What Is the Difference between the 1992 and 2002 Isda Close out Provisions?

Concept

From Ambiguity to Precision in Counterparty Risk

The evolution from the 1992 to the 2002 International Swaps and Derivatives Association (ISDA) Master Agreement represents a critical upgrade in the operating system of the global derivatives market. This progression was not a matter of minor textual adjustments; it was a fundamental re-engineering of the protocols governing how financial institutions manage counterparty default. The core of this redesign lies within the close-out provisions, which dictate the process for terminating transactions and calculating a final settlement amount when a counterparty fails. Understanding the distinction between these two frameworks is essential for appreciating the market’s matured approach to systemic risk, moving from a system that allowed for significant subjectivity to one that mandates a more rigorous, transparent, and equitable process for resolving distressed exposures.

At the heart of the 1992 ISDA’s close-out mechanism was a choice between two distinct valuation methodologies ▴ “Market Quotation” and “Loss.” Market Quotation was designed to be an objective measure, derived from quotes solicited from leading dealers for replacement trades. In practice, during the very moments of market stress when it was most needed, obtaining these quotes became exceedingly difficult, rendering the mechanism fragile. The alternative, “Loss,” was an indemnity-based calculation, granting the non-defaulting party broad discretion to determine its total losses and costs in good faith.

This flexibility, while practical, introduced a level of subjectivity that could lead to disputes and perceptions of unfairness. The 1992 framework also contained the now-obsolete “First Method” payment option, a one-way payment system where a defaulting party could not receive a net gain, a provision widely viewed as punitive and largely abandoned in practice in favor of the two-way “Second Method.”

The 2002 ISDA introduced a unified and objectively grounded valuation standard, replacing the bifurcated and less reliable methods of its predecessor.

The 2002 ISDA Master Agreement emerged from the lessons learned during the market crises of the late 1990s, which exposed the structural weaknesses of the 1992 framework. Its primary innovation was the replacement of the dual valuation methods with a single, more robust concept ▴ the “Close-out Amount.” This new methodology was engineered to be a hybrid, combining the flexibility of the “Loss” calculation with stronger requirements for objectivity and transparency. It obligates the determining party to use “commercially reasonable procedures in order to produce a commercially reasonable result,” a standard that English courts have interpreted as requiring objective reasonableness in both the process and the outcome.

This shift represents a profound change in the system’s architecture, moving the determination of damages from a subjective assessment of one party’s internal losses to a more externally verifiable and defensible calculation of market-based replacement costs. This fundamental redesign enhances legal certainty and promotes fairness, reflecting a more sophisticated understanding of risk management in an increasingly interconnected financial system.

Strategy

Systemic Upgrades in Default Management Protocols

The strategic divergence between the 1992 and 2002 ISDA close-out provisions reveals a deliberate effort to enhance the stability and predictability of the over-the-counter (OTC) derivatives market. The 2002 Agreement is not merely an update but a strategic overhaul designed to address the operational vulnerabilities identified in its predecessor. The central strategic shift was the move from a menu of elective, and at times problematic, procedures to a single, standardized, and more resilient protocol for calculating termination payments. This transition reflects a strategic decision by the industry to prioritize legal certainty and procedural fairness over the broader, more ambiguous discretion afforded by the 1992 framework.

Valuation Philosophy a Fundamental Pivot

The most significant strategic departure lies in the philosophy of valuation upon default. The 1992 ISDA presented a choice that created inconsistency in the market, forcing parties to elect between the rigid “Market Quotation” and the highly discretionary “Loss” method. The 2002 ISDA’s “Close-out Amount” consolidates these into a single, more sophisticated methodology.

It empowers the determining party to use a wider array of inputs ▴ including third-party quotes, relevant market data, and even internal information ▴ while holding it to a higher standard of objective, commercial reasonableness. This change was a direct response to the failure of the Market Quotation method to function effectively during periods of market turmoil, when dealer quotes become scarce or unreliable.

Reinforcing the Contractual Framework

Beyond valuation, the 2002 ISDA introduced several other strategic enhancements to the default management process. These changes were designed to create a more comprehensive and responsive system for addressing credit events.

• Elimination of One-Way Payments ▴ The 1992 ISDA permitted the “First Method,” where only the non-defaulting party could receive a payment upon close-out. This was widely seen as punitive. The 2002 ISDA mandates two-way payments, ensuring that if the net value of the terminated trades is in favor of the defaulting party, a payment must be made to them. This creates a more equitable system.
• Introduction of Force Majeure ▴ The 2002 Agreement added a “Force Majeure” Termination Event. This provides a clear, no-fault pathway for terminating transactions when performance becomes impossible due to events outside a party’s control, a critical feature for a global market susceptible to geopolitical and other external shocks.
• Standardized Set-Off Rights ▴ While parties often added set-off provisions to the 1992 Schedule, the 2002 ISDA incorporates a standardized set-off right directly into the main agreement. This allows the non-defaulting party to net the final close-out amount against other amounts owed between the two parties under different agreements, providing greater clarity and efficiency in the final settlement process.

The 2002 ISDA framework was engineered to function robustly under stress, replacing procedural fragility with systemic resilience.

Collectively, these strategic modifications demonstrate a move toward a more standardized, transparent, and resilient market infrastructure. The 2002 ISDA reduces ambiguity, closes loopholes, and establishes clearer protocols that are better equipped to handle the complexities and pressures of a major counterparty default. The framework acknowledges that in a systemic crisis, legal and procedural clarity are paramount to maintaining market stability.

Execution

Operational Mechanics of the Close-Out Process

The execution of the close-out process under the ISDA Master Agreement is a precise, multi-step procedure that demands operational readiness and a deep understanding of the governing framework. The differences in the operational mechanics between the 1992 and 2002 versions are substantial, particularly concerning the determination of the final settlement amount. The 2002 Agreement imposes a more rigorous and documented process on the determining party, reflecting the market’s demand for greater transparency and accountability in the execution of a close-out.

Procedural Flow under the 1992 Agreement

Under the 1992 ISDA, the execution path for a non-defaulting party depended heavily on the pre-negotiated choice of either Market Quotation or Loss. This choice dictated the entire operational workflow for calculating the Settlement Amount.

1. Designation of an Early Termination Date ▴ Upon the occurrence of an Event of Default, the non-defaulting party provides notice to the defaulting party, designating an Early Termination Date for all outstanding transactions.
2. Calculation of Settlement Amount ▴ The non-defaulting party proceeds with the calculation based on the elected method.
   • If Market Quotation ▴ The party was required to attempt to obtain quotes from at least three leading dealers (Reference Market-makers) for the replacement cost of the terminated transactions. The process had specific rules for averaging the quotes. If fewer than three quotes were obtainable, or if the method was believed to produce a commercially unreasonable result, the framework would revert to the Loss method.
   • If Loss ▴ The party would calculate its total gains and losses resulting from the termination. This calculation was an internal process, guided by a good faith and reasonableness standard, but without a prescribed methodology, allowing for significant discretion.
3. Determination of Final Payment ▴ The calculated Settlement Amount is combined with any Unpaid Amounts (payments that were due but not made prior to termination) to arrive at the final figure owed by one party to the other.

The Enhanced Execution Protocol of the 2002 Agreement

The 2002 ISDA streamlines the process by mandating a single calculation methodology, the Close-out Amount, but surrounds it with more demanding procedural requirements. The focus shifts from a choice of methods to a robust and defensible execution of a single, flexible method.

A Stricter Standard of Commercial Reasonableness

The most critical aspect of executing a close-out under the 2002 ISDA is adhering to the heightened standard of commercial reasonableness. As established by English court rulings, this is not a subjective test of what the non-defaulting party believes is reasonable, but an objective one. The party must be prepared to demonstrate to an objective third party that its valuation process was sound and the final number was fair. This means that operational procedures must be in place to:

• Systematically gather valuation data ▴ This includes recording efforts to obtain third-party quotes, gathering relevant market data (e.g. yield curves, volatility surfaces), and, if internal models are used, being able to show that these models are consistent with those used in the normal course of business.
• Document the decision-making process ▴ Key decisions, such as the choice of valuation inputs or the reason for discarding certain quotes, should be documented to create a clear audit trail.
• Ensure consistency ▴ The valuation methodology should be applied consistently across similar types of terminated transactions.

This operational discipline is fundamental. The 2002 ISDA, by design, shifts the burden of proof more heavily onto the party performing the calculation. It demands a level of procedural rigor and transparency in execution that was not explicitly required by the 1992 framework, thereby creating a more stable and predictable system for resolving defaults in the global derivatives market.

Reflection

An Evolving Architecture for Market Resilience

The transition from the 1992 to the 2002 ISDA close-out provisions is more than a historical footnote in contract law; it is a case study in the maturation of a market’s core operating system. The framework evolved to meet the demands of a more complex and interconnected financial world, replacing ambiguity with a mandate for objective, defensible action. This progression prompts a critical question for any market participant ▴ does your own operational framework for risk management and default scenarios possess the same level of clarity, robustness, and procedural integrity?

The knowledge of these provisions is a component of a larger system of intelligence. The ultimate strategic advantage lies in ensuring that internal protocols for valuation, documentation, and execution are not merely compliant, but are architected with the same principles of resilience and transparency that the market itself has learned to demand.