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.

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