What is the International Clearing System?
The International Clearing System is a trading system used when futures contracts or other eligible transactions occur on an international or an inter-country level. It is designed to promote world trade and market efficiency. Most international clearing transactions are administered by an international clearing house.
- The international clearing system is used to clear trades when the parties involved are in different countries.
- Clearing is necessary in order to facilitate efficient trade where the parties know the transaction will be settled in an orderly fashion.
- The London Clearing House Ltd. is the major player in terms of international clearing.
Understanding the International Clearing System
The process of clearing a trade includes all actions and events that take place between the commitment to transact and the settlement. It essentially converts the promise to pay money and deliver the contract into an actual transfer of each from one account to the other.
Clearing is necessary for the matching of all buy and sell orders in the market. It confirms the specific type and quantity of the traded instrument, the transaction price, date, and the identity of the buyer and seller. It creates more efficient markets as parties interact with the clearing corporation rather than with each other.
For example, if a company wanted to purchase a futures contract for wheat from a foreign party, they would need to contact a clearing house, which will use the international clearing system to match the trade with another party. The other party, who will assume the opposite position (selling the wheat contract) in the futures contract, will have also contacted a clearing house in their respective country, who will also use the international clearing system.
Individual countries have their own clearing mechanisms and requirements. Therefore, in a global world with parties trading futures outside of their home markets, a system to coordinate internationally is a must. One of the firms serving in this role is the London Clearing House Ltd. (LCH).
History of the International Clearing System
The function of international clearing was initially performed by the International Commodities Clearing House (ICCH). The ICCH was an independent clearing house providing clearing or central counterparty services in several markets.
The ICCH changed its name to the London Clearing House Ltd. (LCH) in 1992. The company continued to operate as it had before, assuming the counterparty risk when two parties trade, guaranteeing the settlement of the trade. To mitigate risk, it imposes minimum requirements on members and collects initial and variation margin or collateral for executed trades.
The LCH's members include most major investment banks, broker dealers, and international commodity houses. Oversight is by the national securities regulator or central bank in each jurisdiction in which the LCH operates.
The LCH operates an open-access model with a choice of execution venues. LCH Ltd. is the group’s UK-registered clearing house. It has clearing services for rates, foreign exchange, repurchase agreements, or repos, and fixed income, commodities, cash equities, equity derivatives, and other financial products.
In 2003, the LCH merged with Paris's Clearnet, a clearing house for the Paris markets.
Example of an International Clearing House Trade
Assume that a U.S. investor is buying a contract from Tokyo. Therefore, assume the buyer is a U.S. resident and the seller is from Japan.
The international clearing house will receive the trade details including the type and quantity of the traded instrument, the price, the trade date, and the identity of the buyer and seller. This information comes from local institutions or domestic clearing houses.
The international clearing house has relationships with the domestic institutions, clearing houses (called clearing members), and banks which allow the international clearing house to guarantee transactions since the clearing members are handling the trade details and the banking member will process fund transfers.
Trade details managed by the domestic member include those listed above, as well as maintaining minimum capital requirements and controlling who is allowed to trade in the first place. Depending on the product being traded, the international clearing house will also receive the initial margin and variation margin once it is confirmed that the trade is an inter-country one.
Therefore, international clearing is a team effort on the part of domestic parties, as well as international clearing members and banks. All these parties allow for the seamless settlement of transactions, and for the delivery of products and the receipt or payment of funds.