A clearing house stands between two clearing firms, typically big banks, in a trade. Clearing firms must follow a strict set of rules and regulations in order to engage in transactions and have the clearing house as the intermediary. The clearing house lies in the middle of the market, keeping track of all transactions made, matching buyers to sellers, fixed leg to floating leg. This way, if one of the clearing firms defaults on its obligations, the clearing house covers it.
That’s the gist of it.
Want a more comprehensive answer?
Clearing House Meaning
In banking and finance, clearing refers to turning the promise of payment into an actual cash flow from one place to another.
A clearing house is an intermediary between two counterparties in a transaction.
It acts as the counterparty to both sides, replacing any direct relationship between the two original trading counterparties.
If you are the buyer, the clearing house will ensure your payment gets to the seller. And if you’re the seller? The clearing house ensures the securities you deliver get to the buyer.
To increase efficiency across financial markets.
A clearing house enables multilateral netting between all counterparties.
Netting means it aggregates long and short positions, offsetting opposing positions. As a result, fewer transactions need to be settled and the overall trading exposure is reduced, which lowers capital requirements and mitigates risk.
Another benefit of a clearing house is that it reduces counterparty credit risk.
By assuming the legal responsibility for the trade, the clearing house removes the credit risk the two original counterparties would otherwise have on each other. Instead?
The clearing house has counterparty risk on counterparty A and on counterparty B.
Counterparties A and B technically also have counterparty credit risk on the clearing house, but this is damn near insignificant. Why?
Because if the original counterparty in a trade defaults, the CCP will find another to complete the deal. As such, they only need to care about market risk (loss of value in a trade due to changes in market conditions).
These counterparties are clearing firms, as we’ll see below:
What Is A Clearing Firm
Clearing firms are the counterparties clearing their trades through the clearing house. They’re also called clearing brokers, or members/participants of the clearing house.
To become clearing members in a clearing house, it’s common for them to have to contribute to a default fund.
This is a fund into which all clearing members are required to pay significant cash deposits, in proportion to the volume of their business. The purpose?
To cover the live deals of a clearing member that happens to default. Those cash reserves will cover the member’s failure, and serve to pay its outstanding obligations.
This is why counterparty credit risk is very low when clearing trades through a clearing house.
It’s common for clearing members to clear in the name of external clients.
These clients do not have access to the clearing house, either because they do not meet the requirements or because the costs are not worthwhile. It can also be simply because they don’t want to be directly exposed to the clearing house.
The client will pay the clearing firm, which will then pay the clearing house.
In this case, the client has counterparty credit risk with the clearing member through which they choose to access the market.
Likewise, the clearing member is exposed to the credit risk of its clients, as they make payments to the clearing house before collecting money from the client. This works like an overdraft.
So, what does the clearing member get in exchange for clearing trades for a client?
The clearing member assumes financial responsibility for the client’s trades, and posts initial and variation margin to the clearing house. It collects the margin from the client.
And on top of the margin, it charges a fee for the clearing service.
Types of Clearing House
Clearing houses are key players in today’s financial markets.
For instance, all stock exchanges use clearing houses.
The brokerage house where you open an account to trade stocks may or may not be a clearing firm. If it is not, it will arrange with a clearing firm to execute your buy and sell orders.
Clearing houses are fundamental to the integrity and credibility of the public exchanges for which they operate, as they guarantee the performance of every single transaction.
It’s common for big public stock exchanges to be their own clearing house, such as the London Stock Exchange.
Also, a simple wire transfer involves another type of clearing house.
In the United States, the ACH (Automated Clearing House) network processes financial transactions for consumers, businesses, and federal, state, and local governments.
But when we talk about clearing, it is most common to refer to over-the-counter derivatives trading, where counterparty risk is more significant.
Clearing houses that clear financial instruments, such as the LCH SA, are generally called central counterparty clearing houses (CCPs).
Again, for a trade to enter a CCP, it must be transacted via a clearing member.
Say a hedge fund wants to trade Total Return Swaps (TRS) through a CCP but it is not a member of the CCP.
It will go up to a bank that is.
Then the bank will pay the initial margin to the CCP in the name of the hedge fund. And then ask the hedge fund to pay the initial margin plus a fee.
In the US, the equivalent of a CCP is known as a derivatives clearing organization (DCO) and is regulated by the Commodity Futures Trading Commission (CFTC). Clearing members are known as futures commission merchants (FCM).
Let’s wrap things up with an overview of everything we covered:
Difference between Clearing Firm and Clearing House
A clearing house acts as a central counterparty between two sides of a trade.
What they receive from counterparty A is what they pay to counterparty B.
As such, there are three entities involved. The counterparty A, which pays the clearing house, which pays the counterparty B.
These counterparties can also clear trades for clients that do not have access to the clearing house.
In this case, they’re called clearing firms.
So, imagine counterparty A (which is not a member of the clearing house) does a trade with counterparty B (a member of the clearing house).
They may go to C, a firm that also has access to the clearing house, which will act as the clearing firm for counterparty A.
In this case there are four entities involved: Counterparty A which pays clearing firm C which pays the clearing house which pays counterparty B.
Counterparty A itself may be acting on behalf of a client, in which case it is the execution broker, but that’s beyond the point here. You see how complicated it can get, right?
The biggest derivatives clearing houses are the London Clearing House, followed by the Chicago Mercantile Exchange, then Eurex, and ICE.
Clearing firms are typically your big banks such as JP Morgan, Barclays, BNP Paribas, Deutsche Bank, HSBC, and Goldman Sachs.
A pension fund might do only a few swaps a year to cover currency risk.
And so paying for membership in a clearing house is not worth it.
Additionally, the enormous amounts of cash that clearing firms must post to the CCP as collateral, plus the legal and regulatory compliance obligations, are not worth the effort. The solution?
For a fee, these clearing firms (major banks) clear trades for the pension fund.
As a result, the pension fund does not have to worry about counterparty credit risk as much.
This is because, as we’ve seen, clearing houses must be financially robust in order to sustain the default of one of its participants.
As such, the financial health of the clearing house is an important consideration for firms when they are contemplating becoming clearing members.
In essence, a clearing house becomes the buyer to every seller and the seller to every buyer for all transactions.
When settling a position there is no need to find the original counterparty of the initial trade.
It becomes irrelevant who the original clearing members that the counterparty dealt with at the beginning of the trade.