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 clearinghouse.
- The international clearing system is used to clear trades when the parties involved are in different countries.
- Clearing is necessary to facilitate efficient trade and give participating parties peace of mind that their transactions 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 clearinghouse, 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 clearinghouse 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 clearinghouse 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 performed 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 U.K.-registered clearinghouse. 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 clearinghouse for the Paris markets.
International Clearing System Example
Assume that a U.S. investor is buying a contract from Tokyo, which likely means that the buyer is a U.S. resident and the seller is a Japanese resident.
The international clearinghouse 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 clearinghouses, which are also responsible for maintaining minimum capital requirements and controlling who is allowed to trade in the first place.
The international clearinghouse has relationships with the domestic institutions, clearinghouses (called clearing members), and banks. These relationships allow the international clearinghouse to guarantee transactions since the clearing members are handling the trade details and the banking member will process fund transfers. Depending on the product being traded, the international clearinghouse will receive the initial margin and variation margin once it is confirmed that the trade is an inter-country one.
International clearing is a team effort on the part of domestic parties, 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.