By: James Patterson, Volume 102 Staff Member

Imagine two roads running through a rural county. One is ungraded, dark, and winding. The other is straight, well lit, and nicely paved. Imagine also that the county’s roads have tolls that are levied based on the dangerousness of the type of vehicle (e.g., motorcycles pay more than cars).[2] After a slew of accidents, the county commissions a study that recommends two regulatory changes based on a conclusion that the paved road is the safest road. First, the county mandates that certain types of vehicles must use the paved road. At the same time, the county decides to decrease tolls on the paved road.

Note what is happening here. The same regulatory principle—the paved road is safer—is expressed in two related but distinct rules. Consider the difference in the possible effects of the two rules. Mandating use of the paved road has the potential to both divert traffic to the paved road and incentivize some drivers to not bother driving at all. The decrease in toll very likely will incentivize use of the paved road, increasing traffic on that road. At first blush all of this is a good thing. The paved road is safer, after all. But what if it isn’t as safe as the county thinks? And will the increase in traffic on the road contribute, paradoxically, to a decrease in safety?

In this brief Post, my aim is to point out a similar effect materializing in the regulation of over-the-counter (OTC) cleared derivatives.[3] The regulatory principle discussed here is the general view that derivatives cleared by a clearinghouse are safer. Clearinghouses offer several intermediary functions that reduce counterparty risk on trades.[4] However, the idea that these attributes make clearinghouses effective against systemic risk is not a forgone conclusion.[5] Implementing all manner of different regulations under the blunt principle that cleared transactions are safer may not sufficiently account for the effects of the rules on each other—and these effects could serve to undermine the principle itself. This Post calls attention to this very situation developing in OTC-cleared derivative regulation, suggesting it is a good time to examine the role of clearinghouses with renewed scrutiny.


The first regulations to consider are mandatory clearing requirements. In the context of the analogy, these regulations represent the county mandating vehicles to use a specific road. In June 2008, there was $683.7 trillion in outstanding over-the-counter derivatives contracts.[6] The regulatory principle here, again, is that clearinghouses are safer.[7] The rules simply require certain trades to be facilitated by clearinghouses to take advantage of the safety features of these entities.[8] Just like the premise that all vehicles would benefit from a more well-lit road, better-kept pavement, and fewer sharp turns, so too parties to derivative trades would benefit from the netting, collateral, and collective liability of clearinghouses. The system of mandatory clearing requirements is complex with many exceptions.[9] An analysis of the rules themselves can be saved for another day.

What general effects can we conclude the mandatory clearinghouse rule had on the derivatives market? That is, can we detect any broad macro-effects? Predictably, OTC derivative volumes have fallen since 2010 and the percentage of OTC derivative trades that use clearinghouses has increased. According to the Bank for International Settlements (BIS), at the end of June 2017, market value of OTC derivatives had dropped below $13 trillion, its lowest level since 2007.[10] Also unsurprisingly, the percentage of OTC derivative trades conducted through clearinghouses climbed to 51%.[11] It appears that our rough analogy holds. Clearinghouse requirements inevitably will make OTC derivatives trades unattractive for a range of investors that will simply opt for other trades. The traffic that continues, also predictably, largely uses the mandated “road.”


Capital requirements for financial institutions were, are, and will continue to be a debated topic. Generally, the theory is that financial institutions must maintain a specified amount of residual capital to guard against losses.[12] This is generally expressed as some form of the ratio of liabilities to assets.[13] However, this ratio can take on many forms. The series of conferences of the Basel Committee for Banking Supervision (Basel I, II, and III) generally advocated using capital ratios that use in their calculation a valuation of assets adjusted for risk.[14] There are many conceivable ways to categorize risk. Germane to this discussion are C.F.R. provisions that determine the capital risk adjustments based on attributes of derivative assets. Institutions regulated by the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) are all subject to a similar set of risk-weighting regulations.[15] Interestingly, by way of a footnote, clearinghouses have recently become incredibly significant in the calculation of risk of OTC-cleared derivatives for the purposes of capital ratios.

Derivative risk is determined under the regulations by the sum of two values: the current value of an asset and a regulation-defined value called Potential Future Exposure (PFE).[16] The PFE is determined by multiplying the notional amount of the contract by a multiplier given in Table One of the regulations.[17] The multiplier depends on the type of derivative and term of the contract.[18] Generally, the longer the term, the higher the multiplier, which leads to a higher PFE.[19] This makes sense, as it is reasonable to say that a risk taken on for a longer period of time constitutes more potential exposure to that risk.

Perhaps originally not considered in the tables, clearinghouses have become a key determinant in calculating PFE. One of the key functions of a clearinghouse in OTC-derivative trades is to collect margin payments from parties to the contract. The clearinghouse evaluates the value of the contract each day and adjusts the margin required from each party accordingly.[20] Notice how this “compresses” the maturity of a contract. Should economic or other conditions turn the outcome in favor of one of the party, that party does not have to wait until the maturity of the contract to realize its (potential) gain. That gain (and the counterparty’s loss) is essentially realized each day, when both parties must adjust their margin in response to the clearinghouse’s evaluation of the contract. This process, known as “marking to market,” therefore could be viewed as reducing time to maturity of a derivative contract to simply the next time the contract is “marked.” This function of clearinghouses enters into PFE regulatory scheme in footnote one of Table One of the respective regulations. It states that “[f]or a derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments in the derivative contract.”[21] So, if a derivative contract was settled on a daily basis—as cleared derivatives frequently are—then one could argue that the time outstanding to the next payment is one day. This puts any contract that is settled daily into the lowest multiplier bracket. Even if the term of the contract is greater than 5 years, settling daily means banks can use the lowest multiplier instead of the highest and as a result, the calculated risk exposure decreases. And of course this means that—almost by magic—a bank’s capital requirements would instantly decrease, meaning it would have more free capital to pursue other investments.

In August of 2017, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation released a three-page guidance appearing to indicate that cleared derivatives can indeed be considered settled daily.[22] Naturally, there is considerable debate on whether this is the correct interpretation,[23] but starting at the end of last year, firms have begun to adjust their accounting of derivatives accordingly.

First, the question is: what kind of effect can this interpretation of a footnote have on the valuation of derivatives, and consequently, capital ratios of financial institutions? The answer is: enormous. Prior to the shift in the interpretation of U.S. regulations, Switzerland-based UBS began considering cleared trades as settled daily, and saved nearly $300 million in cap space.[24] In the U.S., Goldman Sachs began accounting for OTC-cleared derivatives as settled daily beginning in the third quarter of fiscal year 2017. Goldman Sachs’ FY17 third quarter financials are noteworthy: By applying the new interpretation to its OTC-cleared derivatives, the firm reported a 96% decrease in interest assets.[25] Reported assets at the end of quarter two were $143 billion.[26] The quarter three reported assets was $5.27 billion, a remarkable drop of nearly $140 billion.[27] The precise net effect on capital ratios for Goldman is unclear, but undoubtedly beneficial.[28]

The next question is: What will financial institutions do with extra room in their capital cushion? Returning to our analogy, we might expect this to act to directly incentivize increased use of the clearinghouse “road.” After all, firms can enter potentially lucrative derivative transactions without penalty to capital ratios. This is what should draw the attention of regulators. We might expect to observe a firm adopting the interpretation, reporting a dramatic reduction in derivative value, and then increasing OTC-cleared derivative holdings, as the firm uses its free capital to enter more of the same trade. Goldman Sachs displayed exactly this tendency in its fiscal year 2017 fourth quarter financials. Following the dramatic drop outlined above to $5.27 billion, Goldman reported an increase of $119 million in OTC-cleared assets, an increase of 2.3%.[29]

This may or may not be significant, and it is difficult to predict with precision the behavior of financial institutions. But, note what is going on here. Expression of faith in clearinghouses manifests explicitly in regulations requiring OTC derivatives to be cleared (see Part I above), but this faith is also realized in measuring risk of assets and consequently, capital requirements. Both regulations appear to increase overall volume of OTC-cleared derivatives. Again, this is supposed to be a good thing. But what will the combined effects be?


Relatively recent history is a bitter reminder to forsake overconfidence in just about anything. Any gravitation to a corner of the market held up for its robust safety ought to raise questions. It’s worth picking up the debate of clearinghouses with new vigor. Clearinghouses are not invincible; if the financial regulatory system is driven a dependence on clearinghouses, what happens if one were to fail?[30] Further, there is room to argue that the benefits of clearing do not necessarily extend to all trades, particularly the complex bespoke OTC derivatives discussed here.[31] Changing various pieces of the regulatory scheme can indeed make a safe road more dangerous—an unfortunate situation after we just told everyone to drive on it.

  1. A little bit of history. The first formal clearinghouse in the United States was established right here at the Minneapolis Grain exchange in 1891. Ann E. Peck & Philip McBride Johnson, Futures Markets: Their Economic Role 6 (1985). The original building is just fourteen blocks from the University of Minnesota Law School.
  2. This seems to be supported by statistics. Traffic Safety Facts, 2012 Data, National Highway Traffic Safety Administration (2014), But see Motorcycles are Safer than Cars,, (last viewed Feb. 2, 2018).
  3. Over the counter transactions are arranged between the parties and are not conducted on an exchange. See generally Christopher L. Culp, OTC-Cleared Derivatives: Benefits, Costs, and Implications of the “Dodd-Frank Wall Street Reform and Consumer Protection Act”, 20 J. Applied Fin. 1 (2010).
  4. For a discussion on the functions of a clearinghouse and the benefits of cleared trades, see Mark J. Roe, Clearinghouse Overconfidence, 101 Cal. L. Rev. 1641, 1657–61 (2013).
  5. For a discussion on why clearinghouses may not have the systemic value they are touted to have, see Roe, supra note 2; Stephen J. Lubben, Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw, 10 Va. L. & Bus. Rev. 127 (2015); Craig Pirrong, The Clearinghouse Cure, 31 Regulation 44 (2008).
  6. Bank for International Settlements, OTC Derivatives Market Activity in the First Half of 2008 1 (2008),
  7. This of course is debated. See, e.g., Roe, supra note 4.
  8. Commodities Exchange Act as Modified by the Dodd-Frank Act §2(h)(1)(A).
  9. For example, the end-user exception. See generally Jeremy A. Liabo, The New Threat to Financial Reform: The End-User Exception to Dodd-Frank Mandatory Swap Clearance, 45 John Marshall L. Rev. 117 (2011).
  10. Bank for International Settlements, Statistical release: OTC derivatives statistics at end-June 2017 2 (2017),
  11. Id. at 5.
  12. See generally Michael S. Barr et al., Financial Regulation: Law and Policy 259–74 (2016).
  13. Id.
  14. Id. at 273. In the early Basel era, the U.S. also implemented a simple ratio of capital to average total assets. Id.
  15. The provisions in question here are those pertaining to risk adjustment for derivatives. The respective regulations are 12 C.F.R. § 3.34 for OCC-regulated institutions, 12 C.F.R. § 217.34 for Board-regulated institutions, and 12 C.F.R. § 324.34 for FDIC-supervised institutions. Table 1 of each of these sections follows identical calculations and from here on I will simply refer to “Table One.”
  16. 12 C.F.R. §3.34.
  17. Id.
  18. Id.
  19. See id. table 1 to § 3.34.
  20. See generally Barr et al., supra note 12 at 1084.
  21. Id.
  22. Regulatory Capital Treatment of Certain Centrally Cleared Derivative Contracts Under Regulatory Capital Rules (Aug. 14, 2017),
  23. Much of the debate of course centers on a characterization of the transaction. In uncleared margin derivatives, variable margin is considered collateral. Accordingly, the margin receiver is considered to be “holding” the funds and so applies interest, known as Price Alignment Interest, or PAI. If a payment is no longer considered holding of collateral, then it is considered a daily settling of profit and loss and resets the value to zero. It seems like PAI would not apply. But, there is a payment by the collateral receiver identical to PAI. Those in the settled-to-market camp argue that this payment is no longer interest, but exists just the same so that cleared and uncleared transactions are economically equivalent. There is substantial legal back-and-forth on the subject.
  24. Luke Clancy, UBS Saves Sfr295m in Capital via Swaps Margin Change, (Aug. 4, 2016),
  25. Goldman Sachs Group, Inc., Quarterly Report (Form 10-Q) 25 (Nov. 3, 2017).
  26. Id.
  27. See id.
  28. Lukas Becker, Goldman Swaps Assets Drop $140bn After Margin Change, (Nov. 6, 2017),
  29. Goldman Sachs Group, Inc., Annual Report (Form 10-K) 126 (Feb. 23, 2018).
  30. For a discussion on the potential systemic risk of clearinghouses, see David Skeel, What if a Clearinghouse Fails?, Brookings (Jun. 6, 2017),
  31. Craig Pirrong, The Clearinghouse Cure, 31 Regulation 44, 45 (2008) (“Clearing is not a one size fits all proposition because not all derivatives are alike.”).