What is a Clearing House?
A clearing house acts as an intermediary between a buyer and seller and seeks to ensure that the process from trade inception to settlement is smooth. Its main role is to make certain that the buyer and seller honor their contract obligations. Responsibilities include settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery of the bought/sold instrument, and reporting trading data. Clearing houses act as third parties to all futures and options contracts, as buyers to every clearing member seller, and as sellers to every clearing member buyer.
Understanding Clearing House
The clearing house enters the picture after a buyer and seller have executed a trade. Its role is to consolidate the steps that lead to settlement of the transaction. In acting as the middleman, a clearing house provides the security and efficiency that is integral for financial market stability.
Clearing houses take the opposite position of each side of a trade which greatly reduces the cost and risk of settling multiple transactions among multiple parties. While their mandate is to reduce risk, the fact that they have to be both buyer and seller at trade inception means that they are subject to default risk from both parties. To mitigate this, clearing houses impose margin (initial and maintenance) requirements.
The futures market is most commonly associated with a clearing house, since its financial products are leveraged and require a stable intermediary. Each exchange has its own clearing house. All members of an exchange are required to clear their trades through the clearing house at the end of each trading session and to deposit with the clearing house a sum of money, based on the clearing house's margin requirements, sufficient to cover the member's debit balance.
- A clearing house acts as an intermediary between a buyer and seller and seeks to ensure that the process from trade inception to settlement is smooth.
- In acting as the middleman, a clearing house provides the security and efficiency that is integral for financial market stability.
- To mitigate default risk, clearing houses impose margin (initial and maintenance) requirements.
Futures Clearing House Example
Assume that a trader buys a futures contract. At the outset the clearing house sets the initial and maintenance margin requirements. The initial margin can be viewed as a "good faith" assurance that the trader can afford to hold the trade until it is closed. These funds are held by the clearing firm, within the trader's account, and can't be used for other trades. This helps offset any losses the trader may experience while in a trade.
The maintenance margin, usually a fraction of the initial margin requirement, is the amount that has to be available in the trader's account to keep the trade open. If the trader's account equity drops below this threshold then the account receives a margin call and has to be replenished to satisfy the initial margin requirements.
If the trader doesn't meet the margin call, the trade will be closed since the account cannot reasonably withstand further losses. This way, there is always sufficient money in the account to cover any losses which may occur. When the trade is closed, the remaining margin funds are released and the trader can use them to place future trades.
This process helps reduce the risk to individual traders. For example, if two people agree to trade, and there is no one else to verify and back the trade, it is possible that one party could back out of the agreement, or be unable to produce the funds to hold up their end of the transaction. This is termed transactional risk and is obviated by the involvement of a clearing house. Each party to the trade knows that the clearing house will have collected enough funds from both parties to quell worries about credit or default risk from either party.
Stock Market Clearing Houses
Stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, have clearing firms. They ensure that stock traders have enough money in their account, whether using cash or broker-provided margin, to fund the trades they are placing.
The clearing division of these exchanges acts as the middle man, helping facilitate the smooth transfer of funds. When an investor sells a stock they own, they want to know that the money will be delivered to them. The clearing firms makes sure this happens. Similarly, when someone buys a stock, they need to be able to afford it. The clearing firm makes sure that the appropriate amount of funds is set aside for trade settlement when someone buys stocks.