The West Midlands MEP says he is now unlikely to put himself forward as Paul Nuttall's successor over fears he may split support for other 'moderate' candidates.
Mr Etheridge says there are genuine fears among UKIP MEPs that the party was on the verge of becoming a 'far right protest group', with concerns centred around likely leadership bids from Sharia Watch UK founder Anne Marie Waters and deputy leader Peter Whittle.
Other UKIP MEPs, including West Midlands MEP Jim Carver and leadership candidate David Coburn, also told the Express & Star they are ready to quit the party over the rise of Islamophobia within its ranks.
Mr Etheridge said: "If the far right take control, and by that I mean people completely motivated by a hatred of minorities, some of whom have views that put the BNP in the shade, then I will not remain as a member of this party.
"I would still fulfil the message of UKIP in the European Parliament, pushing for proper Brexit, but I could not be a member of any party with a racially motivated agenda."
"We are talking about extreme right wing lunatics. They are against Islam to the point of hate. These are the kind of people that burn the Quran and think Islam is the root of all evil.
"Whilst there may be some problematic issues with Islam, their views are going way, way too far. It reminds me of the 1930s.
"We've got to fight this battle and make a strong stance on what UKIP should stand for. This schism is not in the West Midlands, where our team have stood true to the party's core beliefs."
During the General Election campaign deep divisions emerged within UKIP over the party's 'integration agenda', which criticised Muslims and called for a ban on the wearing of the burka in public.
Mr Etheridge had previously announced his intention to stand for UKIP leader, but says such a move is now unlikely providing a suitable 'moderate' candidate comes forward.
"I'm waiting to see who puts themselves forward but at the moment it is not my burning desire to lead UKIP," he said.
"Whoever is the best person to maintain Nigel Farage's legacy will be the person I back.
"The true libertarians in the party will have to unite behind them to defeat the common threat."