Statement of Richard Shilts, Director, Division of Market Oversight on Meeting to Consider Significant Price Discovery Contract Determinations
April 27, 2010
Introduction
Before discussing the specific Exempt Commercial Market (ECM) contracts under consideration today, I would like to first provide background information with respect to actions taken so far in connection with the implementation of the significant price discovery (SPDC) provisions. Then, I will provide an overview of the contracts being considered today.
As you know, ECMs are essentially unregulated trading facilities that are not required to surveil trading on their markets, and the Commission does not oversee the markets or trading thereon. As Dan Berkovitz explained, Congress, in passing the Reauthorization bill, provided that certain ECM contracts – those declared SPDCs – should come under CFTC oversight authority and be subject to the self-regulatory authority of their ECMs.
Last March, the Commission adopted amendments to its Part 36 rules to implement those provisions of the CFTC Reauthorization Act relating to ECMs on which SPDCs may be traded. The Commission also amended existing regulations applicable to registered entities in order to clarify that those regulations would apply to ECMs with SPDCs.
SPDC Criteria
In determining whether an ECM contract should be declared a SPDC, Congress established four criteria to be considered. They are:
• Price linkage: the extent to which an ECM contract uses or otherwise relies on a daily or final settlement price of a contract listed for trading on or subject to the rules of a DCM or DTEF
• Arbitrage: the extent to which the price of an ECM contract is sufficiently related to the price of a contract listed for trading on or subject to the rules of a DCM or DTEF to permit market participants to effectively arbitrage between the two markets
• 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, the prices generated by contracts being traded or executed on the ECM
• Material liquidity: the extent to which the volume of an ECM contract is sufficient to have a material effect on other contracts listed for trading on or subject to the rules of a DCM, DTEF, or an ECM
Guidance on applying the SPDC criteria
Because the criteria mandated by Congress do not lend themselves to a mechanical checklist or formulaic analysis, the Commission explained in Appendix A to the Part 36 rules how it expects to apply the criteria in making its determinations. The guidance explains that all four criteria need not be present for a SPDC determination.
The criteria, in some cases, may be inter-related. Generally speaking, the arbitrage and price linkage criteria attempt to identify contracts trading on an ECM that are essentially “look-alikes” of a contract listed on a DCM, and have sufficient trading activity to affect prices of the DCM contract. The material liquidity criteria also attempts to identify contracts trading on an ECM that have the potential to affect prices on another market, including contracts listed on a DCM or on the same or another ECM. The material liquidity criteria is somewhat broader in scope than the arbitrage and price linkage criteria and may include contracts that are not structured explicitly as “look-alikes” of another contract but can still affect pricing of that contract. The material price reference criterion focuses on contracts that serve a unique pricing function for a particular location, product or quality. Generally speaking, the guidance provides that contracts that meet the material price reference criterion would be characterized by significant trading volume.
Reporting requirements for all ECMs
The Part 36 rules establish quarterly reporting requirements for ECMs, so the Commission will be notified when ECM contracts start to display possible signs of being a SPDC. ECMs are required to notify the Commission of any contract:
• that averaged 5 or more trades per day over the preceding quarter; and
• for which the ECM 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 were within 2.5 percent of the contemporaneously determined closing, settlement or other daily price of another contract.
Annual reviews
Consistent with Congress’ direction, the Commission’ Part 36 rules provide for an annual review of ECM contracts to evaluate whether any are SPDCs. Staff’s recommendations today are the results of its initial evaluation of all ECM contracts.
Review process and action to date
The Part 36 rules also established a process by which SPDC determinations will be made. First, the Commission’s intent to undertake a SPDC determination with respect to a particular contract is announced in the Federal Register and interested persons are invited to comment. When it completes its analysis of information concerning the contract, including any comments received, the Commission issues an Order in the Federal Register explaining its determination whether the particular contract is or is not a SPDC.
Following a Commission determination that a particular ECM contract is a SPDC, the ECM must submit a written demonstration of compliance with the statutory core principles applicable to ECMs with SPDCs. The written demonstration is due within 90 calendar days of the Commission’s Order with respect to an ECM’s first SPDC, and within 30 calendar days for all of its subsequent SPDCs.
ECMs with SPDCs must establish a self-regulatory regime with respect to those contracts. Those responsibilities generally are set forth in 9 statutory core principles, largely derived from counterpart provisions among the 18 core principles for DCMs. In general, these core principles require the ECM to:
• implement an acceptable trade monitoring program;
• develop an audit trail in order to detect and deter market abuses;
• adopt speculative position limits or position accountability levels, and exemption provisions;
• develop and implement procedures for the exercise of emergency authority;
• make public daily trading information;
• develop a program to monitor compliance with the ECM’s rules;
• establish rules to minimize conflicts of interest in the ECM’s decision-making processes; and
• avoid taking any actions or adopting any rules that result in any unreasonable restraints on trade or impose any material anticompetitive burden on trading on the ECM.
An ECM with a SPDC is not required to take any such self-regulatory responsibility with respect to its non-SPDCs. However, such ECMs are required to satisfy the applicable reporting requirements for all contracts.
Shortly after publication of the final Part 36 rules in the Federal Register, DMO staff advised all ECMs in writing of their responsibilities under the new rules, including the responsibility to file quarterly reports with the Commission as well as provide the terms and conditions of their contracts relying on the 2(h)(3) exemption. The first round of quarterly reports formed a basis for staff’s initial review of all ECM contracts for the purpose of determining which of those contracts warranted further analysis as potential SPDCs. On the basis of this initial review, DMO staff identified approximately 90 ECM contracts that potentially were—or might be expected to develop into—SPDCs, and began its analyses.
ICE Henry Financial LD1 Fixed Price Contract Declared a SPDC
The first contract that the Commission determined to review for a SPDC determination was the Henry Financial LD1 Fixed Price contract traded on ICE. That contract is cash settled based on the final settlement price of the NYMEX physically-delivered Henry Hub-based natural gas futures contract. Staff concluded that this ICE contract satisfies the material liquidity, price linkage and arbitrage criteria for SPDCs. The contract’s very high average daily trading volume indicated that it was relatively liquid. In addition, with respect to the price linkage and arbitrage tests, the ICE contract and NYMEX’s physically-delivered Natural Gas futures contract have the same settlement prices, and ICE uses NYMEX’s forward settlement curve when conducting its mark-to-market accounting procedures to settle the contract on a daily basis. Moreover, traders and voice brokers view this contract as economically equivalent to the NYMEX physically delivered Natural Gas futures contract. Finally, it was found that traders look to both ICE and NYMEX when determining where to execute a trade at the best price. Accordingly, on July 24, 2009, the Commission issued an Order finding that the ICE Henry Financial LD1 Fixed Price contract is a SPDC. ICE then was required to demonstrate its compliance with the ECM SPDC core principles within 90 calendar days.
ICE’s Demonstration of Compliance
Similar to the Commission’s process for reviewing a DCM application, an interdivisional team was assembled to assess ICE’s demonstration of compliance with the SPDC Core Principles. Staff evaluated the ICE rulebook, compliance manual, participation agreement and related procedures adopted by ICE to enable it to comply with the core principles. Staff observed an on-site demonstration in Atlanta of the ICE Market and Trade Practice Surveillance processes and systems, and separately reviewed ICE’s technology, security, test procedures, and business continuity/disaster recovery plans. To carry out its oversight and compliance responsibilities, ICE hired a new director of regulatory affairs and a market surveillance manager and it increased staffing of its Market Surveillance Department. The Commission is receiving large trader position data for this contract. ICE also adopted speculative limits and position accountability provisions that are equivalent to those adopted for NYMEX for its natural gas contract. In conclusion, staff found that ICE has demonstrated full compliance with the ECM SPDC Core Principles.
Reviews of Additional Natural Gas Contracts as SPDCs
Staff then focused on the remaining 90 ECM contracts that were identified as potential SPDCs based on the quarterly reporting requirement (that is, contracts that met the minimum threshold of 5 trades per day) to consider whether they might be SPDCs. The Commission issued FR releases announcing its intent to undertake further analysis with respect to 41 of those contracts, which include:
• 23 natural gas related contracts traded on ICE and NGX
• 16 electricity contracts
• 1 refined petroleum contract
• 1 carbon financial instrument cash contract
Staff has completed its reviews of the natural gas contracts and the carbon financial contract, and has made recommendations that are to be considered today by the Commission. Staff’s complete analyses and recommendations are set out in the Federal Register releases.
The 23 natural gas contracts under consideration today are listed by two ECMs – ICE and Natural Gas Exchange (NGX). ICE is an Atlanta-based company that provides a forum for trading over-the-counter derivatives. ICE was established in May of 2000 to trade OTC energy contracts in an electronic environment and subsequently provided notice to the Commission of its intention to operate as an ECM pursuant to Section 2(h)(3) of the Act in December of 2001. Specifically, products traded on ICE’s OTC platform are primarily related to natural gas, power, natural gas liquids, chemicals and oil products. OTC energy market participants have the ability to trade bilaterally, or have the transaction cleared through the ICE Clear. As noted, ICE already has demonstrated compliance with the SPDC core principles with regard to the Henry Financial LD1 Fixed Price contract. NGX, an Alberta-based company, is an energy exchange providing physical clearing and settlement of natural gas trades.
The natural gas contracts generally can be classified in two broad categories. The largest group includes 17 basis contracts. The term “basis” in this context refers to the difference in the NYMEX settlement price for natural gas at the Henry Hub and the value of natural gas at another important production, storage or consumption center in the US or Canada. Each of these pricing points is distinct from the Henry Hub. Of these natural gas basis contracts, staff believes that 7 meet the criteria to be declared SPDCs based on material price reference and material liquidity. Staff believes that the remaining 10 contracts should not be declared SPDCs at this time because they do not meet the enumerated criteria.
The second category of natural gas contracts includes specialized contracts that are flat price (that is, they are not priced basis another location’s price), contracts that involve physical delivery and are essentially merchandising tools, and contracts that provide a more granular hedging mechanism for market participants.
Staff evaluated each of these contracts considering the SPDC criteria and what we believe to be Congressional intent that contracts traded on unregulated exempt markets that are being used as an integral component of pricing cash market trades, or affecting DCM or other ECM contracts, warrant regulation should come under CFTC oversight. Such contracts affect interstate commerce and the price consumers ultimately pay for the commodity.
Locational Basis Contracts Staff Believes Should be Declared SPDCs
Each of the 7 natural gas contracts that staff recommends should be declared a SPDC is a locational basis contract that prices natural gas at a specific location other than the Henry Hub. These locations are: Southern California border (with Arizona), PG&E Citygate (San Francisco area), Northwest Rockies (Wyoming, Utah, and Colorado), Alberta (Canada), Chicago, Houston Ship Channel, and Waha (West Texas near New Mexico border). While the specific details may differ with respect to the trading activity and open interest, the Division’s observations and basis for its conclusions are the same for each of these contracts – that is, the prices of these contracts are commonly used as a key source of price discovery for the cash market and the contracts all exhibit material liquidity.
Each of these contracts is accepted in the industry as a key reference price for natural gas at a particular important location in the U.S. or Canada. These contracts offer additional pricing information not provided by the active NYMEX and ICE SPDC Henry Hub contracts – that is, they provide critical information about the value of natural gas at a future point in time at a geographically dispersed location – each of which has unique supply and demand characteristics. These contracts also have significant open interest and trading volume and are widely used by cash markets participants for hedging price risks, as well as being key sources of price information. As part of the material liquidity analysis, these basis contracts were found to have a statistically significant effect on other ECM contracts and contracts listed for trading on DCMs.
I will summarize observations for one such contract – the ICE SoCal Financial Basis contract. The Socal contract prices natural gas at the Southern California border, which neighbors Arizona. The Socal hub is a major demand center for gas that flows to Southern California, such as Los Angeles and San Diego, from West Texas. The California Energy Hub, a market center that includes the Socal Border Hub, had an estimated throughput capacity of 900 million cubic feet per day. Moreover, the number of pipeline interconnections at the California Energy Hub was 12 in 2008, up from five in 2003. Lastly, the pipeline interconnection capacity of the California Energy Hub in 2008 was 6.8 billion cubic feet per day, which constituted a 47 percent increase over the pipeline interconnection capacity in 2003.
The Socal contract is cash settled based on the difference between a third-party price index for natural gas at the Socal hub and the final settlement price for NYMEX’s Henry Hub physically-delivered natural gas futures contract. In the case of the Socal contract, the third-party price index is published by Intelligence Press, Inc. Other basis contracts are based on price indices reported by Platts. In all cases, the price indexes is based on fixed-price cash market trades that are conducted during the last five business days of the month and specify delivery throughout the following calendar month.
In the original release, the Commission identified material price reference, price linkage, and material liquidity as the criteria potentially to be considered for SPDC determination. With respect to material price reference, the Commission initially noted that ICE has the exclusive right to use IPI’s Socal price index for cash settlement purposes, and that it publishes its price data and sells price data to the public.
With respect to material price reference, staff believes that the SoCal contract satisfies the price reference criterion set forth in Section 2(h)(7) of the Act and explained in the Guidance. The SoCal contract (and the 6 other ICE locational basis contracts) meet this criterion in that, as noted, the Socal delivery location is a major trading center and distribution point for natural gas in North America, and the ICE price is referred to on a frequent and recurring basis when entering into cash market transactions and when valuing natural gas inventories, production and demand. In that regard, the Socal Border hub is far removed from the Henry Hub and is not directly connected to the Henry Hub by an existing pipeline. Since prices for natural gas at SoCal can diverge from the Henry Hub price, reflecting local supply and demand conditions, a competitive market price representing the value of natural gas at Socal is of much benefit to commercial participants active at that location. It should be noted that NYMEX lists for trading similar basis contracts on its ClearPort platform. However, the NYMEX contracts do not serve a price discovery function since all trades are conducted off of the electronic system and submitted for clearing.
Staff also has concluded that the Socal contract and the 6 other ICE locational basis contracts meet the material liquidity criterion in Section 2(h)(7). The analysis of material liquidity was multi-pronged. Staff considered trading volume (greater than 100,000 contracts per quarter), number of trades per day (significantly more than 5 trades per day reporting threshold), and substantial open interest as indicators of a contract’s size and potential importance. If staff found that the contract in question meets a threshold of trading activity that would render it of potential importance, the Commission performed a statistical analysis to measure the effect that changes to the subject-contract’s prices potentially may have on prices for other contracts listed on an ECM or a DCM. For the SoCal contract and the other 6 contracts, staff is recommending be declared SPDCs, staff found that each of the contracts met the liquidity thresholds. Commission staff also performed a statistical analysis showing that changes in the potential SPDC’s price has a significant and measureable effect on the prices of other ECM contracts and DCM contracts.
With respect to price linkage, staff found that the Socal contract is based in part on the NYMEX Henry Hub price. However, upon further examination, the contemporaneous settlement prices were not within 2.5% of each other on 95% or more of the days. Furthermore, the volume of trading in the Socal contract was less than 5% of the trading volume in the NYMEX Natural Gas contract.
Natural gas Non SPDCs
A total of 10 other contracts which staff believes should not be declared SPDCs are locational basis contracts representing less important natural gas delivery locations away from the Henry Hub. There may be various reasons why a particular hub is of lesser importance. One reason is that the Hub may be directly connected to the Henry Hub. As a result, the Henry Hub futures contract provides a sufficient indication as to the value of natural gas for market participants. Another reason may be that there is different hub in the area that is dominant in terms of pricing. For example, in the Northwest, the Malin hub on the California-Oregon border is not as important as the PG&E Citygate. In view of these considerations, staff does not believe that these locational basis contracts meet the material price reference and material liquidity standards. In making this recommendation, staff is not concluding that these contracts aren’t valuable for the industry or are not widely used for hedging; they don’t appear to qualify as SPDCs under the statutory tests as explained in the Commission’s guidance.
In addition, there are three contracts (ICE Henry Basis, ICE Henry Index, and the NGX 7a Index) serve as specialized hedging tools for industry participants, rather than serve as price discovery mechanisms. In this regard, these contracts are used to adjust prices that are already locked in, or to modify previously established hedges or delivery obligations. For example, the Henry Financial Swing contract is used to price natural gas at the Henry Hub on a particular day. The Henry swing contract does not satisfy the material price reference criteria for SPDC determination, as the swing contract is used to modify traders’ previously established hedge positions established on the NYMEX Henry Hub futures contract. Specifically, price discovery usually is based on the NYMEX Henry Hub futures contract, which specifies the delivery of natural gas over the specified month. Once market participants enter the delivery month, however, they may need to modify their hedge position for one portion of the month (a day, several days, or a week) by using the swing contract.
Finally, two NGX contracts are flat-price contracts that are used to determined the actual price of physically-delivered gas in Alberta or Dawn in Canada. These fixed price contracts do not meet the material liquidity criterion as trading volume is less than 100,000 NYMEX-equivalent contracts. In the case of the Alberta contract, the NGX contract does not meet the material price reference as the ICE cash-settled contract is more important to market participants as a pricing reference (staff has recommended that the ICE Alberta contract be declared a SPDC).
Chicago Climate Exchange (CCX) Carbon Financial Instrument
The other ECM contract under consideration today is the Carbon Financial Instrument or CFI contract traded on the Chicago Climate Exchange.
Chicago Climate Exchange was established to offer various environmental products. It is the only North American exchange that offers voluntary yet legally binding Carbon-related products. That product is the CFI contract, a proprietary carbon allowance/offset instrument which represents 100 metric tons of CO2 equivalent. Allowances are issued to emitting CCX members in accordance with their emission baseline and the CCX Emission Reduction Schedule. Offsets are generated by qualifying offset projects.
The CFI is a cash market instrument and not a derivatives contract. The Chicago Climate Futures Exchange, a subsidiary of Chicago Climate Exchange that operates as designated contract market, lists derivatives on the CCX CFI, as well as futures and option contracts on nitrogen oxide and sulfur dioxide allowances and Regional Greenhouse Gas Initiative allowances.
In its Federal Register notice, the Commission indicated that the CFI contract might satisfy the material liquidity and material price reference factors for SPDC determination. Based on updated trading data provided by CCX and further analysis, staff does not believe that the CFI contract should be declared a SPDC because it does not appear to meet material liquidity and material price reference criteria.
The Commission’s decision to undertake a review of the CFI contract was based on the Exchange’s required quarterly notification filed on July 1, 2009 where eight vintages of CFI contracts were combined. Subsequently, staff found that CCX lists and trades each CFI contract vintage as a separate product and publishes a vintage-specific closing price for each CFI vintage instrument. Based on this information, staff analyzed each individual vintage of the CFI contract and determined that the average number of trades per vintage was one only trade per day. That level of activity is well below the 5-trade per day threshold that the Commission had established for reporting purposes.
With respect to the material price reference criterion, we note that the CFI market is a CCX-created product. The CCX designed all of the parameters of its carbon emission reduction program and it established the rules for membership in the ECM, allowance trading, and the creation of offsets. After detailed analysis, staff has concluded that the CCX CFI contract does not meet the material price reference criterion for a SPDC determination. In that regard, it appears the CCX CFI prices are not widely used as price references to the US carbon market due to the relative small market share of the CCX CFI program in the overall US carbon market and the currently limited potential for the CFI program to be folded into a national mandatory carbon reduction program.
For these reasons, staff recommends that the Commission not find the CCX carbon financial instrument to be a SPDC.
Last Updated: January 24, 2011