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

Concept

The transition from the 1992 International Swaps and Derivatives Association (ISDA) Master Agreement to its 2002 successor represents a fundamental redesign of the market’s core risk management architecture. This evolution centers on the critical mechanism of close-out valuation, the protocol for calculating the final settlement amount when a derivatives contract is terminated prematurely due to a default or other termination event. The shift was a direct response to the systemic lessons learned from market crises of the 1990s, which revealed the operational fragilities and potential for dispute inherent in the earlier framework.

Viewing this change through a systems lens, the 1992 Agreement operated on a principle of delegated authority with a subjective backstop, while the 2002 Agreement implements a system of mandated procedural objectivity. This is the central architectural distinction from which all other differences in close-out valuation flow.

At the heart of the 1992 Agreement were two potential valuation methodologies a non-defaulting party could elect ▴ “Market Quotation” and “Loss”. Market Quotation was the preferred route, a process requiring the non-defaulting party to seek quotes from leading market makers for a replacement transaction. This method was prescriptive, aiming for a degree of objective, market-based evidence. The “Loss” methodology, conversely, was a more flexible and encompassing calculation.

It allowed the non-defaulting party to determine, in its reasonable good faith, the total losses and costs it incurred as a result of the early termination. This standard, while practical, was inherently subjective. Its application relied heavily on the internal models and judgments of the calculating party, creating a significant potential for disagreement, particularly in distressed or illiquid markets where obtaining firm quotes was challenging.

The 2002 ISDA Master Agreement replaces the subjective valuation standards of the 1992 version with a mandate for an objectively reasonable process and outcome.

The 2002 ISDA Master Agreement consolidates these disparate concepts into a single, unified valuation standard known as the “Close-out Amount.” This new protocol completely excises the old methodologies and their elective nature. The Close-out Amount is defined as the amount of losses or costs that are or would be incurred in replacing, or providing the economic equivalent of, the terminated transactions. The defining characteristic of this new system is its explicit standard of conduct.

The determining party is required to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This language, meticulously chosen, shifts the entire framework from the subjective “good faith” determination of the 1992 Loss standard to a higher, more rigorous benchmark of objective commercial reasonableness. This change imposes a procedural and substantive obligation on the calculating party, demanding a process that is not just rational, but defensible to an impartial observer as being commercially sound.

This architectural evolution also addressed a critical flaw in the 1992 framework ▴ the potential for one-way payments. The 1992 Agreement allowed parties to select the “First Method,” a provision where, upon a counterparty’s default, the non-defaulting party was entitled to its net gains but was not obligated to pay out if the net value of the terminated trades was in the defaulting party’s favor. This punitive measure was seen as a significant deterrent to default. The alternative, “Second Method,” required a two-way payment, ensuring that the net value would be paid to the party to whom it was owed, regardless of default status.

The 2002 Agreement definitively resolves this by making the two-way payment system mandatory. This structural change reflects a market-wide consensus that the purpose of a close-out is to crystallize the economic value of a contract, not to create a punitive windfall. The Close-out Amount is always a two-way street, a systemic adjustment that promotes fairness and predictability in the settlement process, reinforcing the stability of the overall financial network.

Strategy

The strategic implications of the shift from the 1992 to the 2002 ISDA Master Agreement’s close-out provisions are profound, fundamentally altering the risk calculus and operational posture of any institution engaged in the derivatives market. The primary strategic change is the deliberate move away from a framework that permitted subjective judgment toward one that mandates objective defensibility. This pivot has direct consequences for how firms manage counterparty risk, structure their internal valuation procedures, and prepare for potential disputes.

From Rationality to Reasonableness a Higher Standard

The core strategic divergence lies in the standard of conduct applied to the valuation process. The 1992 Agreement’s “Loss” calculation required the non-defaulting party to act in good faith and make a “reasonable” determination. English courts interpreted this through the lens of rationality, specifically the “Wednesbury unreasonableness” test.

This standard is a relatively low bar to clear; a determination would only be overturned if it was so irrational that no reasonable party in that position could have possibly made it. This gave the calculating party considerable latitude, as long as its decision-making process was not entirely arbitrary or perverse.

The 2002 Agreement’s “Close-out Amount” imposes a much stricter, dual-pronged obligation. The determining party must use “commercially reasonable procedures” to achieve a “commercially reasonable result.” This is not a test of mere rationality. It is an objective standard. The procedures themselves must be sound and justifiable in the context of prevailing market practices, and the final calculated amount must also fall within a range that would be considered commercially reasonable by an independent, informed observer.

This strategic shift from a subjective to an objective framework means a non-defaulting party can no longer simply rely on its internal models without external validation or benchmarking. Its entire valuation process is now subject to scrutiny against a market-wide standard of commercial practice.

What Constitutes a Commercially Reasonable Procedure?

Under the 2002 framework, establishing and documenting commercially reasonable procedures becomes a paramount strategic objective. While the agreement does not prescribe a specific set of actions, market practice and legal precedent suggest a range of considerations that a determining party must take into account. The goal is to create an evidentiary trail that substantiates the final calculation.

• Sources of Valuation The determining party should consider a variety of information sources. This may include quotes from dealers, data from electronic trading platforms, information from clearing systems, and its own internal models. Relying on a single source, especially an internal one, without cross-verification, is strategically risky.
• Market Conditions The procedures must be adapted to the prevailing market environment. In a stable and liquid market, obtaining multiple, firm quotes from dealers might be the most reasonable procedure. In a volatile or illiquid market, where such quotes are unavailable, the party may need to rely more on internal models, but it must be able to justify why that reliance was commercially reasonable under the circumstances.
• Documentation A core element of a reasonable procedure is the creation of a contemporaneous record of the steps taken. This includes documenting who was contacted for quotes, the quotes received (or the reasons why they were not available), the models used, the inputs for those models, and the rationale for the final determination.

The Elimination of Optionality and Punitive Measures

Another key strategic evolution was the removal of optionality in the payment methodology. The 1992 Agreement presented a choice between the “First Method” (one-way payments) and the “Second Method” (two-way payments). The First Method was a powerful strategic tool for a non-defaulting party, as it could withhold payment even if the net value of the terminated trades favored the defaulting party. This created a significant asymmetry in risk.

The 2002 Agreement completely eliminates the First Method. All close-outs operate on a two-way payment basis. This standardization is a strategic move toward greater market stability and fairness.

It ensures that the close-out process is purely a mechanism for settling the economic value of the terminated trades, removing the punitive element. For institutions, this means that the creditworthiness of a counterparty must be assessed on the basis of its ability to meet its obligations, without the backstop of a potentially punitive close-out calculation that could erase legitimate claims against the non-defaulting party.

The 2002 Agreement standardizes the close-out process by mandating two-way payments, focusing on economic settlement rather than punitive measures.

Comparative Valuation Frameworks

The strategic differences can be best understood through a direct comparison of the operational frameworks mandated by each agreement.

Execution

The execution of a close-out valuation under the 2002 ISDA Master Agreement demands a more rigorous, disciplined, and transparent operational protocol than its 1992 predecessor. The shift from a subjective standard to an objective one transforms the close-out process from an internal calculation into a defensible, auditable procedure. For an institution’s trading, legal, and operations teams, this requires a pre-emptive and systematic approach to valuation governance.

Operationalizing the Close-Out Amount

Executing a close-out under the 2002 Agreement is a multi-stage process that must be meticulously documented. The core challenge is to build a robust evidentiary file that demonstrates adherence to the standard of using “commercially reasonable procedures” to generate a “commercially reasonable result.”

A non-defaulting party, acting as the determining party, must design and follow a clear operational playbook. This playbook should be established well before any termination event occurs and should be part of the firm’s standard operating procedures for counterparty default management.

1. Immediate Assessment and Information Gathering Upon an Early Termination Date, the determining party must begin gathering all relevant information. This includes a complete inventory of all terminated transactions, their terms, and any associated collateral held or posted. The party must also assess the prevailing market conditions to determine the most appropriate valuation procedures. Is the market for the terminated assets liquid? Are reliable quotes obtainable?
2. Selection and Application of Valuation Inputs The determining party must decide which valuation inputs to use. The 2002 Agreement provides a non-exhaustive list of types of information that can be considered, including:
   • Market Quotations Obtaining quotes from leading dealers for replacement trades remains a primary input. The process should involve contacting multiple dealers and documenting the quotes received, or the reasons why quotes were unavailable.
   • Relevant Market Data This can include data from electronic trading platforms, clearing houses, and other recognized market sources that provide insight into the value of the terminated transactions or their hedges.
   • Internal Models If market quotes are unavailable or deemed unreliable, the party may use its own internal valuation models. Crucially, the party must be prepared to defend the model’s construction, its inputs, and its appropriateness for the specific transactions and market conditions. This involves a higher burden of proof than simply stating the model’s output.
3. Calculation and Documentation The final Close-out Amount is calculated by aggregating the gains, losses, and costs associated with replacing or hedging the economic equivalent of the terminated transactions. This calculation must be documented in detail, showing how the various inputs were synthesized into a final number. The documentation should be clear enough for a third party to understand the entire process from information gathering to final calculation.

How Does the Burden of Proof Differ in Practice?

The practical difference in the evidentiary burden between the two agreements is substantial. Under the 1992 “Loss” standard, the non-defaulting party had significant discretion. A challenger would need to prove that the party’s determination was irrational. Under the 2002 “Close-out Amount” standard, the determining party has the affirmative obligation to demonstrate the reasonableness of its actions.

This flips the script. The focus is on the quality and integrity of the determining party’s process.

The 2002 ISDA framework shifts the burden of proof, requiring the calculating party to affirmatively demonstrate the commercial reasonableness of its valuation process.

The table below outlines the contrasting operational workflows and evidentiary requirements for the determining party.

Ancillary Execution Considerations

The 2002 Agreement also introduced other refinements that affect the execution of a close-out. The inclusion of a standardized Set-Off provision (Section 6(f)) provides a clear mechanism for the non-defaulting party to set off the final early termination amount against other amounts owed between the parties, streamlining the final settlement process. Additionally, the provisions for default interest were refined.

Under the 2002 ISDA, the interest rate applied to a late payment by a defaulting party is different from the rate applied to a late payment by a non-defaulting party, addressing an inequity in the 1992 framework where a non-defaulting party could be forced to pay interest at the defaulting party’s higher cost of funding. These changes, while ancillary to the core valuation methodology, contribute to a more predictable and equitable execution of the entire close-out and settlement protocol.

Reflection

Calibrating Your Operational Architecture

The evolution from the 1992 to the 2002 ISDA Master Agreement is a signal of the market’s maturation. It reflects a systemic demand for greater transparency, objectivity, and procedural integrity in the critical moments of counterparty failure. The knowledge of these differences is foundational. The deeper challenge is to examine your own institution’s operational framework.

How is your firm architected to perform under the rigorous demands of the 2002 standard? Is your valuation process a robust, documented, and defensible protocol, or is it a legacy system reliant on individual judgment?

Viewing your counterparty risk management through this lens transforms it from a static legal issue into a dynamic operational capability. The strength of your valuation governance, the clarity of your internal playbooks, and the defensibility of your procedures are now core components of your competitive and strategic posture. The ultimate advantage lies in constructing an internal system that not only complies with the letter of the agreement but embodies its spirit of objective, commercial reasonableness in every executed step.