What is a Clearing House
Clearing houses are an intermediary between buyers and sellers of financial instruments. Further, it is an agency or separate corporation of an exchange responsible for 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.
Breaking Down the Clearing House
Clearing houses take the opposite position of each side of a trade. When two investors agree to the terms of a financial transaction, such as the purchase or sale of a security, a clearing house acts as the middle man on behalf of both parties. The purpose of a clearing house is to improve the efficiency of the markets and add stability to the financial system.
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 clearinghouse's margin requirements, sufficient to cover the member's debit balance.
Futures Clearing House Example
Assume that one trader buys an index futures contract. The initial margin required to hold this trade overnight is $6,160. This amount is held as a "good faith" assurance that the trader can afford the trade. This money is 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.
If the price goes against the trader, and they start losing money, exchanges also set maintenance margin requirements. If the account balance drops below a certain amount,say $5,600, the trader is required to top up the account to meet the initial margin. This is a margin call. 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 on any losses which may occur.
Profits and are realized when the trade is closed. When the trade is closed, the remaining margin funds are released and the trader can use them for other 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 the agreement, or come into financial trouble be unable to produce the funds to hold up their end of the bargain. The clearing firm takes this risk away from the individual trader, as each trader knows that the clearing firm wil be collecting enough funds from all trading parties that they don't need to worry about credit or default risk of the person on the other side of the transaction.
Stock Market Clearing Houses
Stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, have clearing firms. They assure that stock traders have enough money in their account, whether using cash or broker-provided margin, to fund the trades they are taking.
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.