Clearing House in Stock Market: Meaning, Functions

What Is a Clearing House?

A clearinghouse is an organization or entity that acts as an intermediary between buyers and sellers in financial transactions. The clearinghouse streamlines the clearing and settlement process, providing a centralized and standardized mechanism for the efficient transfer of securities and funds between parties.

Many clearinghouses also function as central counterparties (CCPs). In financial transactions, there is always a risk that one party may default on its obligations, potentially leading to financial losses for the other party. The clearinghouse acts as a central counterparty (CCP), assuming the role of the buyer to every seller and the seller to every buyer. By interposing itself in every trade, the clearinghouse ensures that both parties fulfill their contractual obligations.

The stock market involves inherent risks, and the failure of a participant to meet its obligations can have cascading effects on other market participants. To mitigate such risks, clearinghouses implement risk management measures, such as margin requirements. Participants are required to deposit funds (margin) that the clearinghouse can use to cover potential losses in case of a default. This helps protect the financial system from systemic risk.

In the event of a participant default, the financial system requires mechanisms to manage and contain the impact of the default. Clearinghouses have well-defined procedures for default management, including the utilization of the defaulted participant’s collateral to cover losses and prevent disruptions to the market.

Clearinghouses are also commonly referred to as clearing corporations.

Role and Functions of Clearing Houses

The role and functions of clearinghouses in the stock market include:

Risk Management: Clearinghouses serve as central counterparties to all trades, effectively becoming the buyer to every seller and the seller to every buyer. This arrangement, known as novation, helps reduce counterparty risk. In the event that one party defaults on their obligations, the clearinghouse intervenes to ensure the settlement of the trade. By providing a guarantee for trades, clearinghouses enhance market stability and mitigate the risk associated with trading. This risk reduction is particularly important in derivatives such as futures and options.

(Note: Not all clearinghouses serve as central counterparties. We will explain this below.)

Margin Management: Clearinghouses establish and enforce margin requirements. Traders and market participants such as brokers are often required to deposit a certain amount of money or securities as collateral, known as margin, to cover potential losses in their trades. The clearinghouse calculates the margin requirements and ensures that participants maintain adequate margin levels.

Verification and Matching: Clearinghouses verify the details of each trade to ensure that they are accurate and that the terms are consistent between the parties involved. This verification process helps prevent errors and discrepancies in trade execution.

Settlement: Clearinghouses coordinates with central securities depositories (CSDs) to complete the settlement process. This includes transferring ownership of securities from the seller to the buyer and transferring funds from the buyer to the seller. By centralizing this process, clearinghouses ensure the efficient and timely completion of trades.

Daily Reconciliation: At the end of each trading day, clearinghouses reconcile all trades to confirm that records are accurate. They also calculate profits and losses for each participant and update margin requirements accordingly.

Default Resolution: In the unfortunate event of a participant’s default, clearinghouses manage the default process. They may use the defaulting participant’s margin and collateral to cover losses and ensure that all trades are settled without disruption.

Collateral Management: Clearinghouses manage the collateral pledged by participants. This includes marking-to-market and revaluing collateral as market conditions change, ensuring that it remains sufficient to cover potential losses.

Regulatory Compliance: Clearinghouses adhere to stringent regulatory standards and industry best practices. They operate under the oversight of regulatory authorities to ensure the integrity and stability of the financial markets.

What is Central Clearing Counterparty (CCP)?

A Central Clearing Counterparty (CCP) is a specific type of clearinghouse that focuses on reducing the counterparty risk. They often specializes in clearing and settling financial derivative contracts, including futures and options. CCPs act as intermediaries that stand between the buyer and seller in these derivative transactions. Though they primarily operates in derivative markets, they may also handle other financial instruments.

Novation is the process by which a clearinghouse interposes itself between the buyer and the seller in a financial transaction. Instead of the original contracting parties dealing directly with each other, the CCP becomes the counterparty to both sides of the trade. This replacement of the original contracts with new contracts involving the CCP is a fundamental feature of novation.

The primary purpose of novation is to mitigate counterparty risk. By becoming the buyer to every seller and the seller to every buyer, the CCP ensures that it stands in the middle of all transactions. In the event of a default by one of the parties, the defaulting party’s exposure is to the CCP rather than directly to the other party. This significantly reduces the risk of contagion and systemic disruptions caused by defaults.

As part of the novation process, CCPs impose margin requirements on participants. Participants are required to post collateral, such as cash or securities, to the CCP. This collateral serves as a financial buffer to cover potential losses in case of a default.

Other Types of Securities Settlement Mechanisms

Other than Central Counterparty (CCP) clearing, there are various other settlement mechanisms used by clearinghouses in financial markets. The most common type is Delivery Versus Payment (DVP) / Receive Versus Payment (RVP). DVP/RVP is designed to ensure the simultaneous exchange of securities and cash in a financial transaction.

Delivery Versus Payment (DVP) / Receive Versus Payment (RVP)

Delivery Versus Payment (DVP) / Receive Versus Payment (RVP) is a securities settlement method that ensures the simultaneous exchange of securities and cash between two parties involved in a financial transaction.

In DVP (Delivery Versus Payment), the emphasis is on the delivery of securities by the seller simultaneously with the payment made by the buyer. In RVP (Receive Versus Payment), the focus is on the buyer receiving the securities while simultaneously making the payment.

In both DVP and RVP, the settlement process often involves a clearinghouse and/or a Central Securities Depository (CSD) acting as an intermediary. They ensure that the buyer receives the securities, and the seller receives the payment simultaneously.

In many stock markets, including the United States, stocks and bonds are traded and settled through the DVP/RVP mechanism, where the transfer of securities and payment occurs electronically and simultaneously.

On the other hand, derivative products, such as futures and options, are settled through the Central Clearing Counterparty (CCP) mechanism. The CCP becomes the counterparty to both the buyer and the seller, managing the risk associated with default.

Clearing and Settlement Process

In the stock market, the clearing and settlement process is a major part of trading operations, ensuring the smooth and secure transfer of securities and funds between market participants. It involves multiple steps and the coordination of various entities, including clearinghouses, central securities depositories, brokers, and stock exchanges. Here is an overview of the clearing and settlement process:

1. Securities Transaction

The investor initiates a transaction by submitting a buy or sell order to their broker or financial institution, indicating the type and quantity of securities they intend to trade. Subsequently, the broker or financial institution transmits the investor’s order to the stock exchange or trading platform. At this stage, the exchange matches the buy and sell orders and facilitates the execution of the trade.

2. Margin Calculation

Clearinghouses calculate and enforce margin requirements for all participants. They assess the risk associated with each trade and ensure that participants have sufficient collateral (margin) to cover potential losses. Margin requirements are updated regularly based on market conditions, asset prices, and the volatility of the securities involved.

3. Trade Verification and Matching

As trades are executed on the stock exchange, clearinghouses are provided with details of these trades by brokerage firms. Clearinghouses verify the trade details and ensure that they are accurately matched. This step helps in identifying discrepancies and errors.

4. Clearing

Once trade details are verified and matched, clearinghouses act as central counterparties (CCPs). They interpose themselves between the buyer and the seller, becoming the buyer to every seller and the seller to every buyer. By becoming the counterparty to all trades, clearinghouses effectively guarantee the performance and settlement of all transactions. This process is known as novation.

5. Settlement

The actual settlement process involves the transfer of ownership of securities and funds between the participants. Clearinghouses ensure that this settlement process is efficient and secure. They work closely with central securities depositories (CSDs) to facilitate the transfer of securities from the seller’s account to the buyer’s account and the transfer of funds from the buyer to the seller. Settlement can occur on a real-time, same-day, or delayed basis (T+1 or T+2), depending on the market’s rules and regulations.

6. Default Management

In cases of participant defaults, clearinghouses manage the default process. They have established procedures to handle these situations. Clearinghouses use the defaulting participant’s margin and collateral to cover any losses incurred by the non-defaulting parties. This process is designed to ensure that all trades are settled without disruption. If necessary, they may also use their financial resources to ensure the completion of trades and protect the stability of the market.

7. Ownership Transfer

Upon the settlement of a trade, the Central Securities Depository (CSD) takes on the responsibility of accurately updating the legal ownership of securities. The transfer of ownership is recorded electronically within the systems maintained by the CSD.

8. Reconciliation

Clearinghouses conduct daily reconciliation to ensure the accuracy of trade records and the proper allocation of funds and securities. They calculate profits and losses for each participant and adjust margin requirements based on the day’s activities.

In short, clearinghouses are essential to the clearing and settlement process in the stock market. They act as central counterparties, manage margin requirements, reduce counterparty risk, handle defaults, and ensure the accurate and timely settlement of trades.

Examples of Clearing House

In many financial markets, especially those with a diverse range of financial instruments, there is often a separation between clearinghouses (or clearing organizations) that handle different types of securities. This division is usually based on the distinction between cash equities (stocks and bonds) and derivatives (futures and options).

For example, let’s consider the case of the New York Stock Exchange (NYSE).

NYSE, like many other stock exchanges, operates on a T+2 settlement cycle for equity securities. This means that the settlement of stock trades occurs two business days after the trade date. The settlement process for equity securities on NYSE involves the Delivery Versus Payment (DVP) mechanism. DVP ensures the simultaneous exchange of securities and funds, reducing settlement risks.

NYSE relies on Depository Trust and Clearing Corporation (DTCC) / National Securities Clearing Corporation (NSCC) for clearance and settlement of stocks, bonds, ETFs, and UITs, via their Universal Trade Capture (UTC) processing stream.

The NYSE also operates two options markets: NYSE American Options and NYSE Arca Options. The clearing and settlement of options contracts on NYSE often involve a Central Clearing Counterparty (CCP). A CCP interposes itself as the buyer to every seller and the seller to every buyer, guaranteeing the performance of the trade.

NYSE relies on ICE Clear (Intercontinental Exchange Clearing House) for clearance and settlement of option contracts.

Like NYSE, NASDAQ too follows a T+2 settlement cycle for equity securities. The settlement process for equity securities on NASDAQ involves the Delivery Versus Payment (DVP) mechanism. DVP ensures the simultaneous exchange of securities and funds, reducing settlement risks. NASDAQ also operates various options and futures markets. The clearing and settlement of these derivative instruments often involve a Central Clearing Counterparty (CCP). A CCP interposes itself as the buyer to every seller and the seller to every buyer, guaranteeing the performance of the trade. This helps manage counterparty risk in the derivative markets.

What is a Clearing Member?

A clearing member is a financial institution, such as a bank or brokerage, that is a member of a clearinghouse. Clearing members have the authority to clear trades on behalf of themselves and/or their clients, depending upon the type of membership.

Clearing members, who must also be members of the corresponding stock exchange, are responsible for submitting trades to the clearinghouse for clearing and settlement. They are required to meet risk management standards and provide collateral to the clearinghouse.

Clearing Members are also responsible for settling their net obligations with the clearinghouse. They manage their own risks and the risks of their clients. They facilitate the transfer of funds and securities as per the settlement terms determined by the clearinghouse.

General Clearing Members: General Clearing Members are typically large financial institutions, such as banks or major broker-dealers, with the capacity to clear a wide range of financial instruments. They have a direct relationship with the clearinghouse and can clear trades for their own accounts as well as on behalf of their clients.

Direct Clearing Members: Direct Clearing Members, similar to GCMs, have a direct relationship with the clearinghouse. However, their clearing activities have a limited scope, as they can clear trades only for their own accounts.

Indirect Clearing Members: Indirect Clearing Members do not have a direct relationship with the clearinghouse but clear their trades through a General Clearing Member. They are typically smaller financial institutions or market participants that may not meet the criteria for direct membership.

Clearing Firm: Clearing firms act as intermediaries between introducing brokers (or other smaller financial entities) and the clearinghouse. Introducing brokers may not have a direct relationship with the clearinghouse but can clear trades through a clearing firm.

Self-Clearing Broker: A self-clearing broker is a brokerage firm that performs the functions of a clearing firm internally, without relying on the services of an external clearing firms to settle trades. Self-clearing brokers maintain a direct relationship with the clearinghouse.

Major Clearing Houses in the World

Some of the major clearinghouses (clearing corporations) in the world are:

Depository Trust Company (DTC): Based in the United States, DTC is a subsidiary of Depository Trust & Clearing Corporation (DTCC). It is one of the largest clearing corporations globally. It provides clearing and settlement services for a wide range of financial assets, including stocks, bonds, and money market instruments.

Canadian Depository for Securities Limited (CDS): CDS clears and settles most of the Canadian market trades in equities, corporate and government securities and other marketable securities.

ASX Clear: Operating in Australia, ASX Clear provides clearing services for the Australian Securities Exchange (ASX) and the Sydney Futures Exchange (SFE).

Hong Kong Exchanges and Clearing Limited (HKEx): This clearinghouse serves the Hong Kong market and clears a broad range of financial products, including stocks, futures, and options.

National Securities Clearing Corporation (NSCC): A subsidiary of the DTCC, NSCC focuses on the clearing and settlement of securities in the United States.

The Central Depository (Pte) Limited (CDP):  The CDP is a wholly owned subsidiary of the Singapore Exchange Limited (SGX). It provide integrated clearing, settlement and depository facilities for customers in the Singapore Securities Market, including both equities and fixed income instruments.

LCH Ltd: It is a UK- based clearinghouse operating under LCH Group. It offers clearing services for a diverse range of asset classes, including equities, fixed income, FX, rates and repos.

LCH SA: It is a France- based clearinghouse operating under LCH Group. It offers clearing services for credit default swaps (CDS), options on CDS, repos and fixed income, commodities, cash equities, and equity derivatives.

Options Clearing Corporation (OCC): Also based in the United States, OCC specializes in clearing and settling options contracts.

Euroclear: Euroclear operates in Europe and provides post-trade services, particularly in the area of fixed-income securities. It’s an essential part of the European financial infrastructure.

S.D. Indeval: This Mexican CSD’s services include custody, safekeeping, clearing and settlement of securities.

Clearstream: This Luxembourg-based clearing corporation focuses on European markets and provides clearing, settlement, and custody services for various asset classes.

Major Clearing Agencies in the United States are:

• The Depository Trust Company (DTC)
• National Securities Clearing Corporation (NSCC)
• Fixed Income Clearing Corporation (FICC)
• The Options Clearing Corporation (OCC)
• ICE Clear Credit LLC (ICC)
• ICE Clear Europe Limited (ICEEU)
• LCH SA

Clearing Houses vs Exchanges

Exchanges are marketplaces where buyers and sellers come together to trade financial instruments. They provide the platform for executing trades. On the other hand, clearinghouses (also known as clearing corporations) are financial intermediaries responsible for the clearing and settlement of trades executed on the exchanges.

So, how does it work? Exchanges facilitate the execution of trades by matching buy and sell orders. The trades executed on exchanges are sent to the clearinghouse for clearing and settlement. The clearinghouse stands between the buyer and seller, guaranteeing the fulfillment of trade obligations.

In summary, clearinghouses handle the post-trade processes of clearing and settlement, while exchanges provide the marketplace for pre-trade and trade activities where buyers and sellers come together. Both are crucial for the smooth functioning of financial markets.

Aspect	Exchanges	Clearing Houses
Function	Exchanges provide a marketplace for buying and selling financial instruments.	Clearinghouses ensure the orderly settlement of trades by acting as central counterparties.
Role	Exchanges facilitate trade execution by matching buy and sell orders.	They act as intermediaries between buyers and sellers, guaranteeing trade settlement.
Clearing	Exchanges do not handle clearing but focus on price discovery and execution.	Clearinghouses handle trade obligations, calculate participant obligations, and net positions.
Settlement	Exchanges do not manage settlement but rely on clearing houses for this process.	They oversee the actual transfer of securities and funds between trading participants.