In recent years, participants have debated the merits of two different approaches, limited and full two-way payments, to determine the net payments made after an early termination through close-out netting.
In 1987, the first approach, limited two-way payments, was embodied in the ISDA Master Agreement. That approach distinguished between early termination caused by a default and one caused by a termination event, such as illegality. In essence, it provided that, when a party defaulted, it should not be entitled to any net payments, even if the net value of the position between it and its non-defaulting party was in its favor. If there was no default but there was a termination event, however, then the net value would have to be paid, regardless of who paid whom--that is, full two-way payments.
The idea behind not requiring payments to a defaulter was not that the other party should enjoy a windfall gain, but that it should be able to set off any losses to the defaulter, or to its affiliates not covered by the master agreement, before paying any balance.
Since 1987, the limited two-way payments approach has worked well enough, but critics have identified two possible problems: counterparties to a defaulter could walk away with a windfall; and, more subtly, the existence of limited two-way payments may introduce undesirable uncertainty when assessing the position of an insolvent institution.
To meet this concern, the 1992 ISDA Master Agreement allows both limited and full two-way payments to be applied to defaulters and non-defaulters alike. It states that full two-way payments will apply, unless counterparties elect limited two-way payments. This accommodates the Basle Accord proposal published for comment in May 1993, which suggests full two-way payments should be generally applied, and with the Recommendation in this Study to the same effect.
