When it comes to financial transactions, many people like to know that everything will go through smoothly. It’s also nice to know that settlement risks are reduced so that your trade or other transaction will go through. That’s what a clearing house is for. The clearing house takes on the risk of a transaction between two parties and makes sure that it settles.
A clearing house is the common ground between two firms, often called participant firms or clearing firms. The idea is to lower the risk that one of the parties will fail in its obligation during a trade.
How It Works
Many exchanges and OTC markets have clearing houses designed to help smooth transactions and make sure they settle. Participants make collateral/margin deposits to help ensure that there is enough capital for the clearing house to operate properly.
Once a trade is executed between two parties (usually a buyer and a seller in the most basic cases), the clearing house steps in. The trade title is transferred to the clearing house, using a process known as novation. This process means that the clearing house takes on the legal counterparty risk associated with the transaction. This means that the clearing house can help ensure that the trade goes through since it is now responsible for the trade. If one of the parties fails, it’s not as big a deal because the clearing house is now responsible.
A clearing house can help effectively isolate the negative effects from a failing market participant, and limit the spread of problems. If a clearing firm fails, and a settlement failure is the result, the guarantee funds at a clearing house can usually settle the transactions on behalf of the failing clearing firm. However, before the guarantee funds need to be used, clearing houses can often utilize default procedures against a failing clearing firm.
It sounds like the process is a long one, but in reality, it’s possible for a clearing house to settle transactions in a matter of seconds. On highly liquid markets, these transactions take place in a fraction of a second. However, there are some transactions, especially in the OTC markets, that can take days to settle.
It’s important to realize, though, that a clearing house doesn’t have to be a third party. In some cases, brokers are their own clearing houses. Fidelity is one that uses its own clearing house, National Financial Services LLC. Wells Fargo, TD Ameritrade, and E*TRADE are also self clearing. Pay attention to the clearing house, and consider that as you choose a brokerage.
You should also realize that some brokers use the same clearing house. Apex Clearing is used by a few brokerages, including Ally Invest, Firstrade and eOption all use Apex. Understand that if one broker uses the same clearing house as another, one isn’t going to be faster than another.
Other Functions of a Clearing House
A clearing house doesn’t just settle transactions, though. It can serve as an independent third party in other ways. Clearing houses can offer valuation services. Additionally, they can also keep tabs on clearing firms, and their creditworthiness. Clearing houses are designed to help limit wider market risk, and, in general, they do — as long as the parties trading use them.
Indeed, after the recent financial meltdown, many people pointed to the fact that credit default swaps weren’t traded on exchanges, and that clearing houses weren’t used, as one of the issues. Since then, efforts have been put into place to make the process more transparent, and to create an exchange. Additionally, at least one clearing house (Options Clearing Corporation) has expressed an interest in backing equity derivatives as a way to prevent future problems.