- See also "Clearing organization"
Clearing is the process by which the rights and obligations arising from market transactions are formally assigned to the buyer and the seller. Clearing is usually conducted by a distinct organization from the trading operation termed the clearing organization. The clearing organization, which may be affiliated with or legally separate from the venue where the trading takes place; CME Group's Clearing Division and the Options Clearing Corporation are respective examples.
For derivatives transactions, the clearing organization substitutes itself as the counterparty for every trade at the clearing member level. Clearing members act as agents for their customers, their becomes the buyer to each seller of a futures contract or other derivative, and the seller to each buyer for clearing members. It may seem simple but includes a number of risks that need to be managed. There are also significant administrative tasks involved.
The aim of clearing is to ensure that all parties meet their obligations and to minimize the risks on individual and business level as well as the systemic risk that can accumulate when a number of individuals and/or organizations are facing the same type of risk. Clearing also aims to facilitate payment and delivery.
There are two types of clearing: bilateral clearing and central (multilateral) clearing. In bilateral clearing, the parties to the transaction undergo the steps legally necessary to settle the transaction. Central clearing uses a third-party — usually a clearinghouse — to clear trades. Clearinghouses are generally used by the members - usually broker-dealers - who own a stake in the clearinghouse. Only members may access the clearinghouse directly; retail customers and other brokerages gain access by having accounts with member firms.
The process can be multilateral and include three parties, the seller, the buyer and a clearing organization (often called a clearing house). During a multilateral clearing process the clearing organization steps in between the buyer and seller in order to ensure that both parties fulfill their obligations in accordance with the deal. To safeguard against counterparty risk (the risk that liabilities cannot be met when they fall due) a clearing organization will demand collateral from its purchasing members.
Clearing can also be bilateral: the parties complete the deal in direct contact with each other and the seller carries the counterparty risk. The trading parties always carry the market risks involved. They have to make their own assessments of how they expect prices on equity and commodities, or interest and currency rates, to develop. There is also a hybrid between multilateral and bilateral clearing, where a clearing organization is used for the administrative post-trade efficiencies.
It is common practice that banks and other institutions buy and sell instruments from each other numerous times during the course of a day. When all these transactions are cleared, at the end of the day, it is practical to let them cancel each other out to make one single transfer instead of sending money back and forth. This process is called netting and is an integral part of modern clearing.
Post-trade and pre-trade clearing services
There are risks to manage and administrative efficiencies to consider both before and after trading. The post-trade clearing has been described above and includes managing events, such as netting, payment and delivery, as well as risks, from trade execution to settlement. Pre-trade clearing is becoming increasingly important as it meets the needs to asses the risks that can develop into systemic risks such as the events of 2008 have shown.
Technological benefits and challenges
Modern technology has amplified the speed and sophistication of electronic trading and has sparked new business models and financial instruments, such as the infamous credit default swaps. It also brings with it increased risk, as the speed with which business is conducted is staggering and a trader may be involved in numerous simultaneous deals. If a trader surpasses their credit liability or is hit with a bad deal – their credit rating should be affected immediately so that other traders (and the clearing organization) have a reasonable chance to adjust their level of involvement.
The credit crisis has sparked ongoing debate about the need for new regulatory measures. It is becoming clear that an integral part of the response will be a requirement for enhanced and flexible clearing and risk management technology. It takes computers to keep track of the market created by computers in order to calculate the risk at each given moment. Hence the term real-time clearing.
When the clearing is done real-time all the events involved in clearing are done immediately, as opposed to at the end of the trading day. This gives the actors fast and accurate information on which to base e.g. prices, rates and credit ratings. The transparency is improved and the information is always current so that systemic market risks can be identified and managed.
When clearing is done real-time, it is possible to see a party’s trading commitments at any given time and this information can be combined with the updated collateral requirements for the same party. The latter can be calculated by a real-time clearing system as it can take into account parameters for market risk, liquidity risk and credit risk. This gives a complete assessment of the account, i.e. its position, and can be used to make informed decisions when dealing with the party.
The information on position can be gathered for groups of accounts based on what they are trading in, who they are or any other cluster that a clearing organization, exchange or authority wants to measure and calculate.
Real-time clearing, simply put, provides more thorough and timely information about the positions of participants by making it possible to assess all the undertakings made by a single member or by groups of members. It can also indicate what effects many of the interlinkages and interdependencies on the financial arena can have on the economy.