1. This paper outlines the views of IOSCO on market default procedures related to futures and options transactions, especially with regard to transparency of such procedures and best practices on the treatment of positions, funds and assets.

IOSCO notes that certain of its recommendations regarding best practices may not be fully consistent with the domestic insolvency laws in some jurisdictions. It also notes that some jurisdictions have provided expressly for insolvency law to accommodate market default procedures. It recommends disclosure of the relevant insolvency law position.

Note: The term "market authority" is used to refer to the authority in a particular jurisdiction which has statutory or regulatory powers with respect to the exercise of certain regulatory functions over a market. The relevant market authority, depending on the jurisdiction, may be a regulatory body, a self-regulatory organization and / or the market itself. The term "market" includes the clearinghouse for a market. "Market default procedures" means procedures operated by a market authority which are designed to address a default by a market participant. The term "market participant" includes both market members and customers.

Transparency of Default Procedures

2. Transparency of market default procedures is important for the following reasons:

(a) it provides certainty and predictability to market participants;

(b) it facilitates orderly handling in case of an actual default; and

(c) it enables market participants to make an informed assessment about markets.

3. The information which should be disclosed should cover:

- the circumstances in which action may be taken;

- who may take it; and

- the scope of actions which may be taken.

4. The following is a template or a list of information items that should be available to market participants as to market default procedures regarding futures and options transactions:

(1) The circumstances in which action may be taken should be disclosed in some detail. These circumstances might include:

(i) unremedied failure by a market member to meet a test of its solvency under the applicable laws of the jurisdiction;

(ii) suspension, expulsion or termination as a market member or suspension or withdrawal of trading privileges;

(iii) cessation by a market member of any part or all of its operations either through liquidation, winding up or voluntary cessation;

(iv) failure by a market member to pay, within the time specified, any amounts required to be paid to a market including initial margins, variation margins or intra-day margins;

(v) failure by a market member to meet obligations under contracts or the business rules of the market authority which result in payment failure;

(vi) failure to abide by any agreement or understanding entered into with a market authority and failure to comply with any reasonable directions of a market authority where such failure requires the firm to cease operating or renders it unable to comply with its financial obligations toward its customers, or:

(vii) any other event or series of events, whether related or not, occurring which in the opinion of the market authority has a material effect on the capacity of the market member to meet its obligations to the market.

The procedure for identifying the above circumstances should also be disclosed.

(2) The treatment of both proprietary and customer positions, funds and assets should also be disclosed in some detail, including the kinds of cases where customer positions are transferred and those where positions are liquidated.

In cases where positions would be transferred, concrete terms and conditions therefor should be described, including:

(i) where customer positions are transferred automatically, information to the customer that the customer position will be transferred;

(ii) where customers must request a transfer of their positions, any documentation necessary for customers requesting transfer;

(iii) the price of the position at transfer;

(iv) the treatment of pending settlements, for example, unrealized gains, if any, between the customers and the transferring firm;

(v) a possible requirement for remargining positions, for example, where margin cannot be transferred with the positions;

(vi) the availability of indemnifications for transferees;

(vii) the treatment of commissions and fees;

(viii) obligations of transferees to the transferred accounts; and

(ix) any differences in the treatment of different classes of customers.

In cases where positions would be liquidated, concrete terms and conditions therefor should be described, in particular:

(i) where a suspension of trading rights will be imposed in respect of both proprietary and customer positions of the defaulting member, information to the customer that such a suspension will be imposed on the member's customer positions; and

(ii) where all open proprietary and customer positions will be netted together into a single net position for liquidation in the market, information to the customer of such procedure, including how the liquidation price of customer positions will be identified.

(3) The mechanisms to address the defaulting member's and / or clearinghouse's obligations to market counterparties should be disclosed, including:

(i) the use of margin funds;

(ii) the use of other available funds in the market such as exchange guarantee funds;

(iii) the availability of a parent guarantee;

(iv) the possible sale of the defaulting firm's market membership; and

(v) the assessment procedure among market members if any has been established.

Note: "Assessment procedure" means procedure for requiring members of a market to contribute to the costs of a default.

(4) The mechanisms to address the defaulting member's obligations to its customers should be disclosed, including, where applicable:

(i) segregation and / or separate identification of exchange member positions, funds and assets from those of its customers;

(ii) a clearinghouse guarantee;

(iii) insurance of customer accounts and compensation fund mechanisms; and

(iv) the existence of other regulatory funding and / or depository requirements intended to protect customer funds.

(5) There should be a description of how each of the information items above might be affected, if at all, by the occurrence of other events, e.g. insolvency proceedings.

Concerning the items listed in the template, and in order to enhance transparency, it is recommended that information should be available to market participants for each market in clearly understandable terms.

Communications Upon Implementation of Default Procedures

5. It is recommended that market authorities establish mechanisms whereby information collection can be coordinated in the event that default procedures are implemented. Unless disclosure is considered prejudicial to the management of the default procedures, those mechanisms should also provide for such information to be efficiently and effectively communicated to market participants. Those mechanisms may include special communications to market professionals and investors through publication in newspapers, announcements made on the trading floor, faxes, E-Mail and screen-based trading terminals, and a telephone number where market participants can obtain information.

Best Practices on the Treatment of Positions, Funds and Assets

6. Best practices by market authorities with regard to the treatment of positions, funds and assets in the event of a default at a member firm so as to permit the prompt isolation of the problem at the failing firm would include the following:

(1) Proprietary positions of the defaulting firm at the market will be liquidated in the market as swiftly as practicable, taking the potential market effect into account, to contain a possible expansion of the losses.

(2) Proprietary funds and assets of the defaulting firm at the market, such as margin funds, liquidation proceeds, guarantee funds and security deposits, if any, will be used to meet the obligations of the defaulting firm to market counterparties including the clearinghouse.

(3) Customer positions of the defaulting firm at the market will preferably be transferred swiftly to other firms to avoid financial harm to customers, and to avoid spreading the damage from the default; in cases where the nature of the positions makes transfer impracticable, or in cases such as where the customer has not completed the necessary documentation for the transfer or the applicable regulation does not allow for transfers, customer positions may be liquidated in the market as swiftly as practicable, taking the potential market effect into account.

(4) There should also be a mechanism in place to protect customer funds and assets in order to avoid financial harm to customers, and to avoid spreading the damage from the default. This could be obtained by transferring customer funds and assets to other firms or by employing a guarantee system.

7. Where customer positions are to be transferred to other firms, the necessary arrangements for distinguishing firm and customer positions, deposits and accruals should preferably be implemented at the market level in the interests of speed of action.

8. In order to assure that the positions, funds or assets of firms materially related to the failing firm would not be transferred but conserved to address the failing firm's obligations, the underlying nature of participants in omnibus accounts should be identified in jurisdictions where materially related firms may be liable for the obligations of the failing firm.

9. In the event that the position to be liquidated is of a size that may threaten the stability of the market, exchanges and regulators should be provided with sufficient flexibility to dispose of such position in a reasonable amount of time.

10. Relevant market authorities should develop contingency plans addressing the procedures to be implemented to minimize the adverse effects of a firm default. Where there is more than one market authority which could take actions under market default procedures, there should be a clear delineation of respective roles and responsibilities, and a procedure for coordinating actions in each jurisdiction.

11. Where an event or series of events has occurred which in the opinion of the market authority may potentially have a material effect on the capacity of a market member to meet its obligations to the market, but the event or series of events does not yet formally constitute a default, market authorities should consider:

- increasing the monitoring of the member;

- placing restrictions on the ability of the member to take on further positions;

- requiring the member to reduce its risk exposure; and

- consulting with other relevant authorities.