What Is a Clearing Firm and Guide

Clearing firms, also known as clearing corporations or clearing houses, handle the back-end businesses behind making securities trades actually happen once a trade is submitted. Essentially, clearing companies make sure that your money and stocks make it with their intended destinations when you place deals by serving as the intermediary between your account and another buyer or seller’s account.

The Trade Clearing Process
What does this transaction appear to be, and what is a the role of the clearing firm? When a trade is initiated, the clearing organization pairs a buyer and seller and takes on the legal risk linked to the deal. Because the clearing house is actually committed to the success of the trade, it helps to ensure that the trade is completed successfully. In the event that the trade fails, the clearing firm can pay the rest of the party out of a unique capital and minimize the spread of risk throughout the market. Clearing organizations are also accountable for regulating the delivery of securities and reporting data on the trades it mediates.

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Trade Clearing Process

Short Selling
Clearing companies also play a major role in short selling. When traders borrow shares of a stock to be able to brief it, they are effectively borrowing from a clearing firm. This works because the clearing organization technically holds a multitude of the stock certificates for a given stock, and so it is able to seamlessly process the transaction internally. In the event of stocks that are relatively not easy to borrow, brokerages may get in touch with multiple clearing organizations if you want to ask which ones have volume of the stock in question that can be reserved for borrowing.

The clearing firm you select may have an important impact on the stocks it is possible to short.

Clearing Firms for Short Selling

Self-Clearing Firms
In some cases, brokerages can act as their own clearing firm rather than pass trades submitted to the brokerage for an external clearing firm for mediation. These self-clearing firms operate within a brokerage such that the brokerage is able to execute trades internally. Self-clearing organizations are required to have a bigger capital store than typical brokerages considering they are taking on the risk for investments themselves.

Self-clearing businesses can pass on the cost savings of not paying commissions for an external clearing house to its customers by way of lowering commissions, although this is not always the situation. Instead, some self-clearing companies keep their commissions competitive with non-clearing firms in order to improve their margins.

Self Clearing Firms

Examples of Clearing Firms
Two examples of clearing businesses are ETC – Electronic Transaction Clearing – and AXOS Clearing. Both these firms operate as independent clearing houses supervised by the Financial Industry Regulatory Authority and serve as clearing businesses for brokerages that don’t have clearing capacity independently.

The initial margin can be viewed as a good faith assurance that the trader can afford to carry the trade until it is closed. These funds are held by the clearing firm but within the trader’s account, and can’t be used for other trades. The intention is to offset any losses the trader may experience in the transaction.

The maintenance margin, usually a fraction of the original margin requirement, is the amount that must be available in a trader’s account to keep carefully the trade open. In case the trader’s account equity drops below this threshold, the account holder will receive a margin call demanding that the account be replenished to the level that satisfies the initial margin requirements.

If the trader fails to meet up with the margin call, the trade will be closed considering that the account cannot reasonably withstand further losses.

In this example, the clearinghouse has ensured that there is sufficient money in the account to cover any losses that the account holder may suffer in the trade. After the trade is closed, the remaining margin funds are released to the trader.

The process has helped reduce default risk. In its absence, one party could back out of the agreement or fail to produce money owed by the end of the transaction.

In general, this is termed transactional risk and it is obviated by the involvement of a clearinghouse.

Stock Market Clearinghouses
Stock exchanges like the New York Stock Exchange (NYSE) have clearing divisions that ensure a stock trader has enough profit an account to fund the trades being placed. The clearing division acts as the center man, helping facilitate the smooth transfer of the stock shares and the money.

An investor who sells stock shares needs to know that the cash will be delivered. The clearing divisions make sure this happens.

Nearly all transactions in financial markets are handled by clearing organizations – they are simply effectively the backbone of the major exchanges. Almost every trade located with a brokerage is passed to a clearing firm, whether external or internal in the case of self-clearing firms. Although the work of clearing houses goes largely unseen, it is advisable to understand them as a trader given that they play an important role in limiting market-wide risk, directly determine the speed at which trades clear, play a major role simply speaking selling, and impact the total amount investors pay in commissions with their brokerages.
Assume that a trader buys a futures contract. At this time, the clearinghouse has recently set the initial and maintenance margin requirements.

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