- See also "Clearing organization"
Clearing is the process by which the rights and obligations arising from market transactions are formally assigned to the buyers and the sellers. Clearing is usually conducted by a distinct organization from the trading operation termed the clearing organization. The clearing organization may be affiliated with or legally separate from the venue where the trading takes place; CME Clearing and the OCC, formerly known as Options Clearing Corporation, are respective examples. In derivatives exchanges, there is only one clearing organization for each contract, so the clearing venue for any exchange-traded derivative is unambiguous at the time of transaction.
All exchange traded derivatives must be cleared. This requirement is dictated by both tradition and law.
For derivatives transactions, the clearing organization substitutes itself at the clearing member level as the counterparty for every trade on an exchange. At the clearing organization, clearing members represent their own and their customers' trades as well as the customer trades of the brokers (futures commission merchants for commodity derivatives and broker-dealers for equity options) becoming the buyer to each seller of a contract or other derivative, and the seller to each buyer.learing member]]s.
Clearing organizations are accessible only to their clearing members, which mostly are legal persons. Retail customers, local traders, proprietary trading and brokerages gain access by having accounts with clearing member firms.
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.
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.
Pre-trade risk management 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.