Why Was the “First Method” or One-Way Payment System Removed in the 2002 ISDA Master Agreement?

Concept

The operational architecture of the over-the-counter derivatives market underwent a foundational upgrade with the 2002 ISDA Master Agreement. A central element of this recalibration was the decommissioning of the “First Method” for calculating termination payments. To comprehend the logic driving this evolution, one must first view the ISDA Master Agreement as a single, integrated contract designed to govern all transactions between two counterparties.

Its primary function is to create a predictable, enforceable, and stable system for managing counterparty credit risk. The 1992 iteration of the agreement presented a choice in its termination payment mechanics, a choice that fundamentally altered the risk equation upon a default event.

The First Method, often termed a “walkaway clause,” permitted a non-defaulting party to terminate its obligations and make no further payments to the defaulting party, even if the non-defaulting party was “out-of-the-money” on the net value of all transactions. This meant if Counterparty A defaulted, and Counterparty B owed a net amount to A across their portfolio, Counterparty B could, under the First Method, simply walk away, retaining that amount as a windfall. This approach created a punitive asymmetry. Its existence was a direct contradiction to the core objective of the ISDA framework, which is to precisely quantify and settle the net economic value of a terminated portfolio, thereby preventing systemic shocks.

The First Method allowed a non-defaulting party to withhold payments owed to a defaulting counterparty, creating a punitive and asymmetric outcome upon termination.

The alternative, the “Second Method,” mandated a full two-way payment. Under this system, the net value of the terminated transactions is calculated, and whoever owes money pays it, regardless of which party defaulted. If the non-defaulting party is out-of-the-money, it must pay the net amount to the defaulting party’s estate. This mechanism preserves the true economic reality of the trading relationship at the moment of termination.

The 2002 ISDA Master Agreement eliminated the choice entirely, making the two-way payment approach the universal standard. This decision was a direct consequence of the market’s maturation and a systemic recognition that the stability of the network depends on the equitable and predictable settlement of all obligations.

The Single Agreement Principle

The ISDA Master Agreement’s structural integrity rests on the “single agreement” concept, as articulated in Section 1(c) of the document. This clause stipulates that the Master Agreement and all subsequent transaction confirmations constitute a single, unified legal contract. This architecture is the bedrock of close-out netting.

Without it, each transaction could be treated as a separate contract, allowing an insolvent firm’s administrator to “cherry-pick” ▴ demanding payment on profitable contracts while simultaneously defaulting on unprofitable ones. Such a scenario would shatter the risk-mitigating function of derivatives portfolios.

The First Method acted as a corrosive agent on this principle. By allowing a non-defaulting party to ignore its net payment obligations, it partially negated the “single agreement” concept in practice. It suggested that under specific circumstances ▴ a counterparty’s default ▴ the unified portfolio could be fractured to the benefit of one party. The removal of the First Method was a powerful reaffirmation of the single agreement’s sanctity, ensuring that the portfolio is always treated as an indivisible whole for the purposes of termination and settlement.

Strategy

The strategic decision to remove the First Method from the 2002 ISDA Master Agreement was driven by a convergence of regulatory pressure, the pursuit of market stability, and a sophisticated understanding of commercial fairness. The framework of the 1992 agreement, by offering this choice, created a structural vulnerability that was ultimately deemed unacceptable by both regulators and market participants seeking a more robust and predictable financial architecture.

Regulatory Imperatives and Capital Adequacy

A primary catalyst for the change was the stance of banking regulators, particularly in the United States. For regulatory capital purposes, financial institutions are permitted to calculate their credit exposure to a counterparty on a net basis, provided a legally robust bilateral netting agreement is in place. This is a significant benefit, as netting dramatically reduces the reported credit risk, which in turn lowers the amount of regulatory capital a bank must hold against its derivatives portfolio. A lower capital requirement enhances a bank’s return on equity and frees up capital for other activities.

The First Method jeopardized this treatment. Regulators took the position that the “walkaway” nature of the clause undermined the legal certainty of netting. Because the non-defaulting party could avoid payment, the ultimate settlement amount was not a true reflection of the net mark-to-market value of the portfolio. Consequently, institutions that elected the First Method were often required to report their exposures on a gross basis.

This eliminated the capital efficiency benefit of the ISDA Master Agreement, making the First Method a costly and operationally burdensome choice. The 2002 Agreement’s standardization on a two-way payment system aligned the legal framework with regulatory expectations, ensuring the capital benefits of netting were universally available and legally sound.

Eliminating the First Method was essential for aligning the ISDA framework with regulatory capital requirements that favor true, enforceable bilateral netting.

What Was the Impact on Market Stability and Systemic Risk?

The First Method introduced a degree of moral hazard and potential for systemic contagion. It created a “winner-takes-all” scenario in the event of a default, which could have destabilizing effects during periods of market stress. Consider a scenario where a major financial institution defaults. Its counterparties would immediately assess their net positions.

• Counterparties in-the-money ▴ Those owed money by the defaulting firm would initiate close-out procedures to claim their net value.
• Counterparties out-of-the-money ▴ Those who owed money to the defaulting firm and had elected the First Method could simply walk away, withholding payments that would otherwise flow to the defaulting firm’s creditors.

This withholding of payments exacerbates the financial distress of the defaulting entity, making it harder for its administrators to recover value for its creditors, which could include other banks, pension funds, and corporations. This cascade of amplified losses could increase the risk of further defaults across the system. The Second Method, by ensuring that all out-of-the-money counterparties pay their net obligations into the bankruptcy estate, provides a more orderly and equitable distribution of assets, thereby dampening systemic shocks. The 2002 ISDA’s adoption of a mandatory two-way payment system was a strategic move to build a more resilient market infrastructure.

Fairness and the Evolution of Commercial Practice

Over time, market consensus grew that the First Method was commercially unreasonable and inequitable. A derivative contract is a tool for managing price risk, and its value at any given time is a function of market movements. A default is a credit event, separate from the mark-to-market value of the underlying transactions. The First Method conflated these two distinct events, allowing a credit event (the default) to extinguish a legitimate market-based debt.

This was viewed as a punitive measure that went beyond the simple compensation for losses incurred due to the default. The Second Method, in contrast, cleanly separates the two. It first establishes the net mark-to-market value of the terminated portfolio and then handles that amount as a claim in the default proceedings. This is a more logical and commercially sound approach.

The table below illustrates the strategic shift in philosophy between the two approaches.

Execution

The transition from the optionality of the 1992 ISDA to the standardized approach of the 2002 ISDA represented a significant evolution in the operational execution of derivatives close-outs. The introduction of the “Close-Out Amount” as a unified calculation methodology was central to this shift. This new definition replaced the bifurcated “Market Quotation” and “Loss” measures from the 1992 agreement, providing a more flexible and commercially reasonable standard for determining the final settlement amount.

How Is the Close-Out Amount Calculated?

The Close-Out Amount is defined as the amount of losses or costs that the determining party (typically the non-defaulting party) incurs, or the gains it realizes, in replacing or providing the economic equivalent of the material terms of the terminated transactions. The 2002 ISDA requires the determining party to use “commercially reasonable procedures to produce a commercially reasonable result.” This is a principles-based standard that grants a degree of discretion while binding the calculating party to standards of good faith and rational market practice.

The calculation process involves several key steps:

1. Identification of Terminated Transactions ▴ All transactions governed by the single ISDA Master Agreement are identified for termination.
2. Valuation Date ▴ An Early Termination Date is designated, which serves as the “as of” date for all valuations.
3. Economic Equivalent Assessment ▴ The determining party must assess the cost of entering into replacement trades that would replicate the future cash flows of the terminated transactions. This can be done by:
   • Obtaining quotes from third-party dealers for replacement transactions.
   • Using internal pricing models, provided they are consistent with models used for internal accounting and risk management purposes.
   • Considering any other information that, in its commercially reasonable judgment, is relevant.
4. Inclusion of Costs and Gains ▴ The calculation must also include any reasonable costs associated with liquidating or re-establishing hedges related to the terminated portfolio. It must also account for the value of any option rights embedded within the terminated trades.
5. Aggregation and Netting ▴ The gains, losses, and costs for all terminated transactions are aggregated into a single net number. This final figure is the Close-Out Amount. If it is a positive number, it is owed to the determining party. If it is a negative number, its absolute value is owed to the other party.

The Close-Out Amount under the 2002 ISDA is a unified and principles-based metric designed to reflect the true economic cost of replacing a terminated derivatives portfolio.

Quantitative Comparison of Termination Scenarios

To understand the profound difference in execution, consider a simple portfolio between Counterparty A and Counterparty B. Counterparty A enters bankruptcy, triggering an Event of Default.

Portfolio at Termination Date ▴

• Transaction 1 (Interest Rate Swap) ▴ Mark-to-market value is +$10 million from B’s perspective (B is in-the-money).
• Transaction 2 (FX Forward) ▴ Mark-to-market value is -$15 million from B’s perspective (B is out-of-the-money).

The net value of the portfolio from B’s perspective is -$5 million. This means Counterparty B owes a net amount of $5 million to Counterparty A.

The following table demonstrates the divergent outcomes based on the governing agreement and elected method.

This quantitative example makes the operational and financial impact clear. The First Method creates a $5 million windfall for Counterparty B and an equivalent loss for Counterparty A’s creditors. The 2002 ISDA framework prevents this, ensuring the execution of the close-out aligns with the actual economic position of the portfolio, thereby promoting a more stable and equitable resolution.

Reflection

The architectural shift from the 1992 to the 2002 ISDA Master Agreement is a case study in the maturation of a market. The elimination of the First Method was a deliberate design choice, moving the system from a punitive, asymmetric model to one grounded in the principles of economic equity and systemic stability. This evolution compels us to examine our own risk management frameworks. Are our protocols designed merely to win a zero-sum game upon a counterparty’s failure, or are they engineered to contribute to the stability and predictability of the entire system in which we operate?

What Does This Mean for Modern Risk Systems?

Understanding this history is foundational. It informs how we model counterparty credit risk, how we structure legal agreements, and how we build operational procedures for default management. The principles embedded in the 2002 ISDA ▴ the sanctity of the single agreement and the fairness of two-way payments ▴ are now the bedrock of the global derivatives market.

A truly robust operational framework internalizes not just the rules themselves, but the strategic logic that drove their creation. The ultimate advantage lies in designing systems that are not only compliant but are also architecturally aligned with the stable, efficient, and equitable market the industry has collectively worked to build.