By Matthew Hougan
Why would the NYMEX’s enforcement of new limits impact the closing of DXO? After all, the ETN doesn’t actually hold anything—it’s simply a debt note.
That’s one of the questions that readers have asked after our recent look at DXO, the leveraged oil ETN that is being liquidated next week.
The column examined why Deutsche Bank is shutting down the PowerShares DB Crude Oil Double Long ETN (NYSEArca: DXO).
Conventional wisdom says that the note is being liquidated due to concerns that the Commodity Futures Trading Commission will enact new position limits on commodity futures this fall.
But another view needs to be considered—that the fund is actually being liquidated because the New York Mercantile Exchange has started enforcing “accountability limits,” exercising a power it held for years but until now has not much utilized.
Why, some have asked, would that affect an ETN that simply serves essentially as a debt note?
On one level, as explained in the original column:
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 its 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.
That’s the simple case. But it doesn’t fully explain why this would cause DB to shut down DXO. The NYMEX certainly didn’t force it to liquidate the note. Even if it had to reduce its position, DB could have looked for alternative ways to hedge its exposure.
As one industry veteran told me, “Very few money managers are keen on shutting down a half a billion fund unless they have to. Your first response is to look for other choices. DB had several.”
Specifically, it could have:
- Bought similar contracts on another exchange, like ICE.
- It could have diversified its position across multiple months, rather than focusing on the single month that DXO tracked.
- It could have changed the index or used swaps.
I think all of those except swaps are a false choice. ETNs guarantee perfect tracking against their indexes, so they can’t take on even a little bit of performance risk. If an exchange-traded fund deviates from its index, the costs are borne by the shareholders of the fund as tracking error.
If an ETN does, the costs are borne by the fund manager.
But swaps offer the promise of zero tracking error, so why not use swaps?
The same industry source, who commented on background only, said: “The only [reason] that comes to mind is that the fund had become unprofitable, i.e., expenses went higher.”
His point was that regulatory crackdowns may be raising the costs of swaps, which is effectively the way the DB was managing its exposure (whether it bought third-party swaps or managed them itself).
Looked at this way, it’s not surprising why DB singled out the leveraged ETN for closure, while keeping its nonleveraged ETFs open for business. After all, it requires 200% exposure to the crude oil market, but charges the same 0.75% expense ratio as DB’s nonleveraged commodity funds.
The end result of the rising cost of swaps is that we could see ETNs down the road increasing their expense ratios, perhaps to 1%, 1.25% or even 1.5%. I would guess that the cost of providing leveraged exposure to this market will rise even higher.