Clearing House Definition
A clearing house is a mediator between two firms (which may or may not know each other) that are engaged in a financial transaction (wherein one party is a buyer & another party is seller in the said transaction), taking the exact opposite positions for each firm and ensures that there is no risk of default in the transaction.
- Say Mr. A promises Mr. B to sell his shares in Johnson Ltd two weeks later from today. In return, Mr. B has paid him a 20% advance today & promises to pay him balance price for all the shares on that day. Mr. B makes a deal with Mr. C to sell him those shares on the same day he receives it.
- What risk is Mr. B facing here? The risk of non-delivery of shares from Mr. A. What risk is Mr. C facing here? The risk of non-delivery of shares from Mr. B What risk is Mr. A facing here? The risk of default from Mr. B that he will postpone the payment.
- Well, such risks are avoided if a person in between the transaction, takes responsibility for default. That’s the role a Clearing House has to play. So, it facilitates payment transactions or transactions in the nature of derivative or securities. The main purpose is to reduce the risk of honor in trade settlement obligations.
- If you observe, the clearinghouse will always take the exact opposite position for each side of the trade. It acts as a buyer for the person who is selling something. Simultaneously, it acts as a seller for the person who is receiving the same. Thus, it has great importance in the financial markets.
How does Clearing House Work?
The above diagram shows the simplified process of how the transaction actually flows between two parties. The buyer receives the actual goods from the deemed seller (i.e., the clearing house), and the seller receives the consideration for the goods sold to the deemed buyer (i.e., the clearing house).
This makes the transaction secured. The question that arises here is, “will the clearing do the same for free of cost?” The answer is obviously, “No.” The mediator charges a nominal amount from each of the parties to the contract say 0.001% of the trade involved. Isn’t the margin too low? Obviously, yes. But the mediator earns due to huge volumes of trade around the globe.
The clearing house is involved in regular transactions of trading goods (i.e., manual physical delivery or customized contracts) and also in a futures contract or derivatives contracts or option contracts (i.e., automated exchange driven contracts).
Example of Clearing House
Say, the stock is trading at $ 850. You will see a number of contracts as follows:
Here, Mr. C can buy from Mr. R only 5000 stocks at $ 849. The price will move down. Then, you can see Mr. B can buy from Mr. Q at the price of $ 848 to the extent of 10,000 stocks. Mr. Q will be left with 10,000 stocks at $ 848. Now, Mr. Q can increase his price at $ 849 & sell to Mr. C stock to the extent 5000.
The price will not move until one of the parties to the transaction modifies its prices.
- The first and foremost thing a clearing house does is that it ensures a smooth flow of the transaction.
- It guarantees the occurrence of the transaction in the manner planned by the said parties.
- This guarantee is given by checking the repaying capacity & credibility of the parties involved. Now, this applies irrespective of whether the parties are natural or artificial persons.
- It ensures that the system is available during the trading hours. This makes sure that the market is liquid.
- A clearing house also provides standardized norms regarding the quality, quantity, price, minimum ticks, maximum movement of price within a day & maturity for the contract.
- The basic risk each trader faces is non-honoring of the contract & default risk on the side of the buyer.
- Clearing house eliminates such risks & thereby providing an assurance to the financial transaction.
- It is made responsible for settlement between the parties, time limit within which the transaction should get completed, monitoring over the adequacy of margins placed on the accounts of each trader.
- Clearing house ensures that the variable margin is called for in case of the maintenance margin is breached by a trader.
- Ease of transaction.
- It is a secure way of dealing in a financial transaction at a negligible cost.
- Reduction in human-oriented errors.
- Faster processing of transactions.
- There is no need to search eligible counterparty to the transaction.
Actually, there are very least disadvantages to clearing house. The system of clearing house has itself emerged due to flaws in the earlier physical settlement system. Basically, the clearing house is made to advantage the public at large. It can never default due to stringent regulations imposed by the government. We can better call it the limitations rather than the disadvantages.
- Limited settlement hours since the exchange is not available 24 x 7.
- A specific quantum of orders is required. So, you cannot trade in odd lots as per your convenience.
- Lower internet connection may delay placing your orders.
- There is a very minute risk of default on the part of the sub-brokers to the clearing house.
Clearing house is driven by regulations placed upon by the government. Since they are regulated, traders rely upon the system. Today the stock exchange plays the role of mediation. We can see huge volumes of transactions taking place on the exchange. This is possible only through the automated clearing system.
This has been a guide to Clearing House & its Definition. Here we discuss how does clearing house work along with an example, functions, benefits, and disadvantages. You can learn more about from the following articles –