In What Scenarios Might a Firm Prefer a 1992 ISDA over the More Protective 2002 Version?

Concept

The decision to employ the 1992 International Swaps and Derivatives Association (ISDA) Master Agreement in an era dominated by the more robust 2002 version is an inquiry into architectural preference. It reveals a firm’s fundamental posture on risk, control, and counterparty leverage. Viewing these agreements as foundational protocols for the vast over-the-counter derivatives market, the choice is a deliberate one, reflecting a specific strategic objective. The 2002 ISDA was engineered to increase certainty and reduce systemic risk following several market crises.

Its design prioritizes objective, formulaic resolutions during periods of market stress. Conversely, the 1992 ISDA retains a degree of ambiguity and subjectivity in its core termination mechanics. A preference for this older framework is a preference for a system where outcomes are less predetermined and where a firm’s market position and negotiation prowess can be brought to bear at the most critical junctures.

At the heart of this architectural divergence are the mechanisms for calculating payments upon the early termination of a transaction. The 2002 Agreement implements a single, consolidated calculation method known as the “Close-Out Amount.” This process is designed to be a commercially reasonable determination of the firm’s total gains, losses, and costs associated with replacing the economic equivalent of the terminated trades. The methodology is intended to be objective, encompassing the costs of liquidating or re-establishing hedges and valuing option rights.

This creates a predictable, two-way payment obligation where the net value flows to the party to whom it is owed, irrespective of which party defaulted. The system is engineered for stability and the reduction of disputes by narrowing the scope for interpretation.

The 1992 ISDA framework allows for greater discretion in termination valuations, a feature that can be strategically exploited by a well-positioned firm.

The 1992 Agreement presents a more complex and bifurcated landscape. It offers two distinct calculation methods ▴ “Market Quotation” and “Loss.” Market Quotation is a more structured approach, requiring the non-defaulting party to obtain quotes for replacement transactions from leading dealers in the relevant market. This method introduces a reliance on external market participants. The “Loss” method is far more subjective, allowing a party to determine, in good faith, its total losses and costs resulting from the early termination.

This internal calculation can be opaque and difficult for the counterparty to challenge effectively. The choice between these two methods, specified in the Schedule to the agreement, is the first layer of strategic decision-making.

Compounding this complexity, the 1992 ISDA contains two different payment methodologies ▴ the “First Method” and the “Second Method.” The Second Method aligns with the principle of a fair, two-way payment, where the party that is “in the money” receives the net value of the terminated trades. The First Method, however, introduces a controversial one-way payment structure. Under this provision, if the non-defaulting party is out of the money, it is not required to make a payment to the defaulting party. While the enforceability of this “walkaway” clause has been successfully challenged in numerous jurisdictions, particularly after the Lehman Brothers bankruptcy, its inclusion in legacy agreements represents a significant strategic element that sophisticated parties might seek to leverage.

Key Architectural Differences

Understanding the scenarios for preferring the 1992 ISDA requires a granular analysis of its core components against the 2002 version. These differences are not merely technical; they represent fundamentally different philosophies of risk allocation.

• Termination Valuation The 2002 Agreement’s “Close-Out Amount” is a holistic and objective standard. The 1992 Agreement’s choice between the more externalized “Market Quotation” and the highly subjective “Loss” provides a toolkit for strategic positioning. A firm with superior valuation capabilities and market insight may prefer the “Loss” method, confident in its ability to produce a defensible yet favorable calculation of its damages.
• Payment Netting The Second Method under the 1992 ISDA and the standard process under the 2002 ISDA both result in a two-way, netted payment. The First Method of the 1992 ISDA stands apart as a one-way payment mechanism, a feature that, while legally fraught, offers the potential for a non-defaulting party to avoid payments to a defaulter.
• Set-Off Rights The 2002 ISDA includes an explicit set-off provision, allowing a non-defaulting party to set off the early termination amount against other amounts owed between the parties. This is a critical protection. The 1992 ISDA lacks this provision in its standard form, requiring parties to negotiate and add it to the Schedule. A firm might strategically prefer the 1992 version without a set-off clause in specific ring-fencing or bankruptcy scenarios, seeking to isolate liabilities.
• Force Majeure Event The 2002 ISDA introduced a “Force Majeure” Termination Event to address situations where external events beyond a party’s control prevent performance. This was a direct response to the market disruptions of the late 1990s and early 2000s. The 1992 version lacks this specific provision, leaving such scenarios to be handled by the less precise “Illegality” clause, which can create uncertainty.

Why Would a Firm Prefer the 1992 ISDA?

A preference for the 1992 ISDA is a preference for strategic flexibility over standardized certainty. It is a calculated decision that the potential benefits of its more subjective and negotiable framework outweigh the risks of disputes and legal challenges. This choice is most often made by firms that believe they possess a significant advantage in terms of legal resources, valuation expertise, or market power relative to their counterparties.

In these contexts, the ambiguities of the 1992 framework become tools for extracting value and managing risk in a manner that the more rigid 2002 framework would preclude. The older agreement transforms a close-out from a purely mechanical calculation into a strategic negotiation.

Strategy

The strategic selection of an ISDA Master Agreement is a foundational act of financial architecture. It dictates the rules of engagement and the allocation of power in a bilateral derivatives relationship. While the 2002 ISDA is engineered for systemic stability through objectivity, a sophisticated financial institution may strategically opt for the 1992 ISDA to retain specific advantages.

This choice is predicated on a clear-eyed assessment of the firm’s capabilities relative to its counterparties and the specific nature of the trading relationship. The 1992 framework offers a set of levers that can be pulled during periods of stress, provided the firm has the strength and expertise to pull them effectively.

The Asymmetric Power Dynamic

A primary driver for preferring the 1992 ISDA is the existence of an asymmetric power dynamic between two counterparties. A large, money-center bank or a highly sophisticated hedge fund may deliberately choose the 1992 framework when dealing with smaller, regional banks, corporate clients, or less experienced funds. In this context, the perceived weaknesses of the 1992 ISDA are weaponized as strategic strengths.

Consider the choice between “Market Quotation” and “Loss” for calculating the termination amount. A large dealer with a dominant presence in a particular derivatives market is uniquely positioned to benefit from the “Loss” methodology. This firm’s internal trading desks, quantitative analysts, and risk managers can construct a detailed and defensible calculation of their losses that is inherently difficult for an external party to replicate or challenge. The smaller counterparty lacks the visibility into the dealer’s hedging book and the resources to effectively dispute the valuation.

The dealer can, therefore, control the narrative and the ultimate financial outcome of a close-out. The subjectivity of “Loss” becomes a source of significant leverage.

Choosing the 1992 ISDA is a calculated trade-off, exchanging the certainty of the 2002 version for greater strategic flexibility in key scenarios.

Strategic Scenarios for Preferring the 1992 ISDA

The decision to use the 1992 Agreement is not a blanket policy but a targeted strategy applied to specific situations and counterparty types. The following scenarios illustrate the strategic thinking behind this choice.

Scenario 1 the Distressed Debt Opportunity

A special situations hedge fund that trades in the debt of distressed companies might find the 1992 ISDA, particularly with the “First Method” payment provision, to be a valuable tool. These funds often enter into derivatives contracts with companies that have a high probability of default. If the counterparty defaults, the First Method could, in theory, allow the fund to terminate its obligations and “walk away” without making a payment, even if it is out-of-the-money on its trades. While the legal enforceability of these walkaway clauses is highly questionable today and has been largely nullified by bankruptcy court rulings and legislative changes (like amendments to the US Bankruptcy Code), their presence in legacy agreements can still create negotiating leverage.

A fund might use the threat of invoking such a clause, however dubious, to extract concessions from a defaulting counterparty or its creditors during a workout or bankruptcy proceeding. It becomes a powerful, albeit aggressive, bargaining chip.

Scenario 2 Legacy System Integration

For large financial institutions with decades of history, operational inertia is a powerful force. Their risk management systems, legal databases, collateral management platforms, and accounting software may have been built around the architecture of the 1992 ISDA. The process of “re-papering” thousands of counterparty agreements from the 1992 to the 2002 version is a monumental undertaking. It requires extensive legal review, negotiation, and systems updates.

For long-standing, stable counterparty relationships where the perceived risk of default is low, a firm may conclude that the cost and operational risk of migration outweigh the benefits of adopting the more modern agreement. The 1992 ISDA is retained not because it is superior, but because it is deeply embedded in the firm’s operational infrastructure and the cost of change is prohibitive.

Scenario 3 Jurisdictional and Legal Arbitrage

The body of case law interpreting the 1992 ISDA is vast and varies by jurisdiction. A firm may have legal counsel that has identified favorable precedents in a particular jurisdiction (e.g. under English law or New York law) regarding the interpretation of “Loss” or the requirements for obtaining “Market Quotations.” By specifying that jurisdiction in the Schedule and using the 1992 framework, the firm can anchor its agreement in a legal environment where the ambiguities are likely to be resolved in its favor. This is a highly sophisticated strategy that relies on deep legal expertise and a proactive approach to structuring the legal foundations of a trading relationship.

Comparative Strategic Framework

The choice between the two agreements can be summarized in the following table, which frames the key differences in strategic terms.

Execution

The execution of a strategy centered on the 1992 ISDA Master Agreement requires a highly coordinated effort between a firm’s legal, trading, and risk management functions. It is an advanced operational posture that demands precision, foresight, and a robust infrastructure capable of managing heightened levels of uncertainty and potential conflict. The decision moves beyond a theoretical preference and into the realm of practical application, where the ambiguities of the older agreement must be navigated with skill.

The Negotiation and Documentation Protocol

When a firm decides to use the 1992 ISDA, the negotiation of the Schedule becomes the primary battleground. The legal team cannot simply rely on a standard template; they must execute a deliberate strategy to embed the firm’s desired advantages into the document. This involves several key decision points:

• Selection of Calculation Method The firm must decide whether to specify “Market Quotation” or “Loss” as the applicable measure for Early Termination. If the firm believes it has superior internal valuation capabilities, it will push hard for “Loss.” Its counterparty, if well-advised, will resist and argue for the more objective “Market Quotation.” The negotiation may involve defining the term “Loss” with greater specificity in the Schedule to preempt future disputes.
• Defining Reference Market-makers If “Market Quotation” is chosen, the firm’s legal and trading teams must carefully construct the definition of “Reference Market-makers.” They will seek to create a list of dealers with whom they have strong relationships and who are likely to provide favorable quotes.
• The Payment Method Debate The firm may attempt to specify the “First Method” (one-way payment). In the post-Lehman era, this is an extremely aggressive stance and will be met with immediate rejection from any sophisticated counterparty. It is more likely to be found in legacy agreements that have not been amended. In new negotiations, insisting on this point is a clear signal of an adversarial posture.
• The Omission of Set-Off A firm might propose using the 1992 ISDA without adding the customary set-off provision to the Schedule. This would be a significant red flag for a counterparty, as it undermines one of the core protections of netting. This strategy is typically only viable in very specific circumstances, such as when dealing with entities in jurisdictions with unclear bankruptcy laws or when trying to structure a transaction to be bankruptcy-remote.

What Is the Operational Playbook for an Early Termination?

The true test of the chosen ISDA framework occurs when an Early Termination Event is triggered. The operational steps that follow are starkly different under the two agreements, as illustrated by the following playbooks.

1992 ISDA Early Termination Playbook

1. Event and Notification An Event of Default or Termination Event occurs. The non-defaulting party (“Party A”) designates an Early Termination Date and notifies the defaulting party (“Party B”).
2. Method Selection Review Party A’s legal and risk teams immediately review the Schedule to confirm the operative calculation method (“Loss” or “Market Quotation”) and payment method (“First Method” or “Second Method”).
3. Execution Path A If Market Quotation Party A’s trading desk is tasked with obtaining quotations from the specified Reference Market-makers for the cost of replacing the terminated transactions. This process is time-sensitive and must be documented meticulously.
4. Execution Path B If Loss Party A’s risk management and quantitative teams begin a comprehensive internal valuation process. This involves marking all terminated trades to market, calculating the cost of unwinding or replacing all related hedges, and quantifying any ancillary costs. A detailed report is prepared.
5. Payment Calculation Based on the results of the valuation and the operative payment method, Party A calculates the final amount owed. If the First Method is operative and Party A is out-of-the-money, it may assert that no payment is due to Party B.
6. Dispute and Negotiation Party A presents its calculation to Party B. Given the subjectivity (in the case of “Loss”) or potential for variance (in “Market Quotation”), this step is highly likely to lead to a dispute. A period of negotiation ensues, where legal teams and valuation experts from both sides contest the figures. The outcome is often a negotiated settlement to avoid costly litigation.

2002 ISDA Early Termination Playbook

1. Event and Notification An Event of Default or Termination Event occurs. The non-defaulting party (“Party A”) designates an Early Termination Date and notifies the defaulting party (“Party B”).
2. Determining Party Action The non-defaulting party acts as the “Determining Party.” Its risk and trading teams are responsible for calculating the “Close-Out Amount.”
3. Calculation of Close-Out Amount The Determining Party calculates its total gains, losses, and costs in a “commercially reasonable manner.” This is a single, unified calculation that encompasses all aspects of the termination. The standard is one of good faith and objective commercial practice, which is easier to defend and harder to dispute.
4. Application of Set-Off The calculated Close-Out Amount is automatically subject to the agreement’s set-off provision, allowing Party A to net this amount against any other sums owed between the two parties under any other agreement.
5. Statement and Payment Party A delivers a statement to Party B showing the calculation of the Close-Out Amount and the net amount payable. The process is designed to be swift and conclusive, with a clear two-way payment obligation. The potential for disputes is significantly lower due to the objective standard and the consolidation of all calculations into a single amount.

Quantitative Impact Analysis

The following table illustrates a hypothetical close-out scenario to demonstrate the potential financial divergence between the two agreements. Assume Party A is a large dealer and Party B is a smaller regional bank. Party B defaults. Party A’s net position across all trades is out-of-the-money by $5 million.

Reflection

Is Your Documentation an Asset or a Liability?

The architecture of a firm’s legal agreements is as critical as the architecture of its trading systems. The choice between the 1992 and 2002 ISDA Master Agreements transcends mere compliance; it is a declaration of a firm’s posture toward counterparty risk and its confidence in its own internal systems. The knowledge of these differences provides a lens through which to examine your own operational framework.

Is your documentation strategy a passive inheritance of legacy systems, or is it an active and deliberate component of your risk management apparatus? The ultimate edge in the derivatives market is found at the intersection of quantitative insight, technological superiority, and a legal architecture that is purposefully designed to amplify the firm’s strengths at the most decisive moments.