What is a CLEARING HOUSE ?

CLEARING HOUSE – A voluntary association of DFIs that facilitate the clearing of checks or electronic items through the direct exchange of funds between members.

Clearing house is a financial institution formed to facilitate the exchange (clearance) of payments, securities, or derivatives transactions. The clearing house stands between two clearing firms (also known as member firms or participants). Its purpose is to reduce the risk of a member firm failing to honor its trade settlement obligations.

After legally-binding agreement (i.e. execution) of a trade between a buyer and a seller, the role of the clearing house is to centralize and standardize all of the steps leading up to the payment (i.e. settlement ) of the transaction. The purpose is to reduce the cost, settlement risk and operational risk of clearing and settling multiple transactions among multiple parties.

In addition to the above services, central counterparty clearing (CCP) takes on counterparty risk by stepping in between the original buyer and seller of a financial contract, such as a derivative. The role of the CCP is to perform the obligations under the contract agreed between the two counterparties, thereby removing the counterparty risk the parties of the contract had to each other and replacing it with counterparty risk to a highly regulated central counterparty that specializes in managing and mitigating counterparty risk.

Imagine a city with ten banks. Customers of each bank deposit Checks daily, which may be drawn on any of the ten banks. The bank would credit the depositor’s account by the total amount of the checks deposited. For check drawn on a customer of the same bank, the bank would debit the account of the drawer. But checkdrawn on the other banks (termed “the issuing bank”) need to be “presented” to each bank before the depositor bank receives payment to cover the amount credited to the depositor’s account.

All ten banks might have clerks to take check drawn on the other banks to those banks, and wait for payment. Clearing houses were set up to streamline the process by collected all check drawn on the other banks, and collecting payment from that other bank for the total to be cleared.