Clearinghouses are responsible for clearing trades and settling trading accounts. They also collect margin payments. Regulating the delivery of assets to new owners is another responsibility. Clearinghouses are third parties in futures and options contracts. They act as sellers and buyers for every clearing member seller.
The clearinghouse is involved after a buyer or seller has completed a trade. It is responsible for completing the necessary steps to finalize and validate the transaction. The clearinghouse acts as a mediator and provides stability in a financial marketplace by providing security and efficiency.
Clearinghouses take the opposite position for each trade to reduce the risk and cost of multiple transactions between multiple parties. Despite their mandate to reduce risk, they have the responsibility of default risk for both buyers and sellers. Clearinghouses have margin requirements to mitigate this.
Clearinghouse for Futures Market
Because its financial products can be leveraged, the futures market heavily depends on the clearinghouse. They typically require borrowing to invest and require a stable clearinghouse. Each exchange has its clearinghouse. Each exchange member must clear trades at the clearinghouse at each session's end and deposit money with the clearinghouse, according to the clearinghouse's margin requirements. This amount should be sufficient to cover their debt balance.
Functions
A clearing house is a mediator between two parties involved in transacting business. Clearing houses can do much more than that. Let's look at some of the functions more closely. Clearinghouse ensures that transactions are smooth and both parties receive the dues. The clearing house checks the financial ability of each party to enter into legal transactions, whether they are individuals or organizations. Clearing firms ensure that all parties respect the system and adhere to the correct procedures to facilitate a successful transaction. Facilitating smooth transactions will lead to a more liquid marketplace.
The clearinghouse firm creates a level playing field between the parties so they can reach an agreement on their terms of negotiation. The clearinghouse is responsible for setting the price, quality, quantity, maturity, and quantity of the contract. The clearinghouse ensures that the correct goods are delivered to the buyer in terms of quantity and quality so that there is no arbitration or complaints after the transaction.
Example
Let's say that a trader purchases a futures contract. The clearinghouse has set the maintenance and initial margin requirements. This initial margin is a good-faith assurance that the trader has the funds to keep the trade open until it is closed. These funds are not available for use in other trades, but the clearing company keeps them. This is done to compensate any trader's losses in the transaction.
The maintenance margin is usually a fraction of the initial margin requirement. It is the amount that must remain in a trader's account to allow them to continue trading. The account holder will be notified by margin call if the trader's equity falls below the threshold. The account must be replenished to meet the initial margin requirements. The trade will be closed if the trader fails the margin call. This is because the account can't reasonably support further losses.
The clearinghouse ensures that sufficient funds are available in the account to pay for any trade losses. After the trade is completed, any remaining margin funds are released for the trader. This has reduced default risk. Without it, one party could withdraw from the agreement or fail to pay the money owed after the transaction. This is generally known as transactional risk. The involvement of an intermediary eliminates it.
Stock Market Clearinghouses
NYSE has clearing divisions that make sure that stock traders have enough money in their accounts to pay for trades. Clearing divisions act as a middleman, facilitating the transfer of stock shares and money. Investors who have sold stock shares need to ensure that the money is delivered. This is made possible by the clearing divisions.
Initial Margin and Maintenance Margin
Every transaction in the futures market requires a margin. This deposit is equal to a percentage of the contract's total value. Margin includes the initial margin, the amount of the deposit required, and the maintenance margin, which is a smaller amount that must remain in the trader’s account to allow them to maintain their trading position. Let's take, for example, a futures contract on prawns that requires a $1,000 initial margin deposit (which is held at the clearing house) and an $800 maintenance margin.
To retain the contract, the buyer must deposit additional funds into his trading account if the contract's value falls by more than $200 ($1,000-$800=$200) before it expires. If the buyer does not deposit sufficient funds, the clearing firm will sell his position at the highest market price.
