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What Is Clearing and How Does it Work?

Have you ever experienced a delay between sending and receiving funds? This is all part of the clearing process that takes place between financial institutions. So, what is clearing, and how does clearing work in everyday finance? Here’s what you need to know.

What is clearing?

Clearing describes the settling process that financial transactions must go through. Although paying for items with a paper cheque is increasingly uncommon, this provides one of the easiest clearing examples to understand. When a buyer pays a seller with a cheque, the seller deposits this cheque into his or bank account. It then takes several days for the cheque to ‘clear’ and the funds to appear in the account.

The same process applies to any financial transaction that takes place between two or more banks or other institutions. Whether paper cheques or electronic transfers, these transactions must be reconciled through the clearing process. Independent clearing houses facilitate this process, ensuring a more secure system.

Clearing is also frequently used in trading. When a buyer purchases securities, options, or futures, the clearing process validates the transaction. A clearing house ensures that there are sufficient funds to complete the purchase, and the transfer is recorded before the security or funds are delivered to the buyer’s account. It’s a multi-step procedure to settle financial trades, ensuring market orders remain in balance.

What is a clearing house?

While banks handle the clearing process for straightforward transfers, independent clearing houses play an important role in trading. The clearing house serves as an independent third counterparty to verify the investment or trading transaction. If there are any discrepancies, the clearing house gives the counterparties a chance to sort out the issue independently before it is passed on to an exchange committee. 

In return for these services, clearing houses charge a fee which is usually included in the commission paid to any investment broker. Within the UK, the London Clearing House is one of the most important names in trading. Multinational investment banks like JP Morgan and Deutsche Bank also act as clearing houses for traders.

How does clearing work?

What takes place during the clearing process, and how are transactions reconciled? While the specific process depends on the nature of your transaction, there are a few main steps to go through.

  • The clearing house ensures that funds are available.

  • The transaction details are recorded.

  • The funds are held securely until the transaction is complete.

  • Discrepancies are investigated, with the clearing house stepping in as an intermediary.

  • The funds are cleared, and the security is delivered to the buyer.

Essentially, the clearing process protects both parties. The investor wants to sell their security and know that they will receive the money owed for this transaction. The buyer wants to purchase a security and needs to provide adequate funds for this purchase. The clearing house verifies both sides to ensure a smoother transaction.

Example of clearing

As an example of how clearing works, imagine that a trader wants to purchase a futures contract. To hold the trade, there’s a required initial margin of £4,500 which must be held as assurance that the trade will go through. A clearing house would verify this by going into the trader’s account and holding the required margin so that it can’t be used until the transaction is complete. This reduces the risk that the funds are used for other trades, ensuring that all parties uphold their end of the bargain.

The bottom line

Whether it’s in banking or finance, clearing serves an important role. Clearing houses protect both parties in a financial transaction by ensuring that funds are verified, and everything goes according to plan. If any disputes arise, the clearing house steps in to act as a mediator before it’s sent to arbitration. The clearing process also plays a vital role by recording transaction details for future reference.

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