Second Method - ISDA Provision
1992 ISDA Master Agreement
Section 6(e)(i) in a Nutshell™
Full text of Section 6(e)(i)
Related agreements and comparisons
Content and comparisons
- (i) Ignore First Method: No-one in their right mind would ever agree to the First Method, so you don’t need to worry about that. (It provides that on an Event of Default, the Defaulting Party never gets paid anything, even if the total mark-to-market value of its exposure under the 1992 ISDA is massively in its favour).
- (ii) Market Quotation basically defaults to Loss: Market Quotation basically defaults to Loss anyway, seeing as if you can’t get at least three Reference Market-maker quotations, Market Quotation is deemed indeterminable and the Non-defaulting Party determines its Loss instead (only excluding Unpaid Amounts, since they are excluded from Market Quotation).
- (iii) Market Quotation and Loss are needlessly inconsistent: As noted above, for reasons best known to 1992’s ISDA’s crack drafting squad™ (and look: it was a gentler, more naive time, when complexity for the sake of it was half the fun of derivatives practice) Market Quotation excludes Unpaid Amounts, where as Loss includes them, and Loss is calculated in the Termination Currency Equivalent, whereas Market Quotation is not.
Upon a Termination Event under the ISDA Master Agreement it is good to have your payment and calculation methods well-defined. The section Payments on Early Termination (ISDA Master Agreement Section 6(e) and Schedule 1(f)) covers this.
Fun fact: That terrible FT book about derivatives, and other like-minded sources, label the First Method a “limited two-way payments” clause, by which lights Long John Silver was a “limited two-legged pirate”. Less disingenuously also known as a “walkaway clause”, the First Method, which ensured that on close-out a Defaulting Party got paid nothing, regardless of how far in-the-money its Transactions were, was rarely used, even in the heady early 1990s, when derivatives seemed fun, new and mostly harmless.
Under the First Method, a payment is only ever made if the Settlement Amount is payable by the Defaulting Party to the Non-defaulting Party. This is, needless to say, a big fat free option against a Defaulting Party. The First Method is thus a back door to withhold payments that otherwise would due under the ISDA Master Agreement, it is hard to see why anyone in their right mind would give away this kind of optionality at the commencement of a derivative trading relationship, and, predictably, no one did.
Very, very rarely seen.
The Second Method is a method of determining the Early Termination Amount due upon close out of an 1992 ISDA. Unlike the First Method, it requires a payment to be made equal to the net value of the Terminated Transactions to whom it is due, regardless whether it is the Defaulting Party or the Non-defaulting party. I.e., the Defaulting Party might get paid. Nice, huh?
The 1992 ISDA provides alternative ways of arriving at a value for your portfolio of Terminated Transactions. This probably seemed like a good idea to ISDA’s crack drafting squad™ at the time — hey look: acid wash denim seemed a good idea at the time, to someone — but it leads to complexity, confusion, fear and loathing.
- Market Quotation requires at least three arm’s length quotations to value the Transactions to be terminated. Since the Reference Market-makers won’t know anything about the state of your Transactions — and you are hardly likely to tell them — they can hardly be expected to factor your specific Unpaid Amounts into their quotations, so their quotations, if they even give you one, will be to replace the remainder of the Transaction in the abstract, assuming all past payments have been made, and there are no Unpaid Amounts. Therefore, later on in your close-out calculation process, you will have to factor in those Unpaid Amounts yourself.
- Loss allows the Non-defaulting Party to figure out (in "good faith") its losses and costs (minus its gains) replacing Terminated Transactions. While the NDP can to this by reference to dealer quotations, it doesn’t have to. Seeing as, unlike a Reference Market-maker, the NDP itself absolutely does know what the Unpaid Amounts are, ISDA’s crack drafting squad™ thought it easier for the Loss calculation method to factor the Unpaid Amounts in right away, rather than doing that as a separate second step, as per Market Quotation. But this really just confuses things, when it could have all been simple.
- Closing out a 1992 ISDA
- Second Method under the 1992 ISDA
- The generally more sensible, less odious Close-out Amount in the 2002 ISDA.