Clearing house

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See also "Clearing"
See also "Derivatives Clearing Organization"

A clearing house is a crucial financial institution that facilitates the clearing and settlement of transactions in financial markets. It acts as an intermediary between buyers and sellers, ensuring the smooth execution of trades by taking the opposite position in each transaction. This role is essential in mitigating counterparty risk, as the clearing house guarantees the completion of transactions even if one party defaults.[1]

In the U.S., a derivatives clearing organization (DCO) is a type of clearing house that enables parties to substitute its credit for theirs, arranges multilateral settlement or netting of obligations, and provides clearing services that mutualize or transfer credit risk. To clear futures, options on futures, or swaps, a DCO must register with the CFTC. The CFTC may exempt a DCO from registration for swaps if it is comparably supervised by authorities in its home country.

Functions of a Clearing House[edit]

Clearing and Settlement[edit]

Clearing houses are responsible for the process that occurs after a trade is executed, involving the confirmation, reporting, and final settlement of the transaction. This includes the calculation of what parties owe and are owed, and ensuring the correct transfer of funds and securities.[2]

Risk Management[edit]

To manage the risks associated with trading, clearing houses require participants to post margins or performance bonds. These financial deposits help ensure that members have sufficient financial resources to cover potential losses, thus safeguarding the integrity of the market.

Trade Netting[edit]

One of the key functions of a clearing house is to net out positions, which reduces the total number of transactions and, consequently, the amount of money that needs to be transferred. This makes the settlement process more efficient and reduces liquidity needs.

Regulatory Compliance and Reporting[edit]

Clearing houses also play a critical role in regulatory compliance and reporting. They monitor trades, collect and maintain data, and ensure that trading is conducted in accordance with regulatory standards.

Structure and Organization[edit]

Internal and Independent Clearing Houses[edit]

Some financial exchanges operate their own internal clearing houses, while others use independent clearing organizations to handle these functions. This structure depends on the specific needs and regulations of the market in which the exchange operates.[3]

Example: The Options Clearing Corporation (OCC)[edit]

In the United States, all security options trades are cleared through The Options Clearing Corporation (OCC). The OCC serves as a central counterparty for options trades, providing clearing and settlement services to 16 exchanges. The OCC is owned by its member firms, which include the largest U.S. options exchanges.

Regulatory Oversight[edit]

Advent of Swaps Clearing in Clearinghouses After the Dodd-Frank Act[edit]

The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in response to the 2008 financial crisis, brought significant changes to the financial regulatory environment in the United States. One of the pivotal reforms introduced by this legislation was the mandatory clearing of standardized swap transactions through clearinghouses. This move aimed to increase transparency, reduce systemic risk, and enhance the overall stability of the financial markets. The advent of swaps clearing in clearinghouses, as mandated by the Dodd-Frank Act, marked a significant shift in the regulatory landscape for swap market participants and had a profound impact on the operations of Derivatives Clearing Organizations (DCOs) and the broader financial market infrastructure.[4]

Regulatory Framework[edit]

The Commodity Futures Trading Commission (CFTC), as the regulatory authority overseeing the derivatives markets in the United States, implemented a comprehensive regulatory framework to govern the clearing of swaps with the passage of the Dodd Frank Act of 2010. This framework is based on the DCO registration requirements, the statutorily-imposed "DCO Core Principles," and the CFTC's Part 39 Rules. The CFTC's position was clear: any clearinghouse that clears a swap for a U.S. person, whether directly for a U.S. clearing member or indirectly for a U.S. customer of any clearing member, must register with the CFTC as a DCO or obtain an exemption from registration.

Impact on Market Participants[edit]

The requirement for standardized swap transactions to be centrally cleared through a DCO has had a direct and significant impact on market participants. This regulatory shift promotes operational efficiency by reducing the number of transactions that a futures commission merchant (FCM) clearing member must process. Moreover, it addresses previous market practices for cleared swaps, where a customer’s request for the transfer of its swap positions was commonly subject to delay. Customers were often required to either enter into offsetting positions without terminating the original position or unwind their current position with the clearinghouse. The Dodd-Frank Act facilitated the formalization and application of swaps clearing to the futures clearinghouse practice of transferring customer positions and related funds without the close-out and rebooking of the positions, as outlined in CFTC Rule 39.15(d).

U.S. Department of Justice Review[edit]

In 2008, the U.S. Department of Justice initiated a review of clearing services, including their ownership by exchanges. This review was particularly relevant for major entities like the CME Group, which derives significant revenue from its clearing operations.[5].

CME Group's Clearing Services[edit]

Prior to its merger with the Chicago Board of Trade (CBOT) in 2007, CBOT shifted its clearing operations to CME Clearing, which handles a vast majority of U.S. futures transactions. In 2012, CME Group proposed that CME Clearing could also provide third-party custodial services for clearing member firms, suggesting that all excess customer funds could be held by the clearing house, potentially reducing the capital at risk.[6][7]

Historical Context[edit]

Development of Clearing Methods[edit]

The concept of a clearing house has evolved significantly over time. Initially, clearing involved direct settlements between parties. Over time, more structured methods such as clearing through rings and complete clearing were developed, leading to the establishment of formal clearing houses. These institutions have been instrumental in reducing settlement times and enhancing the security and efficiency of financial markets. [8]