How Does the Close-Out Amount Calculation Differ between the 1992 and 2002 ISDA Agreements?

Concept

The transition from the 1992 to the 2002 International Swaps and Derivatives Association (ISDA) Master Agreement represents a critical evolution in the architecture of over-the-counter (OTC) derivatives markets. At the heart of this evolution lies the mechanism for calculating payments upon the early termination of a transaction, a process that moved from a framework of subjective discretion to one of objective commercial reason. Understanding this distinction is fundamental to grasping the operational and risk management principles that govern modern derivatives trading. The 1992 Agreement provided a choice of methodologies, a structure that reflected a market still developing its standardized protocols.

The 2002 Agreement consolidated these choices into a single, more robust standard, reflecting the lessons learned from market stresses and defaults experienced during the preceding decade. This was a deliberate architectural redesign aimed at enhancing legal certainty, reducing disputes, and promoting overall market stability by standardizing the close-out process.

Under the 1992 ISDA Master Agreement, parties had to elect a payment method in the Schedule. The primary choices were the “First Method” and the “Second Method.” The First Method, often referred to as a “one-way payment,” permitted a Non-defaulting Party to terminate its obligations to a Defaulting Party without making a payment, even if the Non-defaulting Party had a net liability (was out-of-the-money) on the terminated transactions. This approach was punitive and its application quickly fell out of favor in the market due to its inherent inequity. Consequently, the “Second Method,” or “two-way payment,” became the market standard.

The Second Method requires a net payment to be made to the party that is “in-the-money,” regardless of whether that party is the defaulting or non-defaulting entity. This principle of two-way payment was carried forward and made mandatory in the 2002 ISDA Agreement, eliminating the First Method entirely.

The calculation of the termination payment itself under the 1992 Agreement (when using the Second Method) involved another election ▴ between “Market Quotation” and “Loss.”

• Market Quotation required the Non-defaulting Party to seek quotes from at least three leading dealers (Reference Market-makers) for a replacement transaction. The payment would be based on the average of these quotes. This method was intended to provide an objective, market-based valuation. In practice, it proved unreliable, particularly during periods of market stress when dealers might be unwilling or unable to provide quotes for defaulted or illiquid contracts.
• Loss provided a more flexible, subjective alternative. It 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 a replacement transaction, the cost of unwinding hedges, and other associated expenses. The legal standard for this determination was essentially one of rationality; the calculation could only be challenged if it was a determination that no reasonable party in the same position could have reached. This is often equated with the English law concept of “Wednesbury unreasonableness.”

This framework, with its elections and its reliance on a subjective “Loss” standard, created significant legal and operational uncertainty. The party performing the calculation had considerable discretion, which could lead to disputes over the final close-out amount. The market recognized the need for a more standardized and objective process, which directly led to the architectural changes implemented in the 2002 ISDA Master Agreement.

Strategy

The strategic shift from the 1992 ISDA Agreement’s close-out mechanism to the 2002 version’s “Close-Out Amount” was a direct response to systemic weaknesses revealed by market events. The previous framework’s reliance on the often-impractical Market Quotation method and the highly subjective Loss method was identified as a source of significant counterparty risk and legal uncertainty. The core strategic objective of the 2002 ISDA drafters was to engineer a single, unified valuation methodology that mandated objectivity and commercial prudence, thereby reducing the scope for disputes and enhancing the predictability of outcomes in a default scenario. This was a move to fortify the very foundations of the OTC derivatives market by creating a more resilient and transparent protocol for managing its most critical stress point ▴ counterparty failure.

From Subjective Loss to Objective Reasonableness

The primary strategic innovation of the 2002 ISDA Master Agreement is the replacement of the “Loss” and “Market Quotation” elections with a single, mandatory calculation method termed the “Close-Out Amount.” This new methodology is defined as the amount of losses or costs that are or would be incurred in replacing, or providing the economic equivalent of, the material terms of the terminated transactions. The key strategic change is the standard by which this calculation must be performed. The determining party must use “commercially reasonable procedures in order to produce a commercially reasonable result.” This phrasing establishes a significantly higher and more rigorous standard than the “good faith” and “rationality” test applied to the “Loss” calculation under the 1992 Agreement.

The 2002 ISDA Agreement replaced the subjective rationality standard for close-out calculations with a dual requirement for objectively commercial procedures and results.

This new standard imposes two distinct obligations on the calculating party:

1. Commercially Reasonable Procedures ▴ This prong focuses on the process. The determining party must act in a way that an objective, informed third party would consider reasonable in the context of the relevant market. This could involve obtaining quotes from dealers, consulting internal pricing models, considering relevant market data feeds, or using a combination of these sources. The key is that the process must be defensible and transparent.
2. Commercially Reasonable Result ▴ This prong focuses on the outcome. The final calculated amount must fall within a range of what would be considered commercially reasonable. It prevents a party from following a technically sound procedure to arrive at an outcome that is punitive or self-serving. It acknowledges that there is no single “correct” price, but a spectrum of reasonable values. The result, however, cannot be an outlier that benefits the calculating party at the expense of fairness.

This dual obligation to be reasonable in both process and outcome represents a profound strategic shift. It moves the entire close-out mechanism from the realm of private, subjective judgment into a space governed by objective, verifiable market standards. This change was specifically designed to give courts a clearer and more robust framework for adjudicating disputes, making it more difficult for a calculating party to justify an aggressive or unfair valuation.

What Are the Practical Implications of This Strategic Shift?

The move to the “Close-Out Amount” framework has significant strategic implications for any institution trading derivatives. The burden of proof on the party calculating the termination payment is substantially higher under the 2002 Agreement. It is no longer sufficient to simply assert a loss in good faith; the party must be prepared to produce evidence documenting the reasonableness of both its procedures and the final figure. This necessitates more rigorous internal policies and procedures for handling defaults.

For example, a firm’s process might now require documenting multiple indicative quotes from dealers, recording screenshots of relevant market data at the time of termination, and archiving the output of any internal valuation models used. This creates a clear audit trail that can be presented to the counterparty, and if necessary, to a court or arbitral tribunal, to justify the calculation. The strategic goal is to create a determination that is not just compliant, but defensible. This proactive approach to documentation and process integrity is a direct consequence of the higher legal standard embedded within the 2002 ISDA’s architecture.

Comparative Framework 1992 Vs 2002 Close Out

The table below provides a consolidated view of the strategic differences between the two agreements’ close-out calculation protocols.

Execution

The execution of a close-out calculation is a critical operational process that crystallizes the risk management framework embedded in the ISDA Master Agreement. The procedural differences between the 1992 and 2002 versions are substantial, moving from a regime of broad discretion to one requiring demonstrable, objective process. For an institutional trading desk, risk management function, or legal department, understanding these executional mechanics is paramount to ensuring compliance, defending a calculation, or challenging a counterparty’s determination.

Executing a Close out under the 1992 ISDA Framework

Upon an Early Termination Date under a 1992 ISDA Agreement where the parties had elected “Loss” and the “Second Method,” the Non-defaulting Party was tasked with calculating its total losses and costs. The execution of this was an internal, and often opaque, process.

Procedural Steps for “loss” Calculation

A Non-defaulting Party would typically undertake the following steps, though the agreement itself prescribed very little in terms of mandatory procedure:

1. Internal Assessment ▴ The first step was an internal assessment of all outstanding transactions with the Defaulting Party. The party would mark its positions to its own internal models or market view.
2. Quantification of Replacement Costs ▴ The party would determine the cost of entering into replacement transactions to replicate the economic profile of the terminated trades. This could be based on an actual replacement trade if one was executed, or a hypothetical one.
3. Inclusion of Hedging Costs ▴ The party would calculate the costs associated with terminating, liquidating, or re-establishing any hedges related to the terminated transactions. This is a critical component, as the terminated swap may have been part of a larger, complex trading book.
4. Aggregation of Other Costs ▴ The “Loss” definition was broad, allowing for the inclusion of funding costs, administrative expenses, and legal fees associated with the default.
5. Good Faith Determination ▴ The final number was certified by the Non-defaulting Party as its good faith determination of its Loss. The primary executional requirement was the internal conviction and assertion that the number was arrived at honestly. The burden of proof to overturn this was high, requiring the challenging party to demonstrate that the calculation was irrational.

Under the 1992 ISDA, the “Loss” calculation was an exercise in good faith assertion, with procedural execution guided more by internal policy than explicit contractual mandate.

The executional challenge was its subjectivity. A party could, in good faith, arrive at a number that another market participant would view as aggressive. The lack of a prescribed, objective process meant that the final figure was heavily dependent on the calculating party’s own models, risk appetite, and interpretation of its costs, making disputes common and difficult to resolve without litigation.

Executing a Close out under the 2002 ISDA Framework

The execution of a “Close-Out Amount” calculation under the 2002 ISDA Agreement is a fundamentally different exercise. It is an evidence-based process designed to withstand external scrutiny. The focus shifts from internal belief to external validation through commercially reasonable actions.

Procedural Steps for “close out Amount” Calculation

The calculating party must now build a robust file to demonstrate the commercial reasonableness of its procedures and result. The execution is methodical and documented.

• Evidence Gathering ▴ Immediately following the designation of an Early Termination Date, the calculating party must gather relevant market data. This includes obtaining indicative or firm quotes from several active market dealers for replacement trades. While there is no strict requirement for a minimum of three quotes as in the old “Market Quotation” method, obtaining multiple data points is a core component of a reasonable procedure.
• Use of Internal Models ▴ The party can use its own internal, industry-accepted valuation models. However, it must be prepared to disclose the key inputs and assumptions of the model to demonstrate their reasonableness. Inputs would include yield curves, volatility surfaces, and credit spreads prevailing at the time of termination.
• Consideration of All Relevant Information ▴ The 2002 definition requires the party to consider information from internal sources (like models) and external sources (like dealer quotes or screen prices). It also allows for adjustments based on the “liquidity, creditworthiness, and hedging costs” associated with the transactions.
• Documentation and Justification ▴ Every step must be documented. Why were certain dealers chosen for quotes? Why was a particular model used? If a dealer quote was ignored in favor of an internal model price, what was the justification? This audit trail is the primary evidence of a “commercially reasonable procedure.”
• Arriving at a Reasonable Result ▴ The final number should reflect a fair market value. A party cannot simply choose the highest possible loss figure from its available data points. It must synthesize the information into a result that is defensible as a reasonable, mid-market-oriented valuation, adjusted for relevant costs.

Illustrative Calculation Comparison

To illustrate the executional difference, consider the termination of a simple interest rate swap. The table below shows a hypothetical breakdown of how the final payment amount might be constructed under each agreement.

The execution under the 2002 framework is more rigorous, transparent, and evidence-driven. It transforms the close-out process from a potential source of conflict into a more standardized, auditable, and ultimately more stable market protocol. This architectural improvement provides greater protection for all market participants by ensuring that the financial consequences of a default are determined by objective market realities, not the subjective will of one of the parties.

Reflection

The evolution from the 1992 to the 2002 ISDA close-out protocol is more than a mere technical adjustment in legal drafting. It is a codification of market maturity. It reflects a systemic understanding that for a global network of bilateral obligations to remain stable, the protocols for managing failure must be robust, transparent, and grounded in objective reality. The framework you operate under defines the tools at your disposal in a crisis.

Does your institution’s operational playbook for counterparty default fully align with the evidentiary burdens of the 2002 Agreement? How is the process of gathering quotes, validating models, and documenting decisions managed, not as a legal formality, but as a core risk management discipline? The strength of a financial agreement lies not in its language during times of stability, but in its procedural integrity during times of stress. The knowledge of these differences is the foundation; the true strategic advantage comes from embedding this integrity into the operational DNA of the firm.