To What Extent Did the Elimination of the “First Method” Impact Credit Negotiations in Derivatives Trading?

Concept

The Asymmetry of Default before Modernization

To comprehend the gravity of eliminating the “First Method,” one must first appreciate its foundational premise within the architecture of the 1992 International Swaps and Derivatives Association (ISDA) Master Agreement. It was a mechanism born from a specific, and now largely superseded, view of counterparty default. The First Method codified a principle known as “Limited Two-Way Payments.” In the event of a counterparty’s default, this provision allowed the non-defaulting party to calculate the net value of all terminated transactions. If that net value was owed to the non-defaulting party, a payment was made.

However, if the calculation showed that the non-defaulting party actually owed money to the defaulting party, the First Method permitted the non-defaulting party to simply walk away, paying nothing. This was often referred to as a “walkaway clause.”

This approach was rooted in the argument that a party should not benefit from its own failure to perform its contractual obligations. It created a starkly asymmetric risk profile. The defaulting party could only ever lose; it could never realize a gain on its portfolio of trades with the non-defaulting counterparty, even if the market had moved significantly in its favor. For the non-defaulting party, it represented a powerful, if blunt, instrument of risk mitigation ▴ a free option that capped its potential loss at zero upon a counterparty’s failure.

The First Method established a default scenario where the defaulting party could only lose, creating a significant and asymmetric power dynamic in derivatives contracts.

The Inevitable Shift to a Symmetrical Framework

The transition away from the First Method was driven by a confluence of regulatory pressure, evolving market sophistication, and a deeper understanding of systemic risk. The alternative, and the eventual market standard, was the “Second Method,” which mandated “Full Two-Way Payments.” Under this symmetric approach, the close-out calculation is performed, and the resulting net amount is paid to the party to whom it is owed, regardless of their status as the defaulting or non-defaulting party. If the non-defaulting party owes the defaulting party, the payment must be made.

The primary catalyst for the widespread abandonment of the First Method was the introduction of the 2002 ISDA Master Agreement. This new agreement did away with the choice between the two methods entirely, hardwiring a single, more sophisticated close-out calculation methodology called “Close-out Amount.” This new standard was philosophically aligned with the Second Method’s principle of full two-way payments. Regulators, particularly in the banking sector, strongly disfavored walkaway clauses, viewing them as a potential source of systemic instability.

Supervisory agencies recognized that the First Method could create perverse incentives and obscure the true net exposures between institutions. For a bank to benefit from regulatory capital relief through netting, it had to demonstrate that its netting agreements were robust and enforceable; the First Method’s walkaway provision was a significant obstacle to this, as it could be challenged under various insolvency laws.

Strategy

Recalibrating the Entire Credit Risk Calculus

The elimination of the First Method was a fundamental strategic inflection point in derivatives trading, forcing a complete recalibration of how credit risk was measured, managed, and priced. The walkaway clause was a crude but powerful tool. Its removal meant that credit risk departments could no longer rely on the comfort of a zero-floor on their exposure to a defaulting counterparty. The potential for a net payment to a bankrupt entity became a real, quantifiable risk that had to be integrated into every aspect of the trading relationship.

This compelled a strategic shift from a simple default/no-default binary to a more nuanced, continuous assessment of counterparty creditworthiness. The focus of negotiation moved decisively toward the Credit Support Annex (CSA). The CSA, which governs the posting of collateral, became the primary battlefield for credit risk mitigation. Negotiations intensified around key terms that were previously of secondary importance:

• Threshold Amounts ▴ The unsecured credit exposure a party was willing to have to its counterparty before collateral must be posted. With the walkaway clause gone, minimizing this threshold became a paramount objective for risk managers.
• Independent Amounts ▴ This is an additional amount of collateral, similar to an initial margin, that one or both parties may be required to post. The demand for Independent Amounts, particularly from weaker counterparties, increased significantly as a way to buffer against potential losses that now had to be paid out.
• Eligible Collateral ▴ The types of assets that could be posted as collateral (e.g. cash, government bonds) and the haircuts applied to them became subject to more rigorous scrutiny. The quality and liquidity of collateral were now directly linked to the potential payout to a defaulting entity.

From a Punitive Model to a Market-Based Mechanism

The strategic move from the First Method’s punitive model to the Second Method’s market-based approach fundamentally altered the economic incentives of a derivatives portfolio. It aligned the close-out process with the economic reality of the underlying transactions. This alignment ensured that the termination of contracts resulted in a settlement that reflected the true market value of the positions, preventing either party from receiving a windfall at the expense of the other due to the default event itself. This shift was critical for the development of a more mature and equitable market.

The end of the walkaway clause transformed credit negotiations, shifting the focus from the punitive terms of default to the proactive management of exposure through collateralization.

This new paradigm paved the way for the rise of Credit Valuation Adjustment (CVA). CVA is the market value of counterparty credit risk. It represents the adjustment to the price of a derivative to account for the possibility of a counterparty’s default. Calculating CVA requires a sophisticated model of potential future exposure (PFE).

Under the First Method, modeling PFE was distorted; the potential exposure was artificially floored at zero. With the move to full two-way payments, CVA models had to be redesigned to account for the possibility of negative exposure becoming a real liability. CVA desks became integral parts of trading operations, actively pricing and hedging the counterparty risk that the First Method had previously allowed firms to ignore.

Execution

The Mechanics of Modern Close Out

The execution of a close-out under the post-First Method regime, specifically under the 2002 ISDA Master Agreement, is a precise, multi-step process. The governing concept is the “Close-out Amount,” a sophisticated replacement for the earlier “Market Quotation” and “Loss” calculations. This process is initiated by the non-defaulting party (or a specified third party) upon designating an Early Termination Date following a default.

The core objective is to determine, in good faith and using commercially reasonable procedures, a single net figure that represents the economic equivalent of replacing the terminated transactions in the current market. This involves a series of calculations:

1. Identification of Terminated Transactions ▴ All outstanding transactions under the single ISDA Master Agreement are identified for termination. The “single agreement” concept is vital here, ensuring all trades are pooled together.
2. Calculation of Individual Close-out Amounts ▴ For each terminated transaction, the determining party calculates its replacement value. This is the gain or loss that would be realized by entering into a replacement transaction on the same terms. This calculation can use various sources of information, including quotes from third-party dealers, data from internal models, and information about relevant market conditions.
3. Aggregation and Netting ▴ The individual Close-out Amounts for all transactions are summed to arrive at a single net figure. This figure represents the total mark-to-market value of the entire portfolio of trades.
4. Inclusion of Unpaid Amounts ▴ Any amounts that were due to be paid by either party before the Early Termination Date but were not paid (“Unpaid Amounts”) are factored into the calculation. Amounts owed to the non-defaulting party are added to the net close-out figure, while amounts owed to the defaulting party are subtracted.
5. Final Settlement ▴ The resulting number is the final settlement amount. If it is a positive number, the defaulting party pays it to the non-defaulting party. If it is a negative number, the non-defaulting party pays the absolute value of that amount to the defaulting party’s estate.

A Quantitative Illustration of the Impact

The practical difference between the First and Second methods is most clearly seen through a quantitative example. Consider a scenario where a bank has two interest rate swaps with a corporate client, both governed by a 1992 ISDA Master Agreement. The client subsequently defaults.

In this scenario, the net value of the terminated portfolio is negative for the bank; it owes the client $3,000,000 on a mark-to-market basis.

• Execution under First Method ▴ The calculation results in a negative number for the non-defaulting Bank. Invoking the “walkaway” clause, the Bank would be permitted to pay nothing to the defaulting client. The client’s estate loses out on the $3,000,000 of value it held in its derivatives portfolio.
• Execution under Second Method / 2002 ISDA ▴ The calculation results in a net amount of $3,000,000 owed to the defaulting client. The non-defaulting Bank is obligated to pay this amount to the client’s estate. This ensures the client’s creditors receive the full economic value of the assets held at the time of default.

The operational reality of the modern framework is a mandatory payment to the defaulting party if the net portfolio value is in their favor, a concept entirely alien to the First Method.

This fundamental change in execution had profound consequences for financial infrastructure. Risk management systems had to be re-architected. They could no longer simply cap exposure at zero. Systems needed to calculate and manage bilateral credit exposure, leading to the development of sophisticated Potential Future Exposure (PFE) and Credit Valuation Adjustment (CVA) engines.

These systems must now model the full distribution of possible future values of a derivatives portfolio, both positive and negative, to accurately price the credit risk embedded in every trade. This move from a simple, punitive legal clause to a complex, market-based risk calculation represents one of the most significant evolutions in the operational management of derivatives trading.

Reflection

Beyond a Clause to a Core Philosophy

The migration from the First Method was far more than a technical update to a legal document. It represented a philosophical maturation of the global derivatives market. The initial architecture, with its walkaway clause, reflected a market in its adolescence ▴ focused on individual counterparty failure with a punitive and self-protective lens.

The modern framework, built on the principle of full two-way payments, reflects a system that has come to understand its own interconnectedness. It acknowledges that risk is a fluid, bilateral entity and that the health of the entire network depends on the fair and predictable resolution of its individual nodes, even those in a state of failure.

Contemplating this evolution prompts a critical examination of one’s own operational framework. Is risk viewed as a one-sided threat to be walled off, or as a dynamic, two-way street to be managed with precision? The systems and protocols in place for collateral management, exposure calculation, and valuation adjustments are the tangible manifestations of this underlying philosophy. The elimination of the First Method serves as a permanent reminder that in a deeply networked financial system, true resilience is found not in clauses that allow one to walk away from obligations, but in frameworks that ensure the equitable and transparent settlement of all accounts, thereby reinforcing the integrity of the market as a whole.