Understanding banking and finance: What is clearing?

In financial transactions, ‘clearing’ is the process of matching purchase and sale orders. This ensures the correct transfer of funds and securities between the buyer and the seller. It involves verifying and matching trade details, such as the quantity and price of the securities, and preparing the documentation needed to make the final settlement.

Clearing is important. It ensures that transactions are executed smoothly and accurately, and reduces the risk of discrepancies and defaults that might undermine trust in the reliability and operational efficiency of the financial markets.

The clearing process explained

• Trade matching: After a trade is executed, the details of the transaction are compared between the buyer’s and seller’s accounts to ensure they agree on the terms. This includes the number of shares, the price, and the date of the transaction.
• Netting: The net obligations of each party are calculated by offsetting buy and sell orders. Netting reduces the number of transactions that need to be settled, thereby lowering the amount of money and securities that need to change hands.
• Risk management: Clearing houses manage the risk that one of the parties involved in the trade may default. The clearing house may require collateral or margin deposits to cover potential losses. This helps ensure the stability and integrity of the financial markets.
• Preparation for settlement: At this stage, the required documents and instructions are created for the actual transfer of funds and securities, which occurs during settlement. This involves updating records and making sure that all parties are ready to complete the transaction.
• Settlement: This is the final step, in which the actual transfer of securities and funds occurs. Settlement can happen on a real-time basis (real-time gross settlement) or at the end of the trading day (batch settlement).

The role of clearing houses

Clearing houses, such as the National Securities Clearing Corporation (NSCC) in the US or Euroclear in Europe, often handle the clearing process on behalf of banks, acting as intermediaries to guarantee the completion of trades and manage the associated risks.

Clearing houses and banks play distinct yet complementary roles in the financial system. While both institutions are crucial, clearing houses perform several functions that banks do not. Here’s a brief explanation of the role that clearing houses play in the process outlined above.

• Central counterparty role

Clearing houses act as a central counterparty to both sides of a transaction. This means they interpose themselves between buyers and sellers in financial markets, becoming the buyer to every seller and the seller to every buyer. This function significantly reduces counterparty risk, ensuring that if one party defaults, the clearing house will still complete the transaction.

• Netting and settlement

Clearing houses perform netting of transactions, which involves offsetting multiple buy and sell orders to determine the net obligations of each party. This process reduces the number of transactions that need to be settled and, consequently, the amount of money and securities that need to be transferred. Banks, on the other hand, typically settle each transaction individually.

• Risk management and margin requirements

Clearing houses manage risk by requiring members to post collateral or margin deposits. This collateral acts as a financial buffer to cover potential losses in case of default. Clearing houses continuously monitor and adjust these margin requirements based on market conditions. Banks do manage risk, but they don’t generally act as intermediaries in the same way, nor do they typically require margin deposits for every transaction.

• Default management

In the event of a default, clearing houses have mechanisms in place to manage the situation and minimise the impact on the financial system. This includes using the defaulting party's collateral, accessing default funds, and in some cases, mutualising losses among other clearing members. Banks manage defaults through their own procedures, but do not have the same centralised mechanisms for handling defaults across multiple counterparties.

• Transparency and regulatory oversight

Clearing houses operate under strict regulatory oversight to ensure their stability and reliability. They must adhere to international standards set by bodies like the International Organization of Securities Commissions (IOSCO) and the Bank for International Settlements (BIS). This level of oversight and standardisation is typically more rigorous than what is required for individual banks, which are regulated primarily for their own solvency and customer protection.

• Specialisation in market infrastructure

Clearing houses specialise in providing infrastructure for clearing and settling trades across various markets, including derivatives, securities, and commodities. They have systems and processes specifically designed to handle large volumes of transactions efficiently and securely. Banks, while they may facilitate transactions, do not specialise in this infrastructure to the same extent.

The key takeaway is that clearing houses provide centralised risk management, netting, and settlement services that significantly reduce systemic risk and ensure the smooth functioning of financial markets. These functions complement those of banks, which focus more on providing financial services such as lending,