Clearing houses do not hog the limelight but they perform one of the most important jobs in the financial sector. With millions of trades taking place every day, our entire financial market system keeps rolling thanks to the unfailing work of our clearing houses. Without a well-functioning clearing system, our financial markets would look like a community of confused honeybees bumping into each other in search of their lost queen.
Today our friends Jinny and Johnny are chatting about the role of clearing houses as a central point in the financial market through which all trades, big or small, must pass.
Johnny: Why do we need a clearing house to settle all trades in the financial market, Jinny? Can’t we settle all trades among ourselves without ever bothering anybody?
Jinny: Well, trading has become so simple these days that anybody can buy or sell without much trouble. You just need a click of the computer’s mouse. But once you are through with clicking the mouse, the work of a clearing house starts. The real challenge for a clearing house lies in ensuring that all buy and sell commitments are fully met.
How would you ensure that without a clearing house? What if the trader on the other side was just clicking his mouse for the sheer fun of it, just like a guy who knocks on the doors of strangers and disappears? To know how serious a buyer or seller is, you would need to know them individually. Forget about anonymously trading by clicking the mouse, you may actually be required to go and meet your counterparty individually, and only then take a decision. How much trading volume would such a market be able to sustain? Practically speaking, if buyers and sellers had to act like their own matchmakers, the market would not be able to generate millions of trades every day. The markets would perhaps not be able even to open the next day if buyers and sellers had to individually settle millions of trades among themselves. In a screen-based trading system, the buyer may be sitting in Delhi while the seller may be sitting in Chennai. How much time would it take to settle millions of trades in such a situation?
Illustration: Jayachandran / Mint
Moreover, different trades may be interconnected. ‘A’ may not be able to settle with ‘B’ unless ‘C’ settles with ‘A’. So without a clearing house, the counterparties may just end up chasing each other.
Johnny: How does the presence of a clearing house ensure that all trades get settled?
Jinny: Different segments of the financial market may have their own clearing house. For instance, you may come across a clearing house for settlement of stock trades, another clearing house for settlement of derivates, and so on. No matter what the market segment is, all clearing houses essentially work as a central counterparty between buyers and sellers. In a screen-based trading system, a buyer does not know who the seller is and a seller does not know who the buyer is. Once the transaction is complete, the task of deciding who owes what, how much and to whom begins.
In most stock markets, the stock exchanges pass on this data to a clearing house which interposes itself as the central counterparty between buyers and sellers. The main advantage of a central counterparty is that buyers and sellers do not have to worry about each other. The central counterparty stands in the middle of a two-way street, taking from the buyer what he owes the seller and taking from the seller what he owes the buyer. Once the parties have delivered what they owe to the other, the central counterparty simply passes on what belongs to whom. So if you have purchased shares, you will receive shares, and if you have sold shares, you will receive money.
Johnny: Standing in the middle of a two-way street could be dangerous. What would a clearing house do if one of the parties fails to fulfil his commitment?
Jinny: The clearing house assumes the role of a fence for protecting one side from the default of the other. The clearing process works on the principle of “novation” in which the clearing house assumes the risk of default from any one of the counterparties. When one of the parties fails to fulfil its commitment, then the clearing house must step in to make good the loss to the other side. To meet these kinds of eventualities, clearing houses maintain what is called a “settlement guarantee fund”. So if you have delivered the shares to the clearing house, then you can rest assured that you will also get the money even if the buyer on the other side fails to deliver the money.
For all practical purposes, a clearing house is your counterparty, but that does not mean that the defaulting party can walk out at its own sweet will. Clearing houses have their own methods of dealing with defaulters.
Johnny: Oh really? I will ask about that some other time.
What: A clearing house acts as a central counterparty between buyers and sellers in our financial markets.
Who: The clearing house assumes the risk of default from the counterparties.
How: The clearing house interposes itself as a central counterparty between buyers and sellers by using a principle of “novation”.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org