[Federal Register Volume 75, Number 85 (Tuesday, May 4, 2010)]
[Notices]
[Pages 23710-23718]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-10305]
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COMMODITY FUTURES TRADING COMMISSION
Order Finding That the ICE PG&E Citygate 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 PG&E Citygate Financial Basis (``PGE'') 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 PGE 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 52210 (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,
[[Page 23711]]
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, Pub. L. 110-246, 122 Stat. 1624 (June 18, 2008).
\3\ 7 U.S.C. 1a(29).
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On March 16, 2009, the CFTC promulgated final rules implementing
the provisions of the Reauthorization Act.\4\ As relevant here, rule
36.3 imposes increased information reporting requirements on ECMs to
assist the Commission in making prompt assessments whether particular
ECM contracts may be SPDCs. In addition to filing quarterly reports of
its contracts, an ECM must notify the Commission promptly concerning
any contract traded in reliance on the exemption in section 2(h)(3) of
the CEA that averaged five trades per day or more over the most recent
calendar quarter, and for which the exchange sells its price
information regarding the contract to market participants or industry
publications, or whose daily closing or settlement prices on 95 percent
or more of the days in the most recent quarter were within 2.5 percent
of the contemporaneously determined closing, settlement or other daily
prices of another contract.
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\4\ 74 FR 12178 (Mar. 23, 2009); these rules became effective on
April 22, 2009.
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Commission rule 36.3(c)(3) established the procedures by which the
Commission makes and announces its determination whether a particular
ECM contract serves a significant price discovery function. Under those
procedures, the Commission will publish notice in the Federal Register
that it intends to undertake an evaluation whether the specified
agreement, contract or transaction performs a significant price
discovery function and to receive written views, data and arguments
relevant to its determination from the ECM and other interested
persons. Upon the close of the comment period, the Commission will
consider, among other things, all relevant information regarding the
subject contract and issue an order announcing and explaining its
determination whether or not the contract is a SPDC. The issuance of an
affirmative order signals the effectiveness of the Commission's
regulatory authorities over an ECM with respect to a SPDC; at that time
such an ECM becomes subject to all provisions of the CEA applicable to
registered entities.\5\ The issuance of such an order also triggers the
obligations, requirements and timetables prescribed in Commission rule
36.3(c)(4).\6\
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\5\ Public Law 110-246 at 13203; Joint Explanatory Statement of
the Committee of Conference, H.R. Rep. No. 110-627, 110 Cong., 2d
Sess. 978, 986 (Conference Committee Report). See also 73 FR 75888,
75894 (Dec. 12, 2008).
\6\ For an initial SPDC, ECMs have a grace period of 90 calendar
days from the issuance of a SPDC determination order to submit a
written demonstration of compliance with the applicable core
principles. For subsequent SPDCs, ECMs have a grace period of 30
calendar days to demonstrate core principle compliance.
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II. Notice of Intent To Undertake SPDC Determination
On October 9, 2009, the Commission published in the Federal
Register notice of its intent to undertake a determination whether the
PGE 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 PGE
contract is a SPDC; IECA concluded that the PGE 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 PGE contract, generally asserting that the PGE
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 Web site: http://www.cftc.gov/lawandregulation/federalregister/federalregistercomments/2009/09-023.html.
\9\ FERC stated that the PGE 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 (references the number of the comment letter (``CL'') in the
public record).
\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
[[Page 23712]]
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 PGE 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 36, Appendix A.
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IV. Findings and Conclusions
a. The PG&E Citygate (PGE) Financial Basis Contract and the SPDC
Indicia
The PGE contract is cash settled based on the difference between
the bidweek price index for the price of natural gas at the PG&E
Citygate for the month of delivery, as published in 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
PG&E Citygate 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 PGE contract is 2,500 million British thermal units
(``mmBtu''), and the unit of trading is any multiple of 2,500 mmBtu.
The PGE 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 PG&E Citygate is part of the Golden Gate Market Center, which
is located in Northern California. The Golden Gate Market Center offers
seven
[[Page 23713]]
different transaction points, which are Malin, Citygate, Kern River
Station, High Desert Lateral, Daggett, Southern Trails and Topock.
Citygate serves as interconnection between the backbone pipeline system
and the local transmission and distribution lines.\15\ The Golden Gate
Market Center had an estimated throughput capacity of two billion cubic
feet per day in 2008. Moreover, the number of pipeline interconnections
at the Golden Gate Market Center was nine in 2008, up from eight in
2003. Lastly, the pipeline interconnection capacity of the Golden Gate
Market Center in 2008 was 6 billion cubic feet per day, which
constituted a 32 percent increase over the pipeline interconnection
capacity in 2003.\16\ The PG&E Citygate is far removed from the Henry
Hub and is not directly connected to the Henry Hub by an existing
pipeline.
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\15\ The cash market transactions included in the comparable
Platts index are those fixed-price gas deliveries from Pacific Gas
and Electric's intrastate transmission system to citygates on PG&E's
local distribution system in Northern California.
\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 PG&E Citygate 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 PG&E Citygate
price. Moreover, exogenous factors, such as adverse weather, can cause
the PG&E Citygate 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 PGE
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 PGE 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 PG&E Citygate 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 PG&E
Citygate 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 PGE 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 ``West Gas End of Day'' and ``OTC
Gas End of Day'' \19\ 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 PGE
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 PG&E Citygate is a major trading center for natural gas in the
United States. Traders, including producers, keep abreast of the prices
of the PGE contract when conducting cash deals. These traders look to a
competitively determined price as an indication of expected values of
natural gas at the PG&E Citygate when entering into cash market
transaction for natural gas, especially those trades providing for
physical delivery in the future. Traders use the ICE PGE contract, as
well as other ICE basis swap contracts, to hedge cash market positions
and transactions--activities which enhance the PGE contract's price
discovery utility. The substantial volume of trading and open interest
in the PGE contract appears to attest to its use for this purpose.
While the PGE contract's settlement prices may not be the only factor
influencing spot and forward transactions, natural gas traders consider
the ICE price to be a critical factor in conducting OTC
transactions.\21\ As a result, the PGE contract satisfies the direct
price reference test.
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\21\ In addition to referencing ICE prices, natural gas market
firms participating in the PG&E Citygate 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 PGE contract's
prices as part of a broad package. The Commission notes that the PG&E
Citygate is a major natural gas trading point, and the PGE contract's
prices are well regarded in the industry as indicative of the value of
natural gas at the PG&E Citygate. Accordingly, the Commission believes
that it is reasonable to conclude that market participants are
purchasing the data packages that include the PGE contract's prices in
substantial part because the PGE contract prices have particular value
to them. Moreover, such prices are
[[Page 23714]]
consulted on a frequent and reoccurring basis by industry participants
in pricing cash market transactions. In light of the above, the PGE
contract meets the indirect price reference test.
NYMEX lists a futures contract that is comparable to the ICE PGE
contract on its ClearPort platform. However, unlike the ICE contract,
none of the trades in the NYMEX, PG&E Citygate 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 PG&E Citygate Basis Swap futures contract are
influenced, in part, by the daily settlement prices of the ICE PGE
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 PGE
price, among other information, as an important indicator as to where
the market is trading. Therefore, the ICE PGE price influences the
settlement price for the NYMEX PG&E Citygate Basis Swap futures
contract. This is supported by an analysis of the daily settlement
prices for the NYMEX and ICE PG&E Citygate contracts. In this regard,
97 percent of the daily settlement prices for the NYMEX PG&E Citygate
Basis Swap futures contract are within one standard deviation of the
PGE contract's price settlement prices.
Lastly, the fact that the PGE 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 PG&E Citygate natural gas prices showed that
55 percent of the observations were more than 2.5 percent different
than the contemporaneous Henry Hub prices. The average PG&E Citygate
basis value between January 2008 and September 2009 was -$0.16 per
mmBtu with a variance of $0.10 per mmBtu.
i. Federal Register Comments
ICE stated in its comment letter that the PGE contract does not
meet the material price reference criterion for SPDC determination. ICE
argued that the Commission appeared to base the case that the PGE
contract is potentially a SPDC on two disputable assertions. First, in
issuing its notice of intent to determine whether the PGE contract is a
SPDC, the CFTC cited a general conclusion in its ECM study ``that
certain market participants referred to ICE as a price discovery market
for certain natural gas contracts.'' \22\ ICE states that CFTC's reason
is ``hard to quantify as the ECM report does not mention'' this
contract as a potential SPDC. ``It is unknown which market participants
made this statement in 2007 or the contracts that were referenced.''
\23\ In response to the above comment, the Commission notes that it
cited the ECM study's general finding that some ICE natural gas
contracts appear to be regarded as price discovery markets merely as an
indicia that an investigation of certain ICE contracts may be
warranted, and was not intended to serve as the sole basis for
determining whether or not a particular contract meets the material
price reference criterion.
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\22\ CL 03.
\23\ CL 03.
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Second, ICE argued that the Commission should not base a
determination that the PGE contract is a SPDC on the fact that this
contract has the exclusive right to base its settlement on the IPI PG&E
Citygate Index price. While the Commission acknowledges that there are
other firms that produce price indices for the PG&E Citygate, 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 PGE swap since ICE has the exclusive right to use the IPI
index.\24\
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\24\ Futures and swaps based on other PG&E Citygate indices have
not met with the same market acceptance as the PGE contract. For
example, NYMEX lists a basis swap contract that is comparable to the
PGE 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 PG&E Citygate Basis Swap
contract versus about 167,000 contracts in ICE's PGE contract.
Moreover, there has been no centralized-market trading in the NYMEX
PG&E Citygate 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 PGE 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 PGE contract price, but rather are indexed based on the
underlying cash price series against which the ICE PGE 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 PG&E Citygate is a major trading center for
natural gas in North America. Traders, including producers, keep
abreast of the prices of the PGE contract when conducting cash deals.
These traders look to a competitively determined price as an indication
of expected values of natural gas at the PG&E Citygate when entering
into cash market transaction for natural gas, especially those trades
that provide for physical delivery in the future. Traders use the ICE
PGE contract to hedge cash market positions and transactions, which
enhances the PGE contract's price discovery utility. While the PGE
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
PGE contract. Instead, traders are interested in the settlement prices,
so the fact that ICE sells the PGE prices as part of a broad package is
not conclusive evidence that market participants are buying the ICE
data sets because they find the PGE prices have substantial value to
them. The Commission notes that the PG&E Citygate is a major natural
gas trading point, and the PGE contract's prices are well regarded in
the industry as indicative of the value of natural gas at the PG&E
Citygate. Accordingly, the Commission believes that it is
[[Page 23715]]
reasonable to conclude that market participants are purchasing the data
packages that include the PGE contract's prices in substantial part
because the PGE contract prices have particular value to them.
ii. Conclusion Regarding Material Price Reference
Based on the above, the Commission finds that the PGE 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 PGE contract's price (direct evidence). Moreover,
the ECM sells the PGE contract's price data to market participants and
it is reasonable to conclude that market participants are purchasing
the data packages that include the PGE contract's prices in substantial
part because the PGE 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 PGE contract. In this regard, the final settlement
of the PGE 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
\25\ 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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\25\ Appendix A to the Part 36 rules.
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To assess whether the PGE 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 PG&E
Citygate price is determined, in part, by the final settlement price of
the NYMEX physically-delivered natural gas futures contract (a DCM
contract), the PG&E Citygate 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, 45 percent of the PG&E Citygate 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 PGE 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
PGE contract during the same period was 108,468 contracts (equivalent
to 27,117 NYMEX contracts, given the size difference).\26\ Thus,
centralized-market trades in the PGE contract amounted to less than the
minimum threshold.
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\26\ The PGE 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 PGE 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 PG&E
Citygate and the Henry Hub are located in two different areas of the
United States. The Henry Hub primarily is a supply center while the
PG&E Citygate 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 \27\ stated that the PGE contract does not meet the price
linkage criterion because basis contracts, including the PGE contract,
are not equivalent to the NYMEX physically-delivered Henry Hub
contract. EI \28\ also noted that the PGE and NYMEX natural gas
contracts are not economically equivalent and that the PGE contract's
volume is too low to affect the NYMEX natural gas futures contract.
WGCEF \29\ stated that the PG&E Citygate 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 PGE 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 \30\ opined that the PGE 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
PGE contract simply reflects a price differential between PG&E Citygate
and the Henry Hub; ``there is no price linkage as contemplated by
Congress or the CFTC in its rulemaking.'' FIEG \31\ acknowledged that
the PGE 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 PG&E Citygate location and
not the NYMEX physically-delivered natural gas futures price.
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\27\ CL 05.
\28\ CL 04.
\29\ CL 02.
\30\ CL 03.
\31\ CL 07.
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ii. Conclusion Regarding the Price Linkage Criterion
Based on the above, the Commission finds that the PGE contract does
not meet the price linkage criterion because
[[Page 23716]]
it fails the price relationship and volume tests provided for in the
Commission's Guidance.
3. Material Liquidity Criterion
To assess whether the PGE 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 PGE market's size
and potential importance, and second performed a statistical analysis
to measure the effect that changes to PGE prices potentially may have
on prices for the NYMEX Henry Hub Natural Gas (a DCM contract), the ICE
NWP Financial Basis contract (an ECM contract) and the ICE Malin
Financial Basis contract (an ECM contract).\32\
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\32\ 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
PGE contract. Based upon on a required quarterly filing made by ICE on
July 27, 2009, the total number of PGE trades executed on ICE's
electronic trading platform was 1,142 in the second quarter of 2009,
resulting in a daily average of 17.8 trades. During the same period,
the PGE contract had a total trading volume on ICE's electronic trading
platform of 99,418 contracts and an average daily trading volume of
1,553.4 contracts. Moreover, the open interest as of June 30, 2009, was
150,299 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.\33\
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\33\ 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,\34\ with updated trading statistics. Specifically, with respect
to its PGE contract, 1,514 separate trades occurred on its electronic
platform in the third quarter of 2009, resulting in a daily average of
22.9 trades. During the same period, the PGE contract had a total
trading volume on its electronic platform of 108,468 contracts (which
was an average of 1,643 contracts per day).\35\ As of September 30,
2009, open interest in the PGE contract was 166,981 \36\ 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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\34\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).
\35\ By way of comparison, the number of contracts traded in the
PGE contract is similar to that exhibited on a liquid futures market
and is roughly equivalent to the volume of trading for the NYMEX
Palladium futures contract during this period.
\36\ By way of comparison, open interest in the PGE 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 PGE 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 above the minimum
reporting level (5 trades per day). Moreover, trading activity in the
PGE contract, as characterized by total quarterly volume, indicates
that the PGE contract experiences trading activity that generally
exceeds that found in thinly-traded markets.\37\ Thus, it is reasonable
to infer that the PGE contract could have a material effect on other
ECM contracts or on DCM contracts.
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\37\ 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 PGE contract potentially could have
on a DCM contract, or on another ECM contract, Commission staff
performed a statistical analysis \38\ using daily settlement prices
(between January 2, 2008, and September 30, 2009) for the PGE contract,
as well as for the NYMEX Henry Hub natural gas contract (a DCM
contract) and the ICE NWP Rockies Financial Basis and ICE Malin
Financial Basis contracts (ECM contracts). The simulation results
suggest that, on average over the sample period, a one percent rise in
the PGE contract's price elicited a 1.1 percent increase in each of the
NYMEX Henry Hub and ICE Malin prices, as well as a 1 percent increase
in the Rockies price.
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\38\ 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 PGE contract's price. The simulation
results suggest that, on average over the sample period, a one-
percent rise in the PGE contract's price elicited a 1.1 percent
increase in the NYMEX Henry Hub and Malin prices, as well as a one
percent increase in the Rockies contract's price. These multipliers
of response emerge with noticeable statistical strength or
significance. Based on such long run sample patterns, if the PGE
contract's price rises by 10 percent, then the price of NYMEX Henry
Hub natural gas futures contract, as well as those for the ICE basis
swap contracts based on the Rockies and Malin hubs, each would rise
by about 10 percent to 11 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 PGE contract. WGCEF, EI, FIEG, ICE and NGSA
generally agreed that the PGE contract does not meet the material
liquidity criterion.
WGCEF \39\ and NGSA \40\ both stated that the PGE 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 PGE
contract is influenced by the underlying PG&E Citygate cash price index
and the final settlement price of the NYMEX Henry Hub natural gas
futures contract, not vice versa. FIEG \41\ stated that the PGE
contract cannot have a material effect on NYMEX contract because the
PGE 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 PGE contract's price
significantly influences the prices of other contracts that are traded
on DCMs and ECMs.
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\39\ CL 02.
\40\ CL 05.
\41\ 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''
[[Page 23717]]
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 PGE contract, in part, on the fact that there have been more than
20 trades per day on average in the PGE contract during the third
quarter of 2009, which is quadruple the five trades-per-day that is
cited in the ICE comment. In addition, the Commission notes that the
number of contracts per transaction in the PGE contract is high
(approximately 72 contracts per transaction) and thus, as noted,
trading volume (measured in contract units) is substantial. The PGE
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 PGE contract, is typically a function of trading activity in
particular lead months and, given sufficient liquidity in such months,
the PGE contract itself would be considered liquid. ICE's analysis of
its own trade data confirms this to be the case for the PGE 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.\42\ 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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\42\ 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 63.4 percent of all transactions in the PGE contract.
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ii. Conclusion Regarding Material Liquidity
Based on the above, the Commission concludes that the PGE contract
meets the material liquidity criterion in that there is sufficient
trading activity in the PGE 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 PGE 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 PGE contract does not meet the price
linkage criterion at this time, the Commission has concluded that the
PGE contract does meet both the material liquidity and material price
reference criteria. Accordingly, the Commission is issuing the attached
Order declaring that the PGE 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 PGE contract,\43\ 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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\43\ 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'') \44\ 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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\44\ 44 U.S.C. 3507(d).
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b. Cost-Benefit Analysis
Section 15(a) of the CEA \45\ 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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\45\ 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
[[Page 23718]]
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'') \46\ 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.\47\ 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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\46\ 5 U.S.C. 601 et seq.
\47\ 66 FR 42256, 42268 (Aug. 10, 2001).
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VI. Order
a. Order Relating to the ICE PG&E Citygate 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 PG&E Citygate 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 PG&E Citygate 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 \48\ with respect to the PG&E
Citygate 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.\49\
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\48\ 7 U.S.C. 1a(29).
\49\ 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. 2010-10305 Filed 5-3-10; 8:45 am]
BILLING CODE P