CFTC position limits claim first ETP victim

On Tuesday, Deutsche Bank announced that it plans to redeem all the outstanding shares of PowerShares DB Crude Oil Double Long ETN (DXO). There isn't anything to report besides what is in the press release, but we have our own speculation as to what caused this drastic step by Deutsche Bank.

However, before we get into any of that, there is the matter of what happens with the $450 million currently invested in the fund. I'm sure that many investors are asking what they should do given that the fund will redeem in about a week. The mechanics of this redemption are as follows: on Sept. 9 DXO will go ex-date similar to what happens when a stock goes ex-dividend. Shortly thereafter, investors holding the ETN should receive the cash value for the net asset value (NAV) of the fund in their account. That is, at least in theory, what should happen, but you should definitely keep an eye on your brokerage account to make sure that all the right boxes got checked and that your money gets returned to you.

Notice that investors will receive the NAV in cash, not the market value. That is an important distinction as this fund has been trading at a premium to its NAV over the past couple of weeks because it stopped creating new shares. So, if you bought this fund recently at a premium, you are out of luck unless you can sell it at the same premium.

For most investors holding DXO, our recommendation would be to sell the fund before the redemption. For one thing, as of the market close on Tuesday, it was trading at a 4.5% premium. We're not sure how long that premium will last over the next couple of days given that the redemption will be NAV in a week, but a little premium is better than no premium. The best reason to not sell DXO that we can think of is that by simply holding it, you will save yourself a transaction cost by just waiting for the cash. Of course, it is a leveraged fund based on a fairly volatile commodity, so the results over a few days pose their own separate risks.

So why did Deutsche Bank decide to take such drastic measures? First, you need to understand that the position limit being threatened was not DXO's, but the position limit allocated to all of Deutsche Bank. ETNs are promissory notes that don't actually hold the underlying securities unlike an ETF would. But that doesn't mean no one is holding that exposure. In fact, because the backing bank of the ETN has promised to pay investors the underlying return of the index being tracked by the ETN, it is holding a commensurate amount of those underlying securities to hedge the bank's exposure.

And that is where we presume Deutsche Bank was faced with a business decision that cost DXO its existence. Because this is a 2x leveraged fund, the actual exposure in contracts required is double what the assets in the fund would indicate. In this case it means that Deutsche Bank had nearly $900 million in oil futures outstanding in order to back DXO.

Deutsche Bank is a large player in the commodities sector, and the US Commodity Futures Trading Commission (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 realised that the best thing for itself would be to redeem this note and free up $900 million in new position availability. Especially if the other businesses generated more money for the firm. Given the circumstances, it is what any rational business person would do when faced with this decision.

Whatever the intentions of the CFTC were, there are always unintended consequences to every regulatory action. By choosing to liquidate DXO rather than trim position limits elsewhere, Deutsche Bank is essentially limiting the options that a whole host of smaller investors had come to depend on in terms of accessing these markets. By forcing Deutsche Bank's hand, the CFTC has unintentionally started what we would describe as the de-democratisation of investing. If this process continues, the asset class of commodities will once again return to being the sole domain of corporations, endowments, and deep-pocketed investors. Why ETFs have been targeted remains a mystery to us given the broad ownership of the funds and what is actually a lack of concentration in terms of investors.

Before I get all sorts of e-mails, let me point out a few things. Yes, we have recently called for increased safeguards and barriers to entry for investors in commodity-based ETPs. Nowhere in that request did we say that they should be banned or suffer forced liquidations. We just wanted a few speed bumps to slow down investors before they plunged into something they didn't understand. Our position on leveraged ETFs is the same.

Click here for our view on what commodity ETF investors should do, given that commodity position limits are being strongly enforced.

Disclosure: Morningstar licenses its indices to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indices.