Clearing house (finance)

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A clearing house is a financial institution formed to facilitate the exchange (i.e., clearance ) of payments, securities, or derivatives transactions. The clearing house stands between two clearing firms (also known as member firms or participants).

Contents

Its purpose is to reduce the risk of a member firm failing to honor its trade settlement obligations. [1] A clearing house provides emergency lending and assists banks when they need help. [2]

Description

After the legally binding agreement (i.e., execution) of a trade between a buyer and a seller, the role of the clearing house is to centralize and standardize all of the steps leading up to the payment (i.e. settlement ) of the transaction. The purpose is to reduce the cost, settlement risk and operational risk of clearing and settling multiple transactions among multiple parties. [3]

In addition to the above services, central counterparty clearing (CCP) takes on counterparty risk by stepping in between the original buyer and seller of a financial contract, such as a derivative. The role of the CCP is to perform the obligations under the contract agreed between the two counterparties, thereby removing the counterparty risk the parties of the contract had to each other and replacing it with counterparty risk to a highly regulated central counterparty that specializes in managing and mitigating counterparty risk. [4] The clearing house mitigates risk by ensuring both parties are financially capable of entering into such a contract, and that parties will receive what they are owed, resulting in a smoother transaction and ultimately a more liquid market. [5]

History

Clearing houses were first proposed in 1636 by Philip Burlamachi, financier to Charles I of England.[ citation needed ]

Bank clearance

The origins of clearing houses date back to bank cheque clearing in the 18th century. The London Clearing-House was established between 1750 and 1770 as a place where the clerks of the bankers of the city of London could assemble daily to exchange with one another the cheques drawn upon and bills payable at their respective houses. It replaced a system of clerks visiting every other banker in London. [6]

Financial exchanges

Financial exchanges, such as commodities futures markets and stock exchanges, began to use clearing houses in the latter part of the 19th century. In 1874 the London Stock Exchange Clearing-House was established for the purpose of settling transactions in stock, the clearing being effected by balance sheets and tickets. The balance of stock to be received or delivered was shown on a balance sheet sent in by each member, and the items are then cancelled against one another and tickets issued for the balances outstanding. [7] As late as 1899, the London Stock Exchange was still the only stock exchange in Europe using a clearing house. [8] The Philadelphia Stock Exchange (founded 1790), the first U.S. stock exchange to use a clearing system, began using a clearing system in 1870, [9] but the much larger New York Stock Exchange (NYSE) still had no clearing system some two decades later in 1891. The Consolidated Stock Exchange of New York used clearing houses from its inception in 1885. This exchange existed in competition with the NYSE from 1885 to 1926 and averaged 23% of NYSE volume. Its competitor Consolidated's use of clearing houses finally forced the NYSE to follow suit (from 1892) to gain the same market advantages of at least prevention of frauds and reneging on bargains. [10] Some major U.S. commodities exchanges, like the New York Coffee Exchange (today the Coffee, Sugar and Cocoa Exchange) and the Chicago Mercantile Exchange did not begin using clearing houses to settle their transactions until the second decade of the 20th century (1914 [11] and 1919, [12] respectively).

Other industries

The British Railway Clearing-House was established in 1842. Its purpose, as defined by the Railway Clearing-House Act of 1850, was "to settle and adjust the receipts arising from railway traffic within, or partly within, the United Kingdom, and passing over more than one railway within the United Kingdom, booked or invoiced at throughout rates or fares." The Irish Railway Clearing-House, established in 1848, had its headquarters in Dublin, and was incorporated by act of parliament in 1860. In 1888 a society was formed in London called the Beetroot Sugar Association for clearing bargains in sugar from sugar beet, and the London Produce Clearing-House was established in the same year for regulating and adjusting bargains in foreign and colonial produce. [13]

Central counterparty clearing

Modern central counterparty clearing (CCP) provides clearing services, and also takes on the counterparty risk of the counterparties (member banks and broker-dealers).

Impact

A 2019 study in the Journal of Political Economy found that the establishment of the New York Stock Exchange (NYSE) clearinghouse in 1892 "substantially reduced volatility of NYSE returns caused by settlement risk and increased asset values", indicating "that a clearinghouse can improve market stability and value through a reduction in network contagion and counterparty risk." [14]

See also

Related Research Articles

<span class="mw-page-title-main">Commodity market</span> Physical or virtual transactions of buying and selling involving raw or primary commodities

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.

A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. Futures exchanges provide physical or electronic trading venues, details of standardized contracts, market and price data, clearing houses, exchange self-regulations, margin mechanisms, settlement procedures, delivery times, delivery procedures and other services to foster trading in futures contracts. Futures exchanges can be organized as non-profit member-owned organizations or as for-profit organizations. Futures exchanges can be integrated under the same brand name or organization with other types of exchanges, such as stock markets, options markets, and bond markets. Non-profit member-owned futures exchanges benefit their members, who earn commissions and revenue acting as brokers or market makers. For-profit futures exchanges earn most of their revenue from trading and clearing fees.

<span class="mw-page-title-main">Credit default swap</span> Financial swap agreement in case of default

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.

Cheque clearing or bank clearance is the process of moving cash from the bank on which a cheque is drawn to the bank in which it was deposited, usually accompanied by the movement of the cheque to the paying bank, either in the traditional physical paper form or digitally under a cheque truncation system. This process is called the clearing cycle and normally results in a credit to the account at the bank of deposit, and an equivalent debit to the account at the bank on which it was drawn, with a corresponding adjustment of accounts of the banks themselves. If there are not enough funds in the account when the cheque arrived at the issuing bank, the cheque would be returned as a dishonoured cheque marked as non-sufficient funds.

Over-the-counter (OTC) or off-exchange trading or pink sheet trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily publicly disclosed.

The Depository Trust & Clearing Corporation (DTCC) is an American post-trade financial services company providing clearing and settlement services to the financial markets. It performs the exchange of securities on behalf of buyers and sellers and functions as a central securities depository by providing central custody of securities.

In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. This process turns the promise of payment into the actual movement of money from one account to another. Clearing houses were formed to facilitate such transactions among banks.

<span class="mw-page-title-main">Securities market</span> Component of the wider financial market

Security market is a component of the wider financial market where securities can be bought and sold between subjects of the economy, on the basis of demand and supply. Security markets encompasses stock markets, bond markets and derivatives markets where prices can be determined and participants both professional and non professional can meet.

Settlement risk, also known as delivery risk or counterparty risk, is the risk that a counterparty fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement. The term covers factors incidental to the settlement process which may suspend or prevent a trade from completing, even though the parties themselves are in agreement, are acting in good faith, and otherwise competent to perform.

<span class="mw-page-title-main">Options Clearing Corporation</span> Financial services business

Options Clearing Corporation (OCC) is a United States clearing house based in Chicago. It specializes in equity derivatives clearing, providing central counterparty (CCP) clearing and settlement services to 16 exchanges. It was started by Wayne Luthringshausen and carried on by Michael Cahill. Its instruments include options, financial and commodity futures, security futures, and securities lending transactions.

<span class="mw-page-title-main">Intercontinental Exchange</span> American exchange and clearing house company

Intercontinental Exchange, Inc. (ICE) is an American company formed in 2000 that operates global financial exchanges and clearing houses and provides mortgage technology, data and listing services. Listed on the Fortune 500, S&P 500, and Russell 1000, the company owns exchanges for financial and commodity markets, and operates 12 regulated exchanges and marketplaces. This includes ICE futures exchanges in the United States, Canada, and Europe; the Liffe futures exchanges in Europe; the New York Stock Exchange; equity options exchanges; and OTC energy, credit, and equity markets.

A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.

The European Multilateral Clearing Facility (EMCF) was a clearing house based in the Netherlands for equity trades done on stock exchanges or multilateral trading facility throughout Europe.

LCH is a financial market infrastructure company headquartered in London that provides clearing services to major international exchanges and to a range of OTC markets. The LCH Group includes two main entities: LCH Limited based in London and LCH SA based in Paris.

The Clearing House Payments Company L.L.C. (PayCo) is a U.S.-based limited liability company formed by Clearing House Association. PayCo is a private sector, payment system infrastructure that operates an electronic check clearing and settlement system (SVPCO), a clearing house, and a wholesale funds transfer system (CHIPS).

<span class="mw-page-title-main">CLS Group</span> Financial infrastructure group

CLS Group, or simply CLS, is a specialized financial market infrastructure group whose main entity is the New York-based CLS Bank. It started operations in 2002 and operates a unique and global central multicurrency cash settlement system, known as the CLS System, which plays a critical role in the foreign exchange market. Although the forex market is decentralised and has no central exchange or clearing facility, firms that chose to use CLS to settle their FX transactions can mitigate the settlement risk associated with their trades. CLS achieve this thanks to a central net and gross payment versus payment settlement service directly connected to the real-time gross settlement systems of participating jurisdictions through accounts at each of their respective central banks.

ICE Clear Credit LLC, a Delaware limited liability company, is a Derivatives Clearing Organisation (DCO) previously known as ICE Trust US LLC which was launched in March 2009. ICE offers trade execution and processing for the credit derivatives markets through Creditex and clearing through ICE Trust™. ICE Clear Credit LLC operates as a central counterparty (CCP) and clearinghouse for credit default swap (CDS) transactions conducted by its participants. ICE Clear Credit LLC is a subsidiary of IntercontinentalExchange (ICE). ICE Clear Credit LLC is a wholly owned subsidiary of ICE US Holding Company LP which is "organized under the law of the Cayman Islands but has consented to the jurisdiction of United States courts and government agencies with respect to matters arising out of federal banking laws."

The Global Association of Central Counterparties or CCP Global, formerly CCP12, is the trade association of central counterparty clearinghouses (CCPs) located in Amsterdam in the Netherlands, and China. It represents 39 primary members, and 3 observer members of CCPs operating across Africa, the Americas, Asia, Australia and Europe and representing over 60 individual CCPs. CCP12 was formed in 2001 by major central counterparty organizations in Europe, Asia and the Americas to share CCP related information and to develop analyses and policy standards for common areas of concern.

<span class="mw-page-title-main">Shanghai Clearing House</span> Financial infrastructure in China

The Shanghai Clearing House, formally the Inter-bank Market Clearing House Co., Ltd., is a significant central counterparty and central securities depository in China, established in 2009 in Shanghai.

References

  1. ↑ Gilman, Theodore (1904). "The Clearing-House System". Journal of Political Economy. 12 (2): 208–224. doi:10.1086/251033. ISSN   0022-3808.
  2. ↑ Gorton, Gary; Tallman, Ellis W. (2016). "Too Big to Fail before the Fed". American Economic Review. 106 (5): 528–532. doi:10.1257/aer.p20161043. ISSN   0002-8282.
  3. ↑ "Speech by Chairman Bernanke on clearinghouses, financial stability, and financial reform". Board of Governors of the Federal Reserve System. Retrieved 2017-10-20.
  4. ↑ Rehlon, Amandeep; Nixon, Dan. "Central counterparties: what are they, why do they matter and how does the Bank supervise them?" (PDF). Bank of England. Retrieved 1 April 2017.
  5. ↑ "What is a Clearing House?". Corporate Finance Institute. Retrieved 31 January 2021.
  6. ↑ Ingram 1911, p. 476.
  7. ↑ Ingram 1911, p. 478.
  8. ↑ Lloyd, H.D. (1899), "Clearing, and clearing houses", Cyclopædia of Political Science, Political Economy, and the Political History of the United States, vol. 1, New York: Maynard, Merrill, and Co, p. 223
  9. ↑ "Philadelphia Stock Exchange | Encyclopedia of Greater Philadelphia". philadelphiaencyclopedia.org. Retrieved 2019-10-30.
  10. ↑ Sobel, R. (2000) The Big Board. Washington, D.C.: Beard Books, p. 131 (Original work published 1965 New York, New York: Free Press)
  11. ↑ Coffee and Tea Industries and the Flavor Field. Spice Mill Publishing Company. 1914. p. 1036.
  12. ↑ Labuszewski, J.W., Nyhoff, J.E., Co R., and Peterson, P.E. The CME Group Risk Management Handbook (2010) Hoboken, New Jersey: John Wiley & Sons, p. 80
  13. ↑ Ingram 1911, pp. 477–478.
  14. ↑ Bernstein, Asaf; Hughson, Eric; Weidenmier, Marc (2019). "Counterparty Risk and the Establishment of the New York Stock Exchange Clearinghouse". Journal of Political Economy. 127 (2): 689–729. doi:10.1086/701033. S2CID   201419723.

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