What’s a clearing house?

In finance, a clearing house is an institution that carries out clearing and settlement for financial and commodities derivatives and securities transactions. Clearing of payment is when the promise of payment is turned into actual movement of money (or other assets).

clearinghouseThe reasons why a clearing firm (also known as member firm or clearing participant) decides to utilize the services of a clearing house vary, but one important aspect is the mitigation of risk. By using a clearing house, the clearing firm is wholly or partly sheltered from to the risk of another clearing firm not honoring its obligation. Of course, it is possible for a clearing house to default, so using a clearing house does not completely remove credit risk.

The process of transferring the trade title to a clearing house is called novation. A novation is only valid if all parties to the original agreement consent to it. For certain markets, such as highly liquid futures markets, the process of novation has been automated and can be carried out in less than 1 second. In other markets, especially OTC markets, the novation process may take several days or even weeks.

When a clearing firm wants to work with a clearing house, the clearing firm must deposit collateral in a margin account at the clearing house. In addition to this, large and well-known clearing houses will typically step in and honor third-party obligations even if there isn’t enough in the margin account to pay for this. A clearing house that guarantees to honor third-party obligations will typically keep a very keen eye on the credit worthiness of any clearing firm it works with, and this will in essence add another layer of security since the clearing house is likely to stop working with a struggling clearing firm before that clearing firm actually begins defaulting on its obligations.

Other benefits of using a clearinghouse:

  • The clearing house mitigates settlement risks by netting offsetting transactions between two or more clearing participants.
  • The clearing house provides independent valuation of collateral.