Title: How Clearinghouses Work and Why They Matter
Short definition
– Clearinghouse (also called a central counterparty or CCP): a financial-market intermediary that becomes the buyer to every seller and the seller to every buyer after a trade executes. Its job is to finalize (clear) and settle trades, manage counterparty risk, and make sure both sides meet their obligations.
Why clearinghouses exist (big picture)
– They reduce transactional and counterparty risk by guaranteeing that trades will complete even if one participant fails to perform. That promotes confidence and efficiency in exchanges for stocks, futures, and options.
Key responsibilities (what a clearinghouse does)
– Novation: legally replace the two original counterparties with itself, so each member faces the CCP rather than an unknown counterparty.
– Netting: offset multiple positions among members to lower the total number of settlements and reduce required cash/asset flows.
– Margining: require collateral (initial and maintenance margins) and collect variation (daily mark-to-market) to cover potential losses.
– Settlement: move cash and securities between accounts to complete transactions.
– Recordkeeping and reporting: keep trade records and report settlement data to regulators and members.
– Default management: enforce rules for handling member failures (margin use, auctions, other resources).
Key jargon (defined)
– Novation: the clearinghouse legally inserts itself into the trade so the original buyer and seller are relieved of direct obligations to each other.
– Initial margin: up-front collateral a trader must post when opening a leveraged position; meant to cover potential losses while a position is open.
– Maintenance margin: the minimum equity level that must remain in an account to keep a position open.
– Mark-to-market (variation margin): the daily gain/loss calculation that adjusts account balances to current market prices.
Step-by-step: what happens after you place a trade
1. Execution: buyer and seller agree on a price on an exchange or through a broker.
2. Submission to clearing: the trade is sent to the exchange’s clearinghouse.
3. Novation/netting: the clearinghouse interposes itself and nets the trade against other positions.
4. Margin collection: initial margin is recorded; the position is marked to market daily and variation margin is collected or paid.
5. Settlement/delivery: cash and securities are transferred according to contract terms.
6. Release: when a position closes or settles, any excess margin is returned.
Role differences: futures vs. equities
– Futures: clearinghouses are central because futures are typically leveraged. Margins are larger drivers of risk management; daily mark-to-market is standard. The CCP’s activity is essential to allow high leverage safely.
– Stock markets: exchanges have clearing divisions that confirm buyers have funds and sellers have the shares. Settlement cycles (e.g., T+2 in the U.S.) and securities custody are the main functions.
Broker vs. clearinghouse — quick distinction
– Broker: executes trades on behalf of clients and may provide access to markets.
– Clearinghouse: handles the post-trade processing, guarantees performance, collects margins, and settles the trade. Some brokers are clearing members; others pass clearing to third-party clearing firms.
Can a clearinghouse fail?