A clearing house is an institution that acts as a central point between banks, brokers or other financial firms to carry out clearing: collecting and checking transactions, matching them and calculating the amounts each participant must pay or deliver. Depending on the market, it may also arrange settlement and, as a central counterparty, guarantee that trades will be completed even if one side fails.
The term covers two broad kinds of organisation. Payment clearing houses, such as automated clearing houses and cheque clearing systems, process transfers between banks' customers. Securities and derivatives clearing houses stand between buyers and sellers in financial markets, taking on counterparty risk. Both reduce the number of bilateral relationships institutions need and make the system more efficient and safer. The closely related term payment clearing house focuses on the first kind.
History
Clearing houses grew out of the need to exchange large numbers of cheques and bills between banks. In London, bank clerks met to swap cheques and settle balances, and a formal clearing house was established in the eighteenth century. In the United States, the New York Clearing House was founded in 1853 and later played a role in managing banking panics by issuing clearing house certificates. Commodity and stock exchanges developed their own clearing houses to guarantee trades. In the twentieth century, electronic systems replaced paper exchange, leading to automated clearing houses for bulk payments and to modern central counterparties for securities and derivatives.
How a payment clearing house works
Member banks send payment instructions to the clearing house, either in batches or one by one. The clearing house validates the messages, sorts them by receiving bank and forwards them. It then calculates each member's net position for the period and sends these figures for settlement, usually in accounts at the central bank. Examples include the automated clearing house network in the United States, Bacs in the UK, and high-value systems such as CHIPS, which is run by The Clearing House in the United States and uses netting to reduce liquidity needs. Rules govern membership, message formats, cut-off times, error handling and what happens if a member cannot settle.
Clearing houses as central counterparties
In securities, futures and derivatives markets, a clearing house that becomes the counterparty to both sides of each trade is called a central counterparty (CCP). Through a legal step known as novation, the original contract between buyer and seller is replaced by two contracts with the CCP. The CCP manages its risk by:
- Admitting members carefully. Only firms meeting financial and operational standards become clearing members.
- Collecting margin. Members post initial margin and pay variation margin as prices move.
- Maintaining a default fund. Members contribute to a shared clearing fund that absorbs losses beyond a defaulter's margin.
- Following a default waterfall. A set order of resources, including the CCP's own capital, is used if a member fails.
After the 2008 financial crisis, the G20 countries agreed that standardised over-the-counter derivatives should be cleared through CCPs, which greatly increased their importance.
Some organisations combine both roles or operate several systems. The UK firm historically called the Cheque and Credit Clearing Company, for example, was folded into Pay.UK, while many exchanges own a clearing house as a separate subsidiary. Card networks perform a clearing-house function for card payments, even though they are rarely described that way.
Benefits
Clearing houses cut costs by replacing many bilateral exchanges with one central link. Netting reduces the amount of money that must move: a bank may send and receive thousands of payments but settle only one net amount. Central counterparties reduce counterparty risk, standardise procedures and make it easier for markets to handle the failure of a participant without wider disruption. Shared rules also improve transparency and legal certainty, especially when combined with laws on settlement finality.
Risks and oversight
Concentrating activity in one institution also concentrates risk. An outage at a payment clearing house can delay millions of payments, and the failure of a major CCP could threaten the financial system. For this reason, clearing houses are overseen by central banks and market regulators and are expected to meet the Principles for Financial Market Infrastructures. Supervisors test their resilience, require recovery and resolution plans, and review their margin models. Debates continue over how much loss-absorbing capital CCPs should hold, how much risk falls on members, and how cross-border clearing should be supervised. Many clearing houses are now designated as a systemically important payment system or financial market infrastructure.