Quick definition Clearing is the step between a trade and settlement. A clearinghouse processes the trade, calculates obligations, and becomes the counterparty to both sides of the trade. What it is When a trade executes: 1. Buyer and seller agree to exchange (order execution) 2. Clearinghouse records the trade (clearing) 3. Clearinghouse becomes counterparty to both (interposition) 4. Buyer and seller transfer cash and securities (settlement) The clearinghouse's job is to ensure that obligations are met. If a counterparty fails, the clearinghouse guarantees the other side. Why it matters Clearing eliminates counterparty risk. Instead of worrying about the other trader defaulting, you know the clearinghouse will step in. Clearinghouses use margin requirements and loss engines to manage risk. They ensure they can cover losses if a member fails. Interposition Interposition is when the clearinghouse becomes the buyer to every seller and the seller to every buyer. This breaks the direct connection between original counterparties. Interposition simplifies settlement and reduces counterparty risk. Margin and clearing Clearinghouses require members to post margin (collateral) to cover potential losses. If prices move against a member, margin requirements increase. Members must maintain minimum capital or risk suspension. Trade confirmation The clearinghouse sends trade confirmations to both sides of the trade, showing: - Security and quantity - Price and total value - Settlement date and instructions Both sides must confirm the trade. If they disagree, the clearinghouse investigates. Practical example You buy 1,000 shares from another trader. The clearinghouse steps in: - They become the seller to you (you bought from them) - They become the buyer from the other trader (they bought from them) If the other trader defaults, the clearinghouse makes you whole. They handle all settlement and risk. Systemic importance Clearinghouses are systemically important. A failure could cascade through the financial system. For this reason, they are heavily regulated and require substantial capital. See also - Settlement - Clearinghouse - Counterparty Risk - Margin
