Avoiding a regulatory battle isn't the only reason why Deutsche Bank is closing its crude oil ETP. There's much more to this story.
News that Deutsche Bank is liquidating the PowerShares DB Crude Oil Double Long ETN (NYSEArca: DXO) is an ominous development for commodity exchange-traded products.
It is the first commodity ETP to succumb to heightened regulatory concerns about the influence that index-based products have on the commodity marketplace. And it is unlikely to be the last.
Deutsche Bank has been tight-lipped about the exact reason it is closing down the exchange-traded note, leaving reporters and analysts to speculate. Most reports, such as this generally solid piece by Morningstar’s Scott Burns, focus on the idea that Deutsche Bank was concerned about the overall size of its position in the crude oil futures market.
Burns writes:
“Deutsche Bank is a large player in the commodities sector, and the CFTC is breathing down everybody's neck about position limits. It is not improbable that Deutsche Bank looked at all the business that it conducts using oil futures--including proprietary trading, hedging for corporate entities, and other bundled commodity investment products--and realized that the best thing for itself would be to redeem this note and free up $900 million in new position availability.”
The Commodities Futures Trading Commission is widely expected to enact new, strict position limits on commodities investors later this year. Some people expect this to lead to forced divestitures by large commodity players like Deutsche Bank. Burns seems to think that Deutsche Bank wanted to get ahead of the curve and cut back on its positions ahead of these forthcoming regulations.
The real story, however, is both more complicated and important than that.
Reading The Tea Leaves
DXO was designed to deliver 200% exposure to the Deutsche Bank Liquid Commodity Index–Oil Index, a managed index of crude oil futures. As of September 1, it had $425 million in assets. Given its 2-for-1 exposure, that means it controlled an $850 million footprint in the crude oil futures space.
When it announced that it was closing the fund, Deutsche Bank gave the following explanation in its press release:
“Limitations imposed by the exchange on which Deutsche Bank manages the exposure of the Notes have resulted in a “regulatory event” as defined in the terms of the Notes, which has caused Deutsche Bank to redeem the Notes.”
The company declined to comment beyond the press release, but it didn’t have to. The key phrase is included right there: “Limitations imposed by the exchange…”
That phrase suggests that it wasn’t vague concerns about CFTC position limits that led to DXO’s closing; rather, it was a specific exchange-driven limitation.
The index that DXO tracks is tied to the performance of crude oil futures listed on the New York Mercantile Exchange. NYMEX, however, has not imposed any new position limits in the past few weeks or months. Meanwhile, DXO has been a large product for some time. In fact, assets are down this year, from $585 million to $425 million since January 1.
If the exchange hasn’t enacted new position limits, and the size of the fund has actually decreased, why was it forced to close now?
The answer, I believe, is that the NYMEX has decided to exercise a discretionary power it has always had, but has rarely used in the past.
Enforcing Accountability Limits
Many people believe that there are no position limits in place for energy futures, but that’s not strictly true. While there may be no federally imposed limit, as outlined in the NYMEX rule book, the NYMEX has two different levels of position limits of its own for most commodities, including crude oil.
On the three days prior to expiration of each contract, NYMEX places strict position limits on the number of contracts any one party can hold. Currently, firms are limited to 3,000 contracts or less. There’s no wiggle room here. This is one of many reasons commodity funds trade out of expiring contracts well ahead of expiration: When you get down to the last few days, you can only hold a small number of contracts. The reason is pretty simple—the exchanges want an orderly unwind of the non-deliverable contracts, so there’s no panic to find oil tankers or train cars full of wheat.
Outside of that three-day window, the exchange has what’s called “accountability limits.” These have wiggle room.
Accountability limits serve as warning bells to the exchange when a firm has taken a significant position in a given commodity contract. Currently, for crude oil, those warning bells are set at 10,000 contracts for any single month’s contract or 20,000 contracts across all months. If you assume each contract has a notional value of about $70,000, that means (on a dollar basis) the accountability limits are currently set at approximately $700 million (for a single month) and $1.4 billion (across all months).
(Position and accountability limits are published here.)
When a firm hits an accountability level, it must explain to the exchange why it is holding such a large position and how it intends to trade it. The exchange may then ask it to not increase its position, or even to reduce it.
But here’s the key thing: nobody makes the exchange do anything. And historically, it has looked the other way.
The exchange’s tendency to allow firms to hold positions above the accountability level came under fire from the CTFC in July. As reported in Bloomberg, CFTC Chairman Gary Gensler told a CFTC hearing on July 29 that traders often had 2 or 3 times the accountability levels for crude oil and other energy contracts, and bemoaned the fact that the exchanges looked the other way.
“They have used this authority [given by accountability levels] to a degree,” Gensler told the hearing. “The majority of the time, however, the exchanges do not execute their authority to require participants to decrease or refrain from increasing the size of their positions.”
From Gensler’s comments, it’s very easy to connect the dots to what happened with DXO.
DXO tracks the DB Optimum Yield – Crude Oil Index, which is currently 100% invested in the July 2010 contract, as disclosed here.
As an ETN, DXO has never been “backed” by contracts the way an ETF would be. Deutsche Bank could choose to essentially be short $1 billion of crude oil and not hedge their liability to DXO. The reality, however, is that every ETN issuer hedges out nearly 100% of their market risk for their ETNs. Deutsche Bank would have hedged its exposure to the index by purchasing the underlying futures contract. Because it is leveraged 2-to-1, that means that, to properly hedge the product, it had to buy $950 million worth of the July 2010 crude oil contract. As mentioned, currently accountability limits are targeted at about $700 million for any one month’s contract.
What’s more, DXO is just one part of the Deutsche Bank suite of commodity ETPs. The PowerShares DB Energy Fund (NYSEArca: DBE) has $281 million in assets, and 25% is pegged to the same June contract. The PowerShares DB Oil Fund (NYSEArca: DBO) has $276 million in assets, pegged to the same contract. The PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC) has $3.4 billion in assets, and 38% is theoretically invested in the same contract.
Its other products in this space are small, except for the PowerShares DB Crude Oil Double Short ETN (NYSEArca: DTO), which has $174.3 million invested at 2-for-1 leverage on the short side of those contracts. In other words, it’s a seller of $345 million in June 2010 crude oil contracts.
If you assume that Deutsche Bank can use its inverse exposure in DTO to hedge some of the long contracts, the firm needed $2.44 billion in exposure to that July 2010 contract to track its indexes perfectly. At that level, Deutsche Bank would control more than 30,000 contracts (virtually all of the contracts outstanding). And more importantly, it would hold far more than the 10,000 contract position limit.
Of course, it’s highly unlikely that Deutsche Bank owned all those contracts directly. The prospectus for the ETFs (DBC, DBE and DBO) allows them to invest in a variety of contracts if it becomes impractical to actually hold the contract that’s in the index. The ETN can also theoretically be hedged using anything, although in practice DB likely sticks very close to the target strategy.
The point, however, is that Deutsche Bank’s footprint in the crude oil space far exceeded the accountability limits in place at the exchange. In the past, the exchange has looked the other way. But it appears that is no longer the case. And in the current environment, it’s likely to stay this way in the future.
What Does This Mean For Other Exchange-Traded Products?
What does this mean for other ETPs? It’s not clear.
The immediate and obvious concern would be the United States Oil Fund (NYSEArca: USO), the largest crude oil futures fund, which has $2.3 billion in crude oil exposure. It already breaks up its exposure into multiple markets, holding approximately $850 million in NYMEX futures and $1.2 billion in ICE futures. That would have it bumping up against one-month accountability limits at NYMEX and well over the edge at ICE (ICE has accountability limits that are comparable to NYMEX’s.)
If it’s true that the NYMEX has gotten tough on accountability limits, ICE might follow suit. If it does, we could see USO forced to spread its exposure across multiple months and/or look for alternative ways to find exposure (swaps, futures on other types of crude oil traded abroad, options, etc.)
All of these are suboptimal ways of gaining exposure (obviously, or the firms would have been doing it already). All of them move true price discovery across other markets, which in the long run makes the market less efficient. And ultimately, moving from the exchanges to over-the-counter swaps just robs Peter to pay Paul, adding a layer of Vaseline over what are otherwise very transparent product.
I don’t think futures based ETPs are going the way of the dodo—there are simply too many smart, innovative players in the market, and clearly enormous end-user demand. But I do think that the commodity ETP space isn’t going to somehow magically settle down. It’s going to get a lot more interesting, quickly.
Matt Hougan is managing director of ETF analytics for Index Publications LLC, the parent company of IndexUniverse.com. He welcomes comments and suggestions for future columns at: mhougan@indexuniverse.com.