CFA, Finance, FRM

Role of Clearing House in Financial Markets

Clearing House

A clearinghouse behaves as a middleman between any two entities or parties (buyers and sellers) who are involved in any sort of financial transaction. It seeks to guarantee that the process from the genesis of the trade until its settlement is plain sailing. It also makes sure that the buyer and seller meet the obligations of their contract.

Clearing Houses works in most of the business areas in the world. Like in future markets: It makes sure that both the parties( buyers and sellers) fulfill all of their obligations related to the futures contract being traded and keep an eye on the proper delivery of that particular instrument.

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The key jobs performed by clearinghouses are as follows:

  • Settle Trading Accounts
  • Clear Trades
  • Supervising delivery of instrument bought or sold
  • Maintaining records of money collected
  • Report the traded data

 Example of a Clearing House:

Mr. A agrees to sell his 100 shares of Company ABC to Mr. X for Rs. 10,000. Now it’s the responsibility of the clearinghouse that Mr. X is delivered 100 shares and Mr. A is delivered Rs. 10,000. Thereby, the clearinghouse ensures that this transaction is completed in an accurate and timely manner.

Functions/Role of Clearing House:

  • Checking the financial potential of the parties: To ensure that the transaction between the two parties happens smoothly, the clearinghouses checks on the financial potential of their customers (either they are individuals or any organization) before they enter into any legal transaction.
  • Follow the proper procedure: The clearinghouses must see that all the parties involved in the proceedings comply with all the rules and legal procedures for a favorable outcome.
  • Setting up the terms of negotiation: The clearinghouse comes up with the common ground where both the parties can agree upon the terms of their arrangement. This duty comes with setting up the details of the contract like the maturity date, quality, and quantity, price, etc.
  • Right delivery of goods: The clearinghouse set the seal on the right delivery of goods concerning the quality and quantity. This is done so that there is no scope of complaints or arbitration thereafter.
  • Imposing margin (initial and maintenance) requirements: To mitigate the cost and risk of settling multiple transactions among multiple parties clearing houses impose margin (initial and maintenance). Margin is a deposit of a percentage of the total value of the contract. There are two different types of margins. Initial margin- the original deposit amount needed and maintenance margin- a slightly small amount that is maintained in the trader’s account for them to continue to hold their trading position.

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To conclude, Clearing Houses are the third parties between buyers and sellers that provide efficiency and stability in the financial markets.

There is a fear in the minds of the traders about the market and getting involved in transactions that may not end well. Thus, here comes the clearinghouses which will take a high amount of risks on behalf of these traders. If the buyer fails to pay the instruments, he/she had purchased, the clearinghouse seeks for the recovery of the funds or waits for them to become available.

 

Author: Disha Agrawal

About the author: Disha Agrawal is an Economics graduate and presently pursuing an MBA with a specialization in Financial Administration from the Prestige Institute of Management and Research, Indore. She is a keen learner and is intrigued by financial markets. She is committed to her work and strives for continuous improvement.

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