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The definition, function, and purpose of a traditional clearing house
In traditional finance terms, a clearinghouse is an independent institution formed to facilitate the exchange of securities, commodities, or derivatives. The clearinghouse stands between two broker firms, taking the opposite side of each party and thus reducing the risk of either party honoring its trade settlement obligations.
The clearinghouse enters the picture after a buyer, and a seller executes a trade. Its role is to accomplish the steps that finalize and validate the transaction. In acting as a middleman, the clearinghouse provides the security and efficiency integral to stability in a financial market.
A traditional clearinghouse is tasked with five crucial roles that add stability, safety, and transparency to markets:
This is the principal role of the clearinghouse. It means that all trades that the exchange reports are up to the required market standards and that each participating party can fulfill their commitment. Once a trade is “cleared” it means the trade is completed, i.e., the buyer has paid for the goods and the seller has delivered the asset.
Besides its function as an overseeing body, the clearinghouse also drastically reduces the number of payments between parties through a "Netting" process. Brokers usually carry out thousands of transactions a day. Settling each transaction would be a logistical nightmare. Netting allows brokers only to pay for the actual outstanding balance of their trading account.
Margin accounts are accounts the brokers hold with the clearinghouse. The amount required to be held on these accounts is often defined by mathematical formulas that consider the risk of the broker's open positions. The margin amount is the collateral a broker must maintain at all times to ensure his open positions.
If the broker can’t meet the margin obligation, the clearinghouse has a procedure to either reduce or liquidate the position. This is called partial or full close-out.
At the agreed time of exchange, the clearinghouse ensures that the seller delivers the money and the buyer transfers the asset in question.
If the required margin amount exceeds the balance, the clearinghouse will issue a margin call, i.e., a request to top up the account.
The clearinghouse is tasked with reporting all activity to regulators and governing bodies. This facilitates oversight since controlling entities don’t have to work out each broker's activity but can view the market as a whole.
It further allows for analytical data such as market depth, flows, trends, and other important statistical measures for all market participants.