What is a Clearing House?

A clearing house refers to an establishment, usually a financial institution that facilitates the exchange of cheques, bills and other derivatives between members. A clearing house acts as an intermediary between a buyer and a seller in the exchange of financial instruments. When banks need to exchange cheques, bills, securities and other derivatives for cash, they go through a clearing house. A clearing house facilitates transactions between two parties and ensures that each of the parties honor their obligations. It is an intermediary between two banks or clearing firms. Clearing houses play important roles in futures contracts and options agreement.

How Does a Clearing House Work?

Oftentimes, a clearing house serves as a third party in a financial transaction, it is an intermediary between a buyer and a seller that ensures the smooth settlement of a trade. A clearing house holds parties in a transaction responsible for the performance of their obligations in order to minimize the risk of settling dispute that ensure in multiple transactions. There are certain maintenance or margin requirements that clearing houses are supposed to meet so that the risk of default by both parties can be hedged. Clearing houses are often used in options and futures contract to enhance financial stability in the market. There are different exchanges in the market and each exchange has its clearing house where members are expected to clear their transactions.

Futures Clearing House Example

When used in futures contract, clearing houses set a maintenance margin requirement for every contract, this is to mitigate the occurrence of default and offset losses associated with the trade. The maintenance margin refers to the amount a trader must have in his account in order to keep the trade open. The funds paid as margin requirements are held in the trader's account and managed by the clearing house. Any trader that fails to meet the maintenance margin requirement gets a margin call which means the funds v must be raised to meet the requirement. If a trader does not meet the margin requirements, it indicates that such trader lacks the capacity to withstand losses that can occur in the trade. The account of any trader that fails to meet the margin call is at the verge of being closed. Once the trade or account is closed, the trader can use the funds for further trades. This is one of the ways that clearing houses prevent risk in transactions. Other crucial functions that clearing houses perform include clearing trades, collecting and training maintenance margin requirements, settling of trading accounts, regulating delivery of instrument, and making trading data available.

Stock Market Clearing Houses

Generally, all stock exchanges have clearing houses, the New York Stock Exchange (NYSE) and the NASDAQ for example have clearing houses that serve as intermediary between buyers and sellers in given transactions. Clearing houses ensure that stock traders are financially fit to engage in trade and that they meet maintenance margin requirements. Clearing houses also ensure clearing of trades, their exchange and delivery between participants. Facilitating seamless exchange of transfer of funds is another important duty of clearing houses. They also ensure that enough funds are kept aside by traders for trade settlement.