Clearing Houses and Central Counterparties

A clearing house, also called a central counterparty (CCP), stands in the middle of every trade on an exchange. Once a trade is matched, the clearing house becomes the buyer to every seller and the seller to every buyer. That way, nobody has to worry whether the stranger on the other side will pay. If one member defaults, the clearing house steps in. It is one of the least visible and most important parts of the financial system.

How central clearing works#

1. Trade: a buyer and seller agree a trade on an exchange.
2. Novation: the clearing house replaces the original contract with two new ones: it buys from the seller and sells to the buyer.
3. Netting: it offsets each member's purchases against its sales, so only net amounts need to move.
4. Risk management: it collects margin and marks positions to market daily.
5. Settlement: cash and securities move, or derivatives settle, according to the rules.

The defences against default#

Clearing houses use several layers of protection, often called a default waterfall:

Because positions are marked to market daily, losses cannot build up unseen for long. See Mark-to-Market and Futures Margin: Initial and Maintenance.

Major clearing houses#

• DTCC (through its subsidiaries NSCC and DTC) clears and settles most US stock trades.
• Options Clearing Corporation (OCC) clears all US listed options.
• CME Clearing clears CME Group futures and options.
• ICE Clear clears ICE's futures and many credit derivatives.
• LCH clears a large share of the world's interest rate swaps.

Why clearing houses matter#

• They remove counterparty risk for traders on exchanges. Your trade is guaranteed even if the original counterparty fails.
• They make anonymous trading possible, because you never need to judge the other side's creditworthiness.
• They reduce systemic risk, which is why regulators required many OTC derivatives to be centrally cleared after the 2008 crisis. See Systemic Risk.
• They concentrate risk, which is why they are heavily regulated and stress tested: a failing clearing house would be a serious event.

Clearing and you#

Most traders never interact with a clearing house directly. Your broker, or the clearing firm it uses, is the clearing member. Effects you might notice include margin requirements set partly by clearing houses, higher margins during volatile periods and settlement timing. In January 2021, sharp rises in clearing house deposit requirements during the GameStop episode led some brokers to restrict buying in certain stocks, a rare moment when clearing became front page news.

Frequently asked questions#

What does a clearing house do?#

It becomes the counterparty to both sides of every trade, nets positions, collects margin and guarantees that trades are settled.

What is the difference between clearing and settlement?#

Clearing covers confirming, netting and managing the risk of trades until they settle. Settlement is the actual transfer of cash and assets. See Settlement.

Can a clearing house fail?#

It is very rare. Clearing houses hold margin, default funds and capital to withstand member failures, but they are regulated closely because a failure would be serious.

Sources#

• Wikipedia, Central counterparty clearing