A mediator between any two entities or parties engaged in a financial transaction
What is a Clearing House?
A clearing house acts as a mediator between any two entities or parties that are engaged in a financial transaction. Its main role is to ensure that the transaction goes smoothly, with the buyer receiving the tradable goods he intends to acquire and the seller receiving the right amount paid for the tradable goods he is selling.
Our Introduction to Corporate Finance Coursegives you an overview of how capital markets work.
Example of a Clearing House
Anyone who engages in any kind of financial transaction wants to be protected in regard to the transaction. The buyer wants to be assured of receiving the goods or services they purchased, and the seller wants to be assured of receiving payment. The clearing house stands in the middle and takes both sides to make sure that both parties are satisfied.
Consider an investor who wishes to sell 500 shares of his stock in Emirates Airlines to another investor. It is the clearing house’s job to make sure that the investor gets paid the proper amount for his 500 shares and that the buyer indeed receives the full amount of shares that he paid for. With a clearing house, both parties can rest assured that a successful transaction will take place.
The diagram above shows the simplified flow of a transaction involving two parties, the seller and the buyer, and in between them, the clearing house firm. The clearing house is not only involved in regular transactions of tradable goods but also of those that involve futures contracts (contracts entered into by two parties wherein the buyer is obliged to buy an asset and the seller to sell an asset for an agreed-upon price on an agreed future date). Because futures contracts take time to be fulfilled, it is beneficial to have a third party (the clearing firm) to ensure that the contract is not broken.
Looking again at the diagram, the seller gives the goods to the clearing house, which then gives them to the futures buyer. In turn, the futures buyer hands the payment to the clearing house who will then give it to the seller. In such an arrangement, both parties are protected and assured that they will both receive what is due to them.
Functions of a Clearing House
As mentioned, a clearing house is basically the mediator between two transacting parties. However, there is also more to what clearing houses do. Let’s take a look at some of their functions in more detail.
- The clearing house guarantees that the transactions will occur smoothly and that both parties will receive what is due to them. This is done by checking the financial capabilities of both parties to enter into a legal transaction, regardless of whether they are an individual or an organization.
- The clearing firm makes sure that the parties involved respect the system and follow the proper procedures for a successful transaction. The facilitation of smooth transactions leads to a more liquid market.
- It is the clearing house firm that provides a level playing field for both parties, where they can agree on the terms of their negotiation. This includes having the responsibility for setting the price, quality, quantity, and maturity of the contract.
- The clearing house makes sure that the right goods are delivered to the buyer, in terms of both quantity and quality, so that at the end of the transaction there are no complaints nor arbitration necessary.
Initial Margin and Maintenance Margin
To protect traders in the futures market, every transaction requires margin – a deposit of a percentage of the total value of the contract. The concept of margin includes the initial margin – the original deposit amount required – and maintenance margin – a slightly smaller amount that must be maintained in the trader’s account in order for them to continue to hold their trading position. For example, let’s say that a futures contract of prawns requires an initial margin deposit of $1,000 (which is held by the clearing house) and a maintenance margin of $800.
If before the contract’s maturity the value of the prawns contract declines by more than $200 ($1,000-$800=$200), then the buyer will need to deposit additional funds in his trading account in order to hold onto the contract. Otherwise, the clearing firm will liquidate his position at the best available market price.
Importance of Clearing Houses
A common fear of traders about the market is getting involved in transactions that don’t end well, with one of the parties not fulfilling their end of the agreement. Clearing houses function to provide extra security so that investors can trade freely, knowing that their investment decisions will be honored and enforced by the clearing firm.
Related Readings
Thank you for reading CFI’s guide on Clearing House. To keep advancing your career, the additional CFI resources below will be useful:
