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

Concept

The transition from the 1992 to the 2002 International Swaps and Derivatives Association (ISDA) Master Agreement represents a critical evolution in the architecture of over-the-counter (OTC) derivatives markets. This was a systemic upgrade, driven by the hard lessons learned from market crises of the late 1990s. The core of this evolution lies in the close-out mechanism, the contractual process for terminating transactions and calculating a final net payment when a default or other termination event occurs.

Understanding the distinction between the two standards is fundamental to grasping the modern framework of counterparty risk management. The 1992 Agreement provided a flexible but sometimes ambiguous framework, while the 2002 Agreement installed a more rigid, objective, and operationally demanding system designed to produce a predictable and commercially defensible outcome in times of market stress.

At the heart of the 1992 framework were two primary methods for calculating the termination payment ▴ “Market Quotation” and “Loss”. Market Quotation was intended to be an objective measure, based on obtaining quotes from reference market-makers for replacement trades. The Loss method was more subjective, allowing the non-defaulting party to determine in good faith its total losses and costs resulting from the termination. The 2002 Agreement retired this dualism.

It introduced a single, unified concept ▴ the “Close-Out Amount.” This concept was engineered to provide greater flexibility than the rigid Market Quotation method, which proved difficult to implement during periods of market illiquidity, while imposing a higher standard of objectivity than the Loss calculation. The shift to the Close-Out Amount reflects a foundational change in philosophy, moving the entire process toward a standard of demonstrable commercial reasonableness that could be scrutinized and validated by an objective third party.

The 2002 ISDA Master Agreement replaced the subjective valuation methods of its 1992 predecessor with a single, objective standard for calculating termination payments.

This structural change was a direct response to the systemic need for greater legal certainty and predictability in the close-out process. The earlier framework, with its elective methods, could lead to disputes over which valuation was appropriate and how it was conducted. The 2002 Agreement’s single standard, while more operationally intensive, was designed to minimize such disputes by establishing a clearer, more robust process. It compels the calculating party to adhere to a procedure that is transparent and grounded in market realities, thereby strengthening the enforceability of close-out netting, which is the bedrock of risk mitigation in the global derivatives market.

Strategy

The strategic redesign of the close-out mechanism in the 2002 ISDA Master Agreement introduced several critical changes that reshaped counterparty risk management. These changes were not merely technical adjustments; they represented a new strategic direction for the derivatives market, emphasizing objectivity, fairness, and operational robustness over the more subjective and flexible standards of the 1992 version.

The Evolution from Subjective to Objective Valuation

The most significant strategic shift is the standard for calculating the termination payment. The 1992 Agreement required the non-defaulting party to determine its “Loss” or “Market Quotation” amount by acting in a manner that was, in essence, rational. English courts interpreted this as the “Wednesbury test of reasonableness,” meaning the determination could only be challenged if it was so irrational that no reasonable non-defaulting party would have made it. This created a high bar for any challenge, granting considerable discretion to the calculating party.

The 2002 Agreement dismantled this subjective safe harbor. It introduced a two-pronged test for calculating the “Close-Out Amount”. The determining party must use “commercially reasonable procedures in order to produce a commercially reasonable result.” This is an objective standard. The process itself must be defensible, and the final number must be justifiable based on prevailing market conditions.

This change significantly raises the burden of proof on the calculating party, requiring a transparent and well-documented valuation process that can withstand external scrutiny. It strategically shifts risk from the defaulting party to the non-defaulting party, which now bears the responsibility of proving its calculations are objectively reasonable.

Standardizing the Payment Flow Two Way Payments

The 1992 Agreement contained a structural choice that had profound implications for fairness. Parties could select either the “First Method” or the “Second Method” for payment calculation. The First Method, often called a one-way payment, allowed a non-defaulting party to collect its net gains but did not require it to pay its net losses to a defaulting party. This was widely viewed as punitive.

The Second Method mandated a two-way payment, where a net sum was owed to the party that was “in the money,” regardless of which party had defaulted. Over time, the market overwhelmingly rejected the First Method. The 2002 Agreement codified this market consensus by eliminating the choice entirely. It provides only for a two-way payment system via the Close-Out Amount, establishing a more equitable and predictable standard that prevents a non-defaulting party from reaping a windfall at the expense of a defaulting party’s other creditors.

What New Termination Events Were Introduced?

The 1992 Agreement’s termination events were primarily focused on credit-related defaults and illegality. The market turmoil of the late 1990s and the events of September 11, 2001, exposed a gap in this framework. There was no clear mechanism for terminating contracts when performance became impossible or impractical due to external events that were not the fault of either party. The 2002 Agreement addressed this by introducing a “Force Majeure” Termination Event.

This provision allows either party to terminate transactions if an event beyond their control prevents performance. It provides a more orderly exit from contracts than relying on default provisions, which may not be applicable in such circumstances. This addition made the agreement more resilient to a wider range of market disruptions.

By integrating a Force Majeure clause, the 2002 Agreement provided a crucial mechanism for managing events that disrupt markets beyond the control of the contracting parties.

Integrating Set off Provisions

Another strategic enhancement in the 2002 Agreement was the inclusion of a standardized set-off provision. Set-off allows a non-defaulting party to reduce the amount it owes on close-out by any other amounts owed to it by the defaulting party outside of the ISDA Master Agreement. While parties could add a set-off clause to the Schedule of the 1992 Agreement, it was not part of the main body of the contract.

The 2002 Agreement integrated a broad set-off right directly into Section 6(f). This strengthened the legal basis for set-off, providing greater certainty and reducing the potential for legal challenges, particularly in cross-border insolvency proceedings.

Execution

The execution of a close-out under the 2002 ISDA Master Agreement is an operationally intensive process that demands precision, documentation, and a deep understanding of market mechanics. The shift to an objective standard of commercial reasonableness transformed the close-out calculation from a largely internal assessment into a defensible, auditable procedure. For the non-defaulting party, now known as the “Determining Party,” this imposes a significant procedural burden, but also provides a clear roadmap for arriving at a robust and enforceable final payment amount.

The Calculation of the Close out Amount

Executing the calculation of the Close-Out Amount is a multi-stage process. The Determining Party must, as of the Early Termination Date or as soon as reasonably practicable thereafter, determine the value of all terminated transactions. The 2002 Agreement grants flexibility in how this is done; the party may consider quotations from third parties, relevant market data, or information from internal models. The critical constraint is that whatever procedures are used, they must be commercially reasonable.

This means the Determining Party must be able to provide a clear rationale for its chosen valuation methodology. For example, if it uses a model, it must be prepared to explain the model’s inputs and assumptions and why that model is appropriate for the specific transactions and prevailing market conditions. If it relies on dealer quotes, it should obtain them from entities active in the relevant market. The process is designed to approximate the economic cost of replacing the terminated transactions in the current market.

This calculation must be performed for every single terminated transaction, after which the gains and losses are aggregated into a single net figure. This figure is then combined with any unpaid amounts due under the agreement to arrive at the final Close-Out Amount.

How Does the Objective Standard Affect Legal Risk?

The introduction of the objective “commercially reasonable” standard has significant consequences for legal risk and operational procedure. While the 1992 Agreement’s subjective standard made challenges difficult, the 2002 Agreement’s objective standard invites scrutiny. A defaulting party can now challenge a close-out calculation on the grounds that the procedures were flawed or that the result was inconsistent with market reality. This means the Determining Party must build a robust evidentiary record to support its calculation.

This heightened legal risk compels firms to adopt more rigorous internal governance around their close-out procedures. The process can no longer be an ad-hoc exercise. It must be systematic and well-documented.

Every decision, from the choice of valuation inputs to the selection of a valuation model, must be justifiable. This has led many firms to develop detailed internal playbooks for handling ISDA close-outs, specifying the sources of data to be used, the models to be applied, and the internal approvals required before a final Close-Out Amount is communicated to the counterparty.

A Determining Party under the 2002 Agreement must operate with the expectation that its close-out calculations may be subject to legal challenge and discovery.

• Documentation ▴ The execution of a close-out under the 2002 framework lives and dies by its documentation. The Determining Party must create a comprehensive record of its valuation process, including the data sources consulted, the models used, the quotes received, and the rationale for any judgments made. This record is the primary defense in the event of a dispute.
• Consistency ▴ The chosen valuation methodology must be applied consistently across all terminated transactions. Cherry-picking different methods for different trades to achieve a more favorable outcome would fail the “commercially reasonable procedures” test.
• Objectivity ▴ The process must be grounded in objective, observable market facts wherever possible. While models and expert judgment may be necessary for illiquid or complex products, their use must be justifiable and benchmarked against available market information.
• Good Faith ▴ Overarching the entire process is the continuing duty to act in good faith. This means the Determining Party cannot manipulate the calculation to inflate its claim or penalize the defaulting party. The objective is to produce a fair and accurate measure of the economic loss.

Reflection

The architectural evolution from the 1992 to the 2002 ISDA Master Agreement is a case study in how financial market infrastructure adapts to stress. The changes were not cosmetic; they were a fundamental reinforcement of the system’s foundations, designed to replace ambiguity with objectivity. For any institution operating in the derivatives space, understanding this evolution is a prerequisite for effective risk management. The framework you operate within dictates the tools you have at your disposal during a crisis.

Does your firm’s internal playbook for counterparty default reflect the procedural rigor demanded by the 2002 Agreement? Is the process for valuation sufficiently robust and documented to withstand the objective scrutiny it now invites? The knowledge gained here is a component in a larger system of operational intelligence. The ultimate strategic advantage lies in ensuring your internal framework is as robust and resilient as the market architecture it depends upon.