What Is Clearing? Definition, How It Works, and Example

What Is Clearing?

Clearing is the procedure by which financial trades settle; that is, the correct and timely transfer of funds to the seller and securities to the buyer. Often with clearing, a specialized organization acts as the intermediary and assumes the role of tacit buyer and seller to reconcile orders between transacting parties.

Clearing is necessary for the matching of all buy and sell orders in the market. It provides smoother and more efficient markets as parties can make transfers to the clearing corporation rather than to each individual party with whom they transact.

How Clearing Works

Clearing is the process of reconciling purchases and sales of various options, futures, or securities, and the direct transfer of funds from one financial institution to another. The process validates the availability of the appropriate funds, records the transfer, and in the case of securities, ensures the delivery of the security to the buyer. Non-cleared trades can result in settlement risk, and, if trades do not clear, accounting errors will arise where real money can be lost.

An out trade is a trade that cannot be placed because it was received by an exchange with conflicting information. The associated clearinghouse cannot settle the trade because the data submitted by parties on both sides of the transaction is inconsistent or contradictory.

Stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, have clearing firms. They ensure that stock traders have enough money in their account, whether using cash or broker-provided margin, to fund the trades they are taking. The clearing division of these exchanges acts as the middleman, helping facilitate the smooth transfer of funds.

When an investor sells a stock they own, they want to know that the money will be delivered to them. The clearing firms make sure this happens. Similarly, when someone buys a stock, they need to be able to afford it. The clearing firm makes sure that the appropriate amount of funds is set aside for trade settlement when someone buys stocks.

Clearing Banks

Clearing can have a variety of meanings depending on the instrument with which it is associated. In the case of check clearing, this is the process involved in transferring the funds promised on the check to the recipient's account. Some banks place holds on funds deposited by check since the transfer is not instantaneous and may require time to process.

The Federal Reserve Banks provide check collection services to depository institutions. When a depository institution receives a check drawn on another institution, it may send the check for collection to the institution directly, deliver the check to the institution through a local clearinghouse exchange, or use the check-collection services of a correspondent institution or a Federal Reserve Bank.

Clearinghouses

For futures and options, a clearinghouse functions as an intermediary for the transaction, acting as the implicit counterparty to both the buyer and seller of the future or option. This extends to the securities market, where the stock exchange validates the trade of the securities through to settlement.

Clearinghouses charge a fee for their services, known as a clearing fee. When an investor pays a commission to the broker, this clearing fee is often already included in that commission amount. This fee supports the centralizing and reconciling of transactions and facilitates the proper delivery of purchased investments.

When a clearinghouse encounters an out trade, it gives the counterparties a chance to reconcile the discrepancy independently. If the parties can resolve the matter, they resubmit the trade to the clearinghouse for appropriate settlement. But, if they cannot agree on the terms of the trade, then the matter is sent to the appropriate exchange committee for arbitration.

Automated Clearing House

An automated clearing house (ACH) is an electronic system used for the transfer of funds between entities, often referred to as an electronic funds transfer (EFT). The ACH performs the role of intermediary, processing the sending/receiving of validated funds between institutions.

An ACH is often used for the direct deposit of employee salaries and can be used to transfer funds between an individual and a business in exchange for goods and services.

Traditionally, the sending and receiving bank account information needs to be provided, including the account and routing numbers, to facilitate the transaction. This process may also be seen as an electronic check, as it provides the same information as a written check.

Example of Clearing

As a hypothetical example, assume that one trader buys an index futures contract. The initial margin required to hold this trade overnight is $6,160. This amount is held as a "good faith" assurance that the trader can afford the trade. This money is held by the clearing firm, within the trader's account, and can't be used for other trades. This helps offset any losses the trader may experience while in a trade.

This process helps reduce the risk to individual traders. For example, if two people agree to trade, and there is no one else to verify and back the trade, it is possible that one party could back out of the agreement or experience financial trouble and be unable to produce the funds to hold up their end of the bargain.

The clearing firm takes this risk away from the individual trader. Each trader knows that the clearing firm will be collecting enough funds from all trading parties, so they don't need to worry about credit or default risk of the person on the other side of the transaction.

The Bottom Line

The process of clearing ensures that the entities or parties engaged in a financial transaction are protected, receive their due amount, and the transaction goes smoothly. The clearinghouse acts as a third party or mediator for the transaction while the clearing process records the details of the transaction and validates the availability of funds.