What Are the Key Differences between the 1992 and 2002 ISDA Close out Calculation Methods?

Concept

The transition from the 1992 International Swaps and Derivatives Association (ISDA) Master Agreement to its 2002 counterpart represents a critical evolution in the architecture of over-the-counter (OTC) derivatives markets. This was a response to a series of market crises in the late 1990s and early 2000s that exposed certain structural weaknesses in the original framework. The core of this evolution lies in the close-out calculation methodology, the mechanism that determines the financial settlement when a derivatives contract is terminated prematurely due to a default or other specified termination event. Understanding the shift from the 1992 methodologies to the 2002 “Close-out Amount” is to understand a fundamental change in the philosophy of risk allocation and counterparty fairness at the heart of the global financial system.

At its center, the 1992 Agreement presented a choice between two primary valuation methods upon an early termination ▴ “Market Quotation” and “Loss.” It also offered a choice between two payment approaches, the “First Method” and the “Second Method.” The First Method, a one-way payment system, permitted the non-defaulting party to calculate its net gains and demand payment, but if it owed money to the defaulting party, it was not required to pay. This punitive approach was quickly identified as a source of systemic instability, as it could create severe and unpredictable losses for a defaulting entity and its other creditors. The Second Method provided for a two-way payment, a system that has become the universal standard. The 2002 ISDA Master Agreement eliminated the First Method entirely, cementing the two-way payment principle as an industry bedrock.

The 2002 ISDA Agreement replaced the bifurcated ‘Loss’ and ‘Market Quotation’ standards with a single, more objective ‘Close-out Amount’ calculation.

The 1992 Agreement’s valuation choices, Market Quotation and Loss, each presented distinct operational challenges. Market Quotation was designed to be an objective measure, derived by obtaining quotes from leading dealers for replacement transactions. In practice, during times of market stress ▴ precisely when close-outs are most likely ▴ dealers were often unwilling or unable to provide such quotes, rendering the mechanism unreliable. The alternative, Loss, was a more subjective measure.

It allowed the non-defaulting party to determine in good faith its total losses and costs resulting from the termination. While flexible, this subjectivity could lead to disputes, as the defaulting party might perceive the calculation as self-serving. The 2002 Agreement sought to rectify these issues by introducing a single, unified concept ▴ the “Close-out Amount.” This new standard was engineered to be a fairer, more objective, and more robust mechanism, reflecting a market-wide consensus on the need for greater transparency and predictability in the event of a counterparty default.

What Was the Core Philosophical Shift?

The fundamental philosophical divergence between the 1992 and 2002 ISDA close-out methodologies is the movement away from a system that could be perceived as punitive towards the defaulting party to one that is focused on a commercially reasonable and objective replacement cost. The 1992 Agreement, particularly with the availability of the First Method (limited walkaway) and the subjective nature of the “Loss” calculation, contained elements that could be used to penalize a defaulter. The framework gave considerable discretion to the non-defaulting party, operating under a standard of rationality. This meant its calculation would be upheld as long as it was not a determination that no reasonable non-defaulting party could have reached.

The 2002 Agreement re-architected this dynamic. By introducing the unified “Close-out Amount,” the new standard mandates that the determining party must use “commercially reasonable procedures in order to produce a commercially reasonable result.” This is a higher and more rigorous standard. It shifts the focus from the subjective perspective of the non-defaulting party to an objective, verifiable process. The calculation is no longer about what one party reasonably believes its loss to be; it is about what a neutral observer would consider a fair market replacement cost, determined through a commercially sound process.

This change reflects a mature understanding of systemic risk. An overly punitive close-out can exacerbate financial distress, sending destabilizing ripples through the interconnected web of financial counterparties. The 2002 framework, in contrast, is designed to be a circuit breaker that is fair, predictable, and less likely to amplify a crisis.

An Evolution Driven by Market Events

The theoretical distinctions between the two agreements were cast into sharp relief by real-world events. The market turmoil of the late 1990s, including the Asian financial crisis and the collapse of Long-Term Capital Management (LTCM), followed by the corporate defaults of the early 2000s like Enron and WorldCom, provided a live-fire stress test for the 1992 ISDA Master Agreement. These events highlighted the practical difficulties of the Market Quotation method in illiquid or volatile markets and the potential for disputes inherent in the Loss method.

The industry’s collective experience during these crises directly informed the drafting of the 2002 Agreement. There was a clear demand for a more resilient and equitable close-out mechanism. The resulting “Close-out Amount” was a direct answer to these challenges.

It was designed to function effectively even in stressed market conditions and to reduce the scope for disagreement by grounding the calculation in objective commercial practice. The inclusion of new provisions, such as a force majeure termination event, further demonstrated an attempt to create a more comprehensive and robust contractual architecture capable of withstanding a wider range of market shocks.

Strategy

The strategic decision of whether to use the 1992 or 2002 ISDA Master Agreement, particularly in the context of its close-out provisions, hinges on a party’s risk appetite, its negotiating leverage, and its desired balance between discretion and objectivity. The two agreements present fundamentally different strategic frameworks for managing counterparty default. The 1992 Agreement offers greater flexibility and discretion to the non-defaulting party, while the 2002 Agreement provides a more structured, objective, and arguably fairer process for both parties.

Comparing the Calculation Mechanisms

The strategic implications of the two agreements are best understood by a direct comparison of their respective close-out calculation methodologies. The 1992 ISDA forces a choice at the outset between two distinct paths, Loss and Market Quotation, each with its own strategic considerations. The 2002 ISDA consolidates these into a single, hybrid approach.

The 1992 ISDA Framework a Choice of Discretion or Market-Reliance

Under the 1992 Agreement, parties specify in the Schedule to the Agreement which valuation method will apply. This choice is a critical point of negotiation.

• Market Quotation ▴ This method requires the non-defaulting party to obtain quotations from at least three leading dealers in the relevant market (Reference Market-makers) for a replacement transaction. The Settlement Amount is then determined based on the average of these quotes. The strategy here is to rely on the external market for an objective valuation. This can be advantageous for a party that wants to avoid any accusation of a self-serving calculation. However, its primary weakness is its unreliability in stressed markets. If quotes cannot be obtained, the agreement falls back to the Loss method, negating the original strategic choice.
• Loss ▴ This method grants the non-defaulting party the authority to calculate its total losses and costs arising from the termination. This calculation must be made in “good faith” and be “reasonable.” Strategically, this provides maximum flexibility. The non-defaulting party can include a wide range of costs, including the cost of unwinding hedges and internal administrative expenses. The legal standard it must meet is one of rationality ▴ its calculation will stand unless it is one that no reasonable party in its position could have reached. This gives the non-defaulting party significant strategic latitude.

The 2002 ISDA Framework a Mandate for Objectivity

The 2002 Agreement dispenses with the binary choice and introduces the “Close-out Amount.” This is a more prescriptive and holistic methodology.

• Close-out Amount ▴ The Determining Party (typically the non-defaulting party) calculates the “gains, losses and costs” related to the termination. This includes the economic equivalent of replacing the terminated transaction. The key strategic shift is the standard of conduct ▴ the Determining Party must “act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result.” This imposes a dual obligation ▴ the process must be sound, and the outcome must be fair from an objective standpoint. Strategically, this reduces the discretion of the Determining Party. It cannot simply rely on its own internal models without reference to external data if such data is available. It must be prepared to defend both its methodology and the final figure as being objectively commercially reasonable.

The shift to the 2002 ISDA’s ‘Close-out Amount’ reflects an industry-wide strategic move towards greater transparency and predictability in derivatives termination.

Key Strategic Differences in a Table

The following table outlines the core strategic differences between the two frameworks:

How Does the Payment Directionality Change Strategy?

The elimination of the “First Method” in the 2002 ISDA was a monumental strategic change. Under the 1992 Agreement, a party could elect for the First Method, which meant that if a counterparty defaulted, the non-defaulting party could terminate all transactions and demand payment for any amount it was owed on a net basis. If, however, the net position meant the non-defaulting party owed money to the defaulter, it could “walk away” and pay nothing.

This created a perverse incentive system. A firm in financial distress might be pushed into default by a counterparty who was “in the money” on their trades and saw an opportunity to realize a gain while avoiding a corresponding loss. This approach was widely criticized for being inequitable and for increasing systemic risk by placing undue pressure on entities in temporary distress.

The universal adoption of the “Second Method” (two-way payments) in the 2002 Agreement represents a strategic consensus that the purpose of a close-out is to make the non-defaulting party economically whole, not to provide a windfall gain at the expense of a defaulting party and its other creditors. This fosters a more stable and predictable market environment.

Execution

The execution of a close-out under an ISDA Master Agreement is a precise, high-stakes process. The operational differences between the 1992 and 2002 versions are not merely academic; they dictate the specific steps a non-defaulting party must take, the evidence it must gather, and the legal standard its actions will be judged against. A failure to execute the process correctly can lead to protracted legal disputes and potentially jeopardize the recovery of funds.

A Procedural Playbook for Close-Out

Executing a close-out requires a disciplined, step-by-step approach. The following outlines the operational sequence, highlighting the critical execution differences between the two agreements.

1. Triggering The Early Termination ▴ An Early Termination Date must be designated. This occurs upon the occurrence of an Event of Default (e.g. bankruptcy, failure to pay) or a Termination Event (e.g. illegality, tax event). The non-defaulting party must send a notice to the defaulting party specifying the event and designating the Early Termination Date. This process is broadly similar for both agreements.
2. Identifying The Terminated Transactions ▴ All transactions governed by the Master Agreement are terminated as of the Early Termination Date. The Determining Party must compile a complete and accurate list of all such transactions.
3. The Valuation Process The Core Divergence ▴ This is where the execution paths of the 1992 and 2002 agreements diverge most significantly.
   • 1992 ISDA Execution (Market Quotation) ▴ If Market Quotation is the chosen method, the non-defaulting party’s primary task is to contact Reference Market-makers (typically four are specified in the schedule) to request quotes for the cost of entering into a replacement transaction for the entire portfolio of terminated trades. The execution requires meticulous record-keeping of who was contacted, when they were contacted, and the precise quotes received. If fewer than three quotes are obtained, the method fails, and the party must revert to the Loss method.
   • 1992 ISDA Execution (Loss) ▴ If Loss is the method, the non-defaulting party’s execution focus shifts inward. It must calculate, in good faith, all of its losses and costs. This requires compiling evidence of these losses. This can include screenshots of market data at the time of termination, calculations from internal pricing models, and documented costs of unwinding any related hedges. The key is to build a defensible record that supports the “reasonableness” of the determination from its own perspective.
   • 2002 ISDA Execution (Close-out Amount) ▴ The execution under the 2002 Agreement is a hybrid and more demanding process. The Determining Party must use “commercially reasonable procedures.” Operationally, this means it cannot simply rely on one source of information. It should gather a range of data, which could include:
     • Quotations from dealers (even if informal).
     • Data from electronic trading platforms.
     • Information from third-party valuation services.
     • Output from its own internal pricing models, provided those models are recognized industry standards.

     The execution here is about creating a robust, auditable trail that demonstrates a comprehensive and fair attempt to ascertain the market value. The party must be prepared to justify why its chosen procedures were commercially reasonable and why they led to a commercially reasonable result. This is a higher evidentiary burden than under the 1992 Loss method.

4. Calculating The Final Settlement Amount ▴ After the valuation is complete, the gains and losses across all terminated transactions are netted out. Any unpaid amounts that were due prior to the termination are factored in. The result is a single net figure payable by one party to the other.
5. Delivering The Calculation Statement ▴ The non-defaulting party must deliver a statement to the defaulting party showing how the final amount was calculated in reasonable detail. The level of detail required to satisfy this obligation is often a point of contention.

Illustrative Calculation Scenario

To demonstrate the potential for different outcomes, consider a hypothetical scenario where a bank (Non-defaulting Party) closes out a portfolio of interest rate swaps with a defaulted hedge fund (Defaulting Party). The portfolio is, on a net basis, “in the money” to the bank.

Executing a close-out under the 2002 ISDA requires building a robust, auditable record of commercially reasonable procedures and outcomes.

What Is the Role of Good Faith and Commercial Reasonableness?

The concepts of “good faith” and “commercial reasonableness” are central to the execution of a close-out. “Good faith” is a component of both agreements and generally requires that a party act honestly and not with an improper motive. The more significant evolution is the addition of “commercially reasonable procedures” and a “commercially reasonable result” in the 2002 ISDA.

This imposes a procedural and a substantive obligation. A party cannot use a flawed or biased process, even if it coincidentally produces a reasonable outcome. Conversely, a perfect, industry-standard process that produces a bizarre, out-of-market result would also fail the test.

In execution, this means the Determining Party under the 2002 Agreement must constantly self-audit its actions against objective market standards. It must ask not only “What is my loss?” but also “How would a reasonable market participant, acting fairly, calculate the replacement cost of these transactions?” This shift in perspective is the defining feature of executing a close-out under the modern ISDA framework.

Reflection

The evolution from the 1992 to the 2002 ISDA close-out methodology is more than a mere technical adjustment in legal drafting. It is a codification of lessons learned through market crises and a deliberate architectural choice to enhance the stability of the global financial system. The framework you operate within defines the tools available to you in a crisis.

Does your current counterparty risk framework prioritize discretion or objectivity? Is it designed to function under the stress of volatile and illiquid markets, or does it rely on assumptions of normalcy?

How Does This Framework Integrate with Your Own?

The principles embedded in the 2002 ISDA ▴ objectivity, procedural soundness, and commercial reasonableness ▴ provide a robust template for risk management that extends far beyond derivatives. They prompt a critical examination of any internal process where subjective valuation occurs under pressure. The true strength of an operational framework is revealed not in calm markets, but at the point of failure. Viewing the ISDA close-out mechanism not as a static legal document but as a dynamic system for crisis resolution allows an institution to internalize these principles, building a more resilient and defensible operational architecture.