How Does the 2002 ISDA Master Agreement Improve upon the 1992 Version for Close Outs?

Concept

The Systemic Mandate for Close out Certainty

The International Swaps and Derivatives Association (ISDA) Master Agreement provides the foundational architecture for the over-the-counter (OTC) derivatives market. Its primary function is to standardize the legal and credit relationship between counterparties, creating a predictable framework for trillions of dollars in transactions. Within this framework, the close-out mechanism is the critical failsafe, a protocol designed to function under maximum systemic stress. It dictates how parties terminate transactions and calculate a final settlement amount when a default or other termination event occurs.

The evolution from the 1992 to the 2002 ISDA Master Agreement was not a minor recalibration; it was a direct response to market crises of the late 1990s that revealed potential ambiguities and procedural weaknesses in the 1992 framework. The improvements in the 2002 version are centered on enhancing legal certainty, valuation fairness, and operational flexibility during the precise moments when these qualities are most vital.

Understanding the enhancements requires acknowledging the fundamental challenge of a close-out. A default by a major counterparty is a chaotic event. Markets may become illiquid, reliable price sources can evaporate, and the non-defaulting party must act swiftly to mitigate its losses. The 1992 Agreement offered two primary methods for calculating the settlement amount ▴ “Market Quotation” and “Loss.” Market Quotation was a formulaic approach, relying on obtaining quotes from multiple dealers for replacement trades.

While objective, it proved rigid and often unworkable in stressed markets where such quotes were unobtainable. The “Loss” method provided more flexibility, allowing the non-defaulting party to calculate its total losses and costs, but its subjective nature could lead to disputes. The 2002 Agreement’s introduction of a unified “Close-out Amount” methodology was a direct answer to the shortcomings of this binary choice.

The 2002 ISDA Master Agreement refines the close-out process by replacing the rigid dual methodologies of the 1992 version with a single, more flexible standard designed to function effectively during periods of market stress.

A Framework Forged in Market Turmoil

The late 1990s and early 2000s were punctuated by a series of financial crises, including the Asian financial crisis, the Russian debt default, and the collapse of Long-Term Capital Management (LTCM). These events stress-tested the 1992 ISDA Master Agreement on a global scale. In many instances, the Market Quotation method failed because dealers were unwilling or unable to provide quotes in volatile and illiquid markets.

This forced non-defaulting parties to rely on the Loss method, which, while practical, opened the door to protracted legal challenges over the reasonableness of the loss calculation. The market required a new standard that balanced the objectivity of the Market Quotation method with the flexibility of the Loss method.

The 2002 ISDA Master Agreement represents a paradigm shift in this regard. Its “Close-out Amount” is a single, unified standard that allows the determining party to use a variety of commercially reasonable procedures to arrive at a fair valuation. This can include obtaining quotes, consulting information vendors, using internal pricing models, and considering the cost of liquidating hedges.

This approach acknowledges the reality that in a true market crisis, a single, rigid method for valuation is insufficient. The 2002 Agreement provides a toolkit rather than a single tool, empowering the non-defaulting party to produce a valuation that is both fair and defensible, thereby reducing the likelihood of legal disputes and promoting greater stability in the financial system during periods of turmoil.

Strategy

Unifying the Valuation Protocol from a Bifurcated Past

The strategic core of the 2002 ISDA Master Agreement’s improvement lies in its replacement of a bifurcated, and often problematic, valuation choice with a single, more dynamic standard. The 1992 Agreement forced parties to elect, at the outset of their relationship, between two distinct close-out methodologies ▴ Market Quotation or Loss. This choice had profound strategic implications in the event of a default.

Market Quotation was designed for objectivity. The non-defaulting party was required to obtain quotes from at least three leading dealers in the relevant market for a replacement transaction. The average of these quotes would then be used to determine the settlement amount. The strategic advantage of this method was its perceived fairness and the difficulty a defaulting party would have in challenging a value derived directly from market participants.

However, its rigidity was its critical flaw. In a systemic crisis, the very dealers who were supposed to provide quotes were often unwilling to do so, either because they were managing their own risk or because the market for the terminated transactions had ceased to function. This operational failure could leave the non-defaulting party without a clear path to calculating the close-out amount.

Loss offered the necessary flexibility where Market Quotation failed. This method allowed the non-defaulting party to determine, in good faith, its total losses and costs resulting from the early termination. This could include the cost of entering into replacement trades, liquidating hedges, and other associated expenses. The strategic benefit was its workability in any market condition.

The significant drawback was its subjectivity. A defaulting party could argue that the non-defaulting party’s determination was not reasonable, leading to costly and time-consuming litigation. The 2002 Agreement’s “Close-out Amount” was engineered to synthesize the best attributes of both methodologies.

The 2002 ISDA’s “Close-out Amount” provides a holistic valuation framework, integrating various sources of information to create a more resilient and defensible settlement calculation than the predecessor agreement’s rigid options.

The Close out Amount a Superior Valuation Engine

The “Close-out Amount” introduced in the 2002 Agreement is a comprehensive measure of the gains, losses, and costs associated with replacing or obtaining the economic equivalent of the terminated transactions. It explicitly allows the determining party to use a wide array of information sources, including quotes from dealers, data from information vendors, and internal pricing models, provided the procedures used are commercially reasonable. This represents a significant strategic enhancement.

The key distinction is the standard of conduct imposed. The 1992 Agreement’s “Loss” calculation required the non-defaulting party to act in a manner that was not irrational ▴ a standard known in English law as the “Wednesbury” test of reasonableness. The 2002 Agreement imposes a stricter, two-part test ▴ the party must use “commercially reasonable procedures” to produce a “commercially reasonable result.” This higher standard provides greater protection for the defaulting party while still affording the non-defaulting party the flexibility needed to manage a close-out in a crisis.

The following table illustrates the strategic evolution of the close-out valuation methodologies:

Refining Default and Termination Protocols

The 2002 ISDA Master Agreement also introduced several other strategic refinements to the close-out process. These changes were designed to accelerate the termination process and address new types of risk that had become apparent.

• Reduced Grace Periods ▴ The 2002 Agreement shortens the grace periods for certain Events of Default. For a Failure to Pay or Deliver, the cure period was reduced from three local business days to one. This allows the non-defaulting party to act more quickly to limit its exposure to a deteriorating counterparty.
• Force Majeure Event ▴ A new Termination Event, “Force Majeure,” was introduced. This allows for the termination of transactions when an event beyond the parties’ control makes performance impossible or impracticable. This was a critical addition, providing a mechanism to address situations like natural disasters or government actions that prevent payments or deliveries.
• Expanded Set-Off Rights ▴ The 2002 Agreement includes a broader and more explicit set-off provision, allowing the non-defaulting party to set off any amounts owed to it by the defaulting party against the final close-out amount. This enhances the non-defaulting party’s ability to recover what it is owed.

Execution

Executing a Close out a Procedural Comparison

The execution of a close-out under the ISDA Master Agreement is a precise, high-stakes process. The differences between the 1992 and 2002 versions manifest in the specific steps a non-defaulting party must take to calculate and claim the final settlement amount. A procedural failure at any stage can jeopardize the entire close-out, leading to legal challenges and potential financial loss. The 2002 Agreement provides a more robust and clearly defined operational playbook, particularly when market conditions are degraded.

Consider a scenario where a bank (“Non-Defaulting Party”) must terminate its derivatives portfolio with a hedge fund (“Defaulting Party”) that has filed for bankruptcy. The portfolio consists of various interest rate swaps and foreign exchange forwards.

Close-Out Execution under the 1992 ISDA Master Agreement

If the parties had elected Market Quotation, the bank’s operational steps would be as follows:

1. Designate Early Termination Date ▴ The bank must send a notice to the hedge fund specifying the Event of Default and designating an Early Termination Date.
2. Solicit Dealer Quotes ▴ On or as soon as reasonably practicable after the Early Termination Date, the bank must attempt to obtain quotes from at least three leading dealers for replacement transactions that are economically equivalent to the terminated trades.
3. Calculate Settlement Amount ▴ If successful, the bank averages the quotes to determine the Settlement Amount. If the bank cannot obtain the required number of quotes for a particular transaction after reasonable efforts, the Market Quotation method is deemed to have failed for that transaction, and the bank must then use the Loss method.
4. Issue Calculation Statement ▴ The bank must provide the hedge fund with a statement showing its calculation of the Settlement Amount in reasonable detail.

If the parties had elected Loss, the process would be different:

1. Designate Early Termination Date ▴ This step remains the same.
2. Determine Losses and Costs ▴ The bank would calculate its total losses and costs in good faith. This could involve pricing the terminated trades using internal models, obtaining indicative quotes, and calculating the costs of unwinding any related hedges. The key is that the bank is determining its own economic loss.
3. Issue Calculation Statement ▴ As with Market Quotation, the bank must provide a statement detailing its calculation. The burden of proof would be on the defaulting party to show that the bank’s determination was irrational.

Executing a close-out under the 2002 ISDA involves a more rigorous, evidence-based valuation process designed to withstand legal scrutiny while maintaining operational flexibility.

Executing a Close out under the 2002 ISDA Master Agreement

The 2002 Agreement streamlines the execution into a single, more rigorous procedure:

1. Designate Early Termination Date ▴ The initial step of notification is fundamentally the same as in the 1992 version.
2. Determine Close-out Amount ▴ This is the most significant divergence. The bank must determine the Close-out Amount by acting in good faith and using commercially reasonable procedures to produce a commercially reasonable result. The bank has a broad mandate to use various valuation inputs:
   • Market Data ▴ It can use quotes from dealers, but it is not required to obtain a specific number. It can also use data from electronic trading platforms and information vendors.
   • Internal Models ▴ The bank can use its own internal pricing models, provided these models are used in the regular course of its business for similar transactions.
   • Hedge Information ▴ The cost of terminating, liquidating, or re-establishing any hedges related to the terminated transactions can be included.
3. Issue Calculation Statement ▴ The bank must provide a statement detailing the calculation of the Early Termination Amount, which is the sum of the Close-out Amounts for all terminated transactions. The statement must be more detailed than under the 1992 Agreement, explaining the valuation methods used and the inputs considered.

Valuation in a Stressed Market a Hypothetical Case Study

The superior execution framework of the 2002 Agreement becomes most apparent in a stressed market. Let’s extend our scenario ▴ the hedge fund’s bankruptcy occurs during a severe market dislocation, and liquidity for the specific type of long-dated interest rate swaps in the portfolio has vanished. No dealers are providing firm quotes.

The following table illustrates the potential outcomes under each agreement:

Reflection

From Reactive Calculation to Proactive Valuation

The transition from the 1992 to the 2002 ISDA Master Agreement marks a fundamental shift in the philosophy of risk management during market distress. The architecture of the 2002 Agreement acknowledges that a close-out is not a simple accounting exercise but a complex risk mitigation procedure that must be executed under the most adverse conditions. It moves beyond a framework that could fail under pressure, offering instead a resilient protocol designed for operational integrity. The knowledge of these mechanics is a component of a larger system of institutional preparedness.

The ultimate question for any counterparty is how their own internal procedures for valuation, hedging, and legal response are calibrated to the sophisticated toolkit the 2002 Agreement provides. The framework exists; its strategic potential is realized only through deliberate and rigorous internal implementation.