of global Bitcoin ETFs. This concentration of custody presents a systemic risk. What happens if Coinbase experiences an operational glitch, a security breach, or even regulatory scrutiny? The entire ETF category could be shaken. While US Bancorp, Citi, and State Street are exploring crypto-ETF custody relationships, they are currently playing catch-up.

This isn’t just about security. It’s about operational risk. More ETFs mean more fees for Coinbase, but also more regulatory attention and a higher probability that a single incident could spook the entire market. The reliance on a single counterparty creates a significant point of failure.

AP and Market Maker Constraints

Authorized Participants (APs) and market makers also face challenges. They depend on a limited number of venues for pricing and borrowing, and many altcoins lack the derivatives depth needed to hedge creation/redemption flows without significantly impacting the market. This can lead to wider spreads and potential trading halts.

The SEC’s July 29th in-kind order, allowing Bitcoin and Ethereum trusts to settle creations with actual coins rather than cash, has tightened tracking. However, it also requires APs to source, hold, and manage the tax implications of each basket. This is manageable for BTC and ETH, but becomes increasingly complex for thinner, less liquid assets.

Plumbing Under Load: Creation and Redemption Challenges

APs and market makers can handle higher creation/redemption volume for liquid coins. Their primary constraint is the availability of short positions. When a new ETF launches on a token with limited borrow, APs may demand wider spreads or simply step back, leaving the fund to trade on cash creations with higher tracking error. Exchanges may halt trading if reference prices stop updating, a risk highlighted by Dechert’s October analysis.

The key takeaway is that the infrastructure isn’t infinitely scalable. The ability to efficiently create and redeem ETF shares is crucial for maintaining tight tracking and preventing significant premiums or discounts.

Index Providers: The Quiet Gatekeepers

Index providers wield significant, often overlooked, power. Generic standards tie ETF eligibility to surveillance agreements and reference indices that meet exchange criteria, effectively controlling who designs the benchmarks. A handful of firms, such as CF Benchmarks, MVIS, and S&P, dominate traditional ETF indexing. The crypto market is following a similar pattern, with platforms defaulting to indices they recognize, making it harder for new entrants to gain traction, even with superior methodologies.

The 2026 Launch Bucket: A Tiered Approach

Here’s a breakdown of potential ETF launches, categorized by risk and complexity:

Single-Asset Majors: BTC / ETH

• Custody: Coinbase still dominates with 80%+ share, but banks like US Bank (via NYDIG) and Citi are re-entering at a smaller scale. Concentration risk remains high.
• Index/Benchmark: Mostly direct spot exposure; no index provider, or simple NAV calculation off a single reference rate. Benchmarks from CF Benchmarks, CoinDesk, and Bloomberg Galaxy are used for marketing.
• AP/Creation-Redemption: SEC now allows in-kind creations/redemptions, tightening spreads and reducing slippage. Competition is primarily on fees and marketing.
• 19b-4 Needed?: No, as long as products fit the generic Commodity-Based Trust Share standards.

Single-Asset Altcoins: SOL, XRP, DOGE, LTC, etc.

• Custody: Thinner and more concentrated: Coinbase plus a handful of specialists. Smaller custodians will struggle to meet security and insurance costs.
• Index/Benchmark: Some funds will be pure single-asset; others will wrap a futures-linked or blended index. Indexers gain leverage as gatekeepers.
• AP/Creation-Redemption: Real borrow and short constraints in thin markets. Expect wider spreads and episodic creations.
• 19b-4 Needed?: Often no, if each underlying meets the generic futures/ISG test.

Single-Asset Long-Tail & Meme-Coin ETPs: TRUMP, BONK, etc.

• Custody: Very few top-tier custodians will touch these illiquid names, relying on smaller or offshore custodians.
• Index/Benchmark: Pricing leans on composite indexes built from centralized exchanges, increasing the risk of manipulation.
• AP/Creation-Redemption: APs are often issuers’ affiliates. Expect wide spreads, persistent NAV discounts/premiums, and frequent creation halts.
• 19b-4 Needed?: Yes, in most cases, requiring a slower and less certain approval process.

Broad Large-Cap & “Top-N” Index ETPs

• Custody: Usually consolidated with a single provider for simplicity.
• Index/Benchmark: Indices from CF Benchmarks, CoinDesk, Bloomberg Galaxy, etc., determine inclusion rules and weights.
• AP/Creation-Redemption: More creation/redemption line items, but APs can net flows across components.
• 19b-4 Needed?: No, for “plain vanilla” index trusts where every component meets the Generic Standards.

Thematic / Sector Index ETPs

• Custody: Multi-provider if certain tokens are only supported by niche custodians.
• Index/Benchmark: Indexers must balance thematic purity with generic regime compliance.
• AP/Creation-Redemption: Fragile creations due to sourcing multiple illiquid names.
• 19b-4 Needed?: Often yes, if the index holds even one asset that fails the futures/ISG test.

Options-Overlay ETPs: Adding Complexity

Options-overlay strategies on single-asset BTC/ETH or multi-asset/thematic indexes add further complexity. These require derivatives plumbing and introduce new operational risks related to collateralization and margin. They also typically fall outside the Generic Standards, requiring full 19b-4 approval.

The Inevitable Cull: Survival of the Fittest

ETF.com tracks dozens of closures each year, with funds below $50 million struggling to cover costs. James Seyffart predicts crypto ETF liquidations by late 2026 or early 2027. The most vulnerable will be duplicate single-asset funds with high fees, niche index products, and thematic bets that can’t adapt to market changes.

Fee wars will accelerate the cull. New Bitcoin ETFs launched in 2024 at 20-25 basis points, undercutting earlier filers. As the market becomes crowded, issuers will cut fees further, leaving long-tail funds unable to compete.

Secondary-market mechanics will crack first on thin underlyings. Demand spikes can force premiums until APs source enough coins. If borrow disappears during volatility, the AP stops creating, and the premium persists. Several early crypto index ETFs saw net redemptions and persistent discounts as investors favored brand-name single-asset funds.

For Bitcoin, Ethereum, and Solana, the dynamic reverses. More ETF wrappers deepen spot-derivative connections, tighten spreads, and reinforce their status as core institutional collateral. Bitwise predicts ETFs will absorb more than 100% of net new supply in these three assets, creating a positive feedback loop.

What the Rules Still Gate and Who Decides

Generic standards exclude actively managed, leveraged, and “novel feature” ETPs, which must file individual 19b-4 proposals. SEC Commissioner Caroline Crenshaw warned that the standards could flood the market with products that skip individual vetting, creating correlated fragilities. The rules channel the flood toward the most liquid, most institutionalized corners of crypto.

The stakes are simple: will ETF-palooza consolidate crypto’s institutional infrastructure around a few dominant coins and custodians, or broaden access and distribute risk? For Bitcoin, the flood is a coronation. For the long tail, more ETFs mean more legitimacy but also more fragmentation and a higher likelihood of fund closures.

Generic standards made it easy to launch crypto ETFs. They did not make it easy to keep them alive.