What Are the Primary Differences in the Close-Out Calculation between the Two Agreements?

Concept

When a derivatives contract terminates unexpectedly, the central challenge is one of valuation. The core distinction between the 1992 and 2002 International Swaps and Derivatives Association (ISDA) Master Agreements lies in the philosophical and methodological approach to this valuation. Your direct experience with the ambiguity of a counterparty default likely reveals the critical nature of this process. The 2002 Agreement was engineered to replace the procedural fragility and subjectivity inherent in its predecessor, establishing a new, more robust operational standard for the market.

The 1992 ISDA framework presented a choice between two primary valuation methods upon early termination ▴ Market Quotation and Loss. The first, Market Quotation, was a procedure-driven approach. It required the determining party to seek quotes from independent dealers for a replacement transaction. The second method, Loss, was a more discretionary, principle-based calculation where the determining party assessed its total economic damages.

The 1992 Agreement also contained a structural choice between the “First Method,” a one-way payment system where a defaulting party could never receive a payment, and the “Second Method,” which allowed for two-way payments. The market overwhelmingly adopted the Second Method, rendering the First Method obsolete and leading to its removal from the 2002 version.

The fundamental shift from the 1992 to the 2002 ISDA agreement is the replacement of a subjective rationality test with a standard of objective commercial reasonableness.

The operational deficiencies of the 1992 methods became apparent in turbulent markets. Market Quotation often failed when dealers, facing systemic stress, were unwilling or unable to provide the required quotes. Loss, conversely, was criticized for its inherent subjectivity, which could lead to disputes over whether the determining party’s calculation was truly “reasonable.” Legal precedent interpreted the 1992 standard of “reasonable determination in good faith” as a test of rationality, a relatively low bar for the calculating party to clear.

In response to these systemic weaknesses, the 2002 ISDA Master Agreement introduced a unified valuation standard known as the “Close-out Amount.” This single methodology dispenses with the binary choice of the 1992 version. Its central requirement is that the determining party must “act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result.” This language is not a cosmetic alteration; it represents a fundamental architectural change. Courts have affirmed that this imposes a higher, objective standard. The calculation must be one that a reasonable market participant would find commercially sound, effectively aligning the contractual process with the objective standard a court would apply.

Strategy

Selecting between the 1992 and 2002 ISDA Master Agreements is a strategic decision that directly impacts a firm’s allocation of counterparty risk, its operational burden during a crisis, and its litigation exposure. The choice is an architectural one, defining the system through which a firm will manage the financial consequences of a default. The strategies embedded within each agreement reflect different philosophies on discretion, transparency, and defensibility.

The Strategic Calculus of the 1992 ISDA Framework

The 1992 Agreement’s dual-method approach offers distinct strategic pathways, each with its own risk-reward profile.

• Loss Calculation This method provides maximum strategic flexibility. A firm with sophisticated internal valuation models and a strong view on its hedging costs might prefer this approach, as it allows those internal metrics to drive the close-out sum. The strategy here is to retain control over the valuation process. This discretion, however, creates a corresponding strategic risk. The subjectivity of the calculation makes it more susceptible to challenges from the counterparty, potentially leading to protracted and costly disputes.
• Market Quotation This protocol appears to offer a more objective, transparent strategy by relying on external market data. The strategic advantage is its procedural clarity. The critical flaw in this strategy is its fragility under pressure. In illiquid or systemically stressed markets ▴ precisely when a close-out is most likely ▴ the mechanism often breaks down. Dealers may refuse to provide quotes, or the quotes provided may not reflect a tradable market, rendering the process unreliable.

The 2002 ISDA a Unified Strategy of Objective Defensibility

The 2002 Agreement’s “Close-out Amount” methodology consolidates the valuation process into a single, more robust strategic framework. The core strategy is to create a valuation that is not just internally justifiable but externally defensible. By mandating “commercially reasonable procedures” to achieve a “commercially reasonable result,” the framework shifts the focus from subjective belief to objective evidence.

The strategic decision between the agreements hinges on a trade-off between the operational flexibility of the 1992 framework and the objective defensibility of the 2002 standard.

This single standard provides a more resilient system. It allows the determining party to use a range of inputs ▴ including third-party quotes, internal models, and market data ▴ so long as the process is commercially sound. This integrated approach avoids the procedural rigidity of Market Quotation while curbing the pure subjectivity of the Loss method.

The strategic payoff is a reduction in legal uncertainty and a higher probability that the calculated amount will withstand judicial scrutiny. A secondary strategic enhancement in the 2002 ISDA involves default interest, which provides for different rates depending on whether the payor is a defaulting party, a refinement absent from the 1992 version.

Comparative Strategic Frameworks

The following table outlines the core strategic differences between the valuation methodologies.

Execution

The execution of a close-out calculation is a precise operational protocol where the architectural differences between the two ISDA agreements become manifest. The procedural steps, permissible data inputs, and legal burdens diverge significantly, demanding distinct operational capabilities from the determining party.

Executing a Close-Out under the 1992 ISDA

Executing a valuation under the 1992 framework requires a firm to commit to one of two distinct procedural paths at the outset.

• Executing Market Quotation The operational mandate is to obtain quotes from four pre-agreed Reference Market-makers for a transaction economically equivalent to the terminated one. The highest and lowest quotes are then disregarded, and the remaining two are averaged to determine the settlement amount. The execution risk is procedural failure; if fewer than three quotes are obtained, the method fails, and the calculation typically reverts to the Loss method. This creates significant uncertainty in volatile markets where dealer participation is not guaranteed.
• Executing Loss This protocol is an internal valuation exercise. The determining party must calculate, in good faith, the total losses and costs it has incurred due to the early termination. This can include the cost of replacing the transaction or unwinding associated hedges. The execution requires robust internal systems for quantifying these economic damages. The process is operationally intensive and requires meticulous record-keeping to substantiate the “reasonableness” of the final figure, even if that standard is the lower bar of rationality.

What Is the Execution Protocol for the 2002 ISDA Close-Out Amount?

The execution of the 2002 “Close-out Amount” is a more dynamic and evidence-based process. It is designed to produce a result that is defensible to a neutral observer or a court. The determining party must use “commercially reasonable procedures,” a standard that was tested and clarified in cases like Lehman Brothers vs. National Power Corporation, which confirmed the standard is objective.

The execution is not tied to a single, rigid procedure. Instead, it involves gathering and synthesizing relevant information from multiple sources. The 2002 Agreement explicitly permits the use of various inputs to construct the final valuation. This flexibility is a core component of its design, intended to ensure a commercially sound result can be achieved even when certain data sources are unavailable.

Executing a 2002 ISDA close-out requires a firm to build a defensible portfolio of evidence demonstrating that its procedures and final result were objectively reasonable.

A key operational difference from the 1992 Market Quotation is that there is no mandated number of quotes; a single quote may suffice if relying on it is commercially reasonable under the circumstances. Furthermore, the 2002 ISDA explicitly allows for the inclusion of “execution fees” as part of the recoverable expenses, a clarification from the 1992 text.

Permissible Inputs for 2002 Close-Out Amount

The execution of a Close-out Amount calculation requires a systematic approach to data gathering and analysis. The following table details the types of information a determining party can use.

Reflection

The evolution from the 1992 to the 2002 ISDA Master Agreement reflects a maturation of the derivatives market’s operating system. The knowledge of these differences provides more than a legal or compliance advantage; it prompts a deeper introspection into a firm’s own operational architecture. How does your current framework align with the principles of objectivity and defensibility embodied in the 2002 standard? Are your internal valuation models and data sourcing protocols sufficiently robust to execute a “commercially reasonable” calculation under pressure?

How Does Your Counterparty Risk Framework Inform Agreement Choice?

The choice of governing agreement is an active instrument of risk management. Your firm’s strategy for counterparty selection, risk tolerance, and dispute resolution should directly inform which framework is employed. Viewing this decision as a static back-office function is a systemic vulnerability. Instead, it should be integrated into the firm’s broader system of intelligence, a dynamic component of a superior operational framework designed to preserve capital and ensure execution certainty in all market conditions.