How Does the 2002 ISDA Close-Out Amount Improve upon the 1992 Market Quotation Method?

Concept

The transition from the 1992 ISDA Master Agreement’s Market Quotation mechanism to the 2002 ISDA’s Close-Out Amount represents a fundamental re-architecture of counterparty risk management. This evolution was not a minor recalibration. It was a direct response to systemic failures observed in distressed markets, where the rigid, theoretical approach of the 1992 framework proved inadequate.

The core of the upgrade lies in its shift from a prescriptive, and often impractical, polling process to a flexible, commercially reasonable standard. This grants the determining party the ability to use a wider, more relevant set of inputs to ascertain the true economic cost of replacing a terminated derivatives portfolio.

Under the 1992 Agreement, the Market Quotation method was an attempt to impose objective order on a disorderly event. It mandated the party calculating the termination payment to solicit quotes from four leading dealers in the specific derivative product. This system was predicated on the assumption that a functioning, liquid market with willing participants would always be available to provide these quotes. The reality, particularly during periods of systemic stress like the defaults of the late 1990s and early 2000s, was starkly different.

Dealers were often unwilling to provide quotes for transactions they had no intention of executing, especially for illiquid products or when the default of a major counterparty cast a pall over the entire market. The result was a process that could be paralyzed by its own rigidity, failing to produce a reliable valuation when it was most needed.

The 2002 ISDA’s Close-Out Amount, in contrast, is built on a foundation of commercial reality. It dispenses with the strict four-dealer polling requirement. Instead, it establishes a guiding principle ▴ the determining party must use commercially reasonable procedures to produce a commercially reasonable result. This framework is inherently more robust and adaptable.

It allows for the use of a variety of valuation inputs, including internal models, data from electronic trading platforms, and quotes from a single source if that is the most reasonable approach under the circumstances. This flexibility ensures that a valuation can be performed even in illiquid or volatile markets where the 1992 method would have failed.

The 2002 ISDA Close-Out Amount replaces a rigid, quote-based mechanism with a flexible, principles-based standard to achieve a more accurate valuation in real-world market conditions.

A pivotal conceptual change was the rejection of the “value clean” approach that was a feature of the 1992 Market Quotation. The old method required valuing the terminated transactions as if they would run to their scheduled maturity, ignoring the creditworthiness of the counterparties and any embedded termination or option rights. This created a valuation that was disconnected from the true economic risk of the positions.

The 2002 Close-Out Amount reverses this, explicitly requiring that the valuation reflects the credit quality of the determining party and all material terms of the transaction, including option rights. This produces a figure that more accurately represents the actual loss or gain experienced by the non-defaulting party.

Strategy

The strategic impetus behind the development of the 2002 ISDA Close-Out Amount was the need to create a more resilient and objective system for managing counterparty default. The flaws in the 1992 Market Quotation method had become glaringly apparent, and the new framework was designed to address these weaknesses directly. The strategy can be understood as a move from a prescriptive to a principles-based system, prioritizing economic reality over procedural formalism and enhancing objectivity in the process.

What Was the Core Strategic Flaw of Market Quotation?

The primary strategic flaw of the 1992 Market Quotation was its reliance on external inputs from parties who had no economic stake in the outcome. Requesting quotes from four reference market-makers created a process that was theoretically sound but practically fragile. During a major credit event, the very moment when a robust close-out mechanism is most critical, several issues would consistently arise:

• Dealer Reluctance ▴ In a stressed market, dealers are focused on managing their own risk. They have little incentive to devote time and resources to providing quotes for a hypothetical replacement transaction, especially for complex or illiquid derivatives.
• Inaccurate Pricing ▴ Even when quotes were provided, their reliability was questionable. Without the prospect of actually executing a trade, the quotes could be conservative, wide, or simply not reflect the true, executable market level. The process lacked the price discovery discipline of a real transaction.
• Operational Failure ▴ In many instances, it was simply impossible to obtain the required number of quotes, leaving the determining party in a state of procedural paralysis and legal uncertainty.

This fragility meant that the Market Quotation method was least effective when it was most needed. The 2002 ISDA’s strategy was to internalize the valuation process, grounding it in the principle of commercial reasonableness and empowering the determining party to use a broader and more reliable set of tools to arrive at a fair value.

The Shift to Objective Reasonableness

A key strategic shift in the 2002 ISDA was the introduction of a higher standard of conduct for the determining party. The 1992 Agreement’s “Loss” calculation (the alternative to Market Quotation) required the determining party’s calculations to be “reasonable.” The 2002 Close-Out Amount requires the use of “commercially reasonable procedures to produce a commercially reasonable result.” This change in language is substantive. It elevates the standard from a subjective test of rationality to an objective one.

This means the valuation is no longer judged simply on whether the determining party acted in good faith based on its own perspective. Instead, the process and the result are measured against an objective, external standard of what would be considered commercially reasonable in the relevant market. This change was designed to introduce greater objectivity and reduce disputes, as the methodology must now align with what a court would consider a fair and rational process.

The 2002 framework strategically shifts the valuation standard from subjective rationality to objective commercial reasonableness, enhancing the legal defensibility of the close-out calculation.

The table below outlines the core strategic differences between the two valuation methodologies.

Execution

The execution of a close-out under an ISDA Master Agreement is a critical process that determines the final financial settlement between parties following a default or other termination event. The procedural differences between the 1992 and 2002 agreements are substantial, with the latter providing a more robust and commercially viable toolkit for the determining party. Understanding these executional distinctions is paramount for any institution managing derivatives risk.

Executing a Close-Out under the 1992 ISDA

When executing a close-out using the Market Quotation method under the 1992 ISDA, the determining party (typically the non-defaulting party) was bound by a strict and sequential process. The primary objective was to determine a “Settlement Amount” for each terminated transaction.

1. Selection of Reference Market-Makers ▴ The first step was to identify four leading dealers in the relevant type of derivative transaction. The agreement stipulated that these dealers should be of the “highest credit standing.”
2. Solicitation of Quotations ▴ The determining party would then request quotes from these four dealers for a replacement transaction that would have the same economic terms as the terminated one. The quote would represent the cost of entering into such a transaction.
3. Calculation of the Settlement Amount ▴ If three or more quotes were obtained, the Settlement Amount would be the arithmetic mean of the quotes, after discarding the highest and lowest ones. If only two quotes were obtained, the average would be used. If fewer than two quotes were received, the Market Quotation method failed, and the party would have to revert to the “Loss” calculation method.
4. Aggregation and Netting ▴ The Settlement Amounts for all terminated transactions, along with any unpaid amounts due, would be aggregated and netted to arrive at a single lump-sum payment.

This process, while clear on paper, was operationally cumbersome and frequently impractical. The requirement for four dealers of the highest credit standing could be impossible to meet in specialized markets, and the entire structure was vulnerable to market disruption.

Executing a Close-Out under the 2002 ISDA

The 2002 ISDA streamlines the execution by replacing the rigid Market Quotation and subjective Loss methods with the singular, more dynamic Close-Out Amount calculation. The process is guided by the principle of commercial reasonableness, not a rigid checklist.

How Is The Close-Out Amount Actually Determined?

The determining party must act in good faith and use commercially reasonable procedures. The 2002 ISDA provides a non-exhaustive list of information sources that can be used:

• Third-Party Quotations ▴ Quotes can be obtained, but there is no requirement for a specific number. A single quote may be sufficient if it is commercially reasonable. The providers do not need to be of the “highest credit standing.”
• Market Data ▴ Information from any relevant source, including electronic trading screens, broker-dealers, and information services, can be used.
• Internal Models ▴ The determining party can use its own internal pricing models to value the terminated transactions, provided the models are consistent with those used in its regular course of business for similar transactions.

The execution of the 2002 Close-Out Amount is defined by its methodological flexibility, allowing the use of internal models and diverse market data to achieve a commercially sound valuation.

The key is that the chosen methodology must be defensible as commercially reasonable. This gives the determining party the ability to adapt to the prevailing market conditions. For example, in a highly liquid market for a plain vanilla interest rate swap, obtaining multiple dealer quotes might be the most reasonable approach. For a highly structured, illiquid credit derivative in a panicked market, relying on internal models calibrated with whatever market data is available may be the only reasonable option.

The table below provides a direct comparison of the executional steps.

Reflection

The evolution from the 1992 Market Quotation to the 2002 Close-Out Amount is a testament to the market’s capacity for adaptive learning. The framework shifted from a rigid, procedural construct to a principles-based system designed for resilience. This prompts a critical examination of your own internal risk protocols. Are your valuation and risk management systems built on rigid assumptions about market behavior, or do they possess the inherent flexibility to perform under stress?

The knowledge of this evolution is a component of a larger intelligence system. The ultimate strategic advantage lies in ensuring your operational framework mirrors the resilience and commercial pragmatism embodied in the 2002 ISDA, allowing you to not just withstand market dislocations, but to navigate them with precision and authority.