A Clearing House is an intermediary entity acting as a trade-facilitator between the buyer and the seller in the financial markets. An indispensible cog in the system, the clearing house settles buyer/seller accounts, collects margin, clears trades and reports trading data to all parties concerned.
Why Is A Clearing House Essential?
Before everything else, clearing houses provide financial market stability. This is why their role is so prominent in the futures market. Futures are leveraged instruments, therefore they need every bit of stability a clearing house can add to the equation.
The presence of the clearing house as an intermediary explains the modus operandi of all exchanges. Every exchange has its own clearing house. Exchange members have to clear their trades through the clearing house at the end of the trading session. They also need to fulfill the margin requirements posed by the clearing house.
By acting as an intermediary for leveraged financial instruments, the clearing house assumes quite a bit of risk. It uses margin to mitigate this risk.
Beyond market stability, the clearing house also provides security and efficiency in the trading process. Despite advances in technology, it is still quite impossible to properly match millions of sellers to millions of buyers and to execute their transactions seamlessly, without the services of a clearing house.
Example Of ‘Clearing’
A Seller decides to dump 100 shares of company X for $1,000. At the same time, a Buyer picks up 100 shares of company X, for $1,000. Sounds like a match made in heaven.
The Seller and the Buyer do not know of each-other’s existence however. Neither do they know that someone is buying/selling what they are selling/buying.
The clearing house steps in though and it takes the $1,000 from the buyer. It then transfers it to the seller. At the same time, the 100 X shares are transferred to the Buyer.
At the end of the process, the clearing house reports the trade to the parties concerned, which means the Buyer, the Seller, and the Exchange.
The risks assumed by the clearing house are obvious even in this simple setup. What happens if the Buyer does not have the required $1,000 in his/her account? The clearing house covers the other side of trade anyway. Thus, it finds itself $1,000 short.
Obviously, it cannot allow that to happen, so it requires traders to maintain minimum account balances. The risks are amplified when leverage comes into the picture.
How Does Futures Clearing Work?
When an entity buys a futures contract, it has to cover two margin requirements: the initial and the maintenance margin.
The initial margin is a sort of guarantee that the trader can afford to keep the trade open. The maintenance margin is the amount of funds that have to be in the trader’s account for the trade to remain open.
As soon as the trader’s balance dips below the maintenance margin level, he is called upon to deposit more funds, through a margin call.
If he does not make an additional deposit, the clearing house closes the trade. This is the point over which the trader cannot cover more losses.
When the trade is closed, the funds still locked up in the margin requirements are freed up. The trader can then use them for further trading.
Besides mitigating risks for the clearing house, this procedure also eliminates risk for the two parties involved in the trade.
Stock Clearing Houses
It is obvious that stock exchanges such as the NYSE and NASDAQ have their own clearing houses, which facilitate trade in the above described manner between stock traders.