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A clearing house is a financial institution formed to facilitate the exchange (i.e., '' clearance'') of payments, securities, or derivatives transactions. The clearing house stands between two clearing firms (also known as member firms or participants). Its purpose is to reduce the risk of a member firm failing to honor its trade settlement obligations.


Description

After the legally binding agreement (i.e., ''execution'') of a trade between a buyer and a seller, the role of the clearing house is to centralize and standardize all of the steps leading up to the payment (i.e. '' settlement'') of the transaction. The purpose is to reduce the
cost In Production (economics), production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one o ...
,
settlement risk Settlement risk is the risk that a counterparty (or intermediary agent) fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered securi ...
and operational risk of clearing and settling multiple transactions among multiple parties. In addition to the above services,
central counterparty clearing A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in fore ...
(CCP) takes on counterparty risk by stepping in between the original buyer and seller of a financial contract, such as a derivative. The role of the CCP is to perform the obligations under the contract agreed between the two counterparties, thereby removing the counterparty risk the parties of the contract had to each other and replacing it with counterparty risk to a highly regulated central counterparty that specializes in managing and mitigating counterparty risk. The clearing house mitigates risk by ensuring both parties are financially capable of entering into such a contract, and that parties will receive what they are owed, resulting in a smoother transaction and ultimately a more
liquid A liquid is a nearly incompressible fluid that conforms to the shape of its container but retains a (nearly) constant volume independent of pressure. As such, it is one of the four fundamental states of matter (the others being solid, gas, an ...
market.


History

Clearing houses were first proposed in 1636 by Philip Burlamachi, financier to
Charles I of England Charles I (19 November 1600 – 30 January 1649) was King of England, Scotland, and Ireland from 27 March 1625 until his execution in 1649. He was born into the House of Stuart as the second son of King James VI of Scotland, but after ...
.


Bank clearance

The origins of clearing houses date back to bank cheque clearing in the 18th century. The London Clearing-House was established between 1750 and 1770 as a place where the clerks of the bankers of the city of London could assemble daily to exchange with one another the cheques drawn upon and bills payable at their respective houses. It replaced a system of clerks visiting every other banker in London.


Financial exchanges

Financial exchange An exchange, bourse (), trading exchange or trading venue is an organized market (economics), market where (especially) tradable securities, commodity, commodities, foreign exchange market, foreign exchange, futures contract, futures, and option ...
s, such as commodities futures markets and
stock exchange A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for th ...
s, began to use clearing houses in the latter part of the 19th century. In 1874 the
London Stock Exchange London Stock Exchange (LSE) is a stock exchange in the City of London, England, United Kingdom. , the total market value of all companies trading on LSE was £3.9 trillion. Its current premises are situated in Paternoster Square close to St Pa ...
Clearing-House was established for the purpose of settling transactions in
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
, the clearing being effected by
balance sheets In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
and tickets. The balance of stock to be received or delivered was shown on a balance sheet sent in by each member, and the items are then cancelled against one another and tickets issued for the balances outstanding. As late as 1899, the London Stock Exchange was still the only
stock exchange A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for th ...
in Europe using a clearing house. The Philadelphia Stock Exchange (founded 1790), the first U.S. stock exchange to use a clearing system, began using a clearing system in 1870, but the much larger
New York Stock Exchange The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District of Lower Manhattan in New York City. It is by far the world's largest stock exchange by market capitalization of its listed ...
(NYSE) still had no clearing system some two decades later in 1891. The
Consolidated Stock Exchange of New York The Consolidated Stock Exchange of New York, also known as the ''New York Consolidated Stock Exchange'' or ''Consolidated'',See ''Brooklyn Daily Eagle'', Saturday, January 13, 1912, p. 18 was a stock exchange in New York City, New York in direct ...
used clearing houses from its inception in 1885. This exchange existed in competition with the NYSE from 1885 to 1926 and averaged 23% of NYSE volume. Its competitor Consolidated's use of clearing houses, finally forced the NYSE to follow suit (from 1892) to gain the same market advantages of at least prevention of frauds and reneging on bargains. Some major U.S. commodities exchanges, like the New York Coffee Exchange (today the Coffee, Sugar and Cocoa Exchange) and the
Chicago Mercantile Exchange The Chicago Mercantile Exchange (CME) (often called "the Chicago Merc", or "the Merc") is a global derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board, a ...
did not begin using clearing houses to settle their transactions until the second decade of the 20th century, 1914 and 1919 respectively.


Other industries

The British Railway Clearing-House was established in 1842. Its purpose, as defined by the Railway Clearing-House Act of 1850, was "to settle and adjust the receipts arising from railway traffic within, or partly within, the United Kingdom, and passing over more than one railway within the United Kingdom, booked or invoiced at throughout rates or fares." The Irish Railway Clearing-House, established in 1848, had its headquarters in Dublin, and was incorporated by act of parliament in 1860. In 1888 a society was formed in London called the Beetroot Sugar Association for clearing bargains in sugar from
sugar beet A sugar beet is a plant whose root contains a high concentration of sucrose and which is grown commercially for sugar production. In plant breeding, it is known as the Altissima cultivar group of the common beet ('' Beta vulgaris''). Together ...
, and the London Produce Clearing-House was established in the same year for regulating and adjusting bargains in foreign and colonial produce.


Central counterparty clearing

Modern central counterparty clearing (CCP) provides clearing services, and also takes on the counterparty risk of the counterparties (member banks and broker-dealers).


Impact

A 2019 study in the ''Journal of Political Economy'' found that the establishment of the New York Stock Exchange (NYSE) clearinghouse in 1892 "substantially reduced volatility of NYSE returns caused by settlement risk and increased asset values", indicating "that a clearinghouse can improve market stability and value through a reduction in network contagion and counterparty risk."


See also

* Central securities depository *
Automated clearing house An automated clearing house (ACH) is a computer-based electronic network for processing transactions, usually domestic low value payments, between participating financial institutions. It may support both credit transfers and direct debits. Th ...
* National Automated Clearing House


References


Sources

* {{Authority control Securities (finance) Financial markets Securities clearing and depository institutions Settlement (finance)