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

Quindell PLC - Understanding Institutional Investor Analysts.

Recently, I was fortunate enough that a good friend of mine arranged for me to visit a major investment bank in London. While I talked with the director of corporate finance, the subject of Quindell came up and we had an exhilarating, in depth discussion on the company.


What made this discussion particularly interesting was that we both came from opposite ends of the Bull-Bear Spectrum, with me sitting firmly with the bulls and him with the bears.


We discussed all of the major points: cash-flow, business model, Gotham City Reports, etc.


The point when we came together however was when I discussed the validity of his point about the implications of their cash-flow conversion rate (he was saying that this was the main reason why their in-house analyst was bearish on the stock), by discussing how institutional investors had significantly increased their positions in the company since the Gotham City Attack (Fidelity, Milton Asset Management, Artemis, etc).


The reason we came together on this point was because we both agreed that Fidelity (situated on the floor below us at the time I believe) are an excellent team of asset managers, but more than this have much more advanced research methods than investment banks.


Let's take a brief look at why:


1. Analyst Teams vs Analyst Lone-Wolves:

This is possibly the most important point that needs to be raised, which is that large asset management firms like Fidelity will have teams of analysts one one stock rather than just one analyst. The bank that I was visiting had one analyst on Quindell and my host said it was highly likely that Fidelity would have at least three analysts highly familiar with the stock for each sub-fund that had a position in the company.


2. Public Image:


My host at the investment bank I saw made a highly amusing point, that their in-house analyst was banned from meetings (AGMs, analyst meetings, etc) with Quindell.


This may only be a small point in the grand scheme of things, but being close to the company is essential in order to both truly understand how the company works, but also to get further ideas from the upper-management as to the onward progress their likely to make over various timeframes.


According to another friend of mine in the industry, hedge funds and asset management firms in particular are very good at not alienating themselves to firms, regardless of wether they're long or short and tend to be more tactful generally than the large investment banks are.


3. Management Stakes:


Personal stakes in the funds that they manage doesn't necessarily increase the actual level of their stock picking ability, but instead it makes certain that when these fund managers open a position in a stock that they have done their full due diligence and have covered all research bases fully.


Most investment banks will now actually trade or have any sizeable stake in the companies that they rate, as ninety percent of trades at these banks are primary trades, not proprietary trades. Even then, compared to the size of these large asset managers, the proprietary trading desks of these major investment banks are still not vast.


This means that the analysts for these major banks and brokerage firms only risk their jobs if their clients lose substantial percentages, as opposed to their jobs and a significant proportion of their net worth. Therefore, this is another prong in favour of following the asset managers rather than the investment banks and brokerage houses.


To sum up this very brief writeup, I think we can take away an albeit generalised, but pretty accurate view of the key differences between these two sides of banking world. Further to this, I personally believe that following the movements of these large asset managers is a sure fire way to successful stock picks - after all, they get paid such large amounts because they exceptionally good at their jobs and in asset management circles personal management stakes also play a strong incentive in ensuring good decisions are made. I am not saying that the rating from brokerage firms and investment banks should be ignored at all, but that I personally place the movements of respected asset managers higher than them in my personal rankings.


All the best,

The Masked AIM Trader.