2010-10341

FR Doc 2010-10341[Federal Register: May 5, 2010 (Volume 75, Number 86)]

[Notices]

[Page 24641-24648]

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

[DOCID:fr05my10-59]

[[Page 24641]]

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COMMODITY FUTURES TRADING COMMISSION

Order Finding That the HSC\1\ Financial Basis Contract Traded on

the IntercontinentalExchange, Inc., Performs a Significant Price

Discovery Function

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\1\ HSC refers to the Houston Ship Channel, a conduit for ocean

going vessels between the city of Houston, Texas, and the Gulf of

Mexico.

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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 \2\ a notice of its intent to undertake a determination

whether the HSC Financial Basis (``HXS'') 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.\3\ 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 HXS 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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\2\ 74 FR 52206 (October 9, 2009).

\3\ 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'') \4\

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.\5\ 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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\4\ Incorporated as Title XIII of the Food, Conservation and

Energy Act of 2008, Public Law No. 110-246, 122 Stat. 1624 (June 18,

2008).

\5\ 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.\6\ 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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\6\ 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.\7\ The issuance of such an order also triggers the

obligations, requirements and timetables prescribed in Commission rule

36.3(c)(4).\8\

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\7\ 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).

\8\ 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

HXS contract performs a significant price discovery function, and

requested comment from interested parties.\9\ Comments were received

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

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

Incorporated (``EI''), Natural Gas Supply Association (``NGSA''),

Federal Energy Regulatory Commission (``FERC''), and Financial

Institutions Energy Group (``FIEG'').\10\ The comment

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letters from FERC \11\ and Platts did not directly address the issue of

whether or not the HXS contract is a SPDC; IECA concluded that the HXS

contract is a SPDC, but did not provide a basis for its conclusion.\12\

The other parties' comments raised substantive issues with respect to

the applicability of section 2(h)(7) to the HXS contract, generally

asserting that the HXS contract is not a SPDC as it does not meet the

material liquidity, material price reference and price linkage criteria

for SPDC determination. Those comments are more extensively discussed

below, as applicable.

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\9\ 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.

\10\ 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.'' McGraw-Hill, through its division Platts, compiles and

calculates monthly natural gas price indices from natural gas trade

data submitted to Platts by energy marketers. Platts includes those

price indices in its monthly Inside FERC's Gas Market Report

(``Inside FERC''). ICE is an ECM, as noted above. EI is an economic

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

Francisco, CA. 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-

019.html

\11\ FERC stated that the HXS 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.

\12\ 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.\13\ 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.\14\ 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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\13\ In its October 9, 2009, Federal Register release, the

Commission identified material price reference, price linkage and

material liquidity as the possible criteria for SPDC determination

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

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

associated Order.

\14\ 17 CFR part 36, Appendix A.

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IV. Findings and Conclusions

a. The HSC Financial Basis (HXS) Contract and the SPDC Indicia

The HXS contract is cash settled based on the difference between

the price of natural gas at the HSC 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'')

Henry Hub physically-delivered natural gas futures contract for the

same specified calendar month. The Platts bidweek price, which is

published monthly, is based on a survey of cash market traders who

voluntarily report to Platts data on fixed-price transactions for

physical delivery of natural gas at the HSC 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 Platt's 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 HXS contract is 2,500

million British thermal units (``mmBtu''), and the unit of trading is

any multiple of 2,500 mmBtu. The HXS contract is listed for up to 84

calendar months commencing with the next calendar month.

The Henry Hub,\15\ 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

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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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\15\ 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.\16\ Some of the major trading centers include

Alberta, Northwest Rockies, Southern California border and the HSC. 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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\16\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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The HSC is part of the Port of Houston and, as noted above, serves

as a conduit between the Gulf of Mexico and the city of Houston, Texas,

which is one of the largest industrial natural gas consuming areas in

the United States. The 4,200-mile Houston Pipeline, with a capacity of

approximately 2.4 billion cubic feet per day, connects local gas

distribution companies, electric generation plants and industrial

consumers to one of the largest domestic supply basins in Texas.\17\

The Houston Pipeline Company serves the HSC market, the city of

Houston, the Katy Hub, Beaumont/Port Arthur complex, Texas City and

Corpus Christi and includes the Bammel Gas Storage Facility, one of the

largest underground reservoir storage fields in North America with 118

billion cubic feet of natural gas storage capacity.\18\ The cash market

transactions included in the Platts index are those for fixed-price gas

deliveries extending from the east side of Houston to Galveston Bay and

northeastward to the Port Arthur/Beaumont, Texas, area. While the HSC

shares some of the same market fundamentals as the Henry Hub, prices at

the HSC are reflective of the local market, which is driven by

Houston's industrial consumers.

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\17\ http://www.aep.com/newsroom/newsreleases/?id=952.

\18\ http://www.energytransfer.com/midstream_ops.aspx.

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The local price at the HSC 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 HSC price. Moreover,

despite the proximity of the HSC to the Henry Hub, exogenous factors

such as severe weather events can cause the HXS 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 \19\ 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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\19\ 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 HXS

contract. Each of these criteria is discussed below.\20\

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\20\ 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 HXS 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 an 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 ``Gulf Gas End of Day'' and ``OTC Gas End of Day''

\21\ 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 HXS contract.

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\21\ 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'') \22\ 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 HXS contract, while not mentioned by name in the ECM Study, might

warrant further study.

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\22\ 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 significant

price discovery function.\23\ 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

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participants in pricing cash market transactions.

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\23\ 17 CFR part 36, Appendix A.

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The HSC is a major trading center for natural gas in the United

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

HXS contract when conducting cash deals. These traders look to a

competitively determined price as an indication of expected values of

natural gas at the HSC when entering into cash market transaction for

natural gas, especially those trades providing for physical delivery in

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

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

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

The substantial volume of trading and open interest \24\ in the HXS

contract appears to attest to its use for this purpose. While the HXS

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.\25\ As a

result, the HXS contract satisfies the direct price reference test.

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\24\ Source: ICE filings dated July 27, 2009, and November 13,

2009.

\25\ In addition to referencing ICE prices, natural gas market

firms participating in the HSC 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 HXS contract's

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

a major natural gas trading point, and the HXS contract's prices are

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

at the HSC. Accordingly, the Commission believes that it is reasonable

to conclude that market participants are purchasing the data packages

that include the HXS contract's prices in substantial part because the

HXS 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 HXS contract meets the indirect price reference test.

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

contract on its ClearPort platform called the Houston Ship Channel

Natural Gas Basis Swap (Platts IFERC) futures contract. However, unlike

the ICE HXS contract, none of the trades in the NYMEX version of the

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 HSC basis

swap contract are influenced, in part, by the daily settlement prices

of the ICE HXS 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 HXS price, among other information, as an important indicator

as to where the market is trading. Therefore, the ICE HXS price

influences the settlement price for the NYMEX HSC basis swap contract.

This is supported by an analysis of the daily settlement prices for the

NYMEX HSC basis swap contract and the ICE HXS contract. In this regard,

96 percent of the daily settlement prices for the NYMEX HSC basis swap

contract are within one standard deviation of the HXS contract's price

settlement prices.

Lastly, the fact that the HXS 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 HSC natural gas prices (based on the HXS

contract's settlement prices) showed that 64.6 percent of the

observations were more than 2.5 percent different that the

contemporaneous Henry Hub prices. The average HSC basis value between

January 2008 and September 2009 was -$0.26 per mmBtu with a variance of

$0.03 per mmBtu.

i. Federal Register Comments

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

meet the material price reference criterion for SPDC determination. ICE

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

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

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

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.'' \26\ 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.'' \27\ 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 indicia that an investigation of certain ICE

contracts may be warranted, and were 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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\26\ CL 04.

\27\ CL 04.

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WGCEF,\28\ NGSA,\29\ EI \30\ and FIEG \31\ all stated that the HXS

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 HXS contract price, but rather are indexed

based on the underlying cash price series against which the ICE HXS

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 final index

value on which the contract is cash settled after trading ceases.

Instead, the Commission believes that a cash-settled derivatives

contract could meet the price reference criterion 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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\28\ CL 02.

\29\ CL 06.

\30\ CL 05.

\31\ CL 08

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As noted above, the HSC is a major trading center for natural gas

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

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

look to a competitively determined price as an indication of expected

values of natural gas at the HSC when entering into cash market

transaction for natural gas, especially those trades that provide for

physical delivery in the future. Traders use the ICE HXS contract to

hedge cash market positions and transactions, which enhances the HXS

contract's price discovery utility. While the HXS

[[Page 24645]]

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 HXS prices as part of a broad package is not conclusive

evidence that market participants are buying the ICE data sets because

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

notes that the HSC is a major natural gas trading point, and the HXS

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

the value of natural gas at the HSC. Accordingly, the Commission

believes that it is reasonable to conclude that market participants are

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

substantial part because the HXS contract prices have particular value

to them.

ii. Conclusion Regarding Material Price Reference

Based on the above, the Commission finds that the HXS 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 HXS contract's price (direct evidence). Moreover,

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

it is reasonable to conclude that market participants are purchasing

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

part because the HXS 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 HXS contract. In this regard, the final settlement

of the HXS 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

\32\ 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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\32\ Appendix A to the Part 36 rules.

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To assess whether the HXS 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 HXS

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

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

contract), the natural gas price at the HSC is not within 2.5 percent

of the settlement price of the corresponding NYMEX Henry Hub natural

gas futures contract on 95 percent of the days. Specifically, during

the third quarter of 2009, only 35.4 percent of the HSC 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 HXS 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

HXS contract during the same period was 271,056 contracts (equivalent

to 67,764 NYMEX contracts, given the size difference).\33\ Thus,

centralized-market trades in the HXS contract amounted to less than the

minimum threshold.

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\33\ The HXS 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's contract's settlement price to value a position, which is the

case of the HXS 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 HSC and the

Henry Hub are both located in Gulf Coast region of the United States.

The Henry Hub and the HSC are both primarily supply centers, but the

latter point is affected by heavy commercial demand in the local area.

In contrast, the Henry Hub mainly serves as a distribution point for

natural gas that will be consumed at various locations throughout the

United States. 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

NGSA \34\ stated that the HXS contract does not meet the price

linkage criterion because basis contracts, including the HXS contract,

are not equivalent to the NYMEX physically-delivered Henry Hub

contract. EI \35\ also noted that the HXS and NYMEX natural gas

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

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

WGCEF \36\ stated that the HXS 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 HXS contract ``(a) is not

substantially the same as the NYMEX [natural gas

[[Page 24646]]

futures contract] * * * nor (b) does it move substantially in

conjunction'' with the NYMEX natural gas futures contract. ICE \37\

pronounced that the HXS 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 HXS contract simply reflects a price

differential between Houston Ship Channel and the Henry Hub; ``there is

no price linkage as contemplated by Congress or the CFTC in its

rulemaking.'' FIEG \38\ acknowledged that the HXS 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 the HSC and not the NYMEX physically-delivered

natural gas futures price.

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\34\ CL 06.

\35\ CL 05.

\36\ CL 02.

\37\ CL 04.

\38\ CL 08.

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ii. Conclusion Regarding the Price Linkage Criterion

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

size and potential importance, and second performed a statistical

analysis to measure the effect that changes to HXS 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 Socal Border Financial Basis contract (an ECM contract).\39\

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\39\ 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

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

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

electronic trading platform was 2,524 in the second quarter of 2009,

resulting in a daily average of 39.4 trades. During the same period,

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

platform of 209,010 contracts and an average daily trading volume of

3,265.8 contracts.\40\ Moreover, the open interest as of June 30, 2009,

was 313,594 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.\41\

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\40\ The volume of trading was comparable to that of the Chicago

Mercantile Exchange Feeder Cattle futures contract and the NYMEX

Platinum futures contract for the same period.

\41\ 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. The size of the

HXS open interest was comparable to that of the NYMEX No. 2 Heating

Oil futures and the CME Live Cattle futures contracts for the same

period.

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

submitted another quarterly notification filed on November 13, 2009

\42\ with updated trading statistics. Specifically, with respect to its

HXS contract, 2,894 separate trades occurred on its electronic platform

in the third quarter of 2009, resulting in a daily average of 43.8

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

volume on its electronic platform of 271,056 contracts (which was an

average of 4,107 contracts per day). As of September 30, 2009, open

interest in the HXS contract was 309,740 contracts. 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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\42\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).

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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 HXS contract has such

material impact, the Commission reviewed the relevant trading

statistics (noted above). In this regard, the average number 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 HXS contract, as characterized by total quarterly volume,

indicates that the HXS contract experiences greater trading activity

than in thinly-traded contracts.\43\ Thus, it is reasonable to infer

that the HXS contract could have a material effect on other ECM

contracts or on DCM contracts.

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\43\ 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 HXS contract potentially could have

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

performed a statistical analysis \44\ using daily settlement prices

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

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

DCM contract), the ICE AECO Financial Basis and Socal Financial Basis

contracts (ECM contracts). The simulation results suggest that, on

average over the sample period, a one percent rise in the HXS

contract's price elicited a nearly equivalent increase in each of the

NYMEX Henry Hub, ICE AECO and ICE Socal Border prices.

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\44\ Specifically, the Commission 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 HXS contract's price. The simulation

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

percent rise in the HXS contract's price elicited a 0.98 percent

increase in the NYMEX Henry Hub and Socal Border prices, as well as

0.91 percent increase in the AECO price. These multipliers of

response emerge with noticeable statistical strength or

significance. Based on such long run sample patterns, if the HXS

contract's price rises by 10 percent, then the prices of NYMEX Henry

Hub natural gas futures contract and Socal Border Financial Basis

contract would each rise by 9.1 percent, and the price of the AECO

Financial Basis contract would rise by 9.8 percent.

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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 HXS contract. WGCEF, EI, FIEG, ICE and NGSA

generally agreed that the HXS contract does not meet the material

liquidity criterion.

WGCEF \45\ and NGSA \46\ both stated that the HXS 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 HXS

contract is influenced by the underlying HSC cash price index

[[Page 24647]]

and the final settlement price of the NYMEX Henry Hub natural gas

futures contract, not vice versa. FIEG \47\ stated that the HXS

contract cannot have a material effect on NYMEX contract because the

HXS 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 HXS contract's price

significantly influences the prices of other contracts that are traded

on DCMs and ECMs.

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\45\ CL 02.

\46\ CL 06.

\47\ CL 07.

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ICE \48\ 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, 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

HXS contract, in part, on the fact that there have been over 40 trades

per day on average in the HXS contract during the second and third

quarters of 2009, which is far more than 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 HXS contract is high

(approximately 93 contracts per transaction) and thus, as noted,

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

contract also has significant open interest.

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\48\ CL 04.

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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 [84] months of * * * [the] 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

basis swaps, ``about 25-40% 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 HXS contract, is typically a function of trading activity in

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

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

its own trade data confirms this to be the case for the HXS 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 \49\ and ICE \50\ 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. 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.\51\ The Commission

acknowledges that the open interest information it cites above includes

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

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

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

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

agreeable to the position holder regardless of how the position was

initially created.

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\49\ CL 05.

\50\ CL 04.

\51\ 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 65% of all transactions in the HXS contract.

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ii. Conclusion Regarding Material Liquidity

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

meets the material liquidity criterion in that there is sufficient

trading activity in the HXS 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 HXS 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 concluded that the HXS contract does not meet the price

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

HXS contract does meet both the material liquidity and material price

reference criteria. Accordingly, the Commission is issuing the attached

Order declaring that the HXS 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 HXS contract,\52\ 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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\52\ 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'') \53\ 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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\53\ 44 U.S.C. 3507(d).

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b. Cost-Benefit Analysis

Section 15(a) of the CEA \54\ 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)

[[Page 24648]]

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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\54\ 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'') \55\ 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.\56\ 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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\55\ 5 U.S.C. 601 et seq.

\56\ 66 FR 42256, 42268 (Aug. 10, 2001).

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VI. Order

a. Order Relating to the ICE HSC 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 HSC 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 HSC 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 \57\ with respect to the HSC

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.\58\

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\57\ 7 U.S.C. 1a(29).

\58\ 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. 2010-10341 Filed 5-4-10; 8:45 am]

BILLING CODE P

Last Updated: May 5, 2010