2010-10304

FR Doc 2010-10304[Federal Register: May 4, 2010 (Volume 75, Number 85)]

[Notices]

[Page 23704-23710]

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

[DOCID:fr04my10-63]

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COMMODITY FUTURES TRADING COMMISSION

Order Finding That the NWP Rockies 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 22, 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 NWP \2\ Rockies Financial Basis (``NWR'') 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. 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 NWR 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 54550 (October 22, 2009).

\2\ The acronym ``NWP'' indicates the Northwest Pipeline.

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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: [email protected]; Christa Lachenmayr,

Economist, Division of Market Oversight, same address. Telephone: (202)

418-5252. E-mail: [email protected]; or Susan Nathan, Senior Special

Counsel, Division of Market Oversight, same address. Telephone: (202)

418-5133. E-mail: [email protected]

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--ECMs on which significant price discovery contracts

(``SPDCs'') are traded--and treating ECMs in that category as

registered entities under the CEA.\4\ 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).

\4\ 7 U.S.C. 1a(29).

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

the provisions of the Reauthorization Act.\5\ 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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\5\ 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.\6\ The issuance of such an order also triggers the

obligations, requirements and timetables prescribed in Commission rule

36.3(c)(4).\7\

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\6\ Pub. L. 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).

\7\ 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 22, 2009, the Commission published in the Federal

Register notice of its intent to undertake a

[[Page 23705]]

determination whether the NWR contract performs a significant price

discovery function and requested comment from interested parties.\8\

Comments were received from the Federal Energy Regulatory Commission

(``FERC''), Platts, Economists Incorporated (``EI'') and ICE.\9\ The

comment letters from FERC \10\ and Platts did not directly address the

issue of whether or not the NWR contract is a SPDC; ICE's and EI's

comments raised substantive issues with respect to the applicability of

section 2(h)(7) the NWR contract, generally asserting that the NWR

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

material price reference and price linkage criteria for SPDC

determination. ICE's and EI's comments are more extensively discussed

below, as applicable.

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\8\ 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.

\9\ 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 ECM, as noted above. EI

is an economic consulting firm with offices located in Washington,

DC, and San Francisco, CA. The comment letters are available on the

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

federalregister/federalregistercomments/2009/09-031.html.

\10\ FERC stated that the NWR contract is cash settled and does

not contemplate the actual physical delivery of natural gas.

Acccordingly, 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).

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.\11\ 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.\12\ 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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\11\ In its October 22, 2009, Federal Register release, the

Commission identified material price reference, price linkage and

material liquidity as the possible criteria for SPDC determination

of the NWR contract. Arbitrage was not identified as a possible

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

associated Order.

\12\ 17 CFR Part 36, Appendix A.

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IV. Findings and Conclusions

a. The NWP Rockies Financial Basis (NWR) Contract and the SPDC Indicia

The ICE NWR contract is cash settled based on the difference

between the bidweek price of natural gas at the Northwest Pipeline's

Rockies hub for the month of delivery, as published in Platts' Inside

FERC's Gas Market Report, and the final settlement price for the New

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

natural gas futures contract for the same specified calendar month. The

Platts bidweek price, which is published monthly, is based on a survey

of cash market traders who voluntarily report to Platts data on fixed-

price transactions for physical delivery of natural gas at the Rockies

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 Platts 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 NWR contract is 2,500 million British thermal units (``mmBtu''),

and the unit of trading is any multiple of 2,500 mmBtu. The NWR

contract is listed for up to 120 calendar months commencing with the

next calendar month.

The Henry Hub,\13\ which is located in Erath, Louisiana, is the

primary cash market trading and distribution center for natural gas in

the United States. It

[[Page 23706]]

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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\13\ 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.\14\ Some of the major trading centers include

Alberta, Northwest Rockies, Southern California border region 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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\14\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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The Northwest Pipeline's Rockies hub is located in Wyoming, Utah

and Colorado.\15\ The Northwest Pipeline draws natural gas supplies

from the Rocky Mountain region and ships it along a 3,900-mile, bi-

directional transmission system to markets throughout the Rockies and

Pacific Northwest. The Opal market center, a trading region that

includes the Rockies hub, had an estimated throughput capacity of 1.5

billion cubic feet per day in 2008. Moreover, the number of pipeline

interconnections at the Opal market center was eight in 2008, up from

four interconnections in 2003. Lastly, the pipeline interconnection

capacity of the Opal market center in 2008 was six billion cubic feet

per day, which constituted an 86 percent increase over the pipeline

interconnection capacity in 2003.\16\ The Rockies 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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\15\ The Rockies hub includes fixed-price gas delivered into

Northwest Pipeline's mainline in Wyoming, Utah and Colorado between

the Kemmerer and Moab stations. Deliveries at Ignacio, CO, and

elsewhere in zone MO (the area South of Moab, UT, into the San Juan

Mountains) are excluded. Transactions done at Opal, WY, and the

Muddy Creek compressor station (where the Northwest Pipeline

connects with Kern River Gas Transmission, Questar Pipeline and

Colorado Interstate Gas) are used because gas traded at those two

points often is not nominated into a specific pipeline.

\16\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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The local price at the Rockies 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 Rockies price. Moreover,

exogenous factors, such as adverse weather, can cause the Rockies 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 \17\ allow traders to more accurately

discover prices at alternative locations and hedge price risk that is

associated with natural gas at such locations.\18\ In this regard, a

position at 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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\17\ 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.

\18\ 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 Rockies hub.

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In its October 22, 2009, Federal Register notice, the Commission

identified material price reference, price linkage and material

liquidity as the potential SPDC criteria applicable to the NWR

contract. Each of these criteria is discussed below.\19\

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\19\ 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 NWR contract.

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1. Material Price Reference Criterion

The Commission's October 22, 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 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'' \20\ 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 NWR

contract.

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\20\ 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 Rockies hub is a major trading center for natural gas in the

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

of the NWR contract when conducting cash deals. These traders look to a

competitively determined price as an indication of expected values of

natural gas at the Rockies hub when entering into cash market

transactions for natural gas, especially those trades that provide for

physical delivery in the future. Traders use the ICE NWR contract, as

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

and transactions--activities which enhance the NWR contract's price

discovery utility. The substantial volume of trading and open interest

in the NWR contract appears to attest to its use for this purpose.

While the NWR 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.\21\

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\21\ In addition to referencing ICE prices, natural gas market

firms participating in the Rockies 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 when

entering into natural gas transactions.

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

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

none of the trades in the NYMEX Rockies Basis Swap (Platts IFERC)

futures contract are executed in NYMEX's centralized marketplace;

instead, all of the transactions originate as bilateral swaps that are

submitted to

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NYMEX for clearing. The daily settlement prices of the NYMEX Rockies

Basis Swap contract are influenced, in part, by the daily settlement

prices of the ICE NWR 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 NWR price, among other information, as an important

indicator as to where the market is trading. Therefore, the ICE NWR

price influences the settlement price for the NYMEX Rockies Basis Swap

contract. This is supported by an analysis of the daily settlement

prices for the NYMEX and ICE Rockies basis swap contracts. In this

regard, 98 percent of the daily settlement prices for the NYMEX Rockies

Basis Swap contract are within one standard deviation of the NWR

contract's settlement prices.

Lastly, the fact that the NWR 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 Rockies natural gas prices showed that all of

the observations were more than 2.5 percent different than the

contemporaneous Henry Hub prices. Specifically, the average Rockies

basis value between January 2008 and September 2009 was -$1.94 per

mmBtu with a variance of $1.88 per mmBtu.

i. Federal Register Comments

Both EI and ICE stated in their comment letters that the NWR

contract does not meet the material price reference criterion for SPDC

determination. ICE argued that the Commission appeared to base the case

that the NWR contract is potentially a SPDC on a disputable assertion.

In issuing its notice of intent to determine whether the NWR 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 stated 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.

EI also stated that the NWR contract does not satisfy the material

price reference criterion. The commenter argued that other contracts

(physical or financial) are not indexed based on the ICE NWR contract

price, but rather are indexed based on the underlying cash price series

against which the NWR contract is settled. Thus, EI contends that the

underlying cash price series is the authentic reference price and not

the ICE contract itself. The Commission believes that this

interpretation of price reference is too limiting in that it only

considers the final index value on which the contract is cash settled

after trading ceases. Instead, the Commission believes that a cash-

settled derivatives contract could meet the price reference criteria if

market participants ``consult on a frequent and recurring basis'' the

derivatives contract when pricing forward, fixed-price commitments or

other cash-settled derivatives that seek to ``lock in'' a fixed price

for some future point in time to hedge against adverse price movements.

EI also argued that publication of price data in a package format

is a weak justification for material price reference. According to the

commenter, market participants generally do not purchase ICE data sets

for one contract's prices, so the fact that ICE sells the NWR prices as

part of a broad package is not conclusive evidence that market

participants are buying the ICE data sets because they find the NWR

prices have substantial value to them. The Commission notes that the

Rockies hub is a major natural gas trading point, and the NWR

contract's prices are well regarded in the industry as indicative of

the value of natural gas at the Rockies hub. Accordingly, the

Commission believes that it is reasonable to conclude that market

participants are purchasing the data packages that include the NWR

contract's prices in substantial part because the NWR contract prices

have particular value to them.

ii. Conclusion Regarding Material Price Reference

Based on the above, the Commission finds that the NWR 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 NWR contract's price data to market participants

(indirect evidence).

2. Price Linkage Criterion

In its October 22, 2009, Federal Register notice, the Commission

identified price linkage as a potential basis for a SPDC determination

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

of the NWR 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 NWR 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 Rockies

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

NYMEX physically-delivered natural gas futures contract (a DCM

contract), the Rockies 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 2.4 percent of the Rockies

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 NWR 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 NWR contract during the same period was

279,905 contracts (equivalent to 69,976 NYMEX contracts, given the size

difference).\23\ Thus, centralized-market trades in the NWR contract

amounted to less than the minimum threshold.

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\23\ The NWR 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 NWR

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.

While the Rockies hub and the Henry Hub are both supply centers, they

are located in two different areas of the United States. Moreover, the

Rockies hub is somewhat isolated and the two hubs are not directly

connected to each other. These differences contribute to the divergence

between the two price series and, as discussed above, increase the

likelihood that the ``basis'' contract is used for material price

reference.

i. Federal Register Comments

As noted above, ICE and EI addressed the question of whether the

NWR contract is a SPDC. EI noted that the NWR and NYMEX natural gas

contracts are not economically equivalent and that the NWR contract's

volume is too low to affect the NYMEX natural gas futures contract. ICE

opined that the NWR contract's trading volume is too low to affect the

price discovery process for the NYMEX natural gas futures contract. In

addition, ICE states that the NWR contract simply reflects a price

differential between the Rockies and the Henry Hub; ``there is no price

linkage as contemplated by Congress or the CFTC in its rulemaking.''

ii. Conclusion Regarding the Price Linkage Criterion

Based on the above, the Commission finds that the NWR 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 NWR 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 NWR market's size

and potential importance, and second performed a statistical analysis

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

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

PG&E Citygate Financial Basis contract (an ECM contract) and the Malin

Financial Basis contract (an ECM contract).\24\

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\24\ 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.''

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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 22, 2009, Federal Register notice referred to

second quarter 2009 trading statistics that ICE had submitted for its

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

July 27, 2009, the total number of NWR trades executed on ICE's

electronic trading platform was 3,013 in the second quarter of 2009,

resulting in a daily average of 47.1 trades. During the same period,

the NWR contract had a total trading volume on ICE's electronic trading

platform of 276,187 contracts and an average daily trading volume of

4,315 contracts. Moreover, the open interest as of June 30, 2009, was

349,931 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.\25\

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\25\ 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 54550

(October 22, 2009).

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Subsequent to the October 22, 2009, Federal Register notice, ICE

submitted another quarterly notification filed on November 13,

2009,\26\ with updated trading statistics. Specifically, with respect

to its NWR contract, 2,950 separate trades occurred on its electronic

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

44.7 trades. During the same period, the NWR contract had a total

trading volume on its electronic platform of 279,905 contracts (which

was an average of 4,241 contracts per day).\27\ As of September 30,

2009, open interest in the NWR contract was 345,683 contracts.\28\

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.

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\26\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).

\27\ By way of comparison, the number of contracts traded in the

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

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

Mercantile Exchange Feeder Cattle futures contract during this

period.

\28\ By way of comparison, open interest in the NWR contract is

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

contract.

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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 NWR contract

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

Commission staff performed a statistical analysis \29\ using

[[Page 23709]]

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 Rockies, PG&E Citygate and Malin market

centers.\30\ The simulation results suggest that, on average over the

sample period, a one percent rise in the Rockies natural gas price

elicited a 0.254 percent to 0.276 percent increase in the PG&E Citygate

and Malin hub natural gas prices, and a 0.176 percent increase in the

NYMEX Henry Hub natural gas price.

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\29\ Specifically, Commission staff 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 Rockies price. The simulation results

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

in the Rockies natural gas price elicited a 0.176 percent increase

in the NYMEX Henry Hub price, as well as a 0.254 percent to 0.276

percent increase in 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

Rockies 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 1.5 percent to 2.5 percent. The

relatively small magnitude of the multipliers likely reflects the

fact that the Rockies hub is isolated and not directly connected to

the Henry Hub.

\30\ Natural gas prices at the Rockies, PG&E Citygate and Malin

trading centers were obtained by adding the daily settlement prices

of ICE's NWP Rockies Financial Basis, PG&E Citygate Financial Basis

and Malin Financial Basis contracts, respectively, to the

contemporaneous daily settlement prices of the NYMEX Henry Hub

physically-delivered natural gas futures contract.

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i. Federal Register Comments

As noted above, ICE and EI addressed the question of whether the

NWR contract is a SPDC. ICE stated in its comment letter that the NWR

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''

\31\ 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 NWR contract, in part, on the fact that there were nearly

45 trades per day on average in the NWR contract during the third

quarter 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 NWR contract

is high (approximately 95 contracts per transaction) and thus, as

noted, trading volume (measured in contract units) is substantial. The

NWR contract also has substantial open interest.

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\31\ 73 FR 75892 (December 12, 2008).

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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 NWR contract, ``28% of the trades actually executed in the ICE

platform occurred in the single most liquid, usually prompt, month of

the contract.'' EI also expressed its belief that the contract months

should be evaluated individually.

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

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

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

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

its own trade data confirms this to be the case for the NWR 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 and EI both 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 22, 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.\32\ 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 way agreeable to the position holder regardless of how the position

was initially created.

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\32\ 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 44.4 percent of all transactions in the NWR contract.

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ii. Conclusion Regarding Material Liquidity

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

meets the material liquidity criterion in that there is sufficient

trading activity in the NWR 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 NWR 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 NWR contract does not meet the price

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

NWR contract does meet both the material liquidity and material price

reference criteria. Accordingly, the Commission will issue the attached

Order declaring that the NWR 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 NWR contract,\33\ and triggers the obligations,

requirements--both procedural and substantive--and timetables

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

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\33\ See 73 FR 75888, 75893 (Dec. 12, 2008).

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V. Related Matters

a. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (``PRA'') \34\ 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

[[Page 23710]]

assigned OMB control number 3038-0060 to this collection of

information.

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\34\ 44 U.S.C. 3507(d).

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b. Cost-Benefit Analysis

Section 15(a) of the CEA \35\ 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.

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\35\ 7 U.S.C. 19(a).

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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'') \36\ 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.\37\ 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.

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\36\ 5 U.S.C. 601 et seq.

\37\ 66 FR 42256, 42268 (Aug. 10, 2001).

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VI. Order

a. Order Relating to the ICE NWP Rockies 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 NWP Rockies 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 NWP Rockies 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 \38\ with respect to the NWP

Rockies Financial Basis contract and is subject to all the provisions

of the Commodity Exchange Act applicable to registered entities.

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\38\ 7 U.S.C. 1a(29).

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Further, the obligations, requirements and timetables prescribed in

Commission rule 36.3(c)(4) governing core principle compliance by the

IntercontinentalExchange, Inc., commence with the issuance of this

Order.\39\

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\39\ 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. 2010-10304 Filed 5-3-10; 8:45 am]

BILLING CODE P

Last Updated: May 4, 2010