What Is a Clearinghouse?

business man on tablet mobile

A clearinghouse is a financial institution that acts as a middleman between buyers and sellers in a market, ensuring that transactions take place even if one side defaults.

If one side of a deal fails, a clearinghouse can step in to fill the gap, thus reducing the risk that a failure will ripple across financial markets. In order to do this, clearinghouses ask their members for âmarginâ–collateral that is held to keep them safe from their own actions and the actions of other members.

While often described as the âplumbingâ behind financial transactions, clearinghouses became high profile after the 2008 financial crisis, when the collapse of Lehman Brothers Holdings Inc. exposed the need for steady intermediaries in many markets.

Regulations introduced by the Dodd-Frank Act demanded greater clearing requirements, turning the handful of clearinghouses in the country into some of the most systemically important entities in todayâs financial system.

Hereâs a closer look at them.

How Clearinghouses Work

Clearinghouses handle the clearing and settlement for member trades. Clearing is the handling of trades after theyâre agreed upon, while settlement is the actual transfer of ownership–delivering an asset to its buyer and the funds to its seller.

Other responsibilities include recording trade data and collecting margin payments. The margin requirements are usually based on formulas that take into account factors like market volatility, the balance of buy-versus-sell orders, as well as value-at-risk, or the risk of losses from investments.

Because they handle investing risk from both parties in a trade, clearinghouses typically have a âwaterfallâ of potential actions in case a member defaults. Here are the layers of protection a clearinghouse has for such events:

1. Margin requirements by the member itself. If market volatility spikes or trades start to head south, clearinghouses can put in a margin call and demand more money from a member. In most cases, this response tends to cover any losses.
2. The next buffer would be the clearinghouseâs own operator capital.
3. If these arenât enough to staunch the losses, the clearinghouse could dip into the mutual default fund made up from contributions by members. Such an action however could, in turn, cause the clearinghouse to ask members for more money, in order to replenish the collective fund.
4. Lastly, a resolution could be to try to find more capital from the clearinghouse itself again–such as from a parent company.

Are Clearinghouses Too Big to Fail?

Some industry observers have argued that regulations have made clearinghouses too systemically important, turning them into big concentrations of financial risk themselves.

These critics argue that because of their membership structure, the risk of default in a clearinghouse is spread across a group of market participants. And one weak member could be bad news for everyone, especially if a clearinghouse has to ask for additional money to refill the mutual default fund. Such a move could trigger a cascade of selling across markets as members try to meet the call.

Other critics have said the margin requirements and default funds at clearinghouses are too shallow, raising the risk that clearinghouses burn through their buffers and need to be bailed out by a government entity or go bankrupt–a series of events that could meanwhile throw financial markets into disarray.

Clearinghouses in Stock Trading

Stock investors have already probably learned the difference between a trade versus settlement date. Trades in the stock market arenât immediate. Known as âT+2,â settlement happens two days after the trade happens, so the money and shares actually change hands two days later.

In the U.S., the Depository Trust & Clearing Corp. handles the majority of clearing and settling in equity trades. Owned by a financial consortium, the DTCC clears on average more than $1 trillion in stock trades each day.

Clearinghouses in Derivatives Trading

Clearinghouses play a much more central and pivotal role in the derivatives market, since with derivatives products are typically leveraged, so money is borrowed in order to make bigger bets. With leverage, the risk among counterparties in trading becomes magnified, increasing the need for an intermediary between buyers and sellers.

Prior to Dodd-Frank, the vast majority of derivatives were traded over the counter. The Act required that the world of derivatives needed to be made safer and required that most contracts be centrally cleared. With U.S. stock options trades, the Options Clearing Corp. is the biggest clearinghouse, while CME Clearing and ICE Clear U.S. are the two largest in other derivatives markets.

The Takeaway

Clearinghouses are financial intermediaries that handle the mechanics behind trades, helping to back and finalize transactions by members.

But since the 2008 financial crisis, the ultimate goal of clearinghouses has been to be a stabilizing force in the marketplace. They sit in between buyers and sellers since itâs hard for one party to know exactly the risk profile and creditworthiness of the other.

For beginner investors, it can be helpful to understand this âplumbingâ that allows trades to take place and helps ensure financial markets stay stable.

Want to start investing but donât know where to start? SoFi InvestÂ® has financial planners ready to answer any questions. Investors can also choose between the Active Investing or Automated Investing platforms, depending on how hands-on or hands-off they want to be.

Check out SoFi Invest today.

SoFi InvestÂ®
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, http://www.sofi.com/legal.

In our efforts to bring you the latest updates on things that might impact your financial life, we may occasionally enter the political fray, covering candidates, bills, laws and more. Please note: SoFi does not endorse or take official positions on any candidates and the bills they may be sponsoring or proposing. We may occasionally support legislation that we believe would be beneficial to our members, and will make sure to call it out when we do. Our reporting otherwise is for informational purposes only, and shouldnât be construed as an endorsement.


The post What Is a Clearinghouse? appeared first on SoFi.

Source: sofi.com

Worthy Bonds Review: Earn 5% Interest on Your Money

This page may include affiliate links. Please see theÂ disclosure pageÂ for more information. Bonds are often an integral part of a diversified investment portfolio. In our Worthy Bonds review, we’ll introduce you to a unique type of bond investment open to all investors. If a 5% interest is attractive to you, you’ll want to learn about…

The post Worthy Bonds Review: Earn 5% Interest on Your Money appeared first on Debt Discipline.

Worthy Bonds Review: Earn 5% Interest on Your Money was first posted on April 29, 2020 at 6:30 am.

Source: debtdiscipline.com

What Is a SEP IRA and How Does It Work?

SEP IRA stands for Simplified Employee Pension Individual Retirement Account. (Many people mistakenly think âSEPâ stands for âSelf-Employedâ.) Itâs a retirement plan that an employer or self-employed individuals can establish. This account is primarily for…

The post What Is a SEP IRA and How Does It Work? appeared first on Crediful.

Source: crediful.com

How To Get Free Stock: 10 Companies That Will Give You Free Shares

There are quite a few ways to get free stock. This article will look at 10 companies that are offering free shares and cash bonuses to new investors.

The post How To Get Free Stock: 10 Companies That Will Give You Free Shares appeared first on Bible Money Matters and was written by Lorraine Smithills. Copyright Â© Bible Money Matters – please visit biblemoneymatters.com for more great content.

Source: biblemoneymatters.com

My Biggest Financial Mistake – Missing Retirement Contributions In My 20s

Setting up automatic contributions to your 401k or Roth IRA doesnât just set you up for retirement; it lowers your stress. Boy, I wish Iâd done it sooner.Setting up automatic contributions to your 401k or Roth IRA doesnât just set you up for retirement; it lowers your stress. Boy, I wish Iâd done it sooner.

The post My Biggest Financial Mistake – Missing Retirement Contributions In My 20s appeared first on Money Under 30.

Source: moneyunder30.com