How Does the 2002 Isda Master Agreement Differ from the 1992 Version regarding Close Out?

Concept

The architecture of over-the-counter (OTC) derivatives markets rests upon the foundational framework of the ISDA Master Agreement. Its primary function is to standardize the legal and credit relationship between counterparties, creating a single, integrated legal obligation from what would otherwise be a disparate collection of individual trades. The evolution from the 1992 Agreement to the 2002 version was a direct response to systemic stresses observed during the market crises of the late 1990s. These events revealed critical weaknesses in the 1992 Agreement’s close-out mechanism, demonstrating that the procedures for terminating trades and calculating final payments in a default scenario were insufficiently robust for a volatile, and at times illiquid, market environment.

Understanding the distinctions between these two versions is a matter of direct operational and financial significance. The core difference resides in the methodology for calculating the value of terminated transactions upon an event of default. The 1992 Agreement presented a choice between two methods ▴ “Market Quotation” and “Loss”. Market Quotation was a rigid, quote-driven process, while Loss was more subjective.

The 2002 Agreement replaced this binary choice with a single, more flexible standard called the “Close-out Amount”. This was a fundamental redesign, moving the entire close-out system from a somewhat rigid and potentially punitive framework to one based on the principle of commercial reasonableness. This shift directly impacts how a firm calculates its exposure, manages its counterparty risk, and acts to preserve its capital when a counterparty defaults.

What Was the Core Systemic Flaw the 2002 Agreement Addressed?

The central flaw in the 1992 Agreement’s close-out mechanism, exposed by market turmoil, was its reliance on the “Market Quotation” methodology. This procedure required the non-defaulting party to obtain quotes for replacement trades from leading market makers. During periods of extreme volatility or illiquidity, such as the 1998 Russian financial crisis, obtaining the requisite number of quotes (typically three) became practically impossible. Dealers were unwilling or unable to provide firm quotes for sizable or complex derivative portfolios in a distressed market.

This operational failure could paralyze the close-out process, leaving the non-defaulting party unable to crystallize its claim and hedge its resulting open position. The alternative, “Loss,” was based on the non-defaulting party’s good faith determination of its total losses, but its subjective nature often led to disputes. The 2002 Agreement’s “Close-out Amount” was engineered specifically to solve this problem, providing a more resilient and commercially practical valuation method that could function effectively even in moments of severe market stress.

Strategy

The strategic shift from the 1992 ISDA Master Agreement to the 2002 version represents a significant evolution in the philosophy of risk management and dispute resolution in the OTC derivatives market. The replacement of the dual “Market Quotation” and “Loss” methods with the unified “Close-out Amount” was a deliberate move to enhance legal certainty, operational flexibility, and fairness in the critical process of terminating derivative contracts.

The 2002 Agreement’s “Close-out Amount” provides a more flexible and commercially reasonable standard for determining termination payments compared to the rigid methodologies of the 1992 version.

Under the 1992 framework, the choice between Market Quotation and Loss was a key strategic decision made at the time of the agreement’s negotiation. Market Quotation was perceived as more objective, relying on external dealer quotes, but it proved brittle under stress. Loss was more flexible, allowing the non-defaulting party to calculate its damages, but its subjectivity could be challenged, leading to protracted legal battles over the “reasonableness” of the determination.

The 2002 Agreement’s “Close-out Amount” synthesizes the objectives of both, creating a single, robust standard. It allows the determining party to use a wide range of information ▴ including internal models, third-party valuations, and relevant market data ▴ to arrive at a termination value, provided the entire process is “commercially reasonable”.

A Comparative Analysis of Close out Methodologies

The strategic implications of these changes are best understood through a direct comparison of the methodologies. The 1992 Agreement forced a choice that carried significant operational and legal trade-offs. The 2002 Agreement provides a unified framework that prioritizes a commercially sound outcome over procedural rigidity.

This table illustrates the fundamental architectural differences between the valuation approaches:

How Does the Standard of Reasonableness Differ?

A critical strategic distinction lies in the legal standard applied to the valuation. The “Loss” calculation in the 1992 Agreement required the determining party to act “reasonably.” English courts interpreted this as a test of rationality, meaning the determination could only be challenged if it was one that no reasonable party could have reached. The 2002 Agreement imposes a stricter, dual obligation ▴ the procedures used to determine the Close-out Amount must be commercially reasonable, and the final result must also be commercially reasonable. This introduces a more objective standard, providing greater protection to the defaulting party from an unfairly punitive calculation while still giving the non-defaulting party the necessary tools to manage its risk effectively.

• 1992 Standard ▴ The focus was on the rationality of the determining party’s decision. A court would be hesitant to substitute its own judgment unless the outcome was patently irrational.
• 2002 Standard ▴ The focus shifts to an objective market standard. The process and the outcome are both measured against what would be considered commercially reasonable by other market participants. This provides a more balanced and defensible framework.

Execution

The execution of a close-out under an ISDA Master Agreement is a precise operational procedure with significant financial consequences. The shift from the 1992 to the 2002 framework fundamentally altered the playbook for a non-defaulting party. It moved the process away from a rigid, check-the-box exercise (Market Quotation) or a highly subjective damage assessment (Loss) to a more sophisticated, evidence-based valuation exercise (Close-out Amount).

Executing a close-out under the 2002 Agreement demands a robust internal valuation capability and meticulous documentation of commercially reasonable procedures.

Executing a close-out under the 2002 Agreement requires a firm to have a well-defined and defensible process for valuation. The non-defaulting party (the “Determining Party”) must be prepared to demonstrate that both its methodology and its final calculation were commercially reasonable. This involves a greater internal burden but also grants greater control and reduces the risk of the process failing due to external market conditions. The grace periods for certain events of default were also tightened in the 2002 version, requiring firms to have more agile monitoring and response capabilities.

Procedural Steps in Close out Calculation

The operational steps for calculating the final payment differ significantly. The 2002 Agreement provides a more resilient path, especially when market liquidity evaporates.

1. Designation of Early Termination Date ▴ The non-defaulting party must first effectively designate an Early Termination Date by providing notice to the defaulting party as specified in the agreement.
2. Valuation of Terminated Transactions (The Core Difference) ▴
   • Under the 1992 Agreement (Market Quotation) ▴ The Determining Party was required to attempt to get firm quotes from at least three pre-agreed Reference Market-Makers for a replacement transaction. If successful, these quotes formed the basis of the settlement amount. If not, the process could stall or revert to the Loss method if elected.
   • Under the 2002 Agreement (Close-out Amount) ▴ The Determining Party calculates the value of the terminated trades. It has broad discretion to use various sources of information, including, but not limited to:
     • Quotations from third parties (without the rigid requirement of three, or that they be from top-tier banks).
     • Information from internal pricing models and methodologies.
     • Relevant market data regarding interest rates, currency exchange rates, and volatilities.
     • Information about the liquidity of the relevant market.
3. Aggregation and Netting ▴ The values of all terminated transactions are converted to the termination currency and netted into a single lump-sum payment, the “Early Termination Amount.”
4. Inclusion of Unpaid Amounts ▴ Any amounts that were due and payable prior to the Early Termination Date but remained unpaid are added to the calculation.
5. Final Payment ▴ The final Early Termination Amount is communicated to the defaulting party, along with an indemnity for expenses incurred by the non-defaulting party during the enforcement process.

Hypothetical Close out Scenario Analysis

Consider a scenario where a bank needs to close out a portfolio of 10-year interest rate swaps with a defaulting counterparty during a major market crisis. The following table illustrates the potential outcomes under each agreement.

The 2002 ISDA Master Agreement provides a superior operational toolkit for managing risk in the modern financial system. It acknowledges the reality that liquid, quoted markets may not always be available and equips the non-defaulting party with a flexible, yet disciplined, mechanism for determining a fair and defensible close-out value. This architectural improvement enhances the stability and predictability of the entire OTC derivatives ecosystem.

Reflection

Is Your Counterparty Risk Framework Built for Resilience?

The evolution from the 1992 to the 2002 ISDA Master Agreement was more than a simple document update; it was a systemic upgrade in the market’s risk management architecture. The knowledge of these differences prompts a critical self-assessment for any institution engaged in OTC derivatives. It compels one to look beyond the legal text and examine the underlying operational capabilities and philosophical approach to counterparty default.

Does your firm’s internal valuation methodology possess the sophistication and robustness to produce a “commercially reasonable” Close-out Amount that can withstand scrutiny? Are your procedures for gathering market intelligence and documenting valuation inputs sufficiently rigorous? The 2002 Agreement provides a more powerful and flexible tool, but its effective use depends entirely on the quality of the internal systems and processes that support it. Viewing your ISDA documentation not as a static legal document, but as an integrated component of a dynamic risk management system, is the first step toward building a truly resilient operational framework.