2010-10344

FR Doc 2010-10344[Federal Register: May 5, 2010 (Volume 75, Number 86)]

[Notices]

[Page 24633-24640]

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

[DOCID:fr05my10-58]

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COMMODITY FUTURES TRADING COMMISSION

Order Finding That the ICE Chicago Financial Basis Contract

Traded on the IntercontinentalExchange, Inc., Performs a Significant

Price Discovery Function

AGENCY: Commodity Futures Trading Commission.

ACTION: Final Order.

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SUMMARY: On October 9, 2009, the Commodity Futures Trading Commission

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

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

whether the Chicago Financial Basis (``DGD'') contract, traded on the

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

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

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

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

undertook this review based upon an initial evaluation of information

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

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

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

the DGD 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 52198 (October 9, 2009).

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DATES: Effective date: April 28, 2010.

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

Division of Market Oversight, Commodity Futures Trading Commission,

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

Telephone: (202) 418-5515. E-mail: [email protected]; or Susan Nathan,

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

Telephone: (202) 418-5133. E-mail: [email protected]

SUPPLEMENTARY INFORMATION:

I. Introduction

The CFTC Reauthorization Act of 2008 (``Reauthorization Act'') \2\

significantly broadened the CFTC's regulatory authority with respect to

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

category--ECMs on which significant price discovery contracts

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

registered entities under the CEA.\3\ The legislation authorizes the

CFTC to designate an agreement, contract or transaction as a SPDC if

the Commission determines, under criteria established in section

2(h)(7), that it performs a significant price discovery function. When

the Commission makes such a determination, the ECM on which the SPDC is

traded must assume, with respect to that contract, all the

responsibilities and obligations of a registered entity under the Act

and Commission regulations, and must comply with nine core principles

established by new section 2(h)(7)(C).

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

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

2008).

\3\ 7 U.S.C. 1a(29).

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

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

36.3 imposes increased information reporting requirements on ECMs to

assist the Commission in making prompt assessments whether particular

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

its contracts, an ECM must notify the Commission promptly concerning

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

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

calendar quarter, and for which the exchange sells its price

information regarding the contract to market participants or industry

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

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

of the contemporaneously determined closing, settlement or other daily

prices of another contract.

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

April 22, 2009.

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

Commission makes and announces its determination whether a particular

ECM contract serves a significant price discovery function. Under those

procedures, the Commission will publish notice in the Federal Register

that it intends to undertake an evaluation whether the specified

agreement, contract or transaction performs a significant price

discovery function and to receive written views, data and arguments

relevant to its determination from the ECM and other interested

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

consider, among other things, all relevant information regarding the

subject contract and issue an order announcing and explaining its

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

affirmative order signals the effectiveness of the Commission's

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

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

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

obligations, requirements and timetables prescribed in Commission rule

36.3(c)(4).\6\

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

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

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

75894 (Dec. 12, 2008).

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

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

written demonstration of compliance with the applicable core

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

calendar days to demonstrate core principle compliance.

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[[Page 24634]]

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

DGD contract performs a significant price discovery function, and

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

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

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

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

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

Institutions Energy Group (``FIEG'').\8\ The comment letter from FERC

\9\ did not directly address the issue of whether or not the DGD

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

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

comments raised substantive issues with respect to the applicability of

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

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

things, procedures by which the Commission makes and announces its

determination whether a specific ECM contract serves a significant

price discovery function. Under those procedures, the Commission

publishes a notice in the Federal Register that it intends to

undertake a determination whether a specified agreement, contract or

transaction performs a significant price discovery function and to

receive written data, views and arguments relevant to its

determination from the ECM and other interested persons.

\8\ IECA describes itself as an ``association of leading

manufacturing companies'' whose membership ``represents a diverse

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

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

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

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

domestic energy industry whose primary business activity is the

physical delivery of one or more energy commodities to customers,

including industrial, commercial and residential consumers'' and

whose membership consists of ``energy producers, marketers and

utilities.'' ICE is an ECM, as noted above. 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 website: http://www.cftc.gov/

lawandregulation/federalregister/federalregistercomments/2009/09-

017.html.

\9\ FERC stated that the DGD 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

06.

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

required to come into compliance with core principles mandated by

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

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

to the Commission's position limit authority, emergency authority

and large trader reporting requirements, among others.'' CL 01.

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

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

consider the following criteria in determining a contract's significant

price discovery function:

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

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

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

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

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

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

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

settle a position, or close out a position.

Arbitrage--the extent to which the price for the

agreement, contract or transaction is sufficiently related to the price

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

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

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

effectively arbitrage between the markets by simultaneously maintaining

positions or executing trades in the contracts on a frequent and

recurring basis.

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

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

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

consulting, the prices generated by agreements, contracts or

transactions being traded or executed on the electronic trading

facility.

Material liquidity--the extent to which the volume of

agreements, contracts or transactions in a commodity being traded on

the electronic trading facility is sufficient to have a material effect

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

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

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

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

particular contract performs a significant price discovery function,

and one or more criteria may be inapplicable to a particular

contract.\11\ Moreover, the statutory language neither prioritizes the

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

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

rules governing ECMs with SPDCs, the Commission observed that these

criteria do not lend themselves to a mechanical checklist or formulaic

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

determinations it will consider the circumstances under which the

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

be sufficient to support a SPDC determination.\12\ For example, for

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

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

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

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

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

a level sufficient for the contract to perform a significant price

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

a price reference, the Commission will consider the extent to which, on

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

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

established for the contract.

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

Commission identified material price reference, price linkage and

material liquidity as the possible criteria for SPDC determination

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

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

associated Order.

\12\ 17 CFR part 36, Appendix A.

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IV. Findings and Conclusions

a. The Chicago (DGD) Financial Basis Contract and the SPDC Indicia

The DGD contract is cash settled based on the difference between

the bidweek price index for the price of natural gas at the Chicago hub

for the month of delivery, as published in

[[Page 24635]]

Intelligence Press Inc.'s (``IPI's'') Natural Gas Bidweek Survey, and

the final settlement price of the New York Mercantile Exchange's

(``NYMEX's'') physically-delivered Henry Hub natural gas futures

contract for the same calendar month. The 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 Chicago 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 DGD contract is 2,500

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

any multiple of 2,500 mmBtu. The DGD contract is listed for up to 72

calendar months commencing with the next calendar month.

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

primary cash market trading and distribution center for natural gas in

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

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

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

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

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

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

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

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

per day.

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\13\ The term ``hub'' refers to a juncture where two or more

natural gas pipelines are connected. Hubs also serve as pricing

points for natural gas at the particular locations.

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

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

centers in North America.\14\ Some of the major trading centers include

Alberta, Northwest Rockies, Southern California border and the Houston

Ship Channel. For locations that are directly connected to the Henry

Hub by one or more pipelines and where there typically is adequate

shipping capacity, the price at the other locations usually directly

tracks the price at the Henry Hub, adjusted for transportation costs.

However, at other locations that are not directly connected to the

Henry Hub or where shipping capacity is limited, the prices at those

locations often diverge from the Henry Hub price. Furthermore, one

local price may be significantly different than the price at another

location even though the two markets' respective distances from the

Henry Hub are the same. The reason for such pricing disparities is that

a given location may experience supply and demand factors that are

specific to that region, such as differences in pipeline shipping

capacity, unusually high or low demand for heating or cooling or supply

disruptions caused by severe weather. As a consequence, local natural

gas prices can differ from the Henry Hub price by more than the cost of

shipping and such price differences can vary in an unpredictable

manner.

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\14\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.

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The Chicago hub, operated by Nicor, Inc., serves as an

interconnection point for eight interstate pipelines. The firms that

service the Chicago area are ANR Pipeline Company, Natural Gas Pipeline

Company of America, Northern Border Pipe Line, Northern Natural Gas

Company, Midwestern Gas Transmission Company, Alliance Pipeline,

Panhandle Eastern Pipeline Company, and Horizon Pipeline.\15\ The

Chicago Market Center, which includes the Chicago hub, had an estimated

throughput capacity of 100 million cubic feet per day in 2008.

Moreover, the number of pipeline interconnections at the Chicago Market

Center was eight in 2008, up from seven in 2003. Lastly, the pipeline

interconnection capacity of the Chicago Market Center in 2008 was 2.4

billion cubic feet per day, which constituted a 9 percent increase over

the pipeline interconnection capacity in 2003.\16\ The Chicago hub is

far removed from the Henry Hub but is not directly connected to the

Henry Hub by an existing pipeline.

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\15\ See http://www.nicor.com/en_us/commercial/gas_xchange/

chicago_hub.htm.

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

feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf

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The local price at the Chicago 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 Chicago price. Moreover,

exogenous factors, such as adverse weather, can cause the Chicago gas

price to differ from the Henry Hub price by an amount that is more or

less than the cost of shipping, making the NYMEX Henry Hub futures

contract even less precise as a hedging tool than desired by market

participants. Basis contracts \17\ allow traders to more accurately

discover prices at alternative locations and hedge price risk that is

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

position at a local price for an alternative location can be

established by adding the appropriate basis swap position to a position

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

NYMEX or ICE Henry Hub look-alike contract, which cash settle based on

the NYMEX physically-delivered natural gas contract's final settlement

price).

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\17\ Basis contracts denote the difference in the price of

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

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

negative value.

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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 DGD

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 DGD contract.

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1. Material Price Reference Criterion.

The Commission's October 9, 2009, Federal Register notice

identified material price reference as a potential basis for a SPDC

determination with respect to this contract. The Commission considered

the fact that ICE 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 Chicago 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 Chicago 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 DGD 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 ``Midcontinent 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

[[Page 24636]]

historical data. These two packages include price data for the DGD

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 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.\20\ With respect to direct evidence, the

Commission will consider the extent to which, on a frequent and

recurring basis, cash market bids, offers or transactions are directly

based on or quoted at a differential to, the prices generated on the

ECM in question. Direct evidence may be established when cash market

participants are quoting bid or offer prices or entering into

transactions at prices that are set either explicitly or implicitly at

a differential to prices established for the contract in question. Cash

market prices are set explicitly at a differential to the section

2(h)(3) contract when, for instance, they are quoted in dollars and

cents above or below the reference contract's price. Cash market prices

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

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

from the section 2(h)(3) contract, but then quoted or reported at a

flat price. With respect to indirect evidence, the Commission will

consider the extent to which the price of the contract in question is

being routinely disseminated in widely distributed industry

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

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

industry participants in pricing cash market transactions.

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\20\ 17 CFR part 36, Appendix A.

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The Chicago hub is a particularly important trading center and

pricing point for natural gas in the United States. It is one of only

two market centers (the other is ANR's Joliet Hub) located in the

Midwest region. The Chicago Hub is strategically located at a point

where eight major interstate pipelines transporting natural gas from

Canada, the Southwest, and the Gulf of Mexico converge. In particular,

it is linked with three pipelines that also transport gas from the

Henry Hub in Louisiana. As a result, Chicago prices are often compared

with those at the Henry Hub in analyzing bias differences between the

two points during heavy demand periods.\21\

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\21\ http://www.eia.doe.gov/pub/oil_gas/natural_gas/feature_

articles/2003/market_hubs/mkthubsweb.html

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Traders, including producers, keep abreast of the prices of the DGD

contract when conducting cash deals. These traders look to a

competitively determined price as an indication of expected values of

natural gas at the Chicago hub when entering into cash market

transaction for natural gas, especially those trades providing for

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

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

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

discovery utility. The substantial volume of trading and open interest

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

While the DGD 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.\22\ As a result, the DGD contract satisfies the direct

price reference test.

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\22\ In addition to referencing ICE prices, natural gas market

firms participating in the Chicago market may rely on other cash

market quotes as well as industry publications and price indices

that are published by third-party price reporting firms when

entering into natural gas transactions.

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In terms of indirect price reference, ICE sells the DGD contract's

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

Chicago hub is a major natural gas trading point, and the DGD

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

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

Commission believes that it is reasonable to conclude that market

participants are purchasing the data packages that include the DGD

contract's prices in substantial part because the DGD 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 DGD contract meets the

indirect price reference test.

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

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

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

futures contract are executed in NYMEX's centralized marketplace.

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

submitted to NYMEX for clearing. The daily settlement prices of the

NYMEX Chicago Basis Swap futures contract are influenced, in part, by

the daily settlement prices of the ICE DGD 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 DGD price, among other information,

as an important indicator as to where the market is trading. Therefore,

the ICE DGD price influences the settlement price for the NYMEX Chicago

Basis Swap futures contract. This is supported by an analysis of the

daily settlement prices for the NYMEX and ICE Chicago contracts. In

this regard, 97 percent of the daily settlement prices for the NYMEX

Chicago Basis Swap futures contract are within one standard deviation

of the DGD contract's price settlement prices.

Lastly, the fact that the DGD 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 Chicago natural gas prices showed that 47

percent of the observations were more than 2.5 percent different than

the contemporaneous Henry Hub prices. The average Chicago basis value

between January 2008 and September 2009 was -$0.06 per mmBtu with a

variance of $0.04 per mmBtu.

i. Federal Register Comments

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

meet the material price reference criterion for SPDC determination. ICE

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

contract is potentially a SPDC on two disputable assertions. First, in

issuing its notice of intent to determine whether the DGD 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.'' \23\ ICE states that CFTC's

conclusion 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.'' \24\ In response to the above comment, the Commission

notes that it cited the ECM study's general finding

[[Page 24637]]

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. The ECM Study was not intended to serve

as the sole basis for determining whether or not a particular contract

meets the material price reference criterion.

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\23\ CL 03.

\24\ CL 03.

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Second, ICE argued that the Commission should not base a

determination that the DGD contract is a SPDC on the fact that this

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

Chicago Index price. While the Commission acknowledges that there are

other firms that produce price indices for the Chicago market, 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 DGD swap since ICE has the exclusive right to use the IPI

index.\25\

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\25\ Futures and swaps based on other Chicago indices have not

met with the same market acceptance as the DGD contract. For

example, NYMEX lists a basis swap contract that is comparable to the

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

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

approximately 19,000 contracts in the NYMEX Chicago Basis Swap

contract versus about 134,000 contracts in ICE's DGD contract.

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

Chicago 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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WGCEF, NGSA, EI and FIEG all stated that the DGD contract does not

satisfy the material price reference criterion. The commenters argued

that other contracts (physical or financial) are not indexed basis the

ICE DGD contract price, but rather are indexed based on the underlying

cash price series against which the ICE DGD 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

criteria if market participants ``consult on a frequent and recurring

basis'' the derivatives contract when pricing forward, fixed-price

commitments or other cash-settled derivatives that seek to ``lock in''

a fixed price for some future point in time to hedge against adverse

price movements.

As noted above, the Chicago market is a major trading center for

natural gas in North America. Traders, including producers, keep

abreast of the prices of the DGD contract when conducting cash deals.

These traders look to a competitively determined price as an indication

of expected values of natural gas at Chicago when entering into cash

market transaction for natural gas, especially those trades that

provide for physical delivery in the future. Traders use the ICE DGD

contract to hedge cash market positions and transactions, which

enhances the DGD contract's price discovery utility. While the DGD

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, such as those for the

DGD contract. Instead, traders are interested in the settlement prices,

so the fact that ICE sells the DGD prices as part of a broad package is

not conclusive evidence that market participants are buying the ICE

data sets because they find the DGD prices have substantial value to

them. The Commission notes that the Chicago hub is a major natural gas

trading point, and the DGD contract's prices are well regarded in the

industry as indicative of the value of natural gas at Chicago.

Accordingly, the Commission believes that it is reasonable to conclude

that market participants are purchasing the data packages that include

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

prices have particular value to them.

ii. Conclusion Regarding Material Price Reference

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

the ECM (i.e., ICE) sells the DGD contract's price data to market

participants and it is reasonable to conclude that market participants

are purchasing the data packages that include the DGD contract's prices

in substantial part because the DGD contract prices have particular

value to them. Furthermore, such prices are consulted on a frequent and

reoccurring 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 DGD contract. In this regard, the final settlement

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

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

is registered with the Commission as a DCM.

The Commission's Guidance on Significant Price Discovery Contracts

\26\ 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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\26\ Appendix A to the Part 36 rules.

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To assess whether the DGD 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 Chicago

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

NYMEX physically-delivered natural gas futures contract (a DCM

contract), the Chicago price 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, 53 percent of

[[Page 24638]]

the Chicago natural gas prices derived from the ICE basis values were

within 2.5 percent of the daily settlement price of the NYMEX Henry Hub

futures contract. In addition, staff finds that the DGD 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 DGD contract during the same period was 63,499 contracts

(equivalent to 15,875 NYMEX contracts, given the size difference).\27\

Thus, centralized-market trades in the DGD contract amounted to less

than the minimum threshold.

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\27\ The DGD contract is one-quarter the size of the NYMEX Henry

Hub physically-delivered futures contract.

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

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

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

contracts. That is, even though an ECM contract may specifically use a

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

of the DGD 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 Chicago hub

and the Henry Hub are located in two different areas of the United

States. The Henry Hub primarily is a supply center while Chicago

primarily 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

NGSA \28\ stated that the DGD contract does not meet the price

linkage criterion because basis contracts, including the DGD contract,

are not equivalent to the NYMEX physically-delivered Henry Hub

contract. EI \29\ also noted that the DGD and NYMEX natural gas

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

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

WGCEF \30\ stated that the Chicago 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 DGD contract ``(a) is not

substantially the same as the NYMEX [natural gas futures contract] * *

* nor (b) does it move substantially in conjunction'' with the NYMEX

natural gas futures contract. ICE \31\ opined that the DGD contract's

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

NYMEX natural gas futures contract. In addition, ICE states that the

DGD contract simply reflects a price differential between Chicago hub

and the Henry Hub; ``there is no price linkage as contemplated by

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

the DGD 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 Chicago hub and not the

NYMEX physically-delivered natural gas futures price.

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\28\ CL 05.

\29\ CL 04.

\30\ CL 02.

\31\ CL 03.

\32\ CL 07.

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ii. Conclusion Regarding the Price Linkage Criterion

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

and potential importance, and second performed a statistical analysis

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

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

Permian Financial Basis contract (an ECM contract), ICE Waha Financial

Basis contract (an ECM contract) and ICE NGPL TxOk Financial Basis

contract (an ECM contract).\33\

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\33\ As noted above, the material liquidity criterion speaks to

the effect that transactions in the potential SPDC may have on

trading in ``agreements, contracts and transactions listed for

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

a derivatives transaction execution facility, or an electronic

trading facility operating in reliance on the exemption in section

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

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

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

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

Commission in its October 9, 2009, Federal Register notice referred to

second quarter 2009 trading statistics that ICE had submitted for its

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

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

electronic trading platform was 1,572 in the second quarter of 2009,

resulting in a daily average of 24.6 trades. During the same period,

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

platform of 146,193 contracts and an average daily trading volume of

2,284,3 contracts. Moreover, the open interest as of June 30, 2009, was

127,744 contracts, which includes trades executed on ICE's electronic

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

trading platform and then brought to ICE for clearing.\34\

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\34\ ICE does not differentiate between open interest created by

a transaction executed on its trading platform versus that created

by a transaction executed off its trading platform.

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

submitted another quarterly notification filed on November 13,

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

to its DGD contract, 782 separate trades occurred on its electronic

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

11.8 trades. During the same period, the DGD contract had a total

trading volume on its electronic platform of 63,499 contracts (which

was an average of 962 contracts per day).\36\ As of September 30, 2009,

open interest in the DGD contract was 134,031 \37\ 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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\35\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).

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

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

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

Board of Trade's Oats contract during this period.

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

similar to that exhibited on a liquid futures market and is roughly

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

futures contract.

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In the Guidance, the Commission stated that material liquidity can

be identified by the impact liquidity exhibits through observed prices.

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

material impact, the Commission reviewed the relevant

[[Page 24639]]

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

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

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

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

indicates that the DGD contract experiences trading activity similar to

that of other thinly-traded contracts.\38\ However, the DGD contract

has substantial open interest. This factor coupled with the importance

of this trading center as a price reference point, makes it reasonable

to infer that the DGD contract could have a material effect on other

ECM contracts or on DCM contracts.

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

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

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

third quarter of 2009, physical commodity futures contracts with

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

one percent of total trading volume of all physical commodity

futures contracts.

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To measure the effect that the DGD contract potentially could have

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

performed a statistical analysis \39\ using daily settlement prices

(between January 2, 2008, and September 30, 2009) for the DGD contract,

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

contract) and the ICE Waha Financial Basis, ICE Permian Financial Basis

and ICE NGPL TxOk Financial Basis contracts (ECM contracts). The

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

one percent rise in the DGD contract's price elicited a 1 percent

increase in each of the other contracts' prices.

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\39\ Specifically, Commission staff econometrically estimated a

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

vector autoregression model is an econometric model used to capture

the evolution and the interdependencies between multiple time

series, generalizing the univariate autoregression models. The

estimated model displays strong diagnostic evidence of statistical

adequacy. In particular, the model's impulse response function was

shocked with a one-time rise in DGD contract's price. The simulation

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

percent rise in the DGD contract's price elicited a 1percent

increase in the NYMEX Henry Hub and the ICE NGPL TxOk, Permian and

Waha prices. These multipliers of response emerge with noticeable

statistical strength or significance. Based on such long run sample

patterns, if the DGD contract's price rises by 10 percent, then the

price of the other contracts each would rise by about 10 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 DGD contract. WGCEF, EI, FIEG, ICE and NGSA

generally agreed that the DGD contract does not meet the material

liquidity criterion.

WGCEF \40\ and NGSA \41\ both stated that the DGD 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 DGD

contract is influenced by the underlying Chicago cash price index and

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

contract, not vice versa. FIEG \42\ stated that the DGD contract cannot

have a material effect on NYMEX contract because the DGD 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 DGD contract's price significantly

influences the prices of other contracts that are traded on DCMs and

ECMs.

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\40\ CL 02.

\41\ CL 05.

\42\ CL 07.

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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''

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

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

threshold may be subject to scrutiny as a potential SPDC. As noted

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

ICE DGD contract, in part, on the fact that the Chicago hub is an

important pricing point and changes in the DGD contract's prices

significantly affect those of other ECM contracts and DCM contracts.

The DGD contract also has significant open interest.

ICE implied that the statistics provided by ICE were misinterpreted

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

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

``include trades made in all [72] 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.'' ICE stated that only about 25 to

40 percent of the trades occurred in the single most liquid, usually

prompt, month of the contract.

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

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

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

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

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

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

cited above in an appropriate manner for gauging material liquidity.

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

that it provided to the Commission in its quarterly filing and which

are cited above includes 2(h)(1) transactions, which were not completed

on the electronic trading platform and should not be considered in the

SPDC determination process. Commission staff asked ICE to review the

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

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

October 9, 2009, Federal Register notice, as well as the additional

volume information it cites above, includes only transaction data

executed on ICE's electronic trading platform. The Commission

acknowledges that the open interest information it cites above includes

transactions made off the ICE platform.\43\ However, once open interest

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

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

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

agreeable to the position holder regardless of how the position was

initially created.

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\43\ Supplemental data supplied by the ICE confirmed that block

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

that were conducted on the electronic platform; block trades

comprised 64 percent of all transactions in the DGD contract.

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ii. Conclusion Regarding Material Liquidity

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

meets the material liquidity criterion in that there is sufficient

trading activity in the DGD 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).

[[Page 24640]]

4. Overall Conclusion

After considering the entire record in this matter, including the

comments received, the Commission has determined that the DGD 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 DGD contract does not meet the price

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

DGD contract does meet both the material liquidity and material price

reference criteria. Accordingly, the Commission is issuing the attached

Order declaring that the DGD 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 DGD contract,\44\ and triggers the obligations,

requirements--both procedural and substantive--and timetables

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

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\44\ See 73 FR 75888, 75893 (Dec. 12, 2008).

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V. Related Matters

a. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (``PRA'') \45\ imposes certain

requirements on Federal agencies, including the Commission, in

connection with their conducting or sponsoring any collection of

information as defined by the PRA. Certain provisions of Commission

rule 36.3 impose new regulatory and reporting requirements on ECMs,

resulting in information collection requirements within the meaning of

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

3038-0060 to this collection of information.

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

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b. Cost-Benefit Analysis

Section 15(a) of the CEA \46\ requires the Commission to consider

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

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

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

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

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

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

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

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

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

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

interest considerations. The Commission may in its discretion give

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

discretion determine that, notwithstanding its costs, a particular

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

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

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

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

concluded that the Order, required by Congress to strengthen federal

oversight of exempt commercial markets and to prevent market

manipulation, is necessary and appropriate to accomplish the purposes

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

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\46\ 7 U.S.C. 19(a).

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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'') \47\ requires that

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

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

The Commission previously has determined that ECMs are not small

entities for purposes of the RFA.\48\ Accordingly, the Chairman, on

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

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

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

substantial number of small entities.

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\47\ 5 U.S.C. 601 et seq.

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

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VI. Order

a. Order Relating to the Chicago 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 Chicago 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 Chicago Financial Basis

contract, the nine core principles established by new section

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

and is considered a registered entity \49\ with respect to the Chicago

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

Commodity Exchange Act applicable to registered entities.

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

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Further, the obligations, requirements and timetables prescribed in

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

IntercontinentalExchange, Inc., commence with the issuance of this

Order.\50\

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\50\ Because ICE already lists for trading a contract (i.e., the

Henry Financial LD1 Fixed Price contract) that was previously

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

demonstration of compliance with the Core Principles within 30

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

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

David A. Stawick,

Secretary of the Commission.

[FR Doc. 2010-10344 Filed 5-4-10; 8:45 am]

BILLING CODE P

Last Updated: May 5, 2010