- 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. Accordingly, all ICE Futures US contracts are cleared at ICE Clear US, for example, and all contracts traded on options exchanges in the United States are cleared by OCC.
The term clearing sometimes includes also the successful payment and or other fulfillment of contractual obligations, although settlement is a distinct concept. Settlement refers to any payments to or from the clearing organization or the transfer of ownership of commodities in conjunction with deliveries pursuant to contract terms.
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 usually are legal entities. Retail customers, local traders, proprietary trading and brokerages gain access by having accounts with clearing member firms.
Rules and regulations
Clearing organizations are regulated by the same governmental bodies that regulate trading. In the United States, futures clearing organizations are regulated by the CFTC and stock options clearing organizations are regulated by the SEC. In the European Union, clearing organizations are regulated by ESMA with backstopping by "competent authorities" in individual countries. In the United Kingdom, clearing is regulated by the Financial Conduct Authority. Regulation of clearing in China is carried out by the China Securities Regulatory Commission.
Clearing is conducted pursuant to processes and procedures taking the form of clearing organization rules once they are approved by the clearing organization's highest authority, such as its board of directors. The clearing rules are usually approvable or at least reviewable by the regulator before they can be put into effect.
Clearing organizations effectively guarantee financial performance on all open positions by substituting themselves for the original counterparty clearing member in each trade. All clearing members look only to the clearing organization to pay obligations due them on a timely basis.
The three pillars of risk management are limiting access by dealing only with clearing members which are vetted for operational and financial capability, paying and collecting variation margin based on daily marking of positions to market, and collection and maintenance of performance bonds for open positions, also known as initial or variation margin.
Clearing organizations receive trading information directly from exchanges. Except for the accounts for clearing members' own trades, the clearing organization is unaware of the ultimate owners of the contracts on its books.
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.
- PART 38—DESIGNATED CONTRACT MARKETS §38.601 Mandatory clearing. CFTC.
- CFTC Glossary. CFTC.
- Execution, clearing and Settlement. Thismatter.