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A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. These transactions may be executed on a futures exchange or securities exchange, as well as off-exchange in the over-the-counter (OTC) market. A clearing house stands between two clearing firms (also known as member firms or clearing participants) and its purpose is to reduce the risk of one (or more) clearing firm failing to honor its trade settlement obligations. A clearing house reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the credit worthiness of the clearing firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting clearing firm's collateral on deposit. Also, it acts as a clearing firm.
Once a trade has been executed by two counterparties either on an exchange, or in the OTC markets, the trade can be handed over to a clearing house, which then steps between the two original traders' clearing firms and assumes the legal counterparty risk for the trade. This process of transferring the trade title to the clearing house is called novation. It can take fractions of seconds in highly liquid futures markets; or days, or even weeks in some OTC markets.
As the clearing house concentrates the risk of settlement failures into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well-capitalized in order to ensure its survival in the event of a significant adverse event, such as a large clearing firm defaulting or a market crash.
Many clearing house guarantee funds are capitalized with collateral from its clearing firms. In the event of a settlement failure, the clearing firm may be declared to be in default and clearing house default procedures may be utilized, which may include the orderly liquidation of the defaulting firm's positions and collateral. In the event of a significant clearing firm failure, the clearing house may draw on its guarantee fund in order to settle trades on behalf of the failed clearing firm.
When clearing securities, clearing houses either focus on a type of product or on a specific country or region, or sometimes both. The 1990s saw a trend to merged exchanges which led a number of clearing houses associated with those exchanges also merging and consolidating. This led to a number of clearing houses that cover multiple countries and that will clear all three major types of securities, bonds, stocks and derivatives.
In Europe, securities clearing is offered by a variety of Central Counterparties, including EMCF, LCH.Clearnet, SIX x-clear and EuroCCP. Moreover Eurex Clearing, a member of Deutsche Börse Group, provides clearing services for some OTC products in addition to various listed products.
The Options Clearing Corporation is an example of a clearing house that functions for the purpose of clearing equity options and bond derivatives, in order to ensure the proper implementation of these instruments.
In the United States, the merger of the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange into the CME Group saw it set up its own clearing operation while also offering clearing services (for a fee) to other exchanges. Its ClearPort operation also provides clearing for certain over-the-counter trades.
In Europe LCH.Clearnet (formerly known as The London Clearing House), for example, serves major international exchanges and platforms, as well as a range of OTC markets. It clears a broad range of asset classes, including securities, exchange traded derivatives, energy, freight, interbank interest rate swaps, and euro and sterling-denominated bonds and repos; and works closely with market participants and exchanges to identify and develop clearing services for new asset classes.
In the wake of the financial crisis of 2007-2010 and as part of the Obama financial regulatory reform plan of 2009, pressure has been placed on traders of derivatives such as credit default swaps to make their trades on an open exchange with a clearinghouse. In June 2009, Federal Reserve official Alfred Kohn mentioned that the largest credit default swap dealers were working on an exchange, and that only regulatory approval rather than legislation would be required. In March 2010, the Options Clearing Corporation stated that it was moving forward in backing equity derivatives.
In the United States, NACHA-The Electronic Payments Association, formerly the National Automated Clearing House Association, organizes the mechanism for the financial service institutions that participate in the Automated Clearing House (ACH) network. These organizations use the ACH to transfer funds either as debits or credits between participating institutions. Most, but not all, U.S. banks are members of the NACHA. Typical uses of ACH transactions are for automatic payroll programs, monthly mortgage or membership payments, or among non-profit organizations, as a monthly donor/contribution program.
The trades submitted between two market participants are called bilateral trades. Let's say two parties - PartyA and PartyB are entering an agreement to exchange financial flows either over-the-counter or through an exchange. The trade is registered between the counterparties and is called a bilateral trade. Each of the parties has the risk if the other counterparty defaults and would not be able to fulfill its obligations on the trade known as counterparty risk. In order to avoid such risks a central counterparty approach can be used.
The Clearing House acts as a market participant who is taking the risk of the counterparty default and ensures that the payments are performed even in case of default. Once the trade is changed from bilateral to the trade with the Central Counterparty it is considered a Cleared trade. See clearing (finance) for more details.
To achieve this the following steps are taken by the clearing house. The initial bilateral trade is split into two trades, with the Central Counterparty standing in between the parties. The original trade between PartyA and PartyB becomes PartyA <-> Central Counterparty <-> PartyB. The Central Counterparty does not face any market risk as it has two offsetting positions. However it is now facing the counterparty default risk, if the other party of the trade falls in default. To manage this risk, each party is required to hold margin at the clearing house to cover its unsettled positions and the clearing house will monitor this margin level to make sure that it covers outstanding trades.
The advantage of bilateral trades is that they are flexible in terms of agreements. i.e. it is possible to specify all the parameters in the trade and the parties can simply settle the trade as they wish. However a trader as well as dealing with the market risk needs to assess the counterparty risk for the counterparty and when trading. And particularly when derivatives that have future settlement periods the risk can span over an extended period of time. By using a central counterparty such as a clearing house the counterparty risk is reduced as the trader needs to only make sure the clearing house has enough capital to honor the trade and is free to trade with any counterparty that uses the same clearing house. However the central counterparty model does mean restrictions on the type of trades that can be done and there is an additional cost as the clearing house will levy a fee for its services.
In addition to the counterparties, there is an advantage for the market and the financial regulators as it's easy for the clearing house to monitor and report all activity and outstanding positions, which is much harder when trying to have individual parties report their trading activity.
The central counterparty is responsible for: