II-O0020

From:

Sent:

To:

Cc:

Subject:

Attach:

Architzel, Paul <Paul.Architzel@alston.com>

Monday, November 8, 2010 4:28 PM

OTCDefinitions <OTCDefinitions@CFTC.gov>; dfadefinition@cftc.gov

Arbit, Terry <tarbit@CFTC.gov>; Gensler, Gary <GGensler@CFTC.gov>;

O’Malia, Scott <SO’Malia@CFTC.gov>; Dunn, Michael <MDunn@CFTC.gov>;

Chilton, Bart <BChilton@CFTC.gov>; Sommers, Jill <JSommers@CFTC.gov>;

Berkovitz, Dan M <DBerkovitz@CFTC.gov>; Peter.Krenkel@NGX.com;

Cheryl.Graden@tmx.com; Architzel, Paul <Paul.Architzel@alston.com>

FW: Definitions Contained in Title VII of the Dodd-Frank Wall Street Reform

Act

Definitions Contained in Title VII of the Dodd-Frank Wall Street Reform et

al 1.PDF

Dear Mr. Stawick:

We are submitting the attached comment letter on behalf of our client, the Natural Gas Exchange ("NGX"). In this letter

NGX comments on the term "swap" as it is defined under the Dodd-Frank Act and how the Commission should further

clarify the exclusion provided thereunder with respect to exchange-traded and cleared forward contracts.

Please contact the undersigned if you have any questions.

Respectfully submitted,

Paul M. Architzel

Alston & Bird LLP

The Atlantic Building

950 F Street, N.W.

Washington, D.C. 20004-1404

Tel: 202 756-3492

Fax: 202-654-4893

Mobile: 301 785-0115

email: paul.architzel@alston.com

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November 4, 2010

VIA E-MAIL. d.fitdefinitions’@cfic.gov

David A. Stawick

Secretary

Commodity Futures Trading Commission

1155 21st Street, N.W.

Washington, D.C. 20581

Petor Kre~kel

Pre~i(fent and CEO

Nalural Gas Exchang~ Inc.

Sufle 2330, 140 4", Avenue S.W.

Catga~y, AB, Canada T2P 3N3

T (403)974-1705

F (403) 974d71£

peter.Krenke@ngx,com

Re," "Definitions Contained in Title VII of Dodd-Frank Wall Street Reform

and Consumer Protection Act" 75 Fed. Reg. 51429 (August 20, 2010).

Dear Mr. Stawick:

Natural Gas Exchange Inc, ("NGX") appreciates the opportunity to submit its

views in advance of the Commodity Futures Trading Commission ("Commission")

proposing rules relating to the definition of terms in Title VII of [)odd-Frank Wall Street

Reform and Consumer Protection Act ("Dodd-Frank Act"). I,,

The term "swap" is broadly defined under the Dodd-Frank Act, but contains an

exclusion for "any sale of a nonfinancial commodity or security for deferred shipment or

delivery, so long as the transaction is intended to be physically settled.’’~ This is similar,

but not identical, to the forward contract exclusion under section la(27) of the Act, as

amended, which provides that "the term ’future delivery’ does not include any sale of any

cash commodity for deferred shipment or delivery." The Commission previously

provided legal certainty to the market through interpretation of the meaning and extent of

the forward contract exclusion.~ NGX believes that based on the facts and reasoning

discussed below, it is in the public interest for the Commission to address the issue anew,

providing legal certainty with respect to the two exclusions, particularly as applied in the

context of trading such contracts on a multi-lateral trading facility.

Natural Gas Exchange

NGX is a trading and clearing system for energy products in the North American

market and provides electronic trading, central counterparty clearing and data services to

] See Dod&Frank Wall Street Reform and Consumer Protection Act, Public Law No, I I 1-203, 124 Star.

1376 (2010).

2 See Commodity Exchange Act (CEA) §la(47)(B)(ii), 7 U.S.C. §1 et seq. (t999) (as amended by the

Dodd-Frank Act) ("CEA").

3 See CFTC Statutory Interpretation Concerning Forward Transactions, 55 Fed Reg. 39188 (1990) (CCIt ¶]

24,925) ("1990 Statutory Interpretation"),
David A. Stawick

Page 2

the North American natural gas, electricity and oil markets. NGX operates an electronic

marketplace through which NGX contracting parties ("Participants") may enter into,

among other contracts, spot and forward physically settled natural gas and oil contracts

for delivery at various Canadian and U.S. locations. NGX also provides clearing services

through which it acts as central counterparty for transactions entered into on the NGX

electronic marketplace, certain transactions executed in the OTC market and transactions

entered into on a third party exempt commercial market. As discussed in greater detail

below, deliveries of the physically delivered forward contracts take place through

Canadian and U.S. pipeline hubs and oil storage and transmission facilities.

Since March l, 2004, NGX has been a wholty owned subsidiary of TMX Group

Inc.4 NGX’s primary operations are located in Calgary, Alberta. NGX is regulated by

the Alberta Securities Commission ("ASC").5

NGX notified the Commission on November 5, 2002, of its operation as an ECM.

On December 12, 2008, NGX was registered by the Commission as a Derivatives

Clearing Organization ("DCO"). On May 19, 2010, NGX requested that the

Commission’s Division of Market Oversight confirm that it wilt not recommend that the

Commission take enforcement action against NGX, a Foreign Board of Trade ("FBOT"),

in connection with direct access to the NGX market by its U.S. Participants,6 That

request remains pending.

On September 14, 2010, NGX filed with the Commission pursuant to section

723(c)(2)(A) of the Dodd-Frank Act and the Order, a petition for grandfather relief. As

NGX noted in a comment submitted in response to the Commission’s request for

comment on its Order relating to the procedures for filing petitions such claims for relief,

An [exempt commercial market’s] analysis with respect to which regulatory

category is most properly applied to its market may very well depend upon the

Commission’s adoption of rules relating to key definitions. These include the

definition of "swap," and the exemption therefrom for contracts for deferred

shipment or delivery.7

4 TMX Group operates cash and derivative markets [br muItiple asset classes including equities, fixed

income and energy products. TMX Group is a corporation incorporated under the Business Corporations

Act (Ontario) and has its head office in Toronto, Ontario. Its shares have been listed for trading on the

Toronto Stock Exchange since November 2002. TMX Group is a reporting issuer in every province and

territory of Canada.

5 On October 9, 2008, NGX’s status in Alberta changed fiom being an exempt exchange to a recognized

exchange. In addition, NGX became a recognized clearing agency under Alberta laws.

6 The reqt~est for no-action relief was made pursuant to the Commission Policy Statement entitled, "Boards

of Trade Located Outside of the United States and No-Action Relief from the Requirement to Become a

Designated Contract market or Derivatives Transaction Execution Facility," 71 Fed. Reg. 64443

(November 2, 2006.) ("Policy Statement’;).

7 See Comment Letter Of NGX, dated October 18, 20t0, submitted in response to CFTC Request for

comments regarding "ECMiEBOT Grandfather Relief" 75 Fed Reg. 56513 (September 16, 2010)."
David A. Stawick

Page 3

Because NGX lists for trading physically-settled forward contracts, it is vitally

concerned that the meaning of the forward contract exclusion for futures under section

la(27) of the Act and for swaps under la(47(b) of the Act (together the "forward

contract exclusions") be clear, particularly in the context of a traded market. The

guidance that the Commission provides to the market on the issue will fundamentally

effect the regulatory t?amework tbr these markets.

The Forward Contract Exclusion

In 1921, the Futures Trading Acts was enacted to curb widespread instances of

disruptive trading practices and speculation on and off exchanges.‘) Congress sought to

limit price fluctuations related to grain by imposing a ’prohibitive tax’ on "contracts for

future delivery not traded on contract markets.’’I° The Futures Trading Act, however,

specifically excluded from the tax (i) contracts for future delivery made by "owners and

growers of grain, owners and renters of land on which grain was grown and associations

of such persons" and (ii) future delivery contracts made by or through designated

members of boards of trade.~ During the Congressional testimony leading up to

enactment of the Futures Trading Act, witnesses noted that the first exemption was too

narrowly construed and would have taxed a "variety of legitimate commercial

transactions in which delivery of the grain was delayed.1~ To make clear that forward

contracts were to be excluded from taxation, Congress excluded from the term "futures

delivery" "any sale of cash grain for deferred shipment or delivery." ~3 The forward

contract exclusion has remained unchanged from that time. Nevertheless, it has been

subject to interpretation to keep pace with the evolution of markets and contracting

practices.

Statutory Interpretation Concerning Forwards

In a seminal interpretation, the Commission found that the forward contract

exclusion of the Act applied to the purchase or sale of 15-day Brent crude oil contracts,t4

In the 1990 Interpretation, the Commission recognized that "the evolution of commercial

transactions of this variety suggests that more guidance by the Commission is appropriate

~ Se~ee The Futures Trading Act, Pub, L. No. 67-66 § 2, 42 Stat. 187 (1921). In 1936, Congress enacted the

Commodity Exchange Act which essentially replaced the Futures Trading Act.

9 See Characteristics Distinguishing Cash and Forward Contracts and "Trade Options," 50 Fed. Reg. 39656

(~985).

10 .~%e._e Characteristics Distinguishing Cash and Forward Contracts and "Trade Options," 50 Fed. Reg.

39656 (1985).

~ ~ See id

12 See id.

1.3 The House in agreeing to the Senate’s additional exclusionary language added the words "or delivery"

following "shipment."

~4 Sere C FTC Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (t990) (CCH

¶[ 24,925) ("1990 Interpretation").
David A. Stawick

Page 4

than can be accomplished through case-by-case analysis.IS In the 1990 Interpretation, the

Commission concluded that determining whether a commercial transaction fell within the

scope of the exclusion depended on whether the transaction created "specific delivery

obligations.’’~6 The Commission noted in its analysis of the Brent market that its

"emphasis on delivery as the feature distinguishing transactions within the scope of the

Section 2(a)(1) exclusions was first enacted in 1921 as part of the Future Trading Act."

The Commission continued, noting that,

certain other distinguishing characteristics of such contracts have been identified.

In this regard, forward contracts have been described as transactions entered into

for commercial purposes related to the business of a producer, processor,

fabricator, refiner or merchandiser who may wish to purchase or sell a commodity

for deferred shipment or delivery in connection with the conduct of its business. ~7

The Commission concluded that contracts entered into between commercial

participants in connection with their business, which create specific delivery obligations

that impose substantial economic risks of a commercial nature to these participants, but

which may involve in certain circumstances string or chain delivery . . . are within the

scope of the [forward contract] exclusion.~8 Although the Commission acknowledged

that there was not a "definitive list of elements" to consider when determining which

transactions are excluded from the CEA, it noted that

It]he underlying postulate of the exclusion is the Act’s regulatory scheme for

futures trading should not apply to private commercial merchandising transactions

to delivery but in which delivery is deferred for reasons of commercial

convenience or necessity. ~’)

Exclusion of forwards from definition of swaps

The Dodd-Frank Act [br the first time generally brings swaps within a

comprehensive regulatory framework, much as grain futures were brought within a

regulatory framework in the 1922 Act. The Dodd-Frank Act includes within the statutory

framework mandatory clearing and trade execution requirements for certain swaps or

categories of swaps. As noted above, "any sale of a nonfinancial commodity or security

for deferred shipment or delivery, so long as the transaction is intended to be physically

~5 Id. at p 37,365,

16 (noting that "[m]orevover, the delivery obligations of these transactions create substantial economic risk

of a commercial nature to the parties required to make or take delivery tl~ereunder"). The 1990

Interpretation emphasized that "[a]ll pm~ies entering into these contracts must have the capacity to beat"

such risks and cannot discharge these obligations through exchange-style offset," See also CFTC v, CoPetro Marketing Group, Inc., 680 F.2d 573, 578 (1982) (stating that "a cash forward contract is one in

which the parties contemplate physical transfer of the actual cornmodity).

17 ld, at p,a 37, 368.

18 ld. atp. 37369.

19 Sere ] 990 Interpretation at 37,367.
David A, Stawick

Page 5

settled" is excluded from the definition of "swap" and as a consequence, the regulatory

framework that applies to swaps. The exclusion of forward contracts from swaps

regulation is expressed in different words than the forward exclusion li’om futures

reg~lal.i~.m, applying tti~ forward contracts "so long as the transaction is intended to be

physically settled."

Although the language of the tbrward contract exclusion lkom futures regulation

is expressed in different words from the forward contract exclusion l:~om swaps

regulation, Senators Blanche Lincoln and Christopher Dodd, two of the framers of Title

VII of the Dodd-Frank Act, wrote to their colleagues in the House of Representatives,

that

[i]n implementing the derivatives title Congress encourages the CFTC to

clarify through rulemaking that the exclusion from the definition of

swap for "any sale of a nonfinancial commodity or security for deferred

shipment or delivery, so long as the transaction is intended to be

physically settled" is intended to be consistent with the forward contract

exclusion that is currently in the Commodity Exchange Act and the

CFTC’s established policy and orders on this subject, including

situations where commercial parties agree to "book-out" their physical

delivery obligations under a forward contract.;°

Thus, it is anticipated that the Commission, in promulgating rules defining certain

key terms, will clarify that the forward contract exclusion from swap regulation is to be

interpreted in a manner consistent with the current understanding of the forward contract

exclusion from futures regulation.

However, as in 1990, significant changes in the markets, in this case spurred by

technological changes, strongly suggests that in issuing an interpretation removing any

ambiguity with respect to the extent and application of the forward contract exclusion

from swap regulation, the Commission provide additional legal certainty with respect to

the relatively recent development of trading of physically-settled forward contracts on

multi-lateral trading facilities, such as NGX.

Evolution of exchange-traded forward contracts

NGX first listed for trading "Physical Gas Transactions" in February 1994. In

order to provide greater legal certainty for trading of these products by U.S. entities with

direct market access from the U.S., NGX notified the Commission on November 5, 2002,

of its operation as an ECM.

NGX defines a "Physical Gas Transaction" as "a transaction tbr the purchase or

sale of a Physical Gas Product, excluding Bilateral Transactions, the terms of which

20 See Leller from Senators Christopher Dodd and Blanche Lincoln to Congressmen Barney Frank and

Colin Peterson, dated June 30, 2010 at 3. ("Dodd-Lincoln Letter").
David A. Stawick

Page 6

include this Agreement and for greater certainty also includes the particulars applicable to

such Physical Gas Product as set forth in the NGX Product ISst and Schedules ’°F" or

"G". The general terms of the contracts are set forth in the Articles of the Contracting

Party Agreement (’~CPA") and the specific terrns and conditions are in the Product List

and Schedules.

A Participant enters into a Physical Gas Transaction by entering a bid or offer into

the NGX Trading System. Upon execution of the transaction, the Participant will either

be a purchaser or seller of that amount of Physical Gas Product at a price or formula

specified at contract initiation with a specified Physical Settlement Date.2~ NGX does not

specify a standard contract size; rather each Participant will enter bids or offers for the

quantity of gas that it chooses at or above the minimum transaction size of 100 MMBtu

or 100GJ. Upon settlement of a contract, NGX will pay to (or receive from) each

Contracting Party the full notional value of the transacted volume, tnvoiced amounts are

paid on a net basis payable in the same currency.

All obligations of NGX as CCP and a Participant to make or take delivery of the

commodity under the Physical Gas Transactions will be netted and the Contracting

Party’s delivery obligation arising from each Transaction will be satisfied by the delivery

or taking of delivery of the Contract Quantity on a net basis. Thus, each Participant’s

long and short contract obligations are netted to a single amount to deliver or take

delivery.

NGX’s lists for trading physical gas contracts that use three different methods tbr

calculation of the settlement price. The contract price can be based on the electronically

negotiated price (called "Fixed Price Products"), on a reference price to a cash-price

series, such as those published by NGX itself or by an independent, third-party index

provider (called "Index Products"), or by reference to a futures contract price with an

appropriate locational differential (called "Basis Products"). Contracts using these three

types of settlement price methodologies are listed for a significant number of different

delivery locations in Canada.

NGX also lists for trading Physical Oil Transactions, on a separate trading

platform. The buyer and seller agree to pay the agreed upon contract price and take or

make delivery of the specified grade and variety of oil at the specified delivery location.

Each Participant’s obligations to make or take delivery of oil with the same delivery

specification at the same delivery location will be netted, so that the Participant will have

only a single net obligation to make or take delivery of the specified oil at the sanae

delivery location. Payment obligations in the same currency will also be netted. The

Participants must comply with the rules and the procedures of the transportation system

rules, including title transfer procedures, at the delivery location.

~l As defined by the CPA, the "Physical Settlement Date is the Business Day determined by the Exchange

from time to time as posted on the Exchange Website no less than one month prior to the occurrence of

such date .... "
David A, Stawick

Page 7

The CPA includes a detailed Force Majeure provision which details when force

majeure applies, including disruption to the transportation system at a delivery location.

A change in market conditions is specifically excluded from force majeure, as is a

pending reduction in transportation services that has not yet occurred, tt also details the

impact of a single source supply stream that is disrupted on contract obligations.

Contracts may specify one of 17 possible Canadian transportation systems and 5

different delivery locations. In addition, there are 23 different grades or oil products

listed, including, for example, condensate, light sour blend, mixed sour blend, mixed

sweet blend and sweet crude. U.S. contracts may specify one of 5 different delivery

locations, five transportation systems, and 8 crude types. Two pricing conventions are

provided: Fixed Price or Differentials.

A hallmark of the markets for exchange-traded forward contracts are the fact that

market participants are generally commercials and the high proportion of contracts that

result in delivery despite the netting of contractual and delivery obligations. Unlike the

typical futures contract, an exchange-traded forward market may see greater than half the

volume of contracts result in actual delivery. And, it is the intent of market participants

that their contracts result in delivery of the commodity. However, as their supply needs

change, for example, these commercial traders may adjust their contractual obligations by

selling back into the market an amount of the commodity that they previously bought.

This is not done for hedging or speculative purposes, but rather to adjust their bona fide

physical delivery needs, which are dynamic and may change over time, even on a daily

basis.

In contrast to these exchange-traded forward contracts, NGX atso lists for trading

financially-settled contracts for future delivery which it terms to be Financial Contracts,

abbreviated as "Fin." The obligations under these contracts are fully performed by

payment to NGX of amounts due under the contract. This is in vivid contrast to the

nature of the physical forward contracts and to the participants in the two markets. The

financial contracts are traded in the market both by commercials intending to take

delivery as well as commercials and others who do not intend to take delivery of the

contract but instead to use the contract to transfer or assume price risk.

Finally, exchange traded forward contracts tend to delivered in less liquid delivery

locations. As trading at a delivery becomes more liquid, additional, non-commercial

traders may enter the market, altering the nature of the market from an exchange traded

mmket in forward contracts to a market for exchange-traded derivatives. In some

respects, this follows the evolution of futures markets generally, which grew out of the

trading of forward contracts in the Chicago markets,
David A. Stawick

Page 8

Exchange-traded forward contracts are a relatively new development.22 Market

participants intend by their trading in these markets to effectuate contracts resulting in

actual delivery. In light of this fundamental fact of their commercial and delivery nature,

NGX believes that it is part of the Congressional mandate to the Commission to clarify

the meaning and extent of the forward contract exclusions as applied to such markets.

NGX believes that one means by which the Commission could best clarify the forward

contract exclusions as lhey apply to an exchange-~raded market in forward contracts is

through the issuance of a non-exclusive safe-harbor. This would provide the important

legal clarification referred to by Senators Lincoln and Dodd in their letter to a significant

segment of the forward contract market.

Terms of a non-exclusive safe harbor

The terms of a non-exclusive safe harbor for exchange-traded forward contracts

would be grounded in the characteristics noted above: all market participants would be

required to be commercials and a high percentage of contract volume would be required

to result in actual delivery. We would suggest that the percentage of contracts resulting

in physical delivery be greater than 50% of all contracts traded on the market computed

on a rolling three-month average. This would provide the needed flexibility for

commercials to trade out of contracts for delivery as their bona fide need tbr the

commodity changes due to changing commercial developments. If the market becomes

so liquid that it attracts non-commercials, and they are admitted as participants, that

would change the character of the market and it would no longer qualify as a forward

market. Similarly, if the proportion of delivered-upon contracts fell below the 50%

trigger, that would signal the evolution of the market as one listing forward contracts to a

market that is listing futures or swap contracts. At that point, after a short grace period,

the market would be required to begin listing the contracts under the procedures

applicable to futures or swaps, as applicable.

The suggested terms of the non-exclusive safe-harbor would provide a bright-line

test for distinguishing forward from futures markets and are grounded in past

Commission analysis of the forward contract exclusion. The terms are consistent with a

finding that the parties have the intent to make or take delivery, have the ability to do so,

and evidence that delivery in fact routinely takes place.~3

In exercising its rulemaking authority to clarify the meaning of the forward

contract exclusion, as intended by the framers of the Dodd-Frank Act, NGX respectively

petitions the Commission to include within those rules a non-exclusive safe-harbor based

22 Of course, as noted above, the first contracts traded on the Board of Trade of the City of Chicago were

forward contracts as well,

23Se_.__~_ee Characteristics Distinguishing Cash and Forward Contracts and "Trade Options," 50 Fed. Reg. 39656

(1985) (noting that "[t]oward contracts fiequently are not standardized" rather contract terms are often

negotiated, in particular the terms relating to "grade, delivery point and settlement date").
David A. Stawick

Page 9

on the objective factors discussed above. This will provide the needed legal certainty to

an important market segment and fulfill the Commission’s mandate under the DoddFrank Acl and be in the public interest.

NGX commends the Commission’s efforts to continue to safeguard l~rading and

clearing activities and looks forward to working with the Commission throughout the

course of the Dodd-Frank rulemaking process.

We would be happy to discuss our comments above at greater length with the

staff. Please feel free to contact Cheryl Graden at 416-947-4359, or Paul M. Architzel of

Alston & Bird, LLP, outside counsel to NGX at 202-239-3492, if you have any questions

regarding NGX’s comments. On behalf of NGX I thank the Commission for providing

us with the opportunity to provide our thoughts with respect to the Commission’s

rulemaking.

~..ect_~y subm!jI~d,

Peter KrenkeI

President and CEO

C~ Chairman Gensler

Commissioner Dunn

Commissioner Chilton

Commissioner Sommers

Daniel Berkovitz, General Counsel