Clearing

Updated Sep 8, 2024

Definition of Clearing

Clearing refers to the process of reconciling purchases and sales of various financial instruments, including securities, derivatives, and payment instructions. It involves the updating of accounts of the trading parties and arranges for the transfer of funds and securities. Clearing is a crucial step in ensuring the successful completion of a trade, post-execution, by acting as the middleman between buyers and sellers to ensure that transactions are settled accurately and efficiently.

Example

Consider two parties, Party A and Party B, involved in the trading of stocks. Party A agrees to sell 100 shares of a company to Party B at a predetermined price. Once the trade is executed, the clearing process begins. This involves validating that Party A owns the 100 shares and confirming Party B’s intention and capability to pay for these shares. The clearinghouse, or a clearing entity, confirms these details and facilitates the transfer of the shares from Party A to Party B and ensures the respective funds are transferred from Party B to Party A.

This process reduces the risk that one party might default on the transaction. Without clearing, Party A might risk not receiving the payment, and Party B might risk not receiving the shares they agreed to purchase.

Why Clearing Matters

Clearing is foundational to the integrity and efficiency of financial markets. It significantly reduces the market’s risk, ensuring traders and investors can operate with confidence that their transactions will be settled as agreed. Moreover, by mitigating the counterparty risk (the risk that the other party will not fulfill its obligations), clearing helps maintain a stable financial system.

Clearinghouses, which perform the clearing process, also provide a mechanism for the netting of trades, reducing the number of transactions that need to be settled by summing multiple transactions to a single net payment or transfer. This efficiency lowers the amounts of liquidity that parties need to hold, thereby reducing transaction costs.

Frequently Asked Questions (FAQ)

How does a clearinghouse ensure the security of transactions?

A clearinghouse ensures the security of transactions by acting as a counterparty to both sides of a transaction, which means it assumes the risk if either party defaults. This is achieved through a variety of mechanisms, including the collection of margins (a kind of financial security to cover potential losses) and the establishment of default funds paid into by its members to cover losses in case of a member’s failure.

What is the difference between clearing and settlement?

While clearing refers to all processes involved in confirming transaction details and preparing for settlement, settlement is the final step where the actual exchange of securities and funds occurs. In essence, clearing is the preparation and reconciliation process that ensures the correct execution of a transaction, whereas settlement is the process where the transaction is finalized or settled.

Can all financial products be cleared through a clearinghouse?

Most standardized financial products, such as stocks, futures, and options, can be cleared through a clearinghouse. However, some more complex or bespoke financial products, such as certain derivative contracts designed for specific needs of trading parties, might not go through a clearinghouse due to their complexity or lack of standardization. Instead, these might be subject to bilateral clearing, where the two parties manage the clearing process directly between themselves.

What happens if a party defaults on a cleared transaction?

In the event of a default, the clearinghouse steps in to ensure that the transaction is completed. This is facilitated by the financial safeguards the clearinghouse has in place, including the initial and variation margins collected from its members, as well as the default fund contributions. These resources can be used to fulfill the obligations of the defaulting party, protecting the other party from loss and maintaining confidence in the financial system.