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CFTC Designates Seven ICE Natural Gas Contracts as "Significant Price Discovery Contracts," Subjecting Them to Regulatory Oversight

April 27, 2010

The Commodity Futures Trading Commission (CFTC) voted unanimously on April 27 to designate seven natural gas contracts traded on Intercontinental Exchange Inc. (ICE) as "significant price discovery contracts," or SPDCs. As a result of the CFTC's action, the designated contracts will be subject to the CFTC's regulatory and reporting requirements, which include requirements such as position limits, large trader reporting requirements, and enhanced self-regulatory oversight by ICE. Designated SPDCs are: NWP Rockies Financial Basis Contract, HSC Financial Basis Contract, PG&E Citygate Financial Basis Contract, Waha Financial Basis Contract, Chicago Financial Basis Contract, Socal Financial Basis Contract, and Alberta Financial Basis Contract. The CFTC also voted unanimously not to regulate 17 additional contracts, which include the remaining natural gas contracts on ICE, contracts on the Natural Gas Exchange, and the carbon contract on the Chicago Climate Exchange. 

The CFTC's authority to designate SPDCs was introduced in the 2008 Farm Bill, which reauthorized the CFTC and enhanced its authority over Exempt Commercial Markets (ECM), closing the so-called "Enron loophole" that had exempted products traded on ECMs from most substantive CFTC regulation. The law defined SPDCs as contracts that perform a "significant price discovery function" in either the regulated futures markets or the cash markets, based on the extent to which the contracts: (1) are linked to existing exchange-traded contracts; (2) permit arbitrage between ECMs and other markets; (3) are used as a direct price reference for bids, offers or transactions in a commodity; and (4) are traded in a volume that provides material liquidity. The CFTC finalized its rules regarding SPDC designations in March 2009, and designated the first SPDC (the Henry Hub Financial LD1 Fixed Price contract) in June 2009, regulating a contract traded on ICE for the first time. 

The April 27 designations of the ICE natural gas contracts extend the CFTC's regulatory reach further. Each of the seven contracts designated as SPDCs are locational basis contracts that price natural gas at a specific location other than Henry Hub. In making its designation recommendations, CFTC Staff emphasized that contracts designated as SPDCs do not need to meet all four of the statutory criteria for SPDCs, and indeed, the instant designations appear to be driven primarily by whether a contract provides material liquidity and/or serves as a price reference. Specifically, Staff stated that 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. Staff found that each of these contracts is a key reference price for natural gas in the U.S. and Canada, and that these contracts offer additional pricing information not provided by NYMEX and ICE SPDC Henry Hub contracts. Staff also found that these contracts have significant open interest and trading volume and are widely used by cash market participants for hedging price risks. As part of Staff's material liquidity analysis, Staff found these basis contracts to have a statistically significant effect on other ECM contracts and contracts listed for trading on Designated Contract Markets (DCM). 

The contracts designated as SPDCs can be contrasted with those natural gas contracts that Staff did not designate as SPDCs. Ten of the non-designated contracts were locational basis contracts, but Staff found them to represent less important natural gas delivery locations. Staff found that three other non-designated contracts serve as specialized hedging tools for industry participants, rather than serving price discovery mechanisms. These contracts are generally used to adjust prices that are already locked in or to modify previously established hedges or delivery obligations (e.g., the Henry Financial Swing contract). Two of the NGX contracts evaluated are flat-price contracts that are used to determine the actual price of physically delivered gas in Canada; Staff found they did not meet the material liquidity criterion because their trading volume is less than 100,000 NYMEX-equivalent contracts.

The CFTC has yet to act on 16 electricity contracts and one refined petroleum contract that have been identified in the Federal Register as potential SPDCs. The SPDC construct may be subsumed by any legislation Congress enacts regulating over-the-counter derivatives.