Whatever happened to Deutsche’s ETN liquidation? | FT Alphaville

Whatever happened to Deutsche’s ETN liquidation?

Petromatrix’s Olivier Jakob evaluates CFTC weekly trader data on a regular basis, and one thing he was quite looking forward to analysing was the liquidation of Deutsche Bank’s exchange-traded-note — the PowerShares DB Crude Oil Double Long (DXO). Analysts expected the liquidation would flood the curve with up to 11,750 futures contracts.

Yet, as Jakob points out in a recent note, the latest data fails to account for any such liquidation at all (our emphasis):

The Open Interest is not showing a reduction of position that would match the closing of the DXO (July10) and that suggests that either the long hedges were transferred to an internal trading desk within Deutsche or that the trading desk was actually running a naked short on their swap cover to the DXO (and that would have been painful).

That sounds quite mysterious; after all, even Deutsche Bank’s own commodity team had been expecting a bit of a hit on the curve.

Except it’s not actually that much of a mystery. In fact, with his reference to a naked short, Jakob highlights what is potentially DB’s liquidation of the DXO might be connected to.

You see, the way DB’s notes are structured, the funds– or trusts– that issue the notes  are not obliged to own any futures or assets whatsoever. They are only obliged to return the performance of a specific DB index. The funds manage to achieve this not by replicating the index by buying assets — what one could call the traditional ETF method — but by being backstopped by Deutsche Bank’s ability to make good on the performance of the index no matter what. As DXO’s prospectus clearly points out:

The PowerShares DB Crude Oil ETNs are unsecured obligations of Deutsche Bank AG, London Branch, and the amount due on the PowerShares DB Crude Oil ETNs is entirely dependent on Deutsche Bank AG, London Branch’s ability to pay.

So in effect, if you thought you were buying oil as an inflation hedge with the DXO, you would be wrong. You were actually buying returns based on a 100 per cent guarantee by just one counterparty – Deutsche Bank. The fund – or trust – that issued the notes never owned any oil on your behalf.

This is quite clearly set out in Deutsche Bank’s DXO prospectus, which also states to what degree DB is able to use the proceeds as it pleases . As it explains:

We will use the net proceeds from the sale of the securities we offer by this prospectus for general corporate purposes, in connection with hedging our obligations under the securities, or for any other purposes described in the applicable prospectus supplement. General corporate purposes may include additions to working capital, investments in or extensions of credit to, our subsidiaries, and the repayment of indebtedness.

Conflict of interest

What might raise eyebrows, however, is that the prospectus further explains how Deutsche Bank  isn’t even obliged to hedge the exposure in the traditional sense (ie, buying futures).  As Jakob points out they can, and might very well have, opted to run a naked short for the purpose of complimenting their wider trading operations, but not necessarily the interests of their ETN investors.

Here’s the disclosure from Deutsche Bank on the conflict of interest that exists (our emphasis):

The business activities of DBSI may create conflicts of interest DBSI and its affiliates expect to engage in trading activities related to the components of the crude oil indices, futures or options on the components of the crude oil indices, or other derivative instruments with returns linked to the performance of the components of the crude oil indices or the sub-indices that are not for the account of holders of the securities or on their behalf.

These trading activities may present a conflict between the holders’ interest in the securities and the interests that DBSI and its affiliates will have in their proprietary accounts, in facilitating transactions, including futures, options and other derivatives transactions, for their customers and in accounts under their management.

These trading activities, if they influence the levels of the sub-indices, could be adverse to the interests of the holders of the securities. Moreover, DBSI has published and in the future expects to publish research reports and trading advice with respect to some or all of the components of the sub-indices. This research and trading advice is modified from time to time without notice and may express opinions or provide recommendations that are inconsistent with purchasing or holding the securities.

The research and trading advice should not be viewed as a recommendation or endorsement of the securities in any way and investors must make their own independent investigation of the merits of this investment. Any of these activities by DBSI or its affiliates may affect the market price of the components of the crude oil indices and the levels of the sub-indices and, therefore, the market value of the securities. With respect to any of the activities described above, neither DBSI nor its affiliates have any obligation to take the needs of any buyer, seller or holder of the securities into consideration at any time.

What that means is there is absolutely nothing stopping Deutsche Bank from using the ETN short as part of its own wider trading strategy.

And let’s not forget that the ETN’s structure also puts Deutsche Bank in another unique and advantageous  position – that of a ‘master’ authorised participant. All redemptions and issues have to go via it, and it alone. Because of that, we presume, Deutsche Bank would always be in a position to exploit market arbitrage opportunity first.

Alternative authorised participants would only make money if Deutsche itself mispriced the arbitrage. As the literature specifies, you’re trading with DB AG London, not the fund:

There are restrictions on the minimum number of PowerShares DB Crude Oil ETNs that you may redeem directly with Deutsche Bank AG, London Branch, as specified in the prospectus.

Last,  and not least, you might recall Deutsche moved to cut off new issues in two of its agricultural funds back in August after the CFTC pulled back position-limit exemptions from the respective funds, aggregating them instead all under Deutsche Bank’s name.

At the time the move confused the market, because it didn’t make sense that Deutsche Bank should suspend shares in anticipation of new CFTC position regulations. Deutsche declined to offer any further explanation.

The clue, however, was in the CFTC notice all along. This it turns out stated quite clearly the specific nature of the problem:

DMO [Division of market oversight] will work with each of these entities as they transition to positions within current federal speculative limits. The withdrawal of these no-action positions is very specific and limited and does not affect any other no-action or regulatory positions taken by the CFTC or its staff with regard to these entities or other market participants.

They were not seen to be bona fide hedgers anymore.
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Things looking ugly for the UNG
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Statistical arbitrage and the big retail ETF con-fusion
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