2010-10324

FR Doc 2010-10324[Federal Register: May 5, 2010 (Volume 75, Number 86)]

[Notices]

[Page 24655-24662]

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

[DOCID:fr05my10-61]

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COMMODITY FUTURES TRADING COMMISSION

Order Finding That the ICE Waha 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 9, 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 Waha Financial Basis (``WAH'') 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 WAH 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 52202 (October 9, 2009).

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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]; 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'') \2\

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.\3\ 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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\2\ Incorporated as Title XIII of the Food, Conservation and

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

2008).

\3\ 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.\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 9, 2009, the Commission published in the Federal

Register notice of its intent to undertake a determination whether the

WAH contract performs a significant price discovery function, and

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

from the Industrial Energy Consumers of America (``IECA''), Working

Group of Commercial Energy Firms (``WGCEF''), ICE, Platts, Economists

Incorporated (``EI''), Federal Energy Regulatory Commission (``FERC''),

and Financial Institutions

[[Page 24656]]

Energy Group (``FIEG'').\8\ The comment letters from FERC \9\ and

Platts did not directly address the issue of whether or not the WAH

contract is a SPDC; IECA concluded that the WAH contract is a SPDC, but

did not provide a basis for its conclusion.\10\ The other parties'

comments raised substantive issues with respect to the applicability of

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

contract is not a SPDC as it does not meet the material price

reference, price linkage, and material liquidity criteria for SPDC

determination. Those 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\ IECA describes itself as an ``association of leading

manufacturing companies'' whose membership ``represents a diverse

set of industries including: Plastics, cement, paper, food

processing, brick, chemicals, fertilizer, insulation, steel, glass,

industrial gases, pharmaceutical, aluminum and brewing.'' WGCEF

describes itself as ``a diverse group of commercial firms in the

domestic energy industry whose primary business activity is the

physical delivery of one or more energy commodities to customers,

including industrial, commercial and residential consumers'' and

whose membership consists of ``energy producers, marketers and

utilities.'' ICE is an ECM, as noted above. 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''). EI is an economic

consulting firm with offices located in Washington, DC, and San

Francisco, CA. NGSA is an industry association comprised of natural

gas producers and marketers. FERC is an independent Federal

regulatory agency that, among other things, regulates the interstate

transmission of natural gas, oil and electricity. FIEG describes

itself as an association of investment and commercial banks who are

active participants in various sectors of the natural gas markets,

``including acting as marketers, lenders, underwriters of debt and

equity securities, and proprietary investors.'' The comment letters

are available on the Commission's Web site: http://www.cftc.gov/

lawandregulation/federalregister/federalregistercomments/2009/09-

025.html.

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

not contemplate 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, ``the

FERC staff will continue to monitor for any such conflict * * *

[and] advise the CFTC'' should any such potential conflict arise. CL

07.

\10\ IECA stated that the subject ICE contract should ``be

required to come into compliance with core principles mandated by

Section 2(h)(7) of the Act and with other statutory provisions

applicable to registered entities. [This contract] should be subject

to the Commission's position limit authority, emergency authority

and large trader reporting requirements, among others.'' 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 the extent to which, on

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

directly based on, or are determined by referencing, the prices

established for the contract.

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\11\ In its October 9, 2009, Federal Register release, the

Commission identified material liquidity, material price reference

and price linkage as the possible criteria for SPDC determination of

the WAH 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 Waha Financial Basis (WAH) Contract and the SPDC Indicia

The WAH contract is cash settled based on the difference between

the bidweek price index of natural gas at the Waha hub in western Texas

for the month of delivery, as published in Platts' Inside FERC's Gas

Market Report, and the final settlement price of the New York

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

natural gas futures contract for the same 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 Waha 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.

Platts' current policy is to use physical deals into interstate and

intrastate pipelines at the outlet of the Waha header system and in the

Waha vicinity in the Permian Basin in West Texas. Pipelines include El

Paso Natural Gas, Transwestern Pipeline, Natural Gas Pipeline Co. of

America, Northern Natural Gas, Delhi Pipeline, Oasis Pipeline, EPGT

Texas and Lone Star Pipeline. The Platt's

[[Page 24657]]

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 WAH

contract is 2,500 million British thermal units (``mmBtu''), and the

unit of trading is any multiple of 2,500 mmBtu. The WAH contract is

listed for up to 72 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 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 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 Waha hub lies south of the prolific gas deposits in the San

Juan and Permian Basins of West Texas, near the New Mexico border. The

hub is accessible by several interstate and intrastate pipelines that

serve customer bases in both the Western and Midwestern United States.

As noted above, the cash market transactions included in the Platts

index are those fixed-price gas deliveries into the following

pipelines: El Paso Natural Gas, Transwestern Pipeline, Natural Gas

Pipeline Company of America, Northern Natural Gas, Delhi Pipeline,

Oasis Pipeline, EPGT Texas and Lone Star Pipeline. While the Waha

pricing center does not appear to be far removed from the Henry Hub,

the gas from Waha tends to flow to the Western and Midwest whereas the

gas from the Henry Hub tends to flow East of the Mississippi.

The Waha (EPGT) and Waha (CDP/Atmos) Texas Hubs, two market centers

near the Waha Hub, had an estimated throughput capacity in 2008 of 250

million cubic feet per day and 300 million cubic feet per day,

respectively. Moreover, the number of pipeline interconnections at each

market center was 10 in 2008. Lastly, the pipeline interconnection

capacity of the Waha (EPGT) and Waha (CDP/Atmos) Texas Hubs in 2008

were 1.8 billion million cubic feet per day and 2.3 billion cubic feet

per day, respectively.\15\ The Waha hub is removed from the Henry Hub

and is not directly connected to the Henry Hub by an existing pipeline.

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\15\ 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 Waha 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 WAH contract's price.

Moreover, the Waha hub is landlocked and so is less susceptible to

exogenous factors such as extreme weather, which can cause the Waha 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. 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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\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.

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In its October 9, 2009, Federal Register notice, the Commission

identified material price reference, price linkage and material

liquidity as the potential SPDC criteria applicable to the WAH

contract. Each of these criteria is discussed below.\17\

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\17\ 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 WAH contract.

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1. Material Price Reference Criterion

The Commission's October 9, 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 ``OTC Gas End of Day'' \18\ package 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 WAH contract.

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\18\ 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 Commission also noted that its October 2007 Report on the

Oversight of Trading on Regulated Futures Exchanges and Exempt

Commercial Markets (``ECM Study'')\19\ found that in general, market

participants view the ICE as a price discovery market for certain

natural gas contracts. The study did not specify which markets

performed this function; nevertheless, the Commission determined that

the WAH contract, while not mentioned by name in the ECM Study, might

warrant further study.

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\19\ http://www.cftc.gov/idc/groups/public/@newsroom/documents/

file/pr5403-07_ecmreport.pdf.

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The Commission will rely on one of two sources of evidence--direct

or indirect--to determine that the price of a contract was being used

as a material price reference and therefore, serving a

[[Page 24658]]

significant price discovery function.\20\ With respect to direct

evidence, the Commission will consider the extent to which, on a

frequent and recurring basis, cash market bids, offers or transactions

are directly based on or quoted at a differential to, the prices

generated on the ECM in question. Direct evidence may be established

when 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 in

question. Cash market prices are set explicitly at a differential to

the section 2(h)(3) contract when, for instance, they are quoted in

dollars and cents above or below the reference contract's price. Cash

market prices are set implicitly at a differential to a section 2(h)(3)

contract when, for instance, they are arrived at after adding to, or

subtracting from the section 2(h)(3) contract, but then quoted or

reported at a flat price. With respect to indirect evidence, the

Commission will consider the extent to which the price of the contract

in question is being routinely disseminated in widely distributed

industry publications--or offered by the ECM itself for some form of

remuneration--and consulted on a frequent and recurring basis by

industry participants in pricing cash market transactions.

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\20\ 17 CFR part 36, Appendix A.

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The Waha hub is a major trading center for natural gas in the

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

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

competitively determined price as an indication of expected values of

natural gas at Waha when entering into cash market transactions for

natural gas, especially those trades providing for physical delivery in

the future. Traders use the ICE WAH contract, as well as other ICE

basis swap contracts, to hedge cash market positions and transactions--

activities which enhance the WAH contract's price discovery utility.

The substantial volume of trading and open interest in the WAH contract

appears to attest to its use for this purpose. While the WAH 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\ As a result, the

WAH contract satisfies the direct price reference test.

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

firms participating in the Waha 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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In terms of indirect price reference, ICE sells the WAH contract's

prices as part of a broad package. The Commission notes that the Waha

hub is a major natural gas trading point, and the WAH contract's prices

are well regarded in the industry as indicative of the value of natural

gas at the Waha hub. Accordingly, the Commission believes that it is

reasonable to conclude that market participants are purchasing the data

packages that include the WAH contract's prices in substantial part

because the WAH contract prices have particular value to them.

Moreover, such prices are consulted on a frequent and recurring basis

by industry participants in pricing cash market transactions. In light

of the above, the WAH contract meets the indirect price reference test.

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

contract on its ClearPort platform called the Waha Basis Swap (Platts

IFERC) futures contract. However, unlike the ICE contract, none of the

trades in the NYMEX contract 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 version of the WAH contract are influenced, in

part, by the daily settlement prices of the ICE WAH 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 WAH price, among other

information, as an important indicator as to where the market is

trading. Therefore, the ICE WAH price influences the settlement price

for the NYMEX's Waha contract. This is supported by an analysis of the

daily settlement prices for the NYMEX Waha Basis Swap and ICE WAH

contracts. In this regard, 99 percent of the daily settlement prices

for the NYMEX Waha Basis Swap contract are within one standard

deviation of the WAH contract's price settlement prices.

Lastly, the fact that the WAH 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 Waha natural gas prices showed that 96

percent of the observations were more than 2.5 percent different that

the contemporaneous Henry Hub prices. The average Waha basis value

between January 2008 and September 2009 was -$0.98 per mmBtu with a

variance of $0.38 per mmBtu.

i. Federal Register Comments

ICE stated in its comment letter that the WAH contract does not

meet the material price reference criterion for SPDC determination. ICE

argued that the Commission appeared to base the case that the WAH

contract is potentially a SPDC on what it characterizes as a disputable

assertion. In issuing its notice of intent to determine whether the WAH

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.'' \22\ ICE stated

that CFTC's reason is ``hard to quantify as the ECM report does not

mention'' this contract as a potential SPDC. ``It is unknown which

market participants made this statement in 2007 or the contracts that

were referenced.'' \23\ 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.

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\22\ CL 04.

\23\ CL 04.

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WGCEF \24\, EI \25\ and FIEG \26\ all stated that the WAH contract

does not satisfy the material price reference criterion. The commenters

argued that other contracts (physical or financial) are not indexed

based on the ICE WAH contract price, but rather are indexed based on

the underlying cash price series against which the ICE WAH contract is

settled. Thus, they contend 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

[[Page 24659]]

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 material 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.

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\24\ CL 02.

\25\ CL 05.

\26\ CL 08.

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As noted above, the Waha hub is a major trading center for natural

gas in North America. Traders, including producers, keep abreast of the

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

look to a competitively determined price as an indication of expected

values of natural gas at the Waha 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 WAH contract to

hedge cash market positions and transactions, which enhances the WAH

contract's price discovery utility. While the WAH 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

crucial factor in conducting OTC transactions.

Both EI and WGCEF stated that publication of price data in a

package format is a weak justification for material price reference.

These commenters argue that market participants generally do not

purchase ICE data sets for one contract's prices, so the fact that ICE

sells the WAH prices as part of a broad package is not conclusive

evidence that market participants are buying the ICE data sets because

they find the WAH prices have substantial value to them. The Commission

notes that Waha is a major natural gas trading point, and the WAH

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

the value of natural gas at the Waha hub. Accordingly, the Commission

believes that it is reasonable to conclude that market participants are

purchasing the data packages that include the WAH contract's prices in

substantial part because the WAH contract prices have particular value

to them.

ii. Conclusion Regarding Material Price Reference

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

meets the material price reference criterion because cash market

transactions are being priced on a frequent and recurring basis at a

differential to the WAH contract's price (direct evidence). Moreover,

the ECM sells the WAH contract's price data to market participants and

it is reasonable to conclude that market participants are purchasing

the data packages that include the WAH contract's prices in substantial

part because the WAH contract prices have particular value to them.

Furthermore, such prices are consulted on a frequent and recurring

basis by industry participants in pricing cash market transactions

(indirect evidence).

2. Price Linkage Criterion

In its October 9, 2009, Federal Register notice, the Commission

identified price linkage as a potential basis for a SPDC determination

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

of the WAH 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

\27\ 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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\27\ Appendix A to the Part 36 rules.

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To assess whether the WAH 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 natural

gas price at the Waha hub is determined, in part, by the final

settlement price of the NYMEX physically-delivered natural gas futures

contract (a DCM contract), the Waha 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 the days. Specifically, during the

third quarter of 2009, 4.2 percent of the WAH 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 finds that the WAH contract fails to meet the volume threshold

requirement. In particular, the total trading volume in the NYMEX

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 WAH contract

during the same period was 120,050 contracts (equivalent to 30,012

NYMEX contracts, given the size difference).\28\ Thus, centralized-

market trades in the WAH contract amounted to less than the minimum

threshold.

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\28\ The WAH 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. That is, even though an ECM contract may specifically use a

DCM contract's settlement price to value a position, which is the case

of the WAH contract, a substantive difference between the two price

series would rule out the presence of price linkage. 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 Waha hub

and the Henry Hub are located at opposite sides of the Gulf Coast

natural gas market. While the Henry Hub and the Waha hub are both

primarily supply centers, each center has its own unique physical

characteristics that govern the flow of the gas, as well as a

geographically

[[Page 24660]]

unique customer base with a different demand schedule. 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

EI \29\ stated that the WAH and NYMEX natural gas contracts are not

economically equivalent and that the WAH contract's volume is too low

to affect the NYMEX natural gas futures contract. WGCEF \30\ stated

that the WAH contract's price is determined, in part, by the final

settlement price of the NYMEX Henry Hub futures contract. However,

WGCEF goes on to state that the WAH contract ``(a) is not substantially

the same as the NYMEX [natural gas futures contract] * * * nor (b) does

it move substantially in conjunction'' with the NYMEX natural gas

futures contract. ICE \31\ pronounced that the WAH contract's trading

volume is too low to affect the price discovery process for the NYMEX

natural gas futures contract. In addition, ICE stated that the WAH

contract simply reflects a price differential between Waha hub and the

Henry Hub; ``there is no price linkage as contemplated by Congress or

the CFTC in its rulemaking.'' FIEG \32\ acknowledged that the WAH

contract is a locational spread that is based in part on the NYMEX

natural gas futures price, but also questioned the significance of this

fact relative to the price linkage criterion since the key component of

the spread is the price at Waha hub and not the NYMEX physically-

delivered natural gas futures price.

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\29\ CL 06.

\30\ CL 02.

\31\ CL 04.

\32\ CL 08.

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ii. Conclusion Regarding the Price Linkage Criterion

Based on the above, the Commission finds that the WAH 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 WAH 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 WAH contract's

size and potential importance, and second performed a statistical

analysis to measure the effect that changes to WAH prices potentially

may have on prices for the NYMEX Henry Hub Natural Gas (a DCM

contract), the ICE Chicago Financial Basis contract (an ECM contract),

the ICE TexOK Financial Basis contract (an ECM contract) and the ICE

Permian Financial Basis contract (an ECM contract).\33\

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\33\ 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 9, 2009, Federal Register notice referred to

second quarter 2009 trading statistics that ICE had submitted for its

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

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

electronic trading platform was 1,165 in the second quarter of 2009,

resulting in a daily average of 18 trades. During the same period, the

WAH contract had a total trading volume on ICE's electronic trading

platform of 100,490 contracts and an average daily trading volume of

1,570 contracts. Moreover, the open interest as of June 30, 2009, was

96,371 contracts, which includes 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.\34\

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\34\ 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.

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Subsequent to the October 9, 2009, Federal Register notice, ICE

submitted another quarterly notification filed on November 13,

2009,\35\ with updated trading statistics. Specifically, with respect

to its WAH contract, 1,252 separate trades occurred on its electronic

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

19 trades. During the same period, the WAH contract had a total trading

volume on its electronic platform of 120,050 contracts (which was an

average of 1,819 contracts per day).\36\ As of September 30, 2009, open

interest in the WAH contract was 114,238 contracts.\37\ 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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\35\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).

\36\ By way of comparison, the number of contracts traded in the

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

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

Palladium futures contract during this period.

\37\ By way of comparison, open interest in the WAH contract is

roughly equivalent to that in the ICE US Coffee ``C'' futures

contract and the COMEX copper futures contract.

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In the Guidance, the Commission stated that material liquidity can

be identified by the impact liquidity exhibits through observed prices.

Thus, to make a determination whether the WAH contract has such

material impact, the Commission reviewed the relevant trading

statistics (noted above). In this regard, the average number of trades

per day in the second and third quarters of 2009 were well above the

minimum reporting level (5 trades per day). Moreover, trading activity

in the WAH contract, as characterized by total quarterly volume,

indicates that the WAH contract experiences trading activity that is

greater than in thinly-traded contracts.\38\ Thus, it is reasonable to

infer that the WAH contract could have a material effect on other ECM

contracts or on DCM contracts.

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\38\ Staff has advised the Commission that in its experience, a

thinly-traded contract is, generally, one that has a quarterly

trading volume of 100,000 contracts or less. In this regard, in the

third quarter of 2009, physical commodity futures contracts with

trading volume of 100,000 contracts or fewer constituted less than

one percent of total trading volume of all physical commodity

futures contracts.

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To measure the effect that the WAH contract potentially could have

on a DCM contract, or on another ECM contract, Commission staff

performed a statistical analysis \39\ using daily settlement prices

(between January 2, 2008, and September 30, 2009) for the ICE WAH

contract, as well as for the NYMEX Henry Hub natural gas contract

[[Page 24661]]

(a DCM contract) the ICE Chicago Financial Basis contract (an ECM

contract), ICE TexOk Financial Basis contract (an ECM contract) and ICE

Permian Financial Basis contract (an ECM contract).\40\ The simulation

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

rise in the WAH contract's price elicited a 0.8 percent increase in ICE

Chicago and the NYMEX Henry Hub, a 0.9 percent increase in ICE TexOK

and an equivalent increase in ICE Permian prices.

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\39\ Specifically, Commission staff econometrically estimated a

vector autoregression (VAR) model using daily settlement prices. A

vector autoregression model is an econometric model used to capture

the evolution and the interdependencies between multiple time

series, generalizing the univariate autoregression models. 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 WAH contract's price. The simulation

results suggest that, on average over the sample period, a one

percent rise in the WAH contract's price elicited a 0.8 percent

increase in the NYMEX Henry Hub and Chicago prices, as well as 0.9

percent increase in the TexOk contract and a 1 percent increase in

the Permian Basin contract. These multipliers of response emerge

with noticeable statistical strength or significance. Based on such

long run sample patterns, if the WAH contract's price rises by 10

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

contract and the ICE Chicago Financial Basis contract would each

rise by 8 percent. In addition, the price of ICE's TexOk Financial

Basis contract would rise by 9 percent, and the price of the ICE's

Permain Financial Basis would rise by 10 percent.

\40\ Natural gas prices at the Chicago, Permian, and TexOk hubs

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

Financial Basis, Permian Basin Financial Basis and TexOk 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, comments were received from seven individuals and

organizations, with five comments being directly applicable to the SPDC

determination of the ICE WAH contract. WGCEF, EI, FIEG and ICE

generally agreed that the WAH contract does not meet the material

liquidity criterion.

WGCEF \41\ stated that the WAH contract does not materially affect

other contracts that are listed for trading on DCMs or ECMs, as well as

other over-the-counter contracts. Instead, the WAH contract is

influenced by the underlying Waha cash price index and the final

settlement price of the NYMEX Henry Hub natural gas futures contract,

not vice versa. FIEG \42\ stated that the WAH contract cannot have a

material effect on NYMEX contract because the WAH contract trades on a

differential and represents ``one leg (and not the relevant leg) of the

locational spread.'' The Commission's statistical analysis shows that

changes in the ICE WAH contract's price significantly influences the

prices of other contracts that are traded on DCMs and ECMs.

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\41\ CL 02.

\42\ CL 08.

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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''

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. As noted

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

ICE WAH contract, in part, on the fact that there have been nearly 20

trades per day on average in the WAH contract during the second and

third quarters of 2009, which is almost quadruple the five trades-per-

day that is cited in the ICE comment. In addition, the Commission notes

that the number of contracts per transaction in the WAH contract is

high (approximately 96 contracts per transaction) and thus, as noted,

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

contract also has significant open interest.

ICE implied that the statistics provided by ICE were misinterpreted

and misapplied by the Commission. In particular, ICE stated that the

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

``include trades made in all listed 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.'' ICE stated that only about 25 to

40 percent 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 WAH contract, is typically a function of trading activity in

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

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

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

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

cited above in an appropriate manner for gauging material liquidity.

In addition, EI and 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. 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 9, 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. The Commission

acknowledges that the open interest information it cites above includes

transactions made off the ICE platform.\43\ 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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\43\ Supplemental data supplied by the 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 44.3 percent of all transactions in the WAH contract.

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ii. Conclusion Regarding Material Liquidity

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

meets the material liquidity criterion in that there is sufficient

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

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

WAH contract does meet both the material liquidity and material price

reference criteria. Accordingly, the Commission is issuing the attached

Order declaring that the WAH 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 WAH contract,\44\ 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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\44\ 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'') \45\ 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.

[[Page 24662]]

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.

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\45\ 44 U.S.C. 3507(d).

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b. Cost-Benefit Analysis

Section 15(a) of the CEA \46\ 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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\46\ 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'') \47\ 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.\48\ 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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\47\ 5 U.S.C. 601 et seq.

\48\ 66 FR 42256, 42268 (Aug. 10, 2001).

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VI. Order

a. Order Relating to the ICE Waha 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 Order:

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

the Act, hereby determines that the Waha 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 Waha 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 \49\ with respect to the Waha

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

Commodity Exchange Act applicable to registered entities. 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.\50\

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\49\ 7 U.S.C. 1a(29).

\50\ 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. 2010-10324 Filed 5-4-10; 8:45 am]

BILLING CODE P

Last Updated: May 5, 2010