Clearing

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Clearing is the process by which the rights and obligations arising from market transactions are formally assigned to the buyers and the sellers. Clearing is usually conducted by a distinct organization from the trading operation termed the clearing organization. The clearing organization may be affiliated with or legally separate from the venue where the trading takes place; CME Clearing and the OCC, formerly known as Options Clearing Corporation, are respective examples. In derivatives exchanges, there is only one clearing organization for each contract, so the clearing venue for any exchange-traded derivative is unambiguous at the time of transaction. Accordingly, all ICE Futures US contracts are cleared at ICE Clear US, for example, and all contracts traded on options exchanges in the United States are cleared by OCC.

The term clearing sometimes includes also the successful payment and or other fulfillment of contractual obligations, although settlement is a distinct concept. Settlement refers to any payments to or from the clearing organization or the transfer of ownership of commodities in conjunction with deliveries pursuant to contract terms.

Derivatives Clearing

All exchange-traded derivatives must be cleared. This requirement is dictated by both tradition and law.[1]

For derivatives transactions, the clearing organization substitutes itself at the clearing member level as the counterparty for every trade on an exchange. At the clearing organization, clearing members represent their own and their customers' trades as well as the customer trades of the brokers (futures commission merchants for commodity derivatives and broker-dealers for equity options) becoming the buyer to each seller of a contract or other derivative, and the seller to each buyer.learing member]]s.[2]

Clearing organizations are accessible only to their clearing members, which usually are legal entities. Retail customers, local traders, proprietary trading and brokerages gain access by having accounts with clearing member firms.[3]

Regulations

Clearing organizations for derivatives are regulated by the same governmental bodies that regulate derivatives trading. In the United States, futures clearing organizations are regulated by the CFTC and stock options clearing organizations are regulated by the SEC. In the European Union, clearing organizations are regulated by ESMA with backstopping by "competent authorities" in individual countries. In the United Kingdom, clearing is regulated by the Financial Conduct Authority. Regulation of clearing in China is carried out by the China Securities Regulatory Commission.

Clearing is conducted pursuant to processes and procedures taking the form of clearing organization rules once they are approved by the clearing organization's highest authority, such as its board of directors. The clearing rules are usually approvable or at least reviewable by the regulator before they are put into effect.

Clearing organization rules include membership requirements. The rules usually are incorporated by reference into the contractual relationships between the clearing organizations and their clearing members.

Guarantees

Clearing organizations effectively guarantee financial performance on all open positions by substituting themselves for the original counterparty clearing member in each trade. All clearing members look only to the clearing organization to pay obligations due them on a timely basis.

Clearing organizations usually, if not always, create, manage and control a guarantee fund that is available to them to pay clearing members in the event other clearing members' losses exceed available funds. Guarantee funds are composed of mandatory deposits at levels of value stipulated by the clearing organizations from clearing members.

Risk management

The three pillars of risk management are managing exposures to counterparties by dealing only with clearing members which are vetted for operational and financial capability, paying and collecting variation margin based on daily marking of positions to market, and collection and maintenance of performance bonds for open positions, also known as initial or variation margin. The guarantee fund, contributions from exchanges, retained earnings of the clearing house, and third party insurance are also commonly used risk management tools.

Account management

Clearing organizations receive trading information directly from exchanges. Except for the accounts for clearing members' own trades, the clearing organization is unaware of the ultimate owners of the contracts on its books.


References

  1. PART 38—DESIGNATED CONTRACT MARKETS §38.601 Mandatory clearing. CFTC.
  2. CFTC Glossary. CFTC.
  3. Execution, clearing and Settlement. Thismatter.