Can Internal Models Be Used Exclusively to Determine the Close-Out Amount?

Concept

The determination of a close-out amount upon the default of a counterparty in a derivatives transaction is a critical juncture in risk management. The question of whether internal models can be the sole determinant of this amount is a matter of significant operational and legal importance. The architecture of modern derivatives agreements, specifically the ISDA Master Agreement, provides a framework for this process. The 2002 ISDA Master Agreement moved away from the more rigid “Market Quotation” and “Loss” methods of its 1992 predecessor, introducing a more flexible concept ▴ the “Close-out Amount.”

This evolution in the ISDA framework was a direct response to the practical challenges of obtaining firm quotes in distressed market conditions, particularly for complex or illiquid transactions. The Close-out Amount is defined as the gains or losses the surviving party incurs in replacing the economic equivalent of the terminated transactions. The definition explicitly allows for a broader range of inputs to determine this amount.

These inputs include not only quotations from third parties but also relevant market data and, crucially, information from internal sources. This provision for the use of internal information is the gateway for the application of internal models.

The ISDA 2002 Master Agreement’s introduction of the “Close-out Amount” allows for a more flexible valuation process in the event of a counterparty default, specifically permitting the use of internal models.

The core principle governing the calculation of the Close-out Amount is that the determining party must act in good faith and use “commercially reasonable procedures” to produce a “commercially reasonable result.” This principle is the central pillar upon which the entire close-out process rests. The exclusive use of an internal model is permissible only to the extent that it aligns with this principle. An internal model, in this context, is a sophisticated quantitative tool that a financial institution uses in its regular course of business to price and value similar transactions.

The model’s outputs are considered a valid input into the close-out calculation, but they are not automatically dispositive. The model’s credibility and the reasonableness of its application are subject to scrutiny.

The design of the Close-out Amount provision acknowledges the reality that for many complex, bespoke, or illiquid derivatives, a true “market price” may not be readily observable. In such scenarios, an internal model may be the most reliable, or even the only, tool available to estimate the cost of replacement. The model’s valuation would typically be based on a range of factors, including the underlying asset’s price, volatility, interest rates, and other relevant market parameters. The model’s sophistication and its consistent application in the firm’s day-to-day operations are key to its defensibility as a tool for determining the Close-out Amount.

What Is the Role of Commercial Reasonableness

The concept of “commercial reasonableness” is the ultimate arbiter in the determination of the Close-out Amount. This standard is not explicitly defined in the ISDA Master Agreement, leaving it open to interpretation based on the prevailing circumstances and market practices. The exclusive reliance on an internal model will be deemed commercially reasonable if it can be demonstrated that the model produces a result consistent with what a rational market participant would achieve in replacing the transaction. This involves a holistic assessment of the model’s inputs, methodology, and outputs in the context of the available market information.

A firm’s ability to justify the exclusive use of its internal model hinges on its ability to demonstrate the model’s robustness and its consistent application. This includes maintaining detailed documentation of the model’s design, its validation process, and its performance over time. The model should be subject to regular back-testing and independent review to ensure its accuracy and reliability. In a dispute, a court would likely consider evidence of the firm’s internal governance processes around the model as a key indicator of commercial reasonableness.

How Do Internal Models Function in This Context

Internal models used for calculating close-out amounts are typically complex algorithms that take into account a multitude of variables to arrive at a valuation. These models are often the same ones used for daily marking-to-market of positions and for risk management purposes. The models are designed to capture the economic realities of the derivatives they are valuing, including any optionality or other complex features. The use of such a model for determining a close-out amount is an extension of its primary function within the firm’s risk management framework.

The model’s output is a calculated value that represents the firm’s assessment of the replacement cost of the terminated transaction. This value is then used as the basis for the Close-out Amount. The firm’s confidence in its model is a reflection of its investment in the technology, data, and expertise required to build and maintain it. The exclusive use of the model is a testament to the firm’s belief that it provides a more accurate and reliable valuation than any other available method.

Strategy

The strategic decision to rely exclusively on an internal model to determine a close-out amount is a calculated one, balancing the benefits of efficiency and consistency against the risk of legal challenge. While the ISDA Master Agreement permits the use of internal models, the strategy of using them as the sole determinant requires a robust framework of governance and validation. The overarching goal is to create a defensible and transparent process that withstands scrutiny in the event of a dispute.

A key element of this strategy is the proactive documentation of the internal model’s methodology, assumptions, and limitations. This documentation serves as a critical piece of evidence in demonstrating that the model’s application was commercially reasonable. The documentation should be detailed enough to allow an independent third party to understand how the model works and to replicate its results. This level of transparency is essential in building trust with counterparties and, if necessary, with a court or arbitral tribunal.

A successful strategy for using internal models to determine close-out amounts hinges on a foundation of rigorous validation, transparent documentation, and a demonstrable commitment to commercial reasonableness.

Another important strategic consideration is the establishment of a clear governance process for the use of the internal model in a close-out scenario. This process should define the roles and responsibilities of the individuals involved in the calculation, as well as the procedures for reviewing and approving the final Close-out Amount. The governance framework should also include provisions for escalating any contentious issues to senior management or legal counsel. A well-defined governance process helps to ensure that the calculation is performed in a consistent and controlled manner, reducing the risk of errors or manipulation.

What Are the Regulatory Implications

The regulatory landscape for non-cleared derivatives adds another layer of complexity to the use of internal models. Regulatory bodies in many jurisdictions have established rules for the calculation of initial margin, which is a form of collateral intended to cover potential future exposure in the event of a default. These rules often permit the use of internal models, but only if they have been approved by the relevant supervisory authority. The approval process typically involves a rigorous review of the model’s methodology, data sources, and governance framework.

While the rules for initial margin are distinct from the provisions for calculating close-out amounts, they are closely related. A firm that has obtained regulatory approval for its internal margin model is in a much stronger position to defend the use of that same model for determining a close-out amount. The regulatory approval serves as an independent validation of the model’s soundness and provides a powerful argument that its use is commercially reasonable. Conversely, a firm that uses an unapproved model for calculating a close-out amount may face a higher burden of proof in demonstrating its commercial reasonableness.

How to Mitigate the Risk of Disputes

The most effective way to mitigate the risk of disputes over the Close-out Amount is to engage in a transparent and collaborative process with the counterparty, to the extent possible. While a default scenario is by its nature adversarial, providing the counterparty with information about the valuation methodology can help to build trust and reduce the likelihood of a challenge. This could involve sharing a summary of the internal model’s inputs and outputs, or even providing a more detailed explanation of the model’s workings.

In situations where collaboration is not possible, the firm must rely on the strength of its internal processes and documentation to defend its calculation. This includes maintaining a detailed audit trail of all the steps taken to determine the Close-out Amount, from the initial data inputs to the final valuation. The audit trail should be contemporaneous and should capture any judgments or assumptions made during the process. A comprehensive audit trail is an invaluable asset in demonstrating that the firm acted in good faith and in accordance with commercially reasonable procedures.

The following table illustrates the different inputs that can be used to determine the Close-out Amount, highlighting the role of internal models:

Execution

The execution of a close-out calculation using an internal model is a multi-stage process that requires a combination of quantitative expertise, operational discipline, and legal awareness. The process begins with the identification of the terminated transactions and the gathering of all relevant data. This includes the contractual terms of the transactions, as well as the market data that will be used as inputs to the internal model. The quality and completeness of this data are critical to the accuracy of the final valuation.

Once the data has been gathered, the internal model is used to generate a valuation for each of the terminated transactions. The model’s output is a set of cash flows that represent the economic equivalent of the future payments and deliveries that would have been made under the transactions. These cash flows are then discounted to their present value to arrive at a single figure for each transaction. The sum of these figures, adjusted for any unpaid amounts, constitutes the Close-out Amount.

Executing a close-out calculation with an internal model demands a disciplined, multi-stage approach that integrates quantitative analysis, operational precision, and a keen understanding of the governing legal standards.

The execution process does not end with the calculation of the Close-out Amount. The firm must also prepare a detailed report that explains how the calculation was performed and provides supporting evidence for the valuation. This report is a critical piece of documentation that will be used to justify the Close-out Amount to the counterparty and, if necessary, to a court or arbitral tribunal. The report should be written in clear and concise language, and it should be accessible to a non-technical audience.

What Are the Best Practices for Model Governance

A robust model governance framework is essential for any firm that relies on internal models for valuation and risk management. The framework should be designed to ensure the integrity and reliability of the models, and it should be subject to regular review and independent validation. The following are some best practices for model governance:

• Model Inventory A comprehensive inventory of all the models used by the firm, including their purpose, methodology, and ownership.
• Model Documentation Detailed documentation for each model, covering its design, assumptions, limitations, and data sources.
• Model Validation A regular process of independent validation to assess the model’s performance and to identify any potential weaknesses.
• Model Change Management A formal process for managing any changes to the models, including testing and approval procedures.
• Model Risk Management A framework for identifying, measuring, and mitigating the risks associated with the use of the models.

The following table provides a hypothetical example of a close-out calculation for a portfolio of interest rate swaps, illustrating the application of an internal model:

How to Handle a Disputed Calculation

Despite a firm’s best efforts to perform a fair and accurate close-out calculation, disputes can still arise. When a dispute occurs, the firm must be prepared to defend its calculation in a formal setting, such as a court or an arbitration proceeding. The key to a successful defense is the quality of the firm’s documentation and the credibility of its expert witnesses. The firm should be able to demonstrate that it followed a rigorous and transparent process, and that its internal model is a reliable and appropriate tool for the valuation of the terminated transactions.

In a dispute, the firm’s expert witnesses will play a critical role in explaining the workings of the internal model and in justifying its use. The expert witnesses should be individuals with deep knowledge of the model and the relevant market, and they should be able to communicate complex concepts in a clear and persuasive manner. The firm should also be prepared to provide access to the model’s documentation and data, subject to appropriate confidentiality undertakings. A willingness to be transparent can go a long way in building credibility with the trier of fact.

Reflection

The reliance on internal models for the determination of close-out amounts is a testament to the increasing sophistication of financial markets. It reflects a shift towards a more principles-based approach to risk management, one that acknowledges the unique characteristics of complex financial instruments. This approach, however, places a significant burden on firms to ensure the integrity and robustness of their internal systems. The question is not simply whether an internal model can be used, but whether the firm’s entire operational framework is sufficiently robust to support its use.

Ultimately, the defensibility of a close-out calculation comes down to a matter of trust. A firm must be able to trust its own models, and it must be able to earn the trust of its counterparties and, if necessary, the legal system. This trust is not built overnight.

It is the product of a long-term commitment to excellence in risk management, a culture of transparency, and an unwavering adherence to the principle of commercial reasonableness. The firms that will succeed in this environment are those that view their internal models not as a black box, but as a core component of their strategic architecture.