A clearing house is a financial institution formed to facilitate the exchange (i.e., clearance) of payments, securities, or derivatives transactions. The clearing house stands between two clearing firms (also known as member firms or participants). Its purpose is to reduce the risk of a member firm failing to honor its trade settlement obligations.
After legally binding agreement (i.e., execution) of a trade between a buyer and a seller, the role of the clearing house is to centralize and standardize all of the steps leading up to the payment (i.e. settlement ) of the transaction. The purpose is to reduce the cost, settlement risk and operational risk of clearing and settling multiple transactions among multiple parties.
In addition to the above services, central counterparty clearing (CCP) takes on counterparty risk by stepping in between the original buyer and seller of a financial contract, such as a derivative. The role of the CCP is to perform the obligations under the contract agreed between the two counterparties, thereby removing the counterparty risk the parties of the contract had to each other and replacing it with counterparty risk to a highly regulated central counterparty that specializes in managing and mitigating counterparty risk.
Clearing houses were first proposed in 1636 by Philip Burlamachi, financier to Charles I of England.
The origins of clearing houses date back to bank cheque clearing in the 18th century.
Financial exchanges, such as commodities futures markets and stock exchanges, began to use clearing houses in the latter part of the 19th century. As late as 1899, the London Stock Exchange was still the only stock exchange in Europe using a clearing house. The Philadelphia Stock Exchange (founded 1790), the first U.S. stock exchange to use a clearing system, began using a clearing system in 1870, but the much larger New York Stock Exchange (NYSE) still had no clearing system some two decades later in 1891. The Consolidated Stock Exchange of New York used clearing houses from its inception in 1885. This exchange existed in competition with the NYSE from 1885-1926 and averaged 23% of NYSE volume. Its competitor Consolidated’s use of clearing houses, finally forced the NYSE to follow suit (from 1892) to gain the same market advantages of at least prevention of frauds and reneging on bargains. Some major U.S. commodities exchanges, like the New York Coffee Exchange (today the Coffee, Sugar and Cocoa Exchange) and the Chicago Mercantile Exchange did not begin using clearing houses to settle their transactions until the second decade of the 20th century. The New York Coffee Exchange began using clearing houses in 1914. The Chicago Mercantile Exchange began using them even later in 1919.
Central counterparty clearing
Modern central counterparty clearing (CCP) provides clearing services, and also takes on the counterparty risk of the counterparties (member banks and broker-dealers).
A 2019 study in the Journal of Political Economy found that the establishment of the New York Stock Exchange (NYSE) clearinghouse in 1892 “substantially reduced volatility of NYSE returns caused by settlement risk and increased asset values”, indicating “that a clearinghouse can improve market stability and value through a reduction in network contagion and counterparty risk.”
- ^“Speech by Chairman Bernanke on clearinghouses, financial stability, and financial reform”. Board of Governors of the Federal Reserve System. Retrieved 2017-10-20.
- ^Spaulding, William C. “Execution, Clearing, and Settlement”. thismatter.com. Retrieved 2017-10-20.
- ^Rehlon, Amandeep; Nixon, Dan. “Central counterparties: what are they, why do they matter and how does the Bank supervise them?” (PDF). Bank of England. Retrieved 1 April 2017.
- ^Lloyd, H.D. (1899), “Clearing, and clearing houses”, Cyclopædia of Political Science, Political Economy, and the Political History of the United States, 1, New York: Maynard, Merrill, and Co, p. 223)
- ^“Philadelphia Stock Exchange | Encyclopedia of Greater Philadelphia”. philadelphiaencyclopedia.org. Retrieved 2019-10-30.
- ^Sobel, R. (2000) The Big Board. Washington, D.C.: Beard Books, p. 131 (Original work published 1965 New York, New York: Free Press)
- ^Coffee and Tea Industries and the Flavor Field. Spice Mill Publishing Company. 1914. p. 1036.
- ^Labuszewski, J.W., Nyhoff, J.E., Co R., and Peterson, P.E. The CME Group Risk Management Handbook (2010) Hoboken, New Jersey: John Wiley & Sons, p. 80
- ^“Counterparty Risk and the Establishment of the New York Stock Exchange Clearinghouse”. Journal of Political Economy. 2019. doi:10.1086/701033. Retrieved 2019-02-15