Whether you want to purchase stock options or sell off assets, you might need to have an intermediary put in place to make sure the transaction runs smoothly. This is where a clearing house steps in, to help manage the transactional process. So, what is a clearing house, and what are its specific functions? Here’s what you need to know about using a clearing house in finance.
What is a clearing house?
A clearing house serves as a third-party mediator between a buyer and seller engaged in any financial transaction. Although its specific activities will vary depending on the type of transaction involved, generally the clearing house’s main duty is to make sure the transaction runs according to plan. This includes ensuring both parties not only fulfil their ends of the contract but are satisfied with the results. A clearing house validates the transaction, so that the agreed-upon amount is paid by the buyer to the seller.
This full process is called ‘clearing’ and it’s seen not only in the stock market, but also in everyday banking transactions. Each financial market will have its own named clearing house, while major institutions will have an internal clearing department.
Understanding the clearing process
From cheque settlement to futures trading, all financial transactions must go through the clearing process. Clearing ensures that there are sufficient funds to complete the transaction, that all details are recorded correctly, and that the funds remain in place until the transfer has been completed.
Clearing protects both the buyer and seller by authorising all transactions before a money transfer is completed or asset delivered to a buyer. Once a trade has been executed, the clearing house automated payment system steps in to verify and validate all steps. If any discrepancies pop up during this authorisation process, the clearing house gives both parties the chance to resolve the issue before escalating or voiding the transaction.
Role of a clearing house
Here’s a more detailed breakdown of the clearing house meaning and its duties.
Checks that both parties have the financial means to enter the transaction
Verifies that all parties follow required procedures and contractual rules
Acts as intermediary for negotiating price and contract details
Ensures that the assets are delivered on time to the buyer according to specified details
Clearing house meaning in the futures market
When looking at the clearing house definition, one of the primary areas where you’ll see it applied is within the futures market. This is because trading futures contracts involves borrowing money with the intention of investing it later. Without a third-party intermediary like a clearing house to regulate these transactions, it would be easy for either party to back out of their bargain.
As a result, all futures exchanges have their own clearing house, including the New York Stock Exchange’s clearing division as well as the London clearing house. Any members of the exchange must use the designated clearing house to trade.
Clearing house examples
Here’s an example of how a clearing house works, in this case to regulate a futures contract transaction. To get started, the clearing house would set initial and maintenance margin obligations to meet. Imagine that a trader purchases a futures contract, depositing the required initial margin that proves they can afford the trade. The clearing house holds these funds aside in the trader’s account, meaning they can’t be used for additional trading purposes. This ensures that the funds are used for their intended purpose, meeting contractual obligations with the seller.
Clearing houses play a fundamental role in reducing the risk involved with any transaction, while recording and storing important details. However, investors should be aware that they’ll pay for this service. This is usually factored into any broker fees and clearing costs should be factored into the cost of any trade.
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