What Are Clearing Houses and How Do They Work?

Daniel Penzing
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How Do Clearing Houses Work?

Most people are familiar with the term clearing house and think it only applies to financial assets, but clearing houses in fact handle any type of obligation and are transferred through a clearing house.

In the financial world, clearing houses are used for settling securities transactions. The benefit of a clearing house is that it takes the risk of the counterparty defaulting out of the equation and ensuring the transaction will settle as agreed.

Clearing houses were created to help facilitate the exchange of financial instruments by ensuring that both parties in the transaction are able to meet their financial obligations at the agreed upon time. The obligations are netted, and the clearing house issues payment to the party in the transaction that has made the net payment. Clearing houses help reduce the risk involved in these transactions.

Any financial service provider can use a clearing house to facilitate transactions. This can be a stock exchange, a bond exchange, a bank or a futures exchange. They all use clearing houses to ensure that transactions are carried out in an orderly fashion.

How Are Clearing Houses Used for Stock Transactions?

Those who are familiar with the stock markets know that an order to buy or sell shares is not executed until it is made official with the exchange by the dealer trader.

The Magic of Self-Clearing

The clearinghouse is a common sight on every financial exchange. Yet few outside of the financial markets understand how clearinghouses function. What exactly is a clearinghouse? The name itself sounds ominous and frightening; like a high-security prison. You might not be surprised to learn that the name comes from the clearing, or clearing, of securities. A clearinghouse is a type of security depository that holds stocks, bonds, and other securities until buyers and sellers actually exchange them.

The secure nature of a clearinghouse is what makes the securities exchanges possible. A clearinghouse makes it possible for a wide variety of people to trade stocks and bonds with each other with relative ease.

Here’s how it works. Each person or brokerage firm that wishes to buy or sell stocks on a particular exchange needs to have an account with that exchange. When a buyer and seller connect, the clearinghouse acts as the security depositary and safeguards the transaction.

Let’s look a little closer. The way this works is that any time a buyer and seller connect on the exchange, the clearinghouse is automatically notified by the exchange. There are a variety of ways that this can be accomplished. In the early days of the exchanges, brokers had to physically deliver the stock and wire the money to the clearinghouse.

Other Functions of a Clearing House

In many cases, a clearing house will also process payments and issue paychecks where a check is used as the main method of payment.

Clearing houses also maintain records of all financial transactions and maintain accounts as well.

They also perform other functions such as collecting and issuing of receipts for products sold, accepting credit and debit card payments online, recording incoming payments, managing credit and debit cards for their clients, and making cash backed investments.

In Conclusion

  • Clearing houses operate as participants in a barter system. Trading houses and exchanges can take on the role of the seller or the buyer in a transaction. A clearing house, however, acts solely as a third-party that manages the transaction step by step.
  • The goal of a clearing house is to reduce the risk of problems associated with counterparty risk while maintaining a high level of efficiency in terms of trade. Clearing houses achieve this goal by allowing trades to be settled intermediated trades within a set of limitations that each clearing house has.
  • Because a clearing house can reduce counterparty risk, it can benefit both parties involved in a transaction.
  • Essentially, clearing houses help eliminate credit risk amongst parties involved in transactions and have existed since ancient times.
  • Starting in the late nineteenth century, trading houses began to develop clearing houses to manage the bidding process and ensure that everyone involved would fulfill their promises. These clearing houses helped to reduce the risk that traders would not fulfill their obligations.
  • In the late nineteenth century, clearing houses also organized trade activity in different financial markets. In the United States, for example, clearing houses were instrumental in creating the stock and commodities markets.