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2010-10335

  • FR Doc 2010-10335[Federal Register: May 5, 2010 (Volume 75, Number 86)]

    [Notices]

    [Page 24648-24655]

    From the Federal Register Online via GPO Access [wais.access.gpo.gov]

    [DOCID:fr05my10-60]

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    COMMODITY FUTURES TRADING COMMISSION

    Order Finding That the Socal Border Financial Basis Contract

    Traded on the IntercontinentalExchange, Inc., Performs a Significant

    Price Discovery Function

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Final order.

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    SUMMARY: On October 20, 2009, the Commodity Futures Trading Commission

    (``CFTC'' or ``Commission'') published for comment in the Federal

    Register \1\ a notice of its intent to undertake a determination

    whether the Socal Border Financial Basis (``SCL'') contract traded on

    the IntercontinentalExchange, Inc. (``ICE''), an exempt commercial

    market (``ECM'') under sections 2(h)(3)-(5) of the Commodity Exchange

    Act (``CEA'' or the ``Act''), performs a significant price discovery

    function pursuant to section 2(h)(7) of the CEA.\2\ The Commission

    undertook this review based upon an initial evaluation of information

    and data provided by ICE as well as other available information. The

    Commission has reviewed the entire record in this matter, including all

    comments received, and has determined to issue an order finding that

    the SCL contract performs a significant price discovery function.

    Authority for this action is found in section 2(h)(7) of the CEA and

    Commission rule 36.3(c) promulgated thereunder.

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    \1\ 74 FR 53723 (October 20, 2009).

    \2\ 7 U.S.C. 1a(29).

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    DATES: Effective date: April 28, 2010.

    FOR FURTHER INFORMATION CONTACT: Gregory K. Price, Industry Economist,

    Division of Market Oversight, Commodity Futures Trading Commission,

    Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

    Telephone: (202) 418-5515. E-mail: gprice@cftc.gov; or Susan Nathan,

    Senior Special Counsel, Division of Market Oversight, same address.

    Telephone: (202) 418-5133. E-mail: snathan@cftc.gov.

    SUPPLEMENTARY INFORMATION:

    I. Introduction

    The CFTC Reauthorization Act of 2008 (``Reauthorization Act'') \3\

    significantly broadened the CFTC's regulatory authority with respect to

    ECMs by creating, in section 2(h)(7) of the CEA, a new regulatory

    category--

    [[Page 24649]]

    ECMs on which significant price discovery contracts (``SPDCs'') are

    traded--and treating ECMs in that category as registered entities under

    the CEA. The legislation authorizes the CFTC to designate an agreement,

    contract or transaction as a SPDC if the Commission determines, under

    criteria established in section 2(h)(7), that it performs a significant

    price discovery function. When the Commission makes such a

    determination, the ECM on which the SPDC is traded must assume, with

    respect to that contract, all the responsibilities and obligations of a

    registered entity under the Act and Commission regulations, and must

    comply with nine core principles established by new section 2(h)(7)(C).

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    \3\ Incorporated as Title XIII of the Food, Conservation and

    Energy Act of 2008, Public Law 110-246, 122 Stat. 1624 (June 18,

    2008).

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    On March 16, 2009, the CFTC promulgated final rules implementing

    the provisions of the Reauthorization Act.\4\ As relevant here, rule

    36.3 imposes increased information reporting requirements on ECMs to

    assist the Commission in making prompt assessments whether particular

    ECM contracts may be SPDCs. In addition to filing quarterly reports of

    its contracts, an ECM must notify the Commission promptly concerning

    any contract traded in reliance on the exemption in section 2(h)(3) of

    the CEA that averaged five trades per day or more over the most recent

    calendar quarter, and for which the exchange sells its price

    information regarding the contract to market participants or industry

    publications, or whose daily closing or settlement prices on 95 percent

    or more of the days in the most recent quarter were within 2.5 percent

    of the contemporaneously determined closing, settlement or other daily

    prices of another contract.

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    \4\ 74 FR 12178 (Mar. 23, 2009); these rules became effective on

    April 22, 2009.

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    Commission rule 36.3(c)(3) established the procedures by which the

    Commission makes and announces its determination whether a particular

    ECM contract serves a significant price discovery function. Under those

    procedures, the Commission will publish notice in the Federal Register

    that it intends to undertake an evaluation whether the specified

    agreement, contract or transaction performs a significant price

    discovery function and to receive written views, data and arguments

    relevant to its determination from the ECM and other interested

    persons. Upon the close of the comment period, the Commission will

    consider, among other things, all relevant information regarding the

    subject contract and issue an order announcing and explaining its

    determination whether or not the contract is a SPDC. The issuance of an

    affirmative order signals the effectiveness of the Commission's

    regulatory authorities over an ECM with respect to a SPDC; at that time

    such an ECM becomes subject to all provisions of the CEA applicable to

    registered entities.\5\ The issuance of such an order also triggers the

    obligations, requirements and timetables prescribed in Commission rule

    36.3(c)(4).\6\

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    \5\ Public Law 110-246 at 13203; Joint Explanatory Statement of

    the Committee of Conference, H.R. Rep. No. 110-627, 110 Cong., 2d

    Sess. 978, 986 (Conference Committee Report). See also 73 FR 75888,

    75894 (Dec. 12, 2008).

    \6\ For an initial SPDC, ECMs have a grace period of 90 calendar

    days from the issuance of a SPDC determination order to submit a

    written demonstration of compliance with the applicable core

    principles. For subsequent SPDCs, ECMs have a grace period of 30

    calendar days to demonstrate core principle compliance.

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    II. Notice of Intent To Undertake SPDC Determination

    On October 20, 2009, the Commission published in the Federal

    Register notice of its intent to undertake a determination whether the

    SCL contract performs a significant price discovery function and

    requested comment from interested parties.\7\ Comments were received

    from the Federal Energy Regulatory Commission (``FERC''), Platts and

    ICE.\8\ The comment letters from FERC \9\ and Platts did not directly

    address the issue of whether or not the SCL contract is a SPDC; ICE's

    comments raised substantive issues with respect to the applicability of

    section 2(h)(7) to the SCL contract. Generally, ICE asserted that its

    SCL contract is not a SPDC as it does not meet the material liquidity,

    material price reference and price linkage criteria for SPDC

    determination (CL 03). ICE's comments are more extensively discussed

    below, as applicable.

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    \7\ The Commission's Part 36 rules establish, among other

    things, procedures by which the Commission makes and announces its

    determination whether a specific ECM contract serves a significant

    price discovery function. Under those procedures, the Commission

    publishes a notice in the Federal Register that it intends to

    undertake a determination whether a specified agreement, contract or

    transaction performs a significant price discovery function and to

    receive written data, views and arguments relevant to its

    determination from the ECM and other interested persons.

    \8\ FERC is an independent federal regulatory agency that, among

    other things, regulates the interstate transmission of natural gas,

    oil and electricity. McGraw-Hill, through its division Platts,

    compiles and calculates monthly natural gas price indices from

    natural gas trade data submitted to Platts by energy marketers.

    Platts includes those price indices in its monthly Inside FERC's Gas

    Market Report (``Inside FERC''). ICE is an exempt commercial market,

    as noted above. The comment letters are available on the

    Commission's Web site: http://www.cftc.gov/lawandregulation/

    federalregister/federalregistercomments/2009/09-028.html.

    \9\ FERC stated that the SCL contract is cash settled and does

    not contemplate the actual physical delivery of natural gas.

    Accordingly, FERC expressed the opinion that a determination by the

    Commission that a contract performs a significant price discovery

    function ``would not appear to conflict with FERC's exclusive

    jurisdiction under the Natural Gas Act (NGA) over certain sales of

    natural gas in interstate commerce for resale or with its other

    regulatory responsibilities under the NGA'' and further that ``FERC

    staff will continue to monitor for any such conflict * * * [and]

    advise the CFTC'' should any such potential conflict arise. CL 01.

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    III. Section 2(h)(7) of the CEA

    The Commission is directed by section 2(h)(7) of the CEA to

    consider the following criteria in determining a contract's significant

    price discovery function:

    Price Linkage--the extent to which the agreement, contract

    or transaction uses or otherwise relies on a daily or final settlement

    price, or other major price parameter, of a contract or contracts

    listed for trading on or subject to the rules of a designated contract

    market (``DCM'') or derivatives transaction execution facility

    (``DTEF''), or a SPDC traded on an electronic trading facility, to

    value a position, transfer or convert a position, cash or financially

    settle a position, or close out a position.

    Arbitrage--the extent to which the price for the

    agreement, contract or transaction is sufficiently related to the price

    of a contract or contracts listed for trading on or subject to the

    rules of a DCM or DTEF, or a SPDC traded on or subject to the rules of

    an electronic trading facility, so as to permit market participants to

    effectively arbitrage between the markets by simultaneously maintaining

    positions or executing trades in the contracts on a frequent and

    recurring basis.

    Material price reference--the extent to which, on a

    frequent and recurring basis, bids, offers or transactions in a

    commodity are directly based on, or are determined by referencing or

    consulting, the prices generated by agreements, contracts or

    transactions being traded or executed on the electronic trading

    facility.

    Material liquidity--the extent to which the volume of

    agreements, contracts or transactions in a commodity being traded on

    the electronic trading facility is sufficient to have a material effect

    on other agreements, contracts or transactions listed for trading on or

    subject to the rules of a DCM, DTEF or electronic trading facility

    operating in reliance on the exemption in section 2(h)(3).

    [[Page 24650]]

    Not all criteria must be present to support a determination that a

    particular contract performs a significant price discovery function,

    and one or more criteria may be inapplicable to a particular

    contract.\10\ Moreover, the statutory language neither prioritizes the

    criteria nor specifies the degree to which a SPDC must conform to the

    various criteria. In Guidance issued in connection with the Part 36

    rules governing ECMs with SPDCs, the Commission observed that these

    criteria do not lend themselves to a mechanical checklist or formulaic

    analysis. Accordingly, the Commission has indicated that in making its

    determinations it will consider the circumstances under which the

    presence of a particular criterion, or combination of criteria, would

    be sufficient to support a SPDC determination.\11\ For example, for

    contracts that are linked to other contracts or that may be arbitraged

    with other contracts, the Commission will consider whether the price of

    the potential SPDC moves in such harmony with the other contract that

    the two markets essentially become interchangeable. This co-movement of

    prices would be an indication that activity in the contract had reached

    a level sufficient for the contract to perform a significant price

    discovery function. In evaluating a contract's price discovery role as

    a price reference, the Commission will consider whether cash market

    participants are quoting bid or offer prices or entering into

    transactions at prices that are set either explicitly or implicitly at

    a differential to prices established for the contract.

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    \10\ In its October 20, 2009, Federal Register release, the

    Commission identified material liquidity, material price reference

    and price linkage as the possible criteria for SPDC determination of

    the SCL contract. Arbitrage was not identified as a possible

    criterion and will not be discussed further in this document or the

    associated Order.

    \11\ 17 CFR part 36, Appendix A.

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    IV. Findings and Conclusions

    a. The Socal Border Financial Basis (SCL) Contract and the SPDC Indicia

    The SCL contract is cash settled based on the difference between

    the price of natural gas at the Southern California Border hub for the

    month of delivery, as published in Intelligence Press Inc.'s

    (``IPI's'') Natural Gas Bidweek Survey, and the final settlement price

    for New York Mercantile Exchange's (``NYMEX's'') Henry Hub physically-

    delivered natural gas futures contract for the same specified calendar

    month. The IPI bidweek price, which is published monthly, is based on a

    survey of cash market traders who voluntarily report to IPI data on

    fixed-price transactions for physical delivery of natural gas at the

    Socal Border hub conducted during the last five business days of the

    month; such bidweek transactions specify the delivery of natural gas on

    a uniform basis throughout the following calendar month at the agreed

    upon rate. The IPI bidweek index is published on the first business day

    of the calendar month in which the natural gas is to be delivered. The

    size of the SCL contract is 2,500 million British thermal units

    (``mmBtu''), and the unit of trading is any multiple of 2,500 mmBtu.

    The SCL contract is listed for up to 120 calendar months commencing

    with the next calendar month.

    The Henry Hub,\12\ which is located in Erath, Louisiana, is the

    primary cash market trading and distribution center for natural gas in

    the United States. It also is the delivery point and pricing basis for

    the NYMEX's actively traded, physically-delivered natural gas futures

    contract, which is the most important pricing reference for natural gas

    in the United States. The Henry Hub, which is operated by Sabine Pipe

    Line, LLC, serves as a juncture for 13 different pipelines. These

    pipelines bring in natural gas from fields in the Gulf Coast region and

    ship it to major consumption centers along the East Coast and Midwest.

    The throughput shipping capacity of the Henry Hub is 1.8 trillion mmBtu

    per day.

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    \12\ The term ``hub'' refers to a juncture where two or more

    natural gas pipelines are connected. Hubs also serve as pricing

    points for natural gas at the particular locations.

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    In addition to the Henry Hub, there are a number of other locations

    where natural gas is traded. In 2008, there were 33 natural gas market

    centers in North America.\13\ Some of the major trading centers include

    Alberta, Northwest Rockies, Socal and the Houston Ship Channel. For

    locations that are directly connected to the Henry Hub by one or more

    pipelines and where there typically is adequate shipping capacity, the

    price at the other locations usually directly tracks the price at the

    Henry Hub, adjusted for transportation costs. However, at other

    locations that are not directly connected to the Henry Hub or where

    shipping capacity is limited, the prices at those locations often

    diverge from the Henry Hub price. Furthermore, one local price may be

    significantly different than the price at another location even though

    the two markets' respective distances from the Henry Hub are the same.

    The reason for such pricing disparities is that a given location may

    experience supply and demand factors that are specific to that region,

    such as differences in pipeline shipping capacity, unusually high or

    low demand for heating or cooling or supply disruptions caused by

    severe weather. As a consequence, local natural gas prices can differ

    from the Henry Hub price by more than the cost of shipping and such

    price differences can vary in an unpredictable manner.

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    \13\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/

    feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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    The Socal Border hub is located in Southern California on the

    border with Arizona.\14\ The California Energy Hub, a market center

    that includes the Socal Border Hub, had an estimated throughput

    capacity of 900 million cubic feet per day. Moreover, the number of

    pipeline interconnections at the California Energy Hub was 12 in 2008,

    up from five in 2003. Lastly, the pipeline interconnection capacity of

    the California Energy Hub in 2008 was 6,784 million cubic feet per day,

    which constituted a 47 percent increase over the pipeline

    interconnection capacity in 2003.\15\ The Socal Border hub is far

    removed from the Henry Hub and is not directly connected to the Henry

    Hub by an existing pipeline.

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    \14\ The Socal Border hub typically includes fixed-price gas

    delivered into Southern California Gas Co.'s pipeline system from El

    Paso Corp.'s pipeline at Topock and Blythe, CA/Ehrenberg, AZ; from

    Kern River Gas Transmission Co.'s pipeline at Wheeler Ridge and

    Kramer Junction, CA; and from Questar Pipeline Co.'s Southern Trail

    Pipeline at Needles, CA. The Socal price index includes deliveries

    from Pacific Gas and Electric at several points, including the Kern

    River station and Pisgah/Daggett, as well as in-state production.

    \15\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/

    feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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    For all these reasons, the local price at the Socal hub typically

    differs from the price at the Henry Hub. Thus, the price of the Henry

    Hub physically-delivered futures contract is an imperfect proxy for the

    Socal Border price. Moreover, exogenous factors, such as adverse

    weather, can cause the Socal gas price to differ from the Henry Hub

    price by an amount that is more or less than the cost of shipping,

    making the NYMEX Henry Hub futures contract even less precise as a

    hedging tool than desired by market participants. Basis contracts \16\

    allow traders to more accurately discover prices at alternative

    locations and hedge price risk that is associated with natural gas at

    such locations.\17\ In this regard, a position at

    [[Page 24651]]

    a local price for an alternative location can be established by adding

    the appropriate basis swap position to a position taken in the NYMEX

    physically-delivered Henry Hub contract (or in the NYMEX or ICE Henry

    Hub look-alike contract, which cash settle based on the NYMEX

    physically-delivered natural gas contract's final settlement price).

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    \16\ Basis contracts denote the difference in the price of

    natural gas at a specified location minus the price of natural gas

    at the Henry Hub. The differential can be either a positive or

    negative value.

    \17\ Commercial activity in natural gas basis swap contracts is

    evidenced by large positions held by energy trading firms in the

    comparable NYMEX ClearPort basis swap contract for the Socal hub.

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    In its October 20, 2009, Federal Register notice, the Commission

    identified material liquidity, price linkage and material price

    reference as the potential SPDC criteria applicable to the SCL

    contract. Each of these criteria is discussed below.\18\

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    \18\ As noted above, the Commission did not find an indication

    of arbitrage in connection with this contract; accordingly, that

    criterion was not discussed in reference to the SCL contract.

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    1. Material Price Reference Criterion

    The Commission's October 20, 2009, Federal Register notice

    identified material price reference as a potential basis for a SPDC

    determination with respect to this contract. The Commission considered

    the fact that ICE maintains exclusive rights over IPI's bidweek price

    indices. As a result, no other exchange can offer such a basis contract

    based on IPI's Socal bidweek index. While other third-party price

    providers produce natural gas price indices for this and other trading

    centers, market participants indicate that the IPI Socal bidweek index

    is highly regarded for this particular location and should market

    participants wish to establish a hedged position based on this index,

    they would need to do so by taking a position in the ICE SCL swap since

    ICE has the right to the IPI index for cash settlement purposes. In

    addition, ICE sells its price data to market participants in a number

    of different packages which vary in terms of the hubs covered, time

    periods, and whether the data are daily only or historical. For

    example, ICE offers the ``West Gas End of Day'' and ``OTC Gas End of

    Day'' \19\ packages with access to all price data or just current

    prices plus a selected number of months (i.e., 12, 24, 36 or 48 months)

    of historical data. These two packages include price data for the SCL

    contract.

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    \19\ The OTC Gas End of Day dataset includes daily settlement

    prices for natural gas contracts listed for all points in North

    America.

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    The Socal Border hub is a major trading center for natural gas in

    the United States. Traders, including producers, keep abreast of the

    prices of the SCL contract when conducting cash deals. These traders

    look to a competitively determined price as an indication of expected

    values of natural gas at the Socal Border when entering into cash

    market transactions for natural gas, especially those trades providing

    for physical delivery in the future. Traders use the ICE SCL contract,

    as well as other ICE basis swap contracts, to hedge cash market

    positions and transactions--activities which enhance the SCL contract's

    price discovery utility. The substantial volume of trading and open

    interest in the SCL contract appears to attest to its use for this

    purpose. While the SCL contract's settlement prices may not be the only

    factor influencing spot and forward transactions, natural gas traders

    consider the ICE price to be a critical factor in conducting OTC

    transactions.\20\

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    \20\ In addition to referencing ICE prices, natural gas market

    firms participating in the Socal market may rely on other cash

    market quotes as well as industry publications and price indices

    that are published by third-party price reporting firms in entering

    into natural gas transactions.

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    NYMEX lists a futures contract that is comparable to the ICE SCL

    contract on its ClearPort platform. However, unlike the ICE contract,

    none of the trades in the NYMEX SoCal Basis Swap are executed in

    NYMEX's centralized marketplace; instead, all of the transactions

    originate as bilateral swaps that are submitted to NYMEX for clearing.

    The daily settlement prices of the NYMEX SoCal Basis Swap contract are

    influenced, in part, by the daily settlement prices of the ICE SCL

    contract. This is because NYMEX determines the daily settlement prices

    for its natural gas basis swap contracts through a survey of cash

    market voice brokers. Voice brokers, in turn, refer to the ICE SCL

    price, among other information, as an important indicator as to where

    the market is trading. Therefore, the ICE SCL price influences the

    settlement price for the NYMEX SoCal Basis Swap contract. This is

    supported by an analysis of the daily settlement prices for the NYMEX

    and ICE Socal basis swap contracts. In this regard, 99 percent of the

    daily settlement prices for the NYMEX SoCal Basis Swap contract are

    within one standard deviation of the SCL contract's settlement prices.

    Lastly, the fact that the SCL contract does not meet the price

    linkage criterion (discussed below) bolsters the argument for material

    price reference. As noted above, the Henry Hub is the pricing reference

    for natural gas in the United States. However, regional market

    conditions may cause the price of natural gas in another area of the

    country to diverge by more than the cost of transportation, thus making

    the Henry Hub price an imperfect proxy for the local gas price. The

    more variable the local natural gas price is, the more traders need to

    accurately hedge their price risk. Basis swap contracts provide a means

    of more accurately pricing natural gas at a location other than the

    Henry Hub. An analysis of Socal natural gas prices showed that 93

    percent of the observations were more than 2.5 percent different that

    the contemporaneous Henry Hub prices. Specifically, the average Socal

    basis value between January 2008 and September 2009 was -$0.78 per

    mmBtu with a variance of $0.29 per mmBtu.

    i. Federal Register Comments

    As noted above, ICE was the sole respondent which addressed the

    question of whether the SCL contract is a SPDC. ICE stated in its

    comment letter that the SCL contract does not meet the material price

    reference criterion for SPDC determination. ICE argued that the

    Commission appeared to base the case that the SCL contract is

    potentially a SPDC on two disputable assertions. First, in issuing its

    notice of intent to determine whether the SCL contract is a SPDC, the

    CFTC cited a general conclusion in its ECM study ``that certain market

    participants referred to ICE as a price discovery market for certain

    natural gas contracts.'' ICE states that, ``Basing a material price

    reference determination on general statements made in a two year old

    study does not seem to meet Congress' intent that the CFTC use its

    considerable expertise to study the OTC markets.'' In response to the

    above comment, the Commission notes that it cited the ECM study's

    general finding that some ICE natural gas contracts appear to be

    regarded as price discovery markets merely as an indicia that an

    investigation of certain ICE contracts may be warranted, and was not

    intended to serve as the sole basis for determining whether or not a

    particular contract meets the material price reference criterion.

    Second, ICE argued that the Commission should not base a

    determination that the SCL contract is a SPDC merely because this

    contract has the exclusive right to base its settlement on the IPI

    Socal Border Index price. While the Commission acknowledges that there

    are other firms that produce price indices for the Socal hub, as it

    notes above, market participants indicate that the IPI Index is very

    highly regarded and should they wish to establish a hedged position

    based on this index, they would need to do so by taking a position in

    the ICE SCL swap

    [[Page 24652]]

    since ICE has the exclusive right to use the IPI index.\21\

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    \21\ Futures and swaps based on other Socal indices have not met

    with the same market acceptance as the SCL contract. For example,

    NYMEX lists a basis swap contract that is comparable to the SCL

    contract with the exception that it uses a different price index for

    cash settlement. Open interest as of September 30, 2009, was

    approximately 75,000 contracts in the NYMEX SoCal Basis Swap

    contract versus nearly 400,000 contracts in ICE's SCL contract.

    Moreover, there has been no centralized-market trading in the NYMEX

    Socal Basis Swap contract, so that contract does not serve as a

    source of price discovery for cash market traders with natural gas

    at that location.

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    ii. Conclusion Regarding Material Price Reference

    Based on the above, the Commission finds that the SCL contract

    meets the material price reference criterion because it is referenced

    and consulted on a frequent and recurring basis by cash market

    participants when pricing transactions (direct evidence). Moreover, the

    ECM sells the SCL contract's price data to market participants

    (indirect evidence).

    2. Price Linkage Criterion

    In its October 20, 2009, Federal Register notice, the Commission

    identified price linkage as a potential basis for a SPDC determination

    with respect to the SCL contract. In this regard, the final settlement

    of the SCL contract is based, in part, on the final settlement price of

    the NYMEX's physically-delivered natural gas futures contract, where

    the NYMEX is registered with the Commission as a DCM.

    The Commission's Guidance on Significant Price Discovery Contracts

    \22\ notes that a ``price-linked contract is a contract that relies on

    a contract traded on another trading facility to settle, value or

    otherwise offset the price-linked contract.'' Furthermore, the Guidance

    notes that, ``[f]or a linked contract, the mere fact that a contract is

    linked to another contract will not be sufficient to support a

    determination that a contract performs a significant price discovery

    function. To assess whether such a determination is warranted, the

    Commission will examine the relationship between transaction prices of

    the linked contract and the prices of the referenced contract. The

    Commission believes that where material liquidity exists, prices for

    the linked contract would be observed to be substantially the same as

    or move substantially in conjunction with the prices of the referenced

    contract.'' Furthermore, the Guidance proposes a threshold price

    relationship such that prices of the ECM linked contract will fall

    within a 2.5 percent price range for 95 percent of contemporaneously

    determined closing, settlement or other daily prices over the most

    recent quarter. Finally, the Commission also stated in the Guidance

    that it would consider a linked contract that has a trading volume

    equivalent to 5 percent of the volume of trading in the contract to

    which it is linked to have sufficient volume potentially to be deemed a

    SPDC (``minimum threshold'').

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    \22\ Appendix A to the Part 36 rules.

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    To assess whether the SCL contract meets the price linkage

    criterion, Commission staff obtained price data from ICE and performed

    the statistical tests cited above. Staff found that, while the Socal

    Border price is determined, in part, by the final settlement price of

    the NYMEX physically-delivered natural gas futures contract (a DCM

    contract), the Socal hub price is not within 2.5 percent of the

    settlement price of the corresponding NYMEX Henry Hub natural gas

    futures contract on 95 percent or more of the days. Specifically,

    during the third quarter of 2009, only 7 percent of the Socal Border

    natural gas prices derived from the ICE basis values were within 2.5

    percent of the daily settlement price of the NYMEX Henry Hub futures

    contract. In addition, staff found that the SCL contract fails to meet

    the volume threshold requirement. In particular, the total trading

    volume in the NYMEX physically-delivered natural gas contract during

    the third quarter of 2009 was 14,022,963 contracts, with 5 percent of

    that number being 701,148 contracts. The number of trades on the ICE

    centralized market in the SCL contract during the same period was

    507,870 contracts (equivalent to 126,967 NYMEX contracts, given the

    size difference).\23\ Thus, centralized-market trades in the SCL

    contract amounted to less than the minimum threshold.

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    \23\ The SCL contract is one-quarter the size of the NYMEX Henry

    Hub physically-delivered futures contract.

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    Due to the specific criteria that a given ECM contract must meet to

    fulfill the price linkage criterion, the requirements, for all intents

    and purposes, exclude ECM contracts that are not near facsimiles of DCM

    contracts even though the ECM contract may specifically use the

    settlement price to value a position, which is the case of the SCL

    contract. In this regard, an ECM contract that is priced and traded as

    if it is a functional equivalent of a DCM contract likely will have a

    price series that mirrors that of the corresponding DCM contract. In

    contrast, for contracts that are not look-alikes of DCM contracts, it

    is reasonable to expect that the two price series would be divergent.

    The Socal Border hub and the Henry Hub are located in two different

    areas of the United States. Moreover, the Henry Hub is primarily a

    supply center while Southern California is a demand center. These

    differences contribute to the divergence between the two price series

    and, as discussed below, increase the likelihood that the ``basis''

    contract is used for material price reference.

    i. Federal Register Comments

    As noted above, ICE was the sole respondent which addressed the

    question of whether the SCL contract is a SPDC. ICE stated in its

    comment letter that the SCL contract does not meet the price linkage

    criterion for SPDC determination because it fails the volume test

    provided in the Commission's Guidance.

    ii. Conclusion Regarding the Price Linkage Criterion

    Based on the above, the Commission finds that the SCL contract does

    not meet the price linkage criterion because it fails the price

    relationship and volume tests provided for in the Commission's

    Guidance.

    3. Material Liquidity Criterion

    To assess whether the SCL contract meets the material liquidity

    criterion, the Commission first examined volume and open interest data

    provided to it by ICE as a general measurement of the SCL market's size

    and potential importance, and second performed a statistical analysis

    to measure the effect that changes to SCL prices potentially may have

    on prices for the NYMEX Henry Hub Natural Gas (a DCM contract), the ICE

    AECO Financial Basis contract (an ECM contract) and the HSC \24\

    Financial Basis contract (an ECM contract).\25\

    ---------------------------------------------------------------------------

    \24\ The acronym stands for Houston Ship Channel.

    \25\ As noted above, the material liquidity criterion speaks to

    the effect that transactions in the potential SPDC may have on

    trading in ``agreements, contracts and transactions listed for

    trading on or subject to the rules of a designated contract market,

    a derivatives transaction execution facility, or an electronic

    trading facility operating in reliance on the exemption in section

    2(h)(3) of the Act.''

    ---------------------------------------------------------------------------

    The Commission's Guidance (Appendix A to Part 36) notes that

    ``[t]raditionally, objective measures of trading such as volume or open

    interest have been used as measures of liquidity.'' In this regard, the

    Commission in its October 20, 2009, Federal Register notice referred to

    second quarter 2009 trading statistics that ICE had submitted for its

    SCL contract. Based upon on a required quarterly filing made by ICE on

    July 27, 2009, the total number of SCL trades

    [[Page 24653]]

    executed on ICE's electronic trading platform was 8,102 in the second

    quarter of 2009, resulting in a daily average of 126.6 trades. During

    the same period, the SCL contract had a total trading volume on ICE's

    electronic trading platform of 612,452 contracts and an average daily

    trading volume of 9,569 contracts. Moreover, the open interest as of

    June 30, 2009, was 417,121 contracts, which included trades executed on

    ICE's electronic trading platform, as well as trades executed off of

    ICE's electronic trading platform and then brought to ICE for

    clearing.\26\

    ---------------------------------------------------------------------------

    \26\ ICE does not differentiate between open interest created by

    a transaction executed on its trading platform versus that created

    by a transaction executed off its trading platform. 74 FR 53723

    (October 20, 2009).

    ---------------------------------------------------------------------------

    Subsequent to the October 20, 2009, Federal Register notice, ICE

    submitted another quarterly notification filed on November 13,

    2009,\27\ with updated trading statistics. Specifically, with respect

    to its SCL contract, 7,080 separate trades occurred on its electronic

    platform in the third quarter of 2009, resulting in a daily average of

    107.3 trades. During the same period, the SCL contract had a total

    trading volume on its electronic platform of 507,870 contracts (which

    was an average of 7,695 contracts per day).\28\ As of September 30,

    2009, open interest in the SCL contract was 398,875 contracts.\29\

    Reported open interest included positions resulting from trades that

    were executed on ICE's electronic platform, as well as trades that were

    executed off of ICE's electronic platform and brought to ICE for

    clearing.

    ---------------------------------------------------------------------------

    \27\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).

    \28\ By way of comparison, the number of contracts traded in the

    SCL contract is similar to that exhibited on a liquid futures market

    and is roughly equivalent to the volume of trading for the ICE

    Futures U.S. Cotton No. 2 futures contract during this period.

    \29\ By way of comparison, open interest in the SCL contract is

    roughly equivalent to that in the Chicago Board of Trade's soybean

    contract and the Commodity Exchange's Gold futures contract.

    ---------------------------------------------------------------------------

    In Appendix A to Part 36, the material liquidity criterion for SPDC

    determination specifies that an ECM contract should have a material

    effect on another contract. To measure the effect that the SCL contract

    potentially could have on a DCM contract, or on another ECM contract,

    Commission staff performed a statistical analysis \30\ using daily

    settlement prices (between January 2, 2008, and September 30, 2009) for

    the NYMEX Henry Hub natural gas contract (a DCM contract) and price

    levels for the Alberta, Houston Ship Channel (``HSC''), and Socal

    market centers.\31\ The simulation results suggest that, on average

    over the sample period, a one percent rise in the Socal natural gas

    price elicited a 0.8 percent increase in each of the Alberta, HSC, and

    NYMEX Henry Hub prices.

    ---------------------------------------------------------------------------

    \30\ Specifically, the Commission econometrically estimated a

    vector autoregression model using daily natural gas price levels. A

    vector autoregression model is an econometric model used to capture

    the dependencies and interrelationships among multiple time series,

    generalizing the univariate autoregression model. The estimated

    model displays strong diagnostic evidence of statistical adequacy.

    In particular, the model's impulse response function was shocked

    with a one-time rise in Socal price. The simulation results suggest

    that, on average over the sample period, a one percent rise in the

    Socal natural gas price elicited a 0.8 percent increase in the NYMEX

    Henry Hub price, as well as a 0.8 percent increase in each of the

    other two modeled natural gas prices. These multipliers of response

    emerge with noticeable statistical strength or significance. Based

    on such long run sample patterns, if the Socal price rises by 10

    percent, then the price of NYMEX Henry Hub natural gas futures

    contract, as well as those for the Alberta and HSC hubs, each would

    rise by about 8 percent.

    \31\ Natural gas prices at the Alberta, HSC, and Socal trading

    centers were obtained by adding the daily settlement prices of ICE's

    AECO Financial Basis, HSC Financial Basis and Socal Border Financial

    Basis contracts, respectively, to the contemporaneous daily

    settlement prices of the NYMEX Henry Hub physically-delivered

    natural gas futures contract.

    ---------------------------------------------------------------------------

    i. Federal Register Comments

    As noted above, ICE was the sole respondent which addressed the

    question of whether the SCL contract is a SPDC. ICE stated in its

    comment letter that the SCL contract does not meet the material

    liquidity criterion for SPDC determination for a number of reasons.

    First, ICE opined that the Commission ``seems to have adopted a

    five trade-per-day test to determine whether a contract is materially

    liquid. It is worth noting that ICE originally suggested that the CFTC

    use a five trades-per-day threshold as the basis for an ECM to report

    trade data to the CFTC.'' In this regard, the Commission adopted a five

    trades-per-day threshold as a reporting requirement to enable it to

    ``independently be aware of ECM contracts that may develop into SPDCs''

    \32\ rather than solely relying upon an ECM on its own to identify any

    such potential SPDCs to the Commission. Thus, any contract that meets

    this threshold may be subject to scrutiny as a potential SPDC; the

    threshold is not intended to define liquidity in a broader sense. As

    noted above, the Commission is basing a finding of material liquidity

    for the ICE SCL contract, in part, on the fact that there were over 100

    trades per day on average in the SCL contract during the last two

    reporting quarters of 2009, which was far more than the five trades-

    per-day threshold that is cited in the ICE comment. In addition, the

    Commission notes that the number of contracts per transaction in the

    SCL contract is high (approximately 72 contracts per transaction) and

    thus, as noted, trading volume (measured in contract units) is

    substantial. The SCL contract also has substantial open interest.

    ---------------------------------------------------------------------------

    \32\ 73 FR 75892 (December 12, 2008).

    ---------------------------------------------------------------------------

    ICE also stated that ``the statistics [provided by ICE] have been

    misinterpreted and misapplied.'' In particular, ICE stated that the

    volume figures used in the Commission's analysis (cited above)

    ``include trades made in all 120 months of each contract'' as well as

    in strips of contract months, and a ``more appropriate method of

    determining liquidity is to examine the activity in a single traded

    month or strip of a given contract.'' Furthermore, ICE noted that for

    the SCL contract, ``about 29% of the trades occurred in the single most

    liquid, usually prompt, month of the contract.''

    It is the Commission's opinion that liquidity, as it pertains to

    the SCL contract, is typically a function of trading activity in

    particular lead months and, given sufficient liquidity in such months,

    the SCL contract itself would be considered liquid. ICE's analysis of

    its own trade data confirms this to be the case for the SCL contract,

    and thus, the Commission believes that it applied the statistical data

    cited above in an appropriate manner for gauging material liquidity.

    In addition, ICE stated that the trades-per-day statistics that it

    provided to the Commission in its quarterly filing and which are cited

    above includes 2(h)(1) transactions, which were not completed on the

    electronic trading platform and should not be considered in the SPDC

    determination process. The Commission staff asked ICE to review the

    data it sent in its quarterly filings. In response, ICE confirmed that

    the volume data it provided and which the Commission cited in its

    October 20, 2009, Federal Register notice, as well as the additional

    volume information it cites above, includes only transaction data

    executed on ICE's electronic trading platform.\33\ The Commission

    acknowledges that the open interest information it cites above includes

    transactions made off the ICE platform. However, once open interest is

    created, there is no way for ICE to differentiate between ``on-

    exchange'' versus ``off-exchange'' created positions, and all such

    positions are fungible with one another and may be offset in any

    [[Page 24654]]

    way agreeable to the position holder regardless of how the position was

    initially created.

    ---------------------------------------------------------------------------

    \33\ Supplemental data supplied by ICE confirmed that block

    trades in the third quarter of 2009 were in addition to the trades

    that were conducted on the electronic platform; block trades

    comprised 45.7 percent of all transactions in the SCL contract.

    ---------------------------------------------------------------------------

    ii. Conclusion Regarding Material Liquidity

    Based on the above, the Commission concludes that the SCL contract

    meets the material liquidity criterion in that there is sufficient

    trading activity in the SCL contract to have a material effect on

    ``other agreements, contracts or transactions listed for trading on or

    subject to the rules of a designated contract market * * * or an

    electronic trading facility operating in reliance on the exemption in

    section 2(h)(3) of the Act'' (that is, an ECM).

    4. Overall Conclusion

    After considering the entire record in this matter, including the

    comments received, the Commission has determined that the SCL contract

    performs a significant price discovery function under two of the four

    criteria established in section 2(h)(7) of the CEA. Although the

    Commission has determined that the SCL contract does not meet the price

    linkage criterion at this time, the Commission has determined that the

    SCL contract does meet both the material liquidity and material price

    reference criteria. Accordingly, the Commission will issue the attached

    Order declaring that the SCL contract is a SPDC.

    Issuance of this Order signals the immediate effectiveness of the

    Commission's authorities with respect to ICE as a registered entity in

    connection with its SCL contract,\34\ and triggers the obligations,

    requirements--both procedural and substantive--and timetables

    prescribed in Commission rule 36.3(c)(4) for ECMs.

    ---------------------------------------------------------------------------

    \34\ See 73 FR 75888, 75893 (Dec. 12, 2008).

    ---------------------------------------------------------------------------

    V. Related Matters

    a. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') \35\ imposes certain

    requirements on Federal agencies, including the Commission, in

    connection with their conducting or sponsoring any collection of

    information as defined by the PRA. Certain provisions of Commission

    rule 36.3 impose new regulatory and reporting requirements on ECMs,

    resulting in information collection requirements within the meaning of

    the PRA. OMB previously has approved and assigned OMB control number

    3038-0060 to this collection of information.

    ---------------------------------------------------------------------------

    \35\ 44 U.S.C. 3507(d).

    ---------------------------------------------------------------------------

    b. Cost-Benefit Analysis

    Section 15(a) of the CEA \36\ requires the Commission to consider

    the costs and benefits of its actions before issuing an order under the

    Act. By its terms, section 15(a) does not require the Commission to

    quantify the costs and benefits of an order or to determine whether the

    benefits of the order outweigh its costs; rather, it requires that the

    Commission ``consider'' the costs and benefits of its actions. Section

    15(a) further specifies that the costs and benefits shall be evaluated

    in light of five broad areas of market and public concern: (1)

    Protection of market participants and the public; (2) efficiency,

    competitiveness and financial integrity of futures markets; (3) price

    discovery; (4) sound risk management practices; and (5) other public

    interest considerations. The Commission may in its discretion give

    greater weight to any one of the five enumerated areas and could in its

    discretion determine that, notwithstanding its costs, a particular

    order is necessary or appropriate to protect the public interest or to

    effectuate any of the provisions or accomplish any of the purposes of

    the Act. The Commission has considered the costs and benefits in light

    of the specific provisions of section 15(a) of the Act and has

    concluded that the Order, required by Congress to strengthen federal

    oversight of exempt commercial markets and to prevent market

    manipulation, is necessary and appropriate to accomplish the purposes

    of section 2(h)(7) of the Act.

    ---------------------------------------------------------------------------

    \36\ 7 U.S.C. 19(a).

    ---------------------------------------------------------------------------

    When a futures contract begins to serve a significant price

    discovery function, that contract, and the ECM on which it is traded,

    warrants increased oversight to deter and prevent price manipulation or

    other disruptions to market integrity, both on the ECM itself and in

    any related futures contracts trading on DCMs. An Order finding that a

    particular contract is a SPDC triggers this increased oversight and

    imposes obligations on the ECM calculated to accomplish this goal. The

    increased oversight engendered by the issue of a SPDC Order increases

    transparency and helps to ensure fair competition among ECMs and DCMs

    trading similar products and competing for the same business. Moreover,

    the ECM on which the SPDC is traded must assume, with respect to that

    contract, all the responsibilities and obligations of a registered

    entity under the CEA and Commission regulations. Additionally, the ECM

    must comply with nine core principles established by section 2(h)(7) of

    the Act--including the obligation to establish position limits and/or

    accountability standards for the SPDC. Section 4(i) of the CEA

    authorizes the Commission to require reports for SPDCs listed on ECMs.

    These increased responsibilities, along with the CFTC's increased

    regulatory authority, subject the ECM's risk management practices to

    the Commission's supervision and oversight and generally enhance the

    financial integrity of the markets.

    c. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') \37\ requires that

    agencies consider the impact of their rules on small businesses. The

    requirements of CEA section 2(h)(7) and the Part 36 rules affect ECMs.

    The Commission previously has determined that ECMs are not small

    entities for purposes of the RFA.\38\ Accordingly, the Chairman, on

    behalf of the Commission, hereby certifies pursuant to 5 U.S.C. 605(b)

    that this Order, taken in connection with section 2(h)(7) of the Act

    and the Part 36 rules, will not have a significant impact on a

    substantial number of small entities.

    ---------------------------------------------------------------------------

    \37\ 5 U.S.C. 601 et seq.

    \38\ 66 FR 42256, 42268 (Aug. 10, 2001).

    ---------------------------------------------------------------------------

    VI. Order

    a. Order Relating to the ICE Socal Border Financial Basis Contract

    After considering the complete record in this matter, including the

    comment letters received in response to its request for comments, the

    Commission has determined to issue the following:

    The Commission, pursuant to its authority under section 2(h)(7) of

    the Act, hereby determines that the Socal Border Financial Basis

    contract, traded on the IntercontinentalExchange, Inc., satisfies the

    statutory material liquidity and material price reference criteria for

    significant price discovery contracts. Consistent with this

    determination, and effective immediately, the IntercontinentalExchange,

    Inc., must comply with, with respect to the ICE Socal Border Financial

    Basis contract, the nine core principles established by new section

    2(h)(7)(C). Additionally, the IntercontinentalExchange, Inc., shall be

    and is considered a registered entity \39\ with respect to the Socal

    Border Financial Basis contract and is subject to all the provisions of

    the Commodity Exchange Act applicable to registered entities.

    ---------------------------------------------------------------------------

    \39\ 7 U.S.C. 1a(29).

    ---------------------------------------------------------------------------

    Further, the obligations, requirements and timetables prescribed in

    Commission rule 36.3(c)(4) governing

    [[Page 24655]]

    core principle compliance by the IntercontinentalExchange, Inc.,

    commence with the issuance of this Order.\40\

    ---------------------------------------------------------------------------

    \40\ Because ICE already lists for trading a contract (i.e., the

    Henry Financial LD1 Fixed Price contract) that was previously

    declared by the Commission to be a SPDC, ICE must submit a written

    demonstration of compliance with the Core Principles within 30

    calendar days of the date of this Order. 17 CFR 36.3(c)(4).

    Issued in Washington, DC, on April 28, 2010, by the Commission.

    David A. Stawick,

    Secretary of the Commission.

    [FR Doc. 2010-10335 Filed 5-4-10; 8:45 am]

    BILLING CODE P

    Last Updated: May 5, 2010



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