2010-10335

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

[Notices]

[Page 24648-24655]

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

[DOCID:fr05my10-60]

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COMMODITY FUTURES TRADING COMMISSION

Order Finding That the Socal Border Financial Basis Contract

Traded on the IntercontinentalExchange, Inc., Performs a Significant

Price Discovery Function

AGENCY: Commodity Futures Trading Commission.

ACTION: Final order.

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

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

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

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

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

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

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

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

undertook this review based upon an initial evaluation of information

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

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

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

the SCL contract performs a significant price discovery function.

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

Commission rule 36.3(c) promulgated thereunder.

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

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

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DATES: Effective date: April 28, 2010.

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

Division of Market Oversight, Commodity Futures Trading Commission,

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

Telephone: (202) 418-5515. E-mail: [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--

[[Page 24649]]

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

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

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

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

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

price discovery function. When the Commission makes such a

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

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

registered entity under the Act and Commission regulations, and must

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

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

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

2008).

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

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

36.3 imposes increased information reporting requirements on ECMs to

assist the Commission in making prompt assessments whether particular

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

its contracts, an ECM must notify the Commission promptly concerning

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

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

calendar quarter, and for which the exchange sells its price

information regarding the contract to market participants or industry

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

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

of the contemporaneously determined closing, settlement or other daily

prices of another contract.

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

April 22, 2009.

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

Commission makes and announces its determination whether a particular

ECM contract serves a significant price discovery function. Under those

procedures, the Commission will publish notice in the Federal Register

that it intends to undertake an evaluation whether the specified

agreement, contract or transaction performs a significant price

discovery function and to receive written views, data and arguments

relevant to its determination from the ECM and other interested

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

consider, among other things, all relevant information regarding the

subject contract and issue an order announcing and explaining its

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

affirmative order signals the effectiveness of the Commission's

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

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

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

obligations, requirements and timetables prescribed in Commission rule

36.3(c)(4).\6\

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

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

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

75894 (Dec. 12, 2008).

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

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

written demonstration of compliance with the applicable core

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

calendar days to demonstrate core principle compliance.

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II. Notice of Intent To Undertake SPDC Determination

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

Register notice of its intent to undertake a determination whether the

SCL contract performs a significant price discovery function and

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

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

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

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

comments raised substantive issues with respect to the applicability of

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

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

material price reference and price linkage criteria for SPDC

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

below, as applicable.

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

things, procedures by which the Commission makes and announces its

determination whether a specific ECM contract serves a significant

price discovery function. Under those procedures, the Commission

publishes a notice in the Federal Register that it intends to

undertake a determination whether a specified agreement, contract or

transaction performs a significant price discovery function and to

receive written data, views and arguments relevant to its

determination from the ECM and other interested persons.

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

other things, regulates the interstate transmission of natural gas,

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

compiles and calculates monthly natural gas price indices from

natural gas trade data submitted to Platts by energy marketers.

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

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

as noted above. The comment letters are available on the

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

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

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

not contemplate the actual physical delivery of natural gas.

Accordingly, FERC expressed the opinion that a determination by the

Commission that a contract performs a significant price discovery

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

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

natural gas in interstate commerce for resale or with its other

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

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

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

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

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

consider the following criteria in determining a contract's significant

price discovery function:

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

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

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

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

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

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

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

settle a position, or close out a position.

Arbitrage--the extent to which the price for the

agreement, contract or transaction is sufficiently related to the price

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

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

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

effectively arbitrage between the markets by simultaneously maintaining

positions or executing trades in the contracts on a frequent and

recurring basis.

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

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

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

consulting, the prices generated by agreements, contracts or

transactions being traded or executed on the electronic trading

facility.

Material liquidity--the extent to which the volume of

agreements, contracts or transactions in a commodity being traded on

the electronic trading facility is sufficient to have a material effect

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

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

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

[[Page 24650]]

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

particular contract performs a significant price discovery function,

and one or more criteria may be inapplicable to a particular

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

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

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

rules governing ECMs with SPDCs, the Commission observed that these

criteria do not lend themselves to a mechanical checklist or formulaic

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

determinations it will consider the circumstances under which the

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

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

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

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

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

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

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

a level sufficient for the contract to perform a significant price

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

a price reference, the Commission will consider whether cash market

participants are quoting bid or offer prices or entering into

transactions at prices that are set either explicitly or implicitly at

a differential to prices established for the contract.

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

Commission identified material liquidity, material price reference

and price linkage as the possible criteria for SPDC determination of

the SCL contract. Arbitrage was not identified as a possible

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

associated Order.

\11\ 17 CFR part 36, Appendix A.

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IV. Findings and Conclusions

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

The SCL contract is cash settled based on the difference between

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

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

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

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

delivered natural gas futures contract for the same specified calendar

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

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

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

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

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

a uniform basis throughout the following calendar month at the agreed

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

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

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

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

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

with the next calendar month.

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

primary cash market trading and distribution center for natural gas in

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

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

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

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

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

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

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

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

per day.

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

natural gas pipelines are connected. Hubs also serve as pricing

points for natural gas at the particular locations.

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

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

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

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

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

pipelines and where there typically is adequate shipping capacity, the

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

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

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

shipping capacity is limited, the prices at those locations often

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

significantly different than the price at another location even though

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

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

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

such as differences in pipeline shipping capacity, unusually high or

low demand for heating or cooling or supply disruptions caused by

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

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

price differences can vary in an unpredictable manner.

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

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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The Socal Border hub is located in Southern California on the

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

that includes the Socal Border Hub, had an estimated throughput

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

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

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

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

which constituted a 47 percent increase over the pipeline

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

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

Hub by an existing pipeline.

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

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

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

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

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

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

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

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

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

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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

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

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

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

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

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

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

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

allow traders to more accurately discover prices at alternative

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

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

[[Page 24651]]

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

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

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

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

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

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

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

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

negative value.

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

evidenced by large positions held by energy trading firms in the

comparable NYMEX ClearPort basis swap contract for the Socal hub.

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

identified material liquidity, price linkage and material price

reference as the potential SPDC criteria applicable to the SCL

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

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

of arbitrage in connection with this contract; accordingly, that

criterion was not discussed in reference to the SCL contract.

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1. Material Price Reference Criterion

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

identified material price reference as a potential basis for a SPDC

determination with respect to this contract. The Commission considered

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

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

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

providers produce natural gas price indices for this and other trading

centers, market participants indicate that the IPI Socal bidweek index

is highly regarded for this particular location and should market

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

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

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

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

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

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

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

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

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

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

contract.

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

prices for natural gas contracts listed for all points in North

America.

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

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

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

look to a competitively determined price as an indication of expected

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

market transactions for natural gas, especially those trades providing

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

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

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

price discovery utility. The substantial volume of trading and open

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

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

factor influencing spot and forward transactions, natural gas traders

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

transactions.\20\

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

firms participating in the Socal market may rely on other cash

market quotes as well as industry publications and price indices

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

into natural gas transactions.

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

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

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

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

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

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

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

contract. This is because NYMEX determines the daily settlement prices

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

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

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

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

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

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

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

daily settlement prices for the NYMEX SoCal Basis Swap contract are

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

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

linkage criterion (discussed below) bolsters the argument for material

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

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

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

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

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

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

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

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

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

percent of the observations were more than 2.5 percent different that

the contemporaneous Henry Hub prices. Specifically, the average Socal

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

mmBtu with a variance of $0.29 per mmBtu.

i. Federal Register Comments

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

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

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

reference criterion for SPDC determination. ICE argued that the

Commission appeared to base the case that the SCL contract is

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

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

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

participants referred to ICE as a price discovery market for certain

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

reference determination on general statements made in a two year old

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

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

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

general finding that some ICE natural gas contracts appear to be

regarded as price discovery markets merely as an indicia that an

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

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

particular contract meets the material price reference criterion.

Second, ICE argued that the Commission should not base a

determination that the SCL contract is a SPDC merely because this

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

Socal Border Index price. While the Commission acknowledges that there

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

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

highly regarded and should they wish to establish a hedged position

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

the ICE SCL swap

[[Page 24652]]

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

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

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

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

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

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

approximately 75,000 contracts in the NYMEX SoCal Basis Swap

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

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

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

source of price discovery for cash market traders with natural gas

at that location.

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ii. Conclusion Regarding Material Price Reference

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

meets the material price reference criterion because it is referenced

and consulted on a frequent and recurring basis by cash market

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

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

(indirect evidence).

2. Price Linkage Criterion

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

identified price linkage as a potential basis for a SPDC determination

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

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

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

the NYMEX is registered with the Commission as a DCM.

The Commission's Guidance on Significant Price Discovery Contracts

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

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

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

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

linked to another contract will not be sufficient to support a

determination that a contract performs a significant price discovery

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

Commission will examine the relationship between transaction prices of

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

Commission believes that where material liquidity exists, prices for

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

or move substantially in conjunction with the prices of the referenced

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

relationship such that prices of the ECM linked contract will fall

within a 2.5 percent price range for 95 percent of contemporaneously

determined closing, settlement or other daily prices over the most

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

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

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

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

SPDC (``minimum threshold'').

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\22\ Appendix A to the Part 36 rules.

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To assess whether the SCL contract meets the price linkage

criterion, Commission staff obtained price data from ICE and performed

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

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

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

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

settlement price of the corresponding NYMEX Henry Hub natural gas

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

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

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

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

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

the volume threshold requirement. In particular, the total trading

volume in the NYMEX physically-delivered natural gas contract during

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

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

centralized market in the SCL contract during the same period was

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

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

contract amounted to less than the minimum threshold.

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

Hub physically-delivered futures contract.

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

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

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

contracts even though the ECM contract may specifically use the

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

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

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

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

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

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

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

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

supply center while Southern California is a demand center. These

differences contribute to the divergence between the two price series

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

contract is used for material price reference.

i. Federal Register Comments

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

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

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

criterion for SPDC determination because it fails the volume test

provided in the Commission's Guidance.

ii. Conclusion Regarding the Price Linkage Criterion

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

not meet the price linkage criterion because it fails the price

relationship and volume tests provided for in the Commission's

Guidance.

3. Material Liquidity Criterion

To assess whether the SCL contract meets the material liquidity

criterion, the Commission first examined volume and open interest data

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

and potential importance, and second performed a statistical analysis

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

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

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

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

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\24\ The acronym stands for Houston Ship Channel.

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

the effect that transactions in the potential SPDC may have on

trading in ``agreements, contracts and transactions listed for

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

a derivatives transaction execution facility, or an electronic

trading facility operating in reliance on the exemption in section

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

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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 20, 2009, Federal Register notice referred to

second quarter 2009 trading statistics that ICE had submitted for its

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

July 27, 2009, the total number of SCL trades

[[Page 24653]]

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

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

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

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

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

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

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

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

clearing.\26\

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

a transaction executed on its trading platform versus that created

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

(October 20, 2009).

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

submitted another quarterly notification filed on November 13,

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

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

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

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

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

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

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

Reported open interest included positions resulting from trades that

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

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

clearing.

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

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

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

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

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

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

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

contract and the Commodity Exchange's Gold futures contract.

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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 SCL contract

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

Commission staff performed a statistical analysis \30\ using daily

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

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

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

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

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

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

NYMEX Henry Hub prices.

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\30\ Specifically, the Commission econometrically estimated a

vector autoregression model using daily natural gas price levels. A

vector autoregression model is an econometric model used to capture

the dependencies and interrelationships among multiple time series,

generalizing the univariate autoregression model. The estimated

model displays strong diagnostic evidence of statistical adequacy.

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

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

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

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

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

other two modeled natural gas prices. These multipliers of response

emerge with noticeable statistical strength or significance. Based

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

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

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

rise by about 8 percent.

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

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

AECO Financial Basis, HSC Financial Basis and Socal Border Financial

Basis contracts, respectively, to the contemporaneous daily

settlement prices of the NYMEX Henry Hub physically-delivered

natural gas futures contract.

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i. Federal Register Comments

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

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

comment letter that the SCL contract does not meet the material

liquidity criterion for SPDC determination for a number of reasons.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Commission notes that the number of contracts per transaction in the

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

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

substantial. The SCL contract also has substantial open interest.

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\32\ 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 SCL contract, ``about 29% of the trades occurred in the single most

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

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

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

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

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

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

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

cited above in an appropriate manner for gauging material liquidity.

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

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

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

electronic trading platform and should not be considered in the SPDC

determination process. The Commission staff asked ICE to review the

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

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

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

volume information it cites above, includes only transaction data

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

acknowledges that the open interest information it cites above includes

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

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

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

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

[[Page 24654]]

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

initially created.

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\33\ Supplemental data supplied by ICE confirmed that block

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

that were conducted on the electronic platform; block trades

comprised 45.7 percent of all transactions in the SCL contract.

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ii. Conclusion Regarding Material Liquidity

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

meets the material liquidity criterion in that there is sufficient

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

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

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

electronic trading facility operating in reliance on the exemption in

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

4. Overall Conclusion

After considering the entire record in this matter, including the

comments received, the Commission has determined that the SCL contract

performs a significant price discovery function under two of the four

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

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

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

SCL contract does meet both the material liquidity and material price

reference criteria. Accordingly, the Commission will issue the attached

Order declaring that the SCL contract is a SPDC.

Issuance of this Order signals the immediate effectiveness of the

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

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

requirements--both procedural and substantive--and timetables

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

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\34\ 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'') \35\ imposes certain

requirements on Federal agencies, including the Commission, in

connection with their conducting or sponsoring any collection of

information as defined by the PRA. Certain provisions of Commission

rule 36.3 impose new regulatory and reporting requirements on ECMs,

resulting in information collection requirements within the meaning of

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

3038-0060 to this collection of information.

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

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b. Cost-Benefit Analysis

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

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

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

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

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

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

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

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

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

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

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

interest considerations. The Commission may in its discretion give

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

discretion determine that, notwithstanding its costs, a particular

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

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

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

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

concluded that the Order, required by Congress to strengthen federal

oversight of exempt commercial markets and to prevent market

manipulation, is necessary and appropriate to accomplish the purposes

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

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\36\ 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'') \37\ requires that

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

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

The Commission previously has determined that ECMs are not small

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

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

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

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

substantial number of small entities.

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

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

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VI. Order

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

After considering the complete record in this matter, including the

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

Commission has determined to issue the following:

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

the Act, hereby determines that the Socal Border Financial Basis

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

statutory material liquidity and material price reference criteria for

significant price discovery contracts. Consistent with this

determination, and effective immediately, the IntercontinentalExchange,

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

Basis contract, the nine core principles established by new section

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

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

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

the Commodity Exchange Act applicable to registered entities.

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\39\ 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

[[Page 24655]]

core principle compliance by the IntercontinentalExchange, Inc.,

commence with the issuance of this Order.\40\

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

Henry Financial LD1 Fixed Price contract) that was previously

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

demonstration of compliance with the Core Principles within 30

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

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

David A. Stawick,

Secretary of the Commission.

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

BILLING CODE P

Last Updated: May 5, 2010