Clearing House

What Is a Clearing House?

A clearing house is a financial institution, usually attached to an exchange or market, that processes and settles trades after they are agreed. Once two parties trade, the clearing house steps in as the buyer to every seller and the seller to every buyer. This arrangement is called novation. Each party then deals with the clearing house rather than with the original counterparty, so the risk that the other side fails to honor the deal is largely removed.

How It Works

When a trade is cleared, the clearing house records the obligations of each member firm and calculates what they owe or are owed. To protect itself, it requires members to post collateral, often called margin. Members typically post an initial margin when they open a position and a variation margin that is adjusted daily as prices move. A central counterparty may also maintain a default fund, which is shared money contributed by members and used if a member cannot meet its obligations.

Netting is another key function. Instead of settling every individual trade, the clearing house combines a member's many buys and sells into a single net amount. This reduces the number of payments and the total amount of money that changes hands.

Why It Matters to Investors

For an individual investor, clearing houses operate mostly in the background. Their main value is stability. Because the clearing house guarantees performance, a problem at one trading firm is less likely to spread through the market. Investors still face costs and rules set by the clearing house and their broker, and margin requirements can rise quickly during volatile periods, which may require additional funds on short notice.

Clearing houses are common in futures and options markets, and they also handle many over-the-counter derivatives and stock trades. Their rules are generally designed to protect the system as a whole rather than any single investor.