Clearinghouse Definition Examples How It Works

Clearinghouse Definition

Explanation

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Suppose Mr. A promises Mr. B to sell his shares in Johnson Ltd. two weeks from today. In return, Mr. B has paid him a 20% advance today and promises to pay him the balance price for all the shares on that day. Mr. B deals with Mr. C to sell him those shares the same day he receives them.What risk is Mr. B facing here? The risk of non-delivery of shares from Mr. A. What threat is Mr. C facing here? The risk of non-delivery of shares from Mr. B. What threat is Mr. A facing here? Mr. B’s risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more is that he will postpone the payment.One can avoid such risks if a person between the transactions is responsible for the default. That is the role a clearinghouse plays. So, it facilitates payment transactions or transactions like derivatives or securities. The main purpose is to reduce the risk of honor in trade settlement obligations.If you observe, the clearinghouse will always take the exact opposite position for each trade side. It acts as a buyer for the person who is selling something. But simultaneously serves as a seller for the person receiving the same. Thus, it has great importance in the financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more.

How does Clearinghouse Work?

The above diagram shows the simplified process of how the transaction flows between two parties. The buyer receives the actual goods from the deemed seller (i.e., the clearinghouse), and the seller receives the consideration for the goods sold to the supposed buyer (i.e., the clearinghouse).

It makes the transaction secure. The question is, Will the clearing do the same for free of cost? The answer is obviously, “No.” The mediator charges a nominal amount from each party to the contract, say 0.001% of the trade involved. Isn’t the margin too low? Obviously, yes. But the mediator earns due to huge volumes of business around the globe.

The clearinghouse is involved in regular transactions of trading goods (i.e., manual physical delivery or customized contracts) and futures contracts, derivatives contracts, or options contracts (i.e., automated exchange-driven contracts).

Example of Clearinghouse

The stock is trading at $850. You will see several contracts as follows: –

Explanation

Mr. C can buy from Mr. R only 5,000 stocks at $849. The price will move down. Then, you can see Mr. B can buy from Mr. Q at $848 to 10,000 stocks. Mr. Q will remain with 10,000 stocks at $848. Mr. Q can increase his price to $849 and sell to Mr. C stock for 5,000.

The price will not move until one of the parties to the transaction modifies its costs.

So, all these happen in seconds on the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more. The stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more here is the mediator facilitating the trade.

Functions

The first and foremost thing is to ensure a smooth transaction flow.It guarantees the occurrence of the transaction in the manner planned by the said parties.This guarantee is given by checking the repaying capacity and credibility of the parties involved. That applies irrespective of whether the parties are natural or artificial persons.It ensures that the system is available during trading hours. That makes sure that the market is liquid.A clearinghouse also provides standardized norms regarding the quality, quantity, price, minimum ticks, maximum movement of cost within a day, and contract maturity.

Importance

Each trader’s basic risk is non-honoring the contract and default risk on the buyer’s side.Clearinghouse eliminates such risks, thereby assuring the financial transaction.It is responsible for settlement between the parties, the time limit within which the transaction should get completed, and monitoring the adequacy of margins placed on the accounts of each trader.Clearinghouse ensures that the variable margin is called for if a trader breaches the maintenance margin.

Benefits

Ease of transaction.It is a secure way of dealing in a financial transaction at a negligible cost.Reduction in human-oriented errors.Faster processing of transactions.There is no need to search eligible counterpartyCounterpartyA counterparty in a financial transaction is the person or entity on the other side of the agreement. Any trade must have at least two parties who serve as counterparties for each other. For every buyer in a purchasing deal, there must be a seller. And for every seller, there must be a buyer willing to purchase.read more to the transaction.

Disadvantages

There are very few disadvantages to the clearinghouse. The clearinghouse system has emerged due to flaws in the earlier physical settlement system. They made the clearinghouse to advantage the public at large. It can never default due to stringent regulations imposed by the government. We can better call it the limitations rather than the disadvantages.

Limited settlement hours since the exchange is not available 24×7.A specific quantum of orders is required. So, you cannot trade in odd lotsOdd LotsAn odd lot refers to a stock order involving the sale or purchase of fewer than 100 shares, such as 19. For ease of exchange, stock exchanges trade stocks in a standardized unit such as 100 or 1000 shares. However, many small investors cannot afford to invest in a huge portion, leading them to spend on an odd lot of expensive stocks.read more at your convenience.A slower internet connection may delay placing your orders.There is a slight risk of default from the sub-brokers to the clearinghouse.

Conclusion

A clearinghouse driven by regulations placed upon by the government. Since they are regulated, traders rely upon the system. Today the stock exchange plays the role of mediation. We can see huge volumes of transactions taking place on the trade. It is possible only through the automated clearing system.