What Are Clearing Houses?

Effectively a clearing house is a body that guarantees large contracts for buying securities and can also help to reduce costs for large financial institutions at the same time. They also have a part to play in encouraging people to trade on the stock exchange, by putting some security behind the anonymity and stopping deals going awry. 

Now, most retail investors like me aren't going to be allowed to become members - we trade too little and don't want to pay the fees. Also the entire criteria are pretty strict in order to reduce their exposure to risk.

The big point regarding clearing houses is that they reduce something called "settlement risk", which is the idea that when you buy shares the details on the register needs to be changed (this is where we get T+3 contracts, etc). Now, doing this there is an inherent risk that something may go wrong and that one of the buyers of shares may not pay up, so the clearing house comes in and guarantees these large orders.

We only tend to hear about them when something goes wrong and the best way to understand them is to pretend that we're a broker:

1. We have lots of orders coming in for the stock XYZ.

2. To save money on commission costs to the London Stock Exchange (LSE) we aggregate (group) these orders. 

3. We look for a place to do our big aggregated trade.

4. So we go to the stock exchange and put our big order through.

5. As soon as the deal is struck at the stock exchange, the clearing house comes in and guarantee our large order.

- So if the seller doesn't deliver the shares promised, the clearing house will.

- If the buyer doesn't produce the cash required on the correct day, the clearing house will.

6. There is a process that comes in here, which is that of reregistering the assets legally (usually electronically, by companies like Euro CREST), but in terms of understanding the main role of a clearing house, you can stop at point 5.

The way in which this works in raw terms is simply that the clearing house steps in-between the buyer and seller and asks for a deposit (known as margin). This is normally not very large, 10% being a good ball park figure. This then varies depending on what you're trading, so in late 2011 when there was a lot of worry in the market regarding Italian government bonds, the upfront margins required increased, in order to hedge risk for the clearing houses.

All the best,

The Masked Stock Trader