What Are the Key Differences in the Close-Out Calculation Methodology between the 1992 and 2002 Isda Agreements?

Concept

The transition from the 1992 to the 2002 International Swaps and Derivatives Association (ISDA) Master Agreement represents a critical evolution in the market’s core operating system for managing counterparty default. Viewing this shift through a systemic lens reveals a deliberate architectural upgrade designed to enhance stability, reduce legal ambiguity, and align default protocols with a more mature and complex financial landscape. The fundamental change resides in the philosophy of valuation.

The 2002 Agreement codifies a move away from a subjective, often opaque, standard of conduct toward an objective, transparent, and commercially defensible framework. This was a necessary re-engineering of the market’s foundational risk management protocols.

At the heart of any ISDA Master Agreement lies the mechanism for closing out transactions upon a termination event, such as a default. This process involves calculating a single net figure that represents the combined value of all outstanding trades between the two parties. The 1992 Agreement approached this with a degree of flexibility that, while accommodating, ultimately created uncertainty. It offered parties a choice between two distinct valuation methodologies, “Market Quotation” and “Loss,” and two different payment outcomes, the “First Method” and “Second Method.” This optionality introduced significant variance into the close-out process, making outcomes less predictable and more susceptible to dispute.

The 2002 ISDA streamlined this architecture. It replaced the dualistic valuation and payment options with a single, unified concept ▴ the “Close-out Amount.” This was more than a semantic change; it was a fundamental redesign of the system’s logic. The new framework is predicated on the principle of “commercial reasonableness,” a standard that is both procedural and substantive.

The determining party is required to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This introduces a higher standard of care, moving the valuation from a private, potentially self-serving calculation to one that must withstand objective scrutiny based on prevailing market practices. This shift reflects a deeper understanding of the interconnectedness of the financial system, where the failure of one participant can have cascading effects, demanding a close-out process that is robust, fair, and consistently applied.

The core distinction lies in the 2002 ISDA’s mandate for an objectively “commercially reasonable” result, replacing the 1992 ISDA’s more subjective “rational” standard.

What Was the Core Systemic Flaw the 2002 Isda Addressed?

The primary systemic flaw addressed by the 2002 ISDA was the inherent uncertainty and potential for inequitable outcomes embedded in the 1992 Agreement’s close-out mechanism. The 1992 framework’s optionality, particularly the existence of the “First Method” payment option, created a structural vulnerability. Under the First Method, if the net value of the terminated transactions was positive for the defaulting party, the non-defaulting party was not obligated to make a payment. This one-way payment system allowed the non-defaulting party to realize a windfall at the expense of the defaulter’s other creditors, a practice that was widely criticized and rarely agreed to in practice but remained a part of the architecture.

The 2002 ISDA corrected this by making two-way payments mandatory, ensuring that the net value of the portfolio is honored regardless of which party is in the money. This structural change promotes fairness and aligns the close-out process with the broader principles of insolvency law, preventing the non-defaulting party from gaining an undue advantage.

Furthermore, the “Market Quotation” method under the 1992 Agreement was procedurally rigid. It required the non-defaulting party to obtain quotes from at least three major dealers in the relevant market for replacement transactions. While intended to provide an objective valuation, this process could be cumbersome, especially in illiquid or stressed market conditions where obtaining such quotes was difficult or impossible. The alternative, the “Loss” method, was a more subjective measure of the party’s total losses and costs resulting from the termination.

The 2002 ISDA’s “Close-out Amount” integrates the best aspects of both, providing greater flexibility in the types of information that can be used ▴ including internal models, data from a single third party, and other relevant market data ▴ while holding the entire process to the higher standard of commercial reasonableness. This adaptive framework is better suited to the diverse and dynamic nature of modern derivatives markets.

Strategy

The strategic redesign of the close-out methodology in the 2002 ISDA Master Agreement was a direct response to a decade of market experience and legal challenges that revealed the structural limitations of the 1992 framework. The goal was to engineer a more resilient, transparent, and legally defensible system for managing counterparty credit risk. The strategy can be deconstructed into several key architectural upgrades, each designed to minimize disputes, enhance predictability, and ensure that close-out valuations reflect a fair market value, even in times of systemic stress.

Unification of the Valuation Process

The 1992 ISDA presented a bifurcated approach to valuation that created operational complexity and potential for strategic selection of the method that most favored the calculating party. A non-defaulting party had to choose between two distinct methods ▴ Market Quotation or Loss. The 2002 ISDA’s strategy was to eliminate this dichotomy and replace it with a single, more flexible, and robust standard known as the “Close-out Amount.”

• Market Quotation (1992 ISDA) ▴ This method was highly prescriptive. It required the determining party to seek quotations for a replacement transaction from leading dealers in the relevant market (Reference Market-makers). The standard required a minimum of three such quotes to establish a reliable market price. This mechanical process was intended to produce an objective valuation, but its rigidity was a significant weakness. In volatile or illiquid markets, or for highly customized transactions, obtaining the requisite number of quotes could be impractical or impossible, forcing a fallback to the Loss method.
• Loss (1992 ISDA) ▴ This method was a broader, more subjective measure. It allowed the determining party to calculate its total losses and costs arising from the early termination, including the loss of bargain and the cost of hedging. While more flexible than Market Quotation, its subjective nature made it prone to disputes, as the defaulting party could challenge the reasonableness of the claimed losses.

The 2002 ISDA’s “Close-out Amount” synthesizes these concepts into a unified framework. It dispenses with the rigid requirement for multiple quotes and instead allows the determining party to use a wide range of information to arrive at a valuation. This can include quotes from third parties (even a single quote is sufficient), relevant market data, and information from internal sources, provided the procedures used are commercially reasonable. This approach acknowledges that in a sophisticated market, a single, definitive “market price” may not exist, and a commercially reasonable valuation can be derived from various reliable sources.

The 2002 framework strategically empowers the calculating party with flexibility in sourcing valuation data while simultaneously imposing a higher, objective standard of commercial reasonableness on the outcome.

Mandating Equitable Payment Flows

A critical strategic shift was the elimination of the optionality in payment obligations. The 1992 ISDA allowed parties to choose between two payment methods, a choice with profound economic consequences.

• First Method (1992 ISDA) ▴ A one-way payment provision. If the net close-out amount was owed to the defaulting party, the non-defaulting party was not required to pay it. This “walk-away” clause was highly controversial as it provided a potential windfall to the non-defaulting party and violated the principle of equitable treatment of creditors in an insolvency.
• Second Method (1992 ISDA) ▴ A two-way payment provision. The net close-out amount is paid regardless of which party is the defaulter. The party that is “in the money” on a net basis receives the payment.

By the time the 2002 ISDA was drafted, market practice had overwhelmingly rejected the First Method as inequitable. The 2002 Agreement codified this market consensus by making the Second Method (two-way payments) the only permissible approach. This was a strategic decision to enhance legal certainty and fairness, ensuring that the close-out process settles the economic value of the terminated trades without creating an arbitrary penalty against the defaulting party.

Elevating the Standard of Conduct

Perhaps the most significant strategic change was the redefinition of the standard of conduct for the party calculating the close-out amount. This change has been the subject of extensive legal interpretation and has fundamentally altered the responsibilities of the determining party.

The 1992 ISDA required the determining party to act in “good faith and a commercially reasonable manner.” Courts often interpreted this as a test of rationality, meaning the calculation would be upheld as long as it was not arbitrary, perverse, or utterly unreasonable. This was a relatively low bar to clear.

The 2002 ISDA imposes a more stringent, two-part standard. The determining party must use “commercially reasonable procedures in order to produce a commercially reasonable result.” This dual requirement for both the process and the outcome to be commercially reasonable introduces a standard of objective reasonableness. The calculation is no longer judged by the subjective rationality of the determining party but by what an objective, informed third party would consider reasonable in the relevant market. This strategic enhancement was designed to reduce the incidence of aggressive or self-serving valuations and to provide a clearer, more defensible basis for close-out calculations, thereby reducing legal risk for all market participants.

The following table compares the key strategic elements of the two agreements:

Execution

The execution of a close-out calculation under the ISDA Master Agreements is a precise operational procedure. The shift from the 1992 to the 2002 framework fundamentally re-architected this procedure, moving from a rigid, choice-based system to a flexible, principle-based one. Understanding the execution differences is critical for any institution’s risk management and legal functions, as the documentation and defense of a close-out calculation have become more sophisticated.

An Operational Playbook for Close-Out

To illustrate the execution differences, consider a hypothetical scenario ▴ a bank (Non-defaulting Party) must terminate a portfolio of five interest rate swaps with a corporate counterparty (Defaulting Party) that has just filed for bankruptcy. The Early Termination Date is declared as of today.

Execution under the 1992 ISDA (Assuming Market Quotation and Second Method)

1. Identify Reference Market-makers ▴ The bank’s operations team must first identify at least three, and ideally five, leading dealers in the relevant interest rate swap market who are willing and able to provide quotes. This list must be commercially reasonable.
2. Solicit Quotations ▴ The team must contact each Reference Market-maker and request a firm quotation for entering into a replacement transaction that mirrors the material terms of the terminated swaps. The request must specify that the quote is for calculating a close-out amount under an ISDA Master Agreement.
3. Receive and Average Quotes ▴ As quotes are received, they are logged. If at least three quotes are obtained, the bank will typically disregard the highest and lowest (if five or more are received) and average the remaining ones to determine the Market Quotation. If fewer than three quotes are obtained, the method fails, and the bank must revert to calculating its “Loss.”
4. Calculate Settlement Amount ▴ The averaged Market Quotation is combined with any “Unpaid Amounts” (i.e. payments that were due but not made prior to termination) to arrive at the “Settlement Amount.”
5. Determine Final Payment ▴ Because the parties selected the “Second Method,” the Settlement Amount is payable whether it is positive or negative for the bank. The bank sends a statement to the Defaulting Party detailing the calculation and the final amount owed.

Execution under the 2002 ISDA

1. Determine Valuation Strategy ▴ The bank’s risk and legal teams convene to decide on the most commercially reasonable procedure to value the swap portfolio. They are not bound by the “multiple quotes” framework. They might decide that obtaining one firm quote from a top-tier dealer, combined with their own internal, model-based valuation (which is regularly used and validated), and supplemented with observable market data (e.g. Bloomberg CBBT), constitutes a commercially reasonable procedure.
2. Gather Valuation Inputs ▴ The operations team executes the strategy. They may obtain a single indicative quote, run the portfolio through their internal valuation models, and collate all supporting market data. They also consider any costs or gains related to unwinding hedges associated with the terminated trades.
3. Document the Process ▴ Crucially, every decision and data point is meticulously documented. Why was a particular dealer chosen for a quote? How is the internal model calibrated and validated? What market data was deemed relevant? This documentation is essential to defend the “commercially reasonable procedure” prong of the standard.
4. Calculate Close-out Amount ▴ The bank synthesizes all the gathered information to determine a single “Close-out Amount.” This figure represents the total losses or gains of terminating the transactions. The calculation must produce a “commercially reasonable result.”
5. Determine Early Termination Amount ▴ The Close-out Amount is combined with any Unpaid Amounts to arrive at the “Early Termination Amount.” A statement is prepared and sent to the Defaulting Party, detailing the calculation and providing sufficient information to show how the result was reached.

Quantitative Modeling and Data Analysis

The difference in execution is most apparent in the quantitative aspect of the calculation. The following table provides a simplified, hypothetical comparison of the data and calculations involved.

How Does the 2002 Isda Affect System Architecture?

The execution requirements of the 2002 ISDA have significant implications for a financial institution’s internal systems and technology architecture. Compliance with the “commercially reasonable” standard necessitates a more robust and integrated infrastructure.

Systems must be capable of capturing and archiving a wide array of market data used in valuations. This includes not only third-party quotes but also internal model outputs, calibration data, and records of relevant market activity at the time of the close-out. The ability to reconstruct the market environment on the Early Termination Date is critical for defending a calculation.

Furthermore, model risk management becomes paramount. If internal models are used as a primary input for the Close-out Amount, the firm must have a rigorous framework for model validation, back-testing, and documentation. This framework must be sufficient to demonstrate to a court or regulator that reliance on the model was a commercially reasonable procedure. The architecture must also support detailed audit trails, logging every step of the close-out calculation, from data sourcing to the final determination, creating an unassailable record of the process undertaken.

Reflection

The evolution from the 1992 to the 2002 ISDA close-out methodology provides a clear directive for market participants. It underscores that in a systemic crisis, a valuation process must be more than just internally consistent; it must be externally defensible. The knowledge of these differences prompts a critical self-assessment. Does your institution’s current operational framework for derivatives termination possess the robustness to meet the objective standard of commercial reasonableness?

Is the process for data collection, model validation, and record-keeping architected to produce a defensible audit trail years after the event? The 2002 ISDA framework is a component in a larger system of institutional risk intelligence. Mastering its execution is a foundational element in building a truly resilient operational structure, one that not only manages risk but provides a strategic advantage in moments of market dislocation.