What is clearing?
Clearing has many different meanings within the financial markets. In its broadest definition, clearing is a post-trade activity and aims to reduce risk. This often means using a central counterparty (CCP) to eliminate risks associated with the default of a trading counterparty.
In the OTC derivatives markets, ‘bilateral clearing’ means two parties to a trade make their own arrangements to reduce their exposure to each other's default.
All clearing arrangements are designed to help market participants manage various risks - operational, counterparty, settlement, market, and legal - between trade execution and settlement.
CCP clearing means a CCP becomes the legal counterparty to each trading party, providing a guarantee that it will honour the terms of the original trade even if one of the parties defaults before the discharge of its obligations under the trade. This guarantee removes market risk, i.e. the exposure of the remaining party to adverse price movements if it had to replace the original trade at the prevailing market price.
The term clearing in financial markets has several other meanings, and its use may encompass several arrangements.
In many trading firms, clearing refers to the collective post-trade activities that ensure the firm meets its obligations to trading counterparties.
In organised markets such as stock exchanges, clearing could mean one or more of the following:
The calculation of obligations between trading firms. Before CCPs were introduced, stock exchanges’ daily clearing process involved the tabulation of all buys and sells, advising trading firms of their obligations to each other so they could reconcile their records and prepare for settlement.
A central delivery and receipt arrangement in which sellers deliver assets to a clearinghouse which then delivers them to the buyers. When share certificates had to be physically delivered, a clearinghouse was commonly used since it was more efficient and cost effective than each firm managing the process itself.
Multilateral netting, whereby a party’s purchases and sales in the same asset with multiple trading parties are offset and reduced into one net amount. The net amount is delivered to or received from a clearinghouse (or electronic clearing account).
CCP clearing, where trades are legally novated to a CCP. Most CCPs perform multilateral netting because it significantly reduces the value and number of obligations that require settlement, reduces operational risks and, combined with legal novation, reduces capital requirements.