What Are Clearing Houses and How Do They Work?

When you make a financial transaction, the last thing you want to worry about is your money not getting to the correct destination. And that's where clearing houses come in.

Simply put, a clearing house — also known as a participant or clearing firm and NOT to be confused with the marketing firm Publishers Clearing House (you know, the one that shows up at your house with the super-big checks and a bouquet of balloons) — is the common ground between two distinct financial firms. This unique institution takes on the risk of a transaction between two parties and makes sure that it's settled to everyone's satisfaction. It lowers the risk that one of the parties will fail in its obligation during a transaction. It's the financial middle man — like a Brink's truck that drives your money safely from Point A to Point B.

Have you ever noticed the acronym “ACH” on your bank account statement? That means that a clearing house — the Automated Clearing House, to be exact — did its job. This financial network processes a HUGE number of financial transactions, including direct deposits and bill payments. In fact, in 2015 alone, the ACH processed nearly 24 billion transactions worth just shy of $42 trillion.

For investing purposes, stock brokers use these firms for transactions to handle the nitty-gritty of buying and selling a trade. How is this done, and what impact does a clearing house have on your trades?

How Do Clearing Houses Work?

Once a trade is executed between two parties, the clearing house steps in. The trade title is transferred to the firm using a process known as novation. This process means that the clearing house takes on the legal counter-party risk associated with the transaction. The clearing house can help ensure that the trade goes through since it is now responsible for it. If one of the parties fails, it's not as big a deal because the firm 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 firm fails, and a settlement failure is the result, the guarantee funds at the 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.

But clearing houses are also something to keep in the back of your mind when selecting a stock broker. Here's why.

The Magic of Self-Clearing

Many stock brokers and robo advisors — such as Betterment and Wealthfront— use Apex Clearing. Other clearing houses include Pershing LLC and the J.P. Morgan Clearing Corp.

However, the clearing house doesn't have to be a third party. In some cases, the big brokers have their own self-clearing firms. 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.

That's because by self-clearing, brokers can cut their costs and pass the savings along to you (read: lower transaction fees). But don't worry about this being risky — the SIPC (Securities Investor Protection Corporation) protects all clearing house transactions from loss.

To find out who uses which clearing house, check out this list.

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. They're designed to help limit wider market risk, and, in general, they do — as long as the parties trading use them.

Indeed, after the last decade's 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 biggest 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 begun backing equity derivatives as a way to prevent future problems.

In Conclusion

Now, keep in mind that the clearing house used shouldn't be the No. 1 reason why you select a particular broker. After all, brokers and other financial institutions can switch which clearing house they use. It's just something to keep in mind when comparing online brokers or robo advisors. (Hint: Here's what to look for).