In the financial sector, a clearinghouse acts as an authorized middleman between buyers and sellers. The clearinghouse verifies and completes the transaction, guaranteeing that the buyer and seller fulfill their contractual responsibilities.
This role is handled by a certified clearinghouse or an internal clearing division in every financial market.
How does it Work?
A clearinghouse’s tasks comprise “clearing” or “finalizing” trades, settling trading accounts, collecting margin payments, managing asset delivery to new owners, and reporting market information.
Clearinghouses operate as external parties for futures and options contracts, acting as buyers and sellers for each clearing member seller and buyer.
After a buyer and a seller complete a transaction, the clearinghouse comes into the picture. Its job is to complete the processes that complete the transaction and hence authenticate it. The clearinghouse, by acting as a broker, ensures the security and efficiency necessary for financial stability.
A clearinghouse acts properly by taking the opposite side of each trade, lowering the cost and risk of settling many transactions among different parties. While their mission is to minimize exposure, the fact that they must serve as both buyer and seller at the outset of a transaction exposes them to default risk from both sides. Clearinghouses implement margin calls to counteract this.
In the futures market, there is a clearinghouse.
Because its financial products are leveraged, the futures market is extremely reliant on the clearinghouse. That is, they usually entail financing to invest, which necessitates the use of a reliable middleman.
There is a clearinghouse for each exchange. At the end of each trading session, all members of the exchange must clear their trades through the clearinghouse and deposit a sum of money with the clearinghouse that is adequate to cover the member’s debit balance, based on the clearinghouse’s margin requirements.
Consider the case of a trader who purchases a futures contract. The clearinghouse has already established the initial and maintenance margin criteria at this time.
The initial margin can be thought of as a good-faith guarantee that the trader will be able to afford to keep the trade open until it is closed. The clearing business holds this money, but they are kept in the trader’s account and cannot be utilized for other trades. The goal is to compensate for any losses the trader may incur throughout the transaction.
The maintenance margin is the amount that must be obtainable in a broker’s bank to keep the trade open. It is usually a fraction of the initial margin stipulation. If the account equity of the trader falls below this amount, the account holder will receive a margin call requesting that the account be replenished to the level that meets the initial margin requirements.
The deal will be stopped if the trader fails to meet the margin call because the account cannot reasonably absorb further losses.
The clearinghouse has verified that there is enough cash available to offset any liabilities that the account holder may incur during the trade in this case. The outstanding margin funds are returned to the trader once the trade is closed.
The procedure has helped to lessen the danger of default. In the absence of it, one party may withdraw from the agreement or fail to pay the money owed after the transaction.
This is known as transactional risk, and it is eliminated when a clearinghouse is involved.