BAJAJ BROKING
February 18, 2025
8 mins read
Clearing is one of the most essential concepts of the stock market. It refers to the process of settling financial transactions. In simple words, Read more..it means that a buyer should be delivered with a security and a seller should receive cash for selling a security. In the stock market, typically, a clearinghouse takes responsibility for the clearing process, wherein it takes the counterparty risk by becoming a seller for each buyer and a buyer for each seller. Read less
Even if you have bought a company’s stock only once in life, you have experienced the process of clearing. You may or may not understand clearing but you have experienced it. So, what is clearing?
Clearing ensures that a financial transaction is settled, wherein securities are delivered to a buyer and funds are delivered to a seller in a timely manner. As a term, clearing may sound a bit technical, but it is really a simple concept to understand. Read this blog, as it takes a deep dive into this topic by explaining how clearing happens in real-life scenarios.
Clearing is a process used to settle financial transactions. Let us understand what “settle” means in this context. When you buy an asset from a seller, you pay cash to him and get the asset in return.
This transaction cannot be settled unless the money paid by you reaches the seller and the asset is delivered to you. To ensure the smooth execution of a transaction, financial markets use a process called “clearing.”
The objective of clearing is to ensure that funds are transferred to a seller and securities are delivered to a buyer in a timely manner.
During the process of clearing, a specialized organisation usually performs the role of the intermediary by acting as the implicit buyer and seller so that it can reconcile orders between two parties (i.e., the buyer and the seller).
In real life, this is how clearing happens. Both the parties to a transaction (the buyer and the seller) make transfers to a clearing corporation (which acts as the intermediary), instead of making transfers to each other. After this, it is the clearing corporation’s responsibility to settle the transaction.
Types of Clearing
The main types of clearing are explained as follows:
Centralized Clearing: This is the most common type of clearing, wherein a clearing corporation acts as an intermediary for all trades. It is mostly seen in stock exchanges and derivative markets. Here, a clearing corporation takes the counterparty risk. It becomes a seller for each buyer and a buyer for each seller.
Unilateral/Bilateral Clearing: This type of clearing is seen in over-the-counter (OTC) markets, which do not have a clearing corporation. Here, a buyer and a seller settle a transaction themselves. In other words, a buyer pays cash to a seller, who in turn delivers a security to the buyer.
Advantages of Clearing in Finance
The advantages of clearing are explained below:
Smooth execution of transactions: A clearinghouse ensures that financial transactions are executed smoothly.
Reducing the risk of default: A clearinghouse ensures that a buyer gets the security delivered to him and a seller receives the cash due to him. Hence, it reduces the risk of default.
Transparency: A clearinghouse makes sure that the right securities are delivered to a buyer and cash is delivered to a seller and there are no complaints about it. As a result, there is transparency in markets.
How Does a Clearinghouse Work?
Transaction is executed: It all starts with the execution of a transaction. A buyer and a seller agree to exchange assets like stocks, options, futures, bonds, etc.
Clearinghouse is notified: A clearinghouse is notified that a transaction has occurred. As a result, it gets details about the buyer, the seller, and the terms of their trade. It then matches the trade details and makes sure that both the parties agreed on the same terms.
Trade novation: In this step, a clearinghouse takes the counterparty risk. In other words, it becomes the seller for the buyer and the buyer for the seller. As a result, a clearinghouse takes the risk of default and guarantees the completion of a trade.
Margin requirements: Over here, both parties have to put up a margin, which means they have to show their commitment to a trade. They have to prove that they will execute the transaction even if a security’s price moves unfavourably.
Trade settlement: As the final step, a clearinghouse has to ensure that a transaction is settled. In other words, a security is delivered to the buyer and cash is delivered to the seller.
The significance of clearing in investments can be understood from the following:
Guarantees the execution of transactions: A clearinghouse provides a guarantee that the buyer will get security and the seller will get cash. For this purpose, it checks the financial capabilities of both parties involved in a transaction. By providing a guarantee and performing the checks, it ensures the smooth execution of transactions.
Ensures a liquid market: If a market is not sufficiently liquid, it is hardly a market. Imagine that you want to buy a stock but it hardly has any sellers. This is where a clearing house steps in. Because it takes the counter-party risk and results in the smooth execution of transactions, it ensures sufficient liquidity in the market.
Makes sure that both parties fulfil important terms and conditions: A financial transaction has several terms and conditions with regard to the price, quality, quantity, and maturity of the asset being transacted. A clearing house ensures that the buyer and the seller meet all the terms and conditions when it comes to the price, quality, quantity, and maturity of an asset.
Clearing is one of the most important functions performed by a financial market. A clearinghouse is responsible for matching the details of a trade and ensuring that the buyer and the seller agree on the same terms.
Without such an agreement, the buyer and the seller may not agree on the same terms, which may render it impossible to execute a transaction. Then, a clearinghouse takes the counterparty risk. As a result, a buyer knows that a clearinghouse will act as a seller, and a seller knows that a clearinghouse will act as a buyer.
Clearing is also important in the futures and options (F&O) segment of the market. When you buy a futures contract, you have to deposit an initial margin amount. If before the contract’s expiration, the underlying asset's value declines beyond a level, a clearinghouse may tell you to deposit additional funds. If you fail to do so, the clearinghouse can liquidate your position.
The process of clearing involves several calculations for risk management and verification of trade obligations. Let us understand these calculations in detail:
a) Margin Calculations: When you buy an asset using a margin trading facility (MTF), a clearinghouse calculates how much initial and maintenance margin you have to pay. This ensures that potential losses are covered.
b) Netting of Trades: Thanks to the clearing process, transactions are often netted to calculate the final settlement amount. To net a transaction, a clearinghouse offsets buy and sell positions to calculate the net obligations, which need to be paid either by the buyer or the seller. This process reduces the number of settlements and payments required in the market.
c) Collateral Requirements: A clearinghouse is responsible for tracking the value of assets pledged as collateral. This is to ensure that sufficient collateral is maintained to cover potential losses, which can occur if the price moves unfavourably.
d) Mark-to-Market: Clearing also involves market-to-market calculations, which adjust the value of open positions based on the current market price of securities. If the asset’s price moves unfavourably, more margin has to be provided. Conversely, if the asset’s price moves favourably, some part of the margin can be withdrawn.
A clearinghouse performs two extremely important functions in the stock market. First, it reduces the risk of transactions by taking the counterparty risk. Second, it ensures that trades are settled efficiently and without any hassles. In simple words, the clearing process ensures that a market indeed works like a market.
Imagine for a second that you want to initiate a transaction but you do not know whether the other party will fulfil its obligations or not. You will not call it a market unless you are 100% sure that the other party will meet its obligations.
Similarly, when securities and/or cash are not delivered in time, it badly affects the functioning of a market. By taking care of the two most important functions of a market, a clearinghouse plays an extremely critical role.
While clearinghouses offer several benefits, they also have a few limitations, which are explained below:
Possibility of counterparty risk: It is true that clearinghouses take counterparty risk. However, if a lot of people start defaulting at the same time, a clearinghouse may struggle to take on this risk.
Risk gets concentrated: As all transactions are processed through a clearinghouse, it becomes a central institution. If it faces a technical or a financial issue, it can affect the entire market.
Higher cost for participants: Clearinghouses charge fees for the services they provide. They even make participants post margin. For small traders, such margins and fees may be expensive.
Whether you are an investor with a demat account or have only a theoretical interest in the stock market, you should understand the concept of clearing. It is one of the most important concepts governing the stock market. For example, when you are doing margin trading, a clearinghouse makes sure that you and your broker deposit the required margin for your leveraged positions. Hence, without understanding how transactions are settled, you will not be able to develop a deep understanding of the market. Besides, when you understand clearing, you will also be able to understand the role of a clearinghouse and the risks it takes, which will help you broaden your perspective as a student of the market.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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The process of clearing settles transactions in financial markets. It ensures that a buyer gets the delivery of a security and a seller gets cash. It typically takes place through a clearinghouse, which acts as an intermediary between a buyer and a seller.
A clearinghouse is an intermediary between a buyer and a seller. It ensures that transactions are completed, payments are made, and deliveries are taken. When a party defaults, a clearinghouse covers the trade and takes the counterparty risk.
The process of clearing in finance involves confirming and reconciling the details of a trade and ensuring that a trade is settled without hassles. Meanwhile, settlement is the final stage of the clearing process, wherein securities are delivered and payment is made.
In futures and options trading, cleaning is essential because it mitigates counterparty risk, guarantees trade settlement, takes care of margin requirements, and ensures transparency in pricing.
Clearing members perform the role of intermediaries between a stock exchange and market participants. Such members ensure that trades are settled, margin requirements are followed, counterparty risk is managed, and funds & securities are delivered in a timely manner.
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