How Does the Framework Address Differences between the 1992 and 2002 Isda Master Agreements? ▴ Question

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Concept

The transition from the 1992 to the 2002 ISDA Master Agreement represents a critical evolution in the architecture of over-the-counter derivatives markets. This was a response to a decade of market stresses, legal challenges, and the increasing complexity of financial products. The 1992 Agreement, while foundational, contained ambiguities and subjective measures that proved challenging during periods of market turmoil. The 2002 framework was engineered to provide greater certainty, objectivity, and robustness in the critical mechanics of counterparty risk management, particularly in the close-out process following a default.

At the heart of this evolution is a fundamental shift in the philosophy of calculating termination payments. The 1992 Agreement’s reliance on “Loss” and “Market Quotation” introduced a degree of subjectivity that could lead to disputes. The 2002 Agreement’s introduction of a single “Close-out Amount” methodology was a deliberate design choice to create a more objective and transparent standard. This reflects a maturation of the derivatives market, demanding a legal infrastructure that is as resilient and precisely engineered as the financial products it governs.

The 2002 ISDA Master Agreement was designed to replace subjective assessments with objective, commercially reasonable procedures in the event of a counterparty default.

Understanding the differences between these two cornerstone documents is essential for any institution operating in the derivatives space. The choice of agreement has profound implications for risk management, the calculation of potential exposures, and the legal certainty of outcomes during a credit event. The 2002 Agreement reflects a system designed for a more complex and interconnected global financial market, prioritizing clarity and predictability in moments of acute stress.

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Strategy

The strategic decision to migrate from the 1992 to the 2002 ISDA Master Agreement framework is predicated on a desire for enhanced legal certainty and a more robust risk management architecture. The 2002 Agreement introduces several key changes that alter the strategic calculus for counterparties in derivatives transactions. These changes are most pronounced in the areas of close-out valuation, the treatment of termination events, and the mechanics of set-off.

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A Shift in Close out Valuation

The most significant strategic shift is the replacement of the dual measures of “Loss” and “Market Quotation” with a single, unified “Close-out Amount.” This change has profound implications for how a non-defaulting party calculates its termination payment. The 1992 Agreement’s “Loss” calculation was a subjective measure, allowing the non-defaulting party to determine its total losses and costs in good faith. This could lead to a wide range of outcomes and potential for disputes.

The 2002 Agreement’s “Close-out Amount” imposes a stricter, more objective standard. The determining party must use commercially reasonable procedures to produce a commercially reasonable result. This introduces an external, objective benchmark against which the calculation can be judged, reducing the scope for disagreement and enhancing the predictability of the outcome.

The move to a “Close-out Amount” in the 2002 Agreement was a strategic decision to favor objective, verifiable calculations over subjective determinations of loss.

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How Does This Impact Counterparty Risk Management?

For institutions managing counterparty risk, the 2002 Agreement provides a more reliable framework for quantifying potential exposures. The objective nature of the “Close-out Amount” calculation allows for more consistent and predictable modeling of potential losses in the event of a default. This enhanced predictability is a significant strategic advantage in a market where certainty is at a premium.

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Expanded Termination Events and Default Provisions

The 2002 Agreement also introduces a broader range of termination events and refines the definitions of existing events of default. These changes reflect the lessons learned from market events in the 1990s and early 2000s, where certain types of credit deterioration were not adequately captured by the 1992 framework. The inclusion of new termination events, such as those related to credit event upon merger and force majeure, provides counterparties with additional tools to manage their risks proactively.

The table below provides a high-level comparison of some of the key strategic differences between the two agreements:

Provision	1992 ISDA Master Agreement	2002 ISDA Master Agreement
Close-Out Calculation	Choice between “Market Quotation” (requires quotes from reference market-makers) and “Loss” (a subjective measure of the non-defaulting party’s losses).	A single “Close-out Amount” standard, which requires the determining party to act in good faith and use commercially reasonable procedures to produce a commercially reasonable result.
Set-Off	No express set-off provision, relying on rights of set-off under applicable law.	Includes an express contractual set-off provision (Section 6(f)), which provides greater certainty and may be effective in jurisdictions where statutory set-off rights are limited.
Force Majeure	No specific force majeure termination event. Parties would have to rely on illegality or impossibility arguments.	Introduces a new termination event for force majeure, allowing for termination after a waiting period if a force majeure event prevents performance.

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The Strategic Implications of the Set off Provision

The inclusion of an express set-off provision in the 2002 Agreement is another critical strategic enhancement. While the 1992 Agreement relied on the implicit rights of set-off that might exist under the governing law of the contract, the 2002 Agreement provides an explicit contractual right. This can be particularly advantageous in cross-border transactions where the applicable insolvency laws might not provide for robust set-off rights. The explicit provision in the 2002 Agreement gives counterparties a clearer and more dependable mechanism for netting their exposures in a default scenario.

Certainty ▴ The express set-off clause in the 2002 Agreement provides greater legal certainty than relying on the vagaries of applicable insolvency law.
Enforceability ▴ In many jurisdictions, a contractual set-off provision is more likely to be enforced in an insolvency proceeding than a general right of set-off.
Scope ▴ The contractual provision can be drafted to cover a broader range of claims and obligations than might be permitted under statutory set-off.

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Execution

The execution of rights and obligations under the ISDA Master Agreement is most critical during a default. The procedural differences between the 1992 and 2002 Agreements in this context are substantial. A non-defaulting party’s actions in the immediate aftermath of a default are governed by a series of precise steps, and the changes in the 2002 Agreement demand a more rigorous and documented approach to the close-out process.

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Executing the Close out Process

The most significant operational difference lies in the execution of the close-out netting process. The 1992 Agreement’s framework, with its potential for subjectivity, could lead to protracted disputes over the final termination payment. The 2002 Agreement’s architecture is designed to minimize this risk through a more prescriptive and objectively verifiable process.

The following table details the operational steps a non-defaulting party would typically take under each agreement when executing a close-out following an event of default:

Operational Step	1992 ISDA Master Agreement	2002 ISDA Master Agreement
1. Notice of Default	Serve a notice on the defaulting party specifying the event of default and designating an early termination date.	Serve a notice on the defaulting party specifying the event of default and designating an early termination date. The notice requirements are broadly similar.
2. Calculation of Termination Payment	If “Market Quotation” is selected, the non-defaulting party must seek quotes from at least four reference market-makers for replacement transactions. If “Loss” is selected, the party calculates its total losses and costs in good faith.	The determining party calculates the “Close-out Amount.” This involves determining, in a commercially reasonable manner, the losses or costs that would be incurred in replacing the terminated transactions. This can include obtaining quotes or using internal pricing models.
3. Documentation of Calculation	Documentation requirements are less stringent, particularly for the “Loss” calculation. The primary obligation is to act in good faith.	The determining party must be able to provide evidence of the commercial reasonableness of its procedures and the result. This implies a need for detailed record-keeping of all inputs, models, and quotes used in the calculation.
4. Statement of Calculation	Provide a statement to the defaulting party showing the calculation of the termination payment.	Provide a statement to the defaulting party showing the calculation of the “Close-out Amount,” with sufficient detail to explain how the amount was determined.

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What Constitutes Commercially Reasonable Procedures?

A key operational challenge under the 2002 Agreement is ensuring that the procedures used to calculate the “Close-out Amount” are “commercially reasonable.” This is a factual determination that will depend on the specific circumstances of the transaction and the market conditions at the time. Generally, it would involve:

Using reliable market data ▴ Employing prices and volatility surfaces from reputable sources.
Consistent application of models ▴ Using valuation models that are consistent with those used for internal risk management and financial reporting.
Obtaining multiple quotes ▴ Where possible, seeking indicative quotes from other market participants to corroborate the internal valuation.
Documenting the entire process ▴ Maintaining a clear audit trail of all steps taken, data used, and decisions made during the calculation process.

The increased burden of proof under the 2002 Agreement necessitates a more robust internal infrastructure for valuation and risk management. Institutions must be prepared to defend their calculations in a way that was not required under the more subjective “Loss” standard of the 1992 Agreement. This operational rigor is the price of the greater legal certainty that the 2002 framework provides.

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References

ISDA. “Comparison of 1992 and 2002 ISDA® Master Agreements.” International Swaps and Derivatives Association, 2003.
Wood, Philip R. “Title Finance, Derivatives, Securitisations, Set-off and Netting.” Sweet & Maxwell, 2007.
Flavell, Antony C. “A Guide to the 2002 ISDA Master Agreement.” Euromoney Books, 2003.
Hudson, Alastair. “The Law of Finance.” Sweet & Maxwell, 2013.
Gregory, Jon. “The xVA Challenge ▴ Counterparty Credit Risk, Funding, Collateral, and Capital.” Wiley Finance, 2015.

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Reflection

The evolution from the 1992 to the 2002 ISDA Master Agreement is more than a mere technical update. It reflects a fundamental shift in the market’s understanding of risk and the need for a legal architecture that can withstand systemic stress. The framework you choose to operate under is a critical component of your institution’s operational DNA. Does your current framework provide the certainty and objectivity required in today’s markets?

How does your institution’s approach to valuation and risk management align with the principles of commercial reasonableness embedded in the 2002 Agreement? The answers to these questions will shape your resilience in the face of the next market event.