Clearing

What Is Clearing?

Clearing is the set of steps that follow a trade being agreed and come before the trade is finally settlement|settled. During clearing, the trade details are checked and matched, and the obligations of the buyer and seller are calculated and managed. Settlement is the final step, when securities and payment actually change hands. The word also applies to bank payments, but in securities and derivatives markets it usually refers to this post-trade process.

How Clearing Works

In many markets, a central counterparty (CCP) sits between buyers and sellers. Through a process called novation, the CCP replaces the original contract with two new ones: it becomes the buyer to every seller and the seller to every buyer. Each trader then faces the clearinghouse rather than an individual party, so the failure of one participant has a more limited effect on the others.

Clearinghouses reduce counterparty risk by requiring members to post collateral, commonly called margin. Initial margin is set to cover potential losses if a member defaults, and variation margin is exchanged as prices move. Positions that are offset against each other can be combined through netting, which reduces the total amount that needs to change hands.

An Example

Suppose two traders agree a trade in a futures contract. The clearinghouse records it and becomes the counterparty to each side, and both traders post margin. If one trader's losses grow and they fail to add more margin, the clearinghouse closes out their position and uses the margin they posted to cover the loss, before the other trader is affected.

Why It Matters to Investors

Most individual investors never deal with clearing directly, because their broker handles it. However, clearing affects how safely trades are completed and how much collateral the market requires. After the 2008 financial crisis, many jurisdictions required standardized derivative contracts to be cleared centrally, with the aim of reducing the chance that one failing firm could trigger a chain of losses. A trade cleared through a well-capitalized clearinghouse generally carries less risk that the other side will fail to pay or deliver than one settled directly between two parties, although no arrangement removes risk entirely.