Why Was the “First Method” Payment System in the 1992 ISDA Considered Problematic?

Concept

The 1992 ISDA Master Agreement’s “First Method” payment system was not merely a flawed mechanism. It was a structural anomaly in the architecture of derivatives markets, an asymmetric protocol that introduced a critical vulnerability at the heart of counterparty risk management. Its core problem was its unilateral nature. In the event of a default, the First Method stipulated a one-way payment calculation.

Only the non-defaulting party could receive a payment if the net value of the terminated transactions was in its favor. Should the calculation result in a payment being owed to the defaulting party, the non-defaulting party had no obligation to pay. This created a free option for the non-defaulting party, a distortion of the economic reality of the underlying derivative contracts.

This design choice had profound implications. The very foundation of a derivative contract is the reciprocal exchange of risk and reward. The First Method fundamentally broke this symmetry. It created a scenario where a defaulting party, even if holding a portfolio of trades that was significantly in-the-money, could not realize that value upon termination.

This was not a minor detail. It was a direct contradiction of the principle of netting, which is designed to reduce systemic risk by establishing a single, net obligation between two parties. The First Method, in effect, allowed for a selective and opportunistic application of this principle, undermining its very purpose.

The First Method’s one-way payment structure created a fundamental imbalance in the risk-reward profile of derivative contracts, offering a free option to the non-defaulting party.

The consequences of this architectural flaw were not theoretical. They manifested as a significant moral hazard. A non-defaulting party that was out-of-the-money had a powerful incentive to delay the termination of trades. By waiting, they could hope for a favorable market movement that would shift the net position in their favor, or at worst, they would owe nothing.

This ability to “wait and see” introduced a dangerous element of strategic gamesmanship into the default process, a period during which market risk could escalate and the potential for wider systemic contagion could grow. The First Method was, in essence, a back door for the non-defaulting party to walk away from its obligations, a situation that the market quickly recognized as untenable. The eventual and complete removal of the First Method in the 2002 ISDA Master Agreement was a clear acknowledgment of its inherent weaknesses and a necessary step in the evolution of a more robust and equitable market infrastructure.

What Was the Core Architectural Flaw?

The central architectural flaw of the First Method was its violation of the principle of reciprocity in financial contracts. A derivative is a contract whose value is derived from an underlying asset or benchmark. Both parties to the contract agree to a set of future cash flows, the net value of which can be positive or negative for either party at any given time.

The First Method’s one-way payment mechanism ignored this fundamental reality. It treated the default scenario not as a process of settling a net account between two parties, but as a punitive measure against the defaulting party, regardless of the underlying economic value of the positions.

This created a system that was inherently unstable. Financial markets are complex adaptive systems, and the introduction of such a significant asymmetry in a core protocol was bound to have distorting effects. The First Method’s design incentivized behavior that was detrimental to market stability and efficiency.

It encouraged non-defaulting parties to act in their own self-interest, even if that meant exacerbating market volatility or delaying the resolution of a default. This is a classic example of a poorly designed protocol leading to negative emergent properties within the system.

The Impact on Market Perception

The existence of the First Method, even as an option, had a corrosive effect on market confidence. Sophisticated market participants understood the inherent unfairness and the risks it created. As a result, the First Method was very rarely elected in practice. Counterparties were simply unwilling to enter into a long-term trading relationship where one side held such a powerful and uncompensated advantage.

The market, in its collective wisdom, effectively rejected the First Method long before it was officially removed from the ISDA Master Agreement. This market-led obsolescence is a testament to the importance of fair and equitable protocols in maintaining a healthy and functional financial ecosystem. The First Method stands as a cautionary tale in the history of financial engineering, a reminder that the pursuit of short-term advantage at the expense of fundamental principles of fairness and reciprocity can have far-reaching and damaging consequences.

Strategy

The strategic implications of the First Method were profound, extending far beyond the immediate relationship between two counterparties. Its existence created a strategic landscape fraught with moral hazard, distorted incentives, and a fundamental misalignment with the core principles of sound risk management. For a non-defaulting party, the First Method presented a clear, albeit ethically questionable, strategic advantage.

For a defaulting party, it represented a significant and unhedgeable risk. For the market as a whole, it was a source of systemic instability.

The primary strategic problem created by the First Method was the incentive for the non-defaulting party to delay termination. In a volatile market, the value of a derivatives portfolio can fluctuate significantly. If a non-defaulting party was out-of-the-money, the First Method gave them a powerful reason to wait before declaring an early termination date. This “wait-and-see” approach was a form of free option, a risk-free bet on market movements at the expense of the defaulting party and the wider market.

This strategic delay had several negative consequences. It prolonged uncertainty, increased the potential for market contagion, and made the ultimate resolution of the default more complex and costly.

The strategic weakness of the First Method was its creation of a moral hazard, incentivizing non-defaulting parties to delay termination in the hope of favorable market movements.

A Comparison of Payment Calculation Methods

To fully appreciate the strategic deficiencies of the First Method, it is useful to compare it with the Second Method, the two-way payment system that ultimately became the market standard. The following table illustrates the fundamental differences in their operational logic:

Why Was the Second Method Superior?

The superiority of the Second Method lies in its alignment with the fundamental principles of financial markets. It recognizes that a derivative contract is a two-sided agreement, and that both parties have a legitimate claim to the value of their positions. By mandating a two-way payment, the Second Method ensures that the close-out process is a true and fair settlement of all outstanding obligations. This has several important strategic benefits:

• Predictability and Certainty ▴ The Second Method provides a clear and predictable framework for the resolution of defaults. Both parties know that the net value of their positions will be calculated and settled, regardless of who is the defaulting party. This certainty is essential for effective risk management.
• Reduced Systemic Risk ▴ By eliminating the incentive for strategic delay, the Second Method helps to contain the impact of a default and prevent it from spreading to other parts of the financial system. A swift and orderly close-out of positions is crucial in times of market stress.
• Enhanced Market Confidence ▴ The widespread adoption of the Second Method has enhanced confidence in the derivatives market. Market participants know that they are operating within a fair and equitable framework, which encourages greater participation and liquidity.

The evolution from the First Method to the Second Method was a critical step in the maturation of the derivatives market. It represented a move away from a punitive and opportunistic approach to default resolution towards a more principled and systemic approach. The strategic lessons learned from the failure of the First Method continue to inform the design of financial market infrastructure today.

Execution

The execution of a close-out under the 1992 ISDA Master Agreement was a complex process, and the choice between the First Method and the Second Method had a profound impact on the operational mechanics of that process. The First Method, with its one-way payment structure, introduced a series of operational challenges and risks that made its execution problematic. A detailed examination of the execution phase reveals the practical difficulties that ultimately led to the abandonment of this flawed protocol.

Upon the occurrence of an event of default, the non-defaulting party had the right to designate an early termination date. At this point, the process of calculating the settlement amount would begin. Under the First Method, this calculation was performed solely from the perspective of the non-defaulting party. The objective was to determine the amount, if any, that the defaulting party owed.

If the calculation showed that the non-defaulting party was out-of-the-money, the process would simply stop, and no payment would be made. This created a significant operational asymmetry. The non-defaulting party had complete control over the timing and execution of the close-out process, with little or no recourse for the defaulting party.

The operational execution of the First Method was fraught with challenges, including the potential for valuation disputes and the lack of a clear and transparent process for the defaulting party.

Valuation Methodologies under the 1992 ISDA

The 1992 ISDA Master Agreement provided for two primary methods of valuing terminated transactions ▴ “Market Quotation” and “Loss”. The choice of valuation method was independent of the choice between the First and Second Methods, but it had a significant impact on the execution of the close-out process. The following table provides a breakdown of these valuation methods:

A Hypothetical Execution Scenario

To illustrate the practical problems of the First Method, consider the following scenario. Bank A and Bank B have a portfolio of derivative trades governed by a 1992 ISDA Master Agreement with the First Method and Market Quotation selected. Bank B defaults on its obligations.

At the time of default, the net market value of the portfolio is in Bank B’s favor by $10 million. Bank A, as the non-defaulting party, is out-of-the-money.

Under the First Method, Bank A has no obligation to pay the $10 million to Bank B. Furthermore, Bank A has a strategic incentive to delay the designation of an early termination date. It can wait to see if market movements will erode the $10 million value of Bank B’s position. This creates a period of uncertainty and risk.

During this time, Bank B is unable to realize the value of its in-the-money positions, which could have a significant impact on its ability to meet its obligations to other creditors. This scenario highlights the fundamental unfairness and inefficiency of the First Method in practice.

The Move to a More Robust Execution Framework

The problems with the First Method, coupled with the challenges of the Market Quotation and Loss valuation methods, led to significant changes in the 2002 ISDA Master Agreement. The 2002 agreement eliminated the First Method entirely, making the two-way payment system the only option. It also introduced a more streamlined and objective approach to valuation, replacing the problematic Market Quotation and Loss methods with a single “Close-out Amount” calculation.

This new approach gives the determining party more flexibility in how it calculates the close-out amount, but it also imposes a duty to act in a commercially reasonable manner. The evolution of the ISDA Master Agreement from the 1992 version to the 2002 version reflects a clear trend towards a more robust, equitable, and operationally efficient framework for the execution of close-outs.

Reflection

The examination of the First Method’s demise offers a critical lesson in system architecture. A protocol’s resilience is not determined by its performance under normal operating conditions, but by its behavior at points of maximum stress. The First Method failed because it created a destabilizing asymmetry precisely when the system was most vulnerable to collapse. Its legacy compels us to ask a fundamental question of our own operational frameworks ▴ where do the hidden asymmetries lie?

Are there protocols within our own systems that, under pressure, could incentivize behavior that is misaligned with the overall objective of stability and capital preservation? The transition from the First Method to the Second Method was more than a technical adjustment. It was a philosophical shift towards a more robust and equitable system design. This same intellectual rigor must be applied to the continuous evaluation and refinement of our own internal systems, ensuring they are not just efficient in the calm, but resilient in the storm.