Can a Firm Use Internal Models to Calculate the Close-Out Amount under the 2002 ISDA?

Concept

A firm can use internal models to calculate the Close-Out Amount under the 2002 ISDA Master Agreement. The architecture of the agreement explicitly provides for this contingency, viewing a firm’s internal valuation systems as a valid source of market data under specific, controlled conditions. The central objective of the Close-Out Amount calculation is to arrive at the economic equivalent of the terminated transactions, effectively placing the non-defaulting party in the financial position it would have occupied had the agreement not been terminated. This principle governs the entire process.

The 2002 ISDA Master Agreement designates the non-defaulting party as the “Determining Party”. This entity is vested with the responsibility of calculating the termination payment. The execution of this duty is governed by a stringent standard; the Determining Party must act in good faith and employ “commercially reasonable procedures in order to produce a commercially reasonable result”. This standard is objective and represents a higher threshold than the more subjective “rational decision” standard found in the 1992 version of the agreement.

The framework gives the Determining Party significant flexibility in the inputs it can use for this calculation. These inputs are not limited to external quotations. The agreement anticipates scenarios where external data may be unreliable, unavailable, or incapable of producing a commercially reasonable outcome, particularly in distressed or illiquid markets.

The 2002 ISDA Master Agreement permits the use of internal models for calculating the Close-Out Amount, provided the methodology is commercially reasonable and third-party data is prioritized.

It is within this context that internal models become a sanctioned tool. A firm may utilize quotations derived from its own economic models or market data gathered through its internal systems. The primary condition for this use is that the information must be of the same type that the firm uses in the regular course of its business for valuing similar transactions. This requirement ensures that the models are not developed ad-hoc for a specific default but are part of the firm’s established, ongoing risk management and valuation infrastructure.

The use of internal data is a fallback mechanism. The Determining Party must first attempt to source quotations and market data from third parties. Only when the firm believes in good faith that external data is not readily available or would fail to produce a commercially reasonable result can it turn to its internal sources.

Strategy

The strategic decision to employ internal models for calculating the Close-Out Amount under the 2002 ISDA Master Agreement is a function of market conditions, model sophistication, and risk appetite. A firm’s strategy must be built upon a clear understanding of the hierarchy of valuation sources stipulated by the agreement and the operational readiness of its internal systems to withstand scrutiny. The framework prioritizes objectivity and commercial reasonability, making the choice of valuation method a critical component of post-default risk management.

Valuation Source Hierarchy

The 2002 ISDA Agreement establishes a clear, albeit flexible, hierarchy for the data used to determine the Close-Out Amount. The primary sources are external and market-facing, intended to provide the most objective measure of replacement cost.

1. Third-Party Quotations This is the preferred input. The Determining Party should seek quotes for replacement transactions from one or more third-party dealers. These quotes provide a direct, market-tested price for replacing the economic exposure of the terminated trades.
2. Third-Party Market Data In the absence of direct quotes, the firm may rely on relevant market data supplied by third parties. This could include pricing service data, observable inputs from similar transactions, or other verifiable market information that can be used to model the value of the terminated position.
3. Internal Sources The use of a firm’s own models and internally generated data is the final option. This path is available when the Determining Party reasonably believes in good faith that the external sources are either not readily available or would produce a result that is not commercially reasonable. This might occur in a highly volatile or illiquid market where obtaining firm quotes from third parties is impossible or the available quotes are so wide they do not reflect a fair market value.

What Is the Commercially Reasonable Standard?

The cornerstone of the 2002 ISDA’s close-out provision is the standard of commercial reasonability. This standard is objective, moving beyond the mere rationality required by the 1992 agreement. For a calculation to be deemed commercially reasonable, it must be consistent with practices commonly used by dealers in the relevant market. A court would assess whether the procedures used were objectively fair and designed to produce a result that accurately reflects the market value at the time of termination.

This elevated standard means that any internal model used must be robust, well-documented, and consistent with industry norms for valuing similar derivatives. The burden of proof rests on the party challenging the calculation to demonstrate that the Determining Party’s actions failed to meet this standard.

A firm’s reliance on internal models is contingent upon its good-faith belief that external market data is either unavailable or would yield a commercially unreasonable result.

Internal Model Readiness

A firm contemplating the use of internal models must ensure its valuation framework is institutionally sound. The models cannot be arbitrary constructs created in response to a default. They must be integrated into the firm’s daily operations and used for valuing similar transactions in the regular course of business. This pre-supposes a comprehensive system of model validation, back-testing, and documentation that can be presented to the counterparty and, if necessary, a court.

The calculation itself must be transparent. The 2002 ISDA Master Agreement requires the Determining Party to provide a statement detailing the calculations, including any information from internal sources that was used.

The following table outlines the strategic considerations for each valuation approach.

Execution

Executing the calculation of a Close-Out Amount using internal models is a precise operational procedure that demands rigorous documentation and adherence to the principle of commercial reasonability. The process is not merely mathematical; it is a demonstration of procedural fairness designed to withstand legal and counterparty scrutiny. The successful execution hinges on the firm’s ability to transparently apply its pre-existing, validated models to the specific facts of the termination event.

Procedural Steps for Calculation

Upon the designation of an Early Termination Date, the Determining Party must act “on or as soon as reasonably practicable” to perform the calculation. The operational workflow involves several distinct stages.

• Initial Market Sounding The first step is to assess the availability and reliability of external market data. This involves actively seeking firm quotations for replacement transactions from multiple, independent dealers. The results of this process, including any refusals to quote, must be documented.
• Good-Faith Determination If the market sounding reveals that reliable third-party quotes are not available or would produce a commercially unreasonable result, the Determining Party must make a formal, good-faith determination to this effect. This decision should be documented with a clear rationale, referencing the market conditions that justify the use of internal models.
• Internal Model Application The firm then applies its internal valuation models to the terminated transactions. The models used must be the same ones the firm uses in its regular course of business. The inputs for the model should be as objective as possible, drawing from any available market data, even if that data is insufficient on its own to form a complete valuation. All model inputs, assumptions, and configurations must be recorded.
• Preparation of the Calculation Statement The final step is the creation and delivery of a detailed calculation statement to the counterparty. This document is a critical piece of evidence and must be meticulously prepared.

What Information Must the Calculation Statement Contain?

The 2002 ISDA Master Agreement is prescriptive about the contents of the calculation statement. It must provide a transparent view of the entire process, allowing the counterparty to understand and verify the resulting Close-Out Amount. The statement is the primary mechanism for demonstrating that the calculation was performed using commercially reasonable procedures.

The calculation statement must transparently detail the methodologies used, including any internal models and data, to substantiate the commercial reasonability of the Close-Out Amount.

The table below details the essential components of a compliant calculation statement, particularly when internal models are employed.

Managing Potential Disputes

The use of internal models, while permitted, carries a higher risk of dispute than relying on third-party quotes. The terminated counterparty may challenge the result by arguing that the procedures or the outcome were not commercially reasonable. In such a dispute, the defensibility of the calculation rests entirely on the quality of the firm’s models, the rigor of its processes, and the completeness of its documentation.

The burden is on the challenging party to show a lack of commercial reasonability. A well-documented, transparent process that aligns with industry practices for valuing similar instruments is the most effective defense against such challenges.

Reflection

The 2002 ISDA Master Agreement provides a sophisticated mechanism for resolving terminated derivatives, a system that balances flexibility with a demand for objective fairness. The provision allowing for the use of internal models is a recognition that in moments of market dislocation, a firm’s own valuation architecture may be the most reliable source of truth. This places a profound responsibility on the institution. It requires that a firm’s internal models are not merely tools for internal reporting but are robust, validated, and defensible components of its core operational framework.

How does your firm’s current valuation infrastructure measure up to this standard? Is it a system capable of producing a commercially reasonable result that can withstand the intense scrutiny that follows a counterparty default?