What Is the Main Difference in the Close out Calculation between the 1992 and 2002 ISDA?

Concept

The transition from the 1992 International Swaps and Derivatives Association (ISDA) Master Agreement to its 2002 counterpart represents a fundamental re-architecting of the close-out calculation mechanism. This was a deliberate redesign, born from the practical challenges and potential inequities observed in the market. The core of this evolution lies in the shift away from a rigid, bifurcated valuation system toward a unified, principles-based framework. Understanding this distinction is paramount for any institution engaged in derivatives, as it directly impacts risk exposure, the enforceability of claims, and the operational procedures required upon the early termination of a transaction.

The 1992 ISDA Agreement presented the non-defaulting party with a choice between two distinct calculation methodologies ▴ “Market Quotation” and “Loss”. The Market Quotation method was predicated on a seemingly straightforward process of polling a prescribed number of reference market-makers to obtain firm quotes for a replacement transaction. This approach was designed to provide an objective, market-driven valuation.

The “Loss” method, conversely, functioned as a broader, indemnity-based calculation, allowing the non-defaulting party to determine in good faith its total losses and costs resulting from the early termination. This was intended as a fallback for situations where obtaining market quotes was impractical or impossible, such as in illiquid markets or times of systemic stress.

The 2002 ISDA Master Agreement introduces a single, more flexible “Close-out Amount” calculation, replacing the rigid dual-methodology of the 1992 version.

The 2002 ISDA Agreement dispenses with this dualistic structure. It introduces a single, consolidated calculation method known as the “Close-out Amount”. This modernized approach requires the determining party to calculate a termination payment by acting in good faith and using commercially reasonable procedures to produce a commercially reasonable result. This change was a direct response to the shortcomings of the 1992 framework.

The Market Quotation method, while objective in theory, often proved unworkable in practice. During periods of market turmoil ▴ precisely when defaults are most likely ▴ reference dealers were often unwilling or unable to provide the required firm quotes. This could force a non-defaulting party to rely on the Loss method, which itself was subject to disputes over the reasonableness of the loss calculation.

The Close-out Amount in the 2002 ISDA is a more holistic and adaptable mechanism. It explicitly permits the use of a wide range of information sources beyond just dealer quotes. These can include market data, prices from relevant exchanges, and information from internal pricing models, provided their use is commercially reasonable. This grants the calculating party the necessary flexibility to arrive at a fair valuation even when the market for a specific terminated transaction has seized up.

The emphasis shifts from a prescriptive process (obtaining a set number of quotes) to a prescriptive standard (commercial reasonableness). This evolution reflects a maturation of the derivatives market, recognizing that a single, rigid process cannot adequately address the complexities of valuation across all products and market conditions.

Strategy

The strategic implications of choosing between the 1992 and 2002 ISDA Master Agreements are significant, extending beyond mere legal preference to the core of a firm’s counterparty risk management and operational resilience. The primary strategic shift offered by the 2002 Agreement is the move from a test of “rationality” to a standard of “objective reasonableness” in its close-out calculations. This distinction, while seemingly subtle, has profound consequences for the certainty and defensibility of a close-out amount.

The Shift from Rationality to Reasonableness

Under the 1992 ISDA’s “Loss” methodology, the non-defaulting party’s calculation was subject to a test of rationality, often equated with the “Wednesbury unreasonableness” standard in English law. This meant that a calculation could only be successfully challenged if it was so irrational that no reasonable party could have arrived at it. This is a very high bar for a challenger to clear, granting considerable deference to the calculating party. While this might seem advantageous, it also created a degree of legal uncertainty and the potential for protracted disputes over whether a calculation, while perhaps aggressive, was technically “rational.”

The 2002 ISDA’s “Close-out Amount” imposes a stricter, dual-pronged standard. The determining party must use “commercially reasonable procedures” to produce a “commercially reasonable result.” This is an objective test. The focus is on what a reasonable market participant would do in similar circumstances, not just on whether the calculating party’s internal thought process was rational. This shift provides greater clarity and predictability for both parties.

The calculating party has a clearer roadmap for what is expected, and the other party has a more concrete basis for assessing the fairness of the outcome. The user guide to the 2002 ISDA explicitly states that this change was designed to introduce greater objectivity.

The 2002 ISDA’s requirement for “commercially reasonable procedures” establishes an objective standard, contrasting with the more subjective “rationality” test of the 1992 version.

Operational Flexibility in Distressed Markets

A key strategic advantage of the 2002 ISDA framework is its enhanced operational flexibility, particularly during periods of market stress. The 1992 Agreement’s reliance on the Market Quotation method could become a significant liability when liquidity evaporates.

• 1992 Market Quotation ▴ This method’s requirement for obtaining at least three firm quotes from reference market-makers could be impossible to satisfy during a systemic crisis, like the one following the Lehman Brothers collapse. Market makers may refuse to provide quotes for replacement transactions or may provide them at such wide bid-ask spreads that they do not reflect a fair market value.
• 2002 Close-out Amount ▴ This method provides a much wider toolkit for valuation. A non-defaulting party is not solely reliant on external quotes. It can use a variety of inputs, including:
  • Indicative quotes
  • Relevant market data (e.g. yield curves, volatility surfaces)
  • Internal, model-based valuations
  • Information about replacement transactions entered into

This flexibility allows for a more robust and defensible valuation process when traditional pricing sources are unavailable or unreliable. It empowers the non-defaulting party to construct a valuation that reflects economic reality, rather than being hamstrung by a procedural requirement that has become detached from market conditions.

How Does the Close out Calculation Impact Credit Risk Management?

The choice of ISDA Master Agreement has a direct impact on the effectiveness of a firm’s credit risk mitigation strategies. The increased certainty and objectivity of the 2002 ISDA’s Close-out Amount can lead to more accurate and less contentious valuations of counterparty exposure. This, in turn, can have a positive effect on the calculation of credit valuation adjustments (CVA) and the posting of collateral.

The table below compares the key strategic elements of the two agreements’ close-out methodologies:

Execution

The execution of a close-out under an ISDA Master Agreement is a critical process that demands precision and a thorough understanding of the governing contractual terms. The procedural differences between the 1992 and 2002 versions are substantial, and a failure to adhere to the correct methodology can result in significant financial and legal repercussions. For an institution’s legal and operations teams, mastering these differences is essential for effective risk management.

A Procedural Comparison of Close out Execution

Upon the occurrence of an event of default or a termination event, the non-defaulting party must meticulously follow the steps outlined in the agreement to calculate and claim the termination payment. The following table provides a high-level comparison of the execution process under both agreements:

What Constitutes a Commercially Reasonable Procedure?

The central execution challenge in the 2002 ISDA is interpreting and applying the standard of “commercially reasonable procedures.” While the agreement provides flexibility, it is not a license for the calculating party to simply choose the outcome that best suits its interests. Case law has established that both the process followed and the final result must be objectively reasonable. In practice, a firm executing a close-out under the 2002 ISDA should consider the following steps to ensure compliance:

1. Documentation ▴ Maintain a detailed record of all actions taken, information considered, and decisions made during the calculation process. This includes records of any quotes sought (even if indicative), market data snapshots, and the parameters used in any internal models.
2. Consistency ▴ Apply procedures that are consistent with the firm’s normal business practices for valuing similar instruments. Any deviation from standard procedures should be documented and justified.
3. Market Sounding ▴ Where practical, obtain information from third parties. This could involve seeking indicative quotes from dealers, even if they are not the firm quotes required by the 1992 Agreement. Obtaining a single quote from a reputable dealer can be sufficient if it is commercially reasonable to rely on it.
4. Model Validation ▴ If internal models are used, ensure they are properly calibrated and validated. The inputs to the model should be based on observable market data where possible.
5. Timeliness ▴ The calculation should be performed as of the early termination date, or as soon as reasonably practicable thereafter. Unwarranted delays can call into question the commercial reasonableness of the process.

The 2002 ISDA’s “Close-out Amount” framework provides greater adaptability in volatile markets compared to the more rigid methods of the 1992 agreement.

The shift from the 1992 to the 2002 ISDA represents a significant evolution in the mechanics of derivatives close-outs. The 2002 Agreement’s “Close-out Amount” provides a more robust, flexible, and objective framework that is better suited to the complexities of modern financial markets. For institutions, understanding and correctly executing these procedures is not just a matter of legal compliance; it is a fundamental component of sound counterparty risk management.

Reflection

The evolution from the 1992 to the 2002 ISDA Master Agreement reflects a deeper understanding of market dynamics under stress. The architectural shift toward a single, principles-based “Close-out Amount” is a testament to the market’s need for a valuation mechanism that is both robust and flexible. This progression prompts a critical examination of an institution’s own operational frameworks. Is your firm’s approach to counterparty risk and default management built on rigid, prescriptive rules, or does it embody a flexible, principles-based resilience?

The knowledge of these agreements is a component in a larger system of institutional intelligence. The ultimate strategic advantage lies in designing an operational architecture that can adapt and perform with integrity, especially when the markets are at their most unpredictable.