Clearing

Clearing: Definition and Overview

Clearing is the process that finalizes a financial transaction by reconciling buy and sell orders, validating funds or assets, and ensuring their transfer between parties. It often involves a third-party intermediary—typically a clearinghouse or a clearing bank—that acts as the central counterparty to reduce counterparty and settlement risk and to streamline settlement across markets.

Key points
* Clearing matches and validates transactions, records the details, and ensures delivery of funds or securities.
* Clearinghouses often act as implicit buyer to every seller and implicit seller to every buyer (central counterparty).
* Proper clearing reduces settlement risk and the chance of real monetary losses from failed trades.

How Clearing Works

1. Trade execution: Buyer and seller agree on a trade (through an exchange or broker).
2. Trade submission: Trade details are sent to a clearing entity.
3. Validation and margining: The clearing entity verifies that each party has required funds or collateral (including margin for derivatives) and records obligations.
4. Netting: Offsetting obligations between institutions are netted to reduce the number and size of payments.
5. Settlement: Funds and securities are exchanged and ownership is updated.

If submitted trade information conflicts (incomplete or inconsistent data), the trade can become an “out trade” that cannot be settled until the discrepancy is resolved. Persistent disputes may be escalated to exchange arbitration.

Clearinghouses and Their Role

A clearinghouse centralizes trade processing and risk management. Main functions:
* Act as central counterparty (reduces credit risk between counterparties).
* Maintain margin and guarantee funds to cover losses from defaults.
* Net and settle multilateral obligations among participants.
* Charge clearing fees (often bundled into broker commissions).

Examples of major clearing venues include the London Clearing House and clearing operations at exchanges such as the Chicago Mercantile Exchange.

Clearing Banks and Check Clearing

In banking, clearing refers to settling payments and checks between financial institutions. Processes include:
* Check clearing: The recipient bank presents a deposited check to the issuer’s bank (or through a clearing system) to collect funds. Holds may apply until funds are verified.
* Interbank netting: Banks offset mutual obligations so only net amounts are transferred, reducing cash movements.

Federal Reserve Banks provide check-collection services; most checks they process settle within one business day.

Automated Clearing House (ACH)

The ACH is an electronic network for moving funds between bank accounts (an electronic funds transfer system). Common ACH uses:
* Direct deposit of payroll.
* Recurring bill payments and business-to-customer transfers.
* Low-cost, batch-processed transfers with predictable settlement timing.

ACH transfers require account and routing information and function similarly to electronic checks.

Example: Margin and Clearing in Futures

When a trader buys a futures contract, the clearing firm requires an initial margin (a good-faith deposit) held in the trader’s account to cover potential losses. Example:
* Initial margin required: $6,160 (held and unavailable for other trades).
This mechanism reduces the risk that one counterparty’s default leaves the other exposed, since the clearing firm collects and maintains collateral across participants.

Real-World Uses

• Depositing a check: Your bank must clear the check with the issuing bank before funds are available.
• Buying securities: Trades executed through a broker appear immediate but take several days to clear and settle.
• Payroll and bill payments: ACH clears recurring payments electronically and reliably.

Settlement Risk and Out-Trades

Settlement risk arises when one party fails to deliver funds or assets as expected. Out-trades occur when trade data is inconsistent and the clearing entity cannot settle the transaction. These situations can result in accounting errors and financial losses if not resolved.

Examples of Clearing Institutions

• Clearinghouses: London Clearing House, CME Clearing (Chicago Mercantile Exchange).
• Clearing banks and large custodians commonly used in the U.S.: Bank of New York Mellon, JP Morgan Chase, Citi, State Street, Wells Fargo, and others.

Bottom Line

Clearing is essential to modern financial markets and banking. By validating trades, collecting margin, netting obligations, and acting as a central counterparty, clearing processes reduce counterparty and settlement risk and allow markets to operate efficiently and at scale.