What Are the Key Differences between the 1992 and 2002 ISDA Master Agreements regarding Close-Out Amounts?

Concept

The ISDA Master Agreement operates as the foundational charter for the global over-the-counter derivatives market, a systemically critical function that demands precision, predictability, and robustness under stress. Its evolution from the 1992 to the 2002 version reflects a direct response to market crises and the hard-won lessons of counterparty defaults. The core of this evolution resides in the mechanics of terminating transactions and calculating what is owed, a process known as close-out netting.

Understanding the shift in calculating these close-out amounts is to understand a fundamental recalibration in how the market quantifies and manages risk at the moment of failure. The amendments were not cosmetic; they were a structural overhaul designed to enhance stability and fairness in the financial system.

The Pre-2002 Close out Framework

The 1992 ISDA Master Agreement provided two distinct methodologies for calculating the close-out amount following a termination event ▴ Market Quotation and Loss. Parties would specify their chosen method in the Schedule to the Agreement. This choice had significant downstream consequences for how risk was managed and realized upon a counterparty default. The framework also contained a critical, and now largely obsolete, choice between “First Method” and “Second Method” for payments, which added another layer of complexity and potential inequity.

Market Quotation

The Market Quotation method was designed to be the more objective of the two choices. The process required the non-defaulting party to seek quotes from at least three leading dealers in the relevant market for a replacement transaction that would replicate the economic profile of the terminated trade. The amount payable would be based on the average of these quotes. The intent was to arrive at a fair market value by polling active, expert participants.

However, its procedural rigidity became a significant vulnerability during periods of market stress. In illiquid or volatile markets, obtaining the required number of firm quotes from dealers was often impossible, causing the method to fail and forcing the parties to fall back to the Loss method.

Loss

The Loss method was a more subjective calculation. It entitled the non-defaulting party to determine, in good faith, the total losses and costs it incurred as a result of the early termination. This could include the cost of replacement trades, hedging costs, and other associated expenses. While flexible, this flexibility came at a cost.

The calculation was inherently self-determined, which could lead to disputes. The standard for assessing this determination was one of rationality ▴ that the determining party did not reach a conclusion that no reasonable party in its position would have. This subjective standard, while providing a necessary fallback, lacked the objective, third-party validation inherent in the Market Quotation ideal.

The choice between the objective but brittle Market Quotation and the flexible but contentious Loss method defined the risk landscape of the 1992 agreement.

The First Method and Second Method a Critical Distinction

Compounding the choice of calculation was the payment methodology. The 1992 ISDA offered two options:

• The First Method (Limited Two-Way Payments) ▴ Under this construct, if the net close-out amount was a positive value for the non-defaulting party, the defaulting party had to pay. However, if the net amount was positive for the defaulting party (meaning the non-defaulting party was out-of-the-money), the non-defaulting party could “walk away” and was not obligated to pay. This approach was heavily criticized for its inequity and for creating perverse incentives, as it could result in a windfall for the non-defaulting party at the expense of the defaulting party’s other creditors.
• The Second Method (Full Two-Way Payments) ▴ This method required a payment to be made to whichever party was in-the-money on a net basis, regardless of their status as the defaulting or non-defaulting party. This is the universally accepted standard today, as it ensures that the close-out process is a true reflection of the market value of the terminated positions, rather than a punitive measure.

Strategy

The transition from the 1992 ISDA Agreement to the 2002 version represents a significant strategic shift in the philosophy of risk management and counterparty default. The changes were not merely procedural tweaks; they were a deliberate redesign aimed at increasing objectivity, fairness, and operational resilience in volatile market conditions. The introduction of a single, unified “Close-out Amount” was the centerpiece of this strategic overhaul, replacing the bifurcated and often problematic Market Quotation/Loss framework and definitively eliminating the concept of one-way payments.

Abandoning the Bifurcated Model

The primary strategic driver for the 2002 ISDA was the recognition that the 1992 framework could fail when it was needed most. The reliance on Market Quotation, while sound in theory, proved impractical during systemic crises. The new agreement abandoned the dual-method approach in favor of a single, more flexible standard ▴ the “Close-out Amount.”

The Unified “Close-Out Amount”

The 2002 ISDA introduced a consolidated definition of the amount payable on termination. The “Close-out Amount” is a figure representing the losses or gains arising from the termination, to be determined by the non-defaulting party. The critical distinction is the standard to which this determination is held. The calculating party must use “commercially reasonable procedures in order to produce a commercially reasonable result.” This introduces a higher, more objective standard than the “rationality” test applied to the Loss calculation under the 1992 Agreement.

This new standard comprises two distinct obligations:

1. Commercially Reasonable Procedures ▴ The process used to arrive at the valuation must be sound. This involves considering a range of information sources without being rigidly bound to any single one.
2. Commercially Reasonable Result ▴ The outcome of the calculation must be fair and in line with what an objective third party would consider reasonable. This moves the assessment from the subjective perspective of the determining party to an objective market standard.

This unified approach provides far greater flexibility. The determining party is no longer forced to seek a specific number of quotes. Instead, it can use a variety of inputs to inform its calculation, including:

• Quotations from third-party dealers (even a single quote can be sufficient if commercially reasonable).
• Relevant market data from information providers.
• Information from internal sources, such as the firm’s own valuation models, provided they are used in the regular course of business.

The 2002 ISDA’s “Close-out Amount” replaces procedural rigidity with a mandate for commercial reasonableness, enhancing stability in turbulent markets.

The End of Optionality in Payments

A second, equally important strategic shift was the complete removal of the “First Method” (limited two-way payments). The 2002 ISDA mandates full two-way payments in all circumstances. This change was crucial for aligning the agreement with international insolvency principles, which generally prohibit the forfeiture of a debtor’s assets. By ensuring that a defaulting party is still entitled to receive payment if the net value of the terminated trades is in its favor, the 2002 Agreement promotes fairness and reduces systemic risk by treating all creditors more equitably.

Comparative Framework 1992 Vs 2002 Close out Provisions

The table below provides a systematic comparison of the key strategic differences in the close-out mechanics between the two agreements.

Execution

The execution of a close-out under an ISDA Master Agreement is a critical risk management function. The shift from the 1992 to the 2002 framework has profound implications for the operational procedures, data requirements, and internal systems of any institution engaged in OTC derivatives. The 2002 Agreement, with its mandate for “commercially reasonable” conduct, demands a more sophisticated and defensible execution process compared to its predecessor.

The Operational Playbook for a 2002 ISDA Close Out

Executing a close-out under the 2002 ISDA requires a systematic and well-documented process. The following steps outline an operational playbook for a non-defaulting party tasked with determining the Close-out Amount.

1. Designation of Early Termination Date ▴ Upon an Event of Default, the non-defaulting party must effectively designate an Early Termination Date by serving notice to the defaulting party. All outstanding transactions under the agreement will be terminated as of this date.
2. Portfolio Reconciliation ▴ Immediately compile and reconcile a definitive list of all terminated transactions. This ensures both parties agree on the scope of the portfolio being closed out. Any discrepancies must be resolved promptly.
3. Information Gathering ▴ This is the core of the “commercially reasonable procedures.” The determining party must gather valuation information from a range of sources. This process should be documented meticulously. Sources may include:
   • Indicative Quotes ▴ Solicit indicative or firm quotes for replacement trades from several market-making dealers. Unlike the 1992 Market Quotation, there is no fixed number required. The focus is on the quality and relevance of the quotes.
   • Market Data Services ▴ Obtain relevant market data (e.g. yield curves, volatility surfaces, credit spreads) from third-party providers like Bloomberg, Refinitiv, or other specialized services.
   • Internal Valuations ▴ Generate valuations using the firm’s own internal, independently-validated pricing models. The use of these models must be consistent with how they are used in the normal course of business for risk management and reporting.
   • Evidence of Replacement Hedges ▴ If the party enters into actual replacement trades to hedge its exposure, the price of these trades is a powerful piece of evidence for the Close-out Amount.
4. Determination and Calculation ▴ Synthesize the gathered information to arrive at a single Close-out Amount. This is not a simple averaging exercise. The determining party must weigh the different data points based on their quality, relevance, and proximity to the Early Termination Date. The entire rationale for the final figure must be recorded.
5. Issuance of the Close-out Statement ▴ Prepare and deliver a statement to the defaulting party showing the calculation in reasonable detail. This statement should list the terminated transactions and the final Close-out Amount, along with the net sum payable and the payment date.

Quantitative Modeling a Hypothetical Close out Scenario

To illustrate the execution, consider a hypothetical close-out of a small derivatives portfolio. A non-defaulting party, Bank A, terminates its transactions with a defaulting counterparty, Hedge Fund B, under a 2002 ISDA. The Early Termination Date is set for August 14, 2025.

The portfolio consists of two trades:

1. An Interest Rate Swap (IRS) where Bank A pays a fixed rate of 2.5% and receives SOFR on a notional of $50 million.
2. A USD/EUR Forward contract where Bank A will buy €20 million and sell USD at a rate of 1.0800.

Bank A’s valuation team executes the following “commercially reasonable procedures”:

Bank A documents its methodology, noting that it weighted the actual replacement cost of the FX forward most heavily and used a blend of dealer quotes and internal models for the IRS. This documented, multi-faceted approach provides a robust defense that the resulting Close-out Amount of +$940,000 is commercially reasonable.

Reflection

From Procedural Mandate to Reasonableness

The evolution of the ISDA Master Agreement’s close-out provisions is a testament to the market’s capacity for self-correction. The framework moved from a rigid, procedural mandate to a principles-based standard of commercial reasonableness. This places a greater burden of judgment on the determining party, requiring them to construct a valuation that is not just procedurally correct but substantively fair. It demands an operational architecture capable of synthesizing diverse data points into a single, defensible number.

The ultimate measure of success for any institution’s derivatives operation lies in its ability to execute this process with precision and integrity, particularly when market conditions are at their most severe. The strength of the legal documentation is only realized through the quality of its execution.