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Clearing House

A mediator between any two entities or parties engaged in a financial transaction

What is a Clearing House?

A clearing house acts as a mediator between any two entities or parties that are engaged in a financial transaction. Its main role is to ensure that the transaction goes smoothly, with the buyer receiving the tradable goods he intends to acquire and the seller receiving the right amount paid for the tradable goods he is selling.

 

Clearing House

 

Our Introduction to Corporate Finance Course gives you an overview of how capital markets work.

 

Example of a Clearing House

Anyone who engages in any kind of transaction, no matter how small it is, will definitely want to be protected, whichever side he is on in the transaction. The clearing house stands in the middle and takes both sides to make sure that both parties are satisfied.

A case in point is an investor who wishes to sell 500 shares of his investments in Emirates Airlines to another businessman. It is the clearing house’s job to make sure that the investor gets paid the amount equal to his 500 shares and that the businessman, on the other hand, indeed gets the 500 shares in the Emirates Airlines that he paid for. With a clearing house, both parties can rest assured that both of them will do their part and a successful transaction will take place.

The diagram above shows a simplified flow of transaction involving two parties, the seller and the buyer, and in the middle of them is the clearing house firm. The clearing house is not only involved in regular transactions of tradable goods but also of those that involve futures contracts (those that are entered into by two parties wherein the buyer is obliged to buy an asset and the seller to sell an asset for an agreed fixed price at an agreed future date). It is due to the fact that futures contracts take time to be fulfilled, and thus needs a third party to ensure that the contract does not break before it matures.

Looking back at the diagram, the seller gives the goods to the clearing house who then gives it to the futures buyer. In turn, the futures buyer hands the payment to the clearing house who will then give it to the seller. In such an arrangement, both parties are protected and assured that they will both receive what is due to them.

 

Functions of a Clearing House

As mentioned, a clearing house is basically the mediator between two transacting parties. However, there is also more to what clearing houses do. Let’s take a look at some of them.

  1. The clearing house guarantees that the transactions will occur smoothly and that both parties will receive what is due to them. It is done by checking the financial capabilities of both parties to enter into a legal transaction, regardless if they are an individual or an organization.
  2. It makes sure that the parties involved respect the system and follow the procedures that will eventually result in a successful transaction. It, in turn, boosts the confidence of traders and investors in entering into various transactions in the market, leading to a more liquid market.
  3. It is the clearing house firm that provides a level playing field for both parties where they can agree on the terms of their negotiation. It includes setting the price, quality, quantity, and maturity of the contract.
  4. The clearing house makes sure that the right goods are delivered to the buyer not only in terms of quantity but also of quality so that at the end of the transactions, there will be no complaints and arbitration necessary.

 

Initial Margin and Maintenance Margin

To protect traders, every transaction requires margins, which include the initial margin and the maintenance margin. For example, when two individuals engage in a futures contract of prawns worth $1,000, the initial margin is also $1,000, which is given by the buyer and kept by the clearing house under the buyer’s account at the time the transaction commences.

The maintenance margin is also calculated and for the purpose of making an example, let us say that the amount is $800. If before the contract’s maturity the prices of prawns drop by $200, then the buyer will need to put in this same amount to meet the initial margin again. If, however, the value of the account drops to lower than the maintenance margin of $800, then a margin call is made.

For example, if the account’s value declines to $500, then, the buyer will need to post another $500 to bring back the initial margin in the account.

 

Importance of Clearing Houses

The most common fear of traders about the market is getting involved in transactions that don’t end well, with one of the parties not fulfilling their end of the agreement. It may be because of various reasons but the most widespread factor is financial turmoil. Clearing houses, as mentioned earlier, perform a background check of both traders’ financial strengths to ensure that both of them will adhere to their end of the bargain.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Eurex Exchange
  • Japan Exchange Group
  • New York Mercantile Exchange (NYMEX)
  • Securities and Exchange Commission (SEC)

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