Clearing Corporation - Explained
What is a Clearing Corporation?
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Table of ContentsWhat is a Clearing Corporation?How Does a Clearing Corporation Work?Example of How a Clearing Corporation WorksWhy is the Clearing Corporation Important?Key Functions of a Clearing CorporationClearing Corporations vs. Future Contracts
What is a Clearing Corporation?
A clearing corporation refers to an organization that deals with an exchange to settle transactions, usually at a fee. The exchange transactions involve confirmation of delivery as well as settlement. The clearing corporation ensures that trade transactions are prompt and efficient. Another term for a clearing corporation is clearing-house or clearing firms.
How Does a Clearing Corporation Work?
There are many exchange trade transactions that take place in a single day. So, clearing corporations are there to assist in processing what each business entity owes or is owed from a centralized location. Processing such transactions from a central location helps to limit the amount of money and securities that change hands. The clearing corporation ensures that there is the proper execution of the trade. In other words, it works to make sure that the settlement of trade transactions is smoothly done and within a specified time. To do this, it actually takes the position of both the buyer and the seller, where it offsets each and every transaction of a client.
Example of How a Clearing Corporation Works
Lets assume that investors A and B agree to the financial transaction terms like purchasing and selling of corporate security. In this case, a clearing corporation will come in as a middle man. Its role will be to facilitate all the transactions involving the purchase and sale of securities from both ends. Generally, there are a number of tasks involved in such a transaction that the clearing firm is supposed to oversee. They include regulations of securities delivery as well as reporting the trading data. Note that apart from securities, clearing corporations transactions also involve things such as:
- Futures and option contracts
- Stock and bond trades
- Margin money
Why is the Clearing Corporation Important?
Most individuals or organizations are concerned about getting involved in business transactions that do not have a good ending. The reason is that one of the parties may end up not fulfilling their part of the deal. This is where clearing firms come in, to provide assurance so that traders can do their trade transactions free and without fear. In other words, clearing firms provide all-round security to those involved in the exchange. So, when they enter into a business deal, they are sure that their deals will be honored as the clearing firm will enforce the process.
Key Functions of a Clearing Corporation
Apart from mediating between a buyer and a seller, the clearing corporation facilitates other major roles. Below are some of the main functions of a clearing firm.
- It checks the financial abilities of those individuals or businesses entering a legal transaction. They check to give assurance that once the transaction is on, the process will be smooth and that both entities will get what they deserve in that business deal.
- The clearing corporation has a duty of ensuring that both parties who enter into a business transaction, fully respect the existing systems. They should be able to follow the correct procedures until a successful transaction is realized. Note that smooth transaction ensures continuous liquidity in the market, and it is part of the clearing firms' responsibility to maintain it.
- Clearing corporation creates an appropriate field where both parties negotiate and agree to the terms. It is involved in setting price, quality, quantity as well as the contract maturity period.
- Lastly, a clearing corporation ensures that the buyer receives the exact goods that were ordered. So, it checks the quantity and quality of the goods to ensure that they reflect what is stated in the contract, to avoid complaints.
Clearing Corporations vs. Future Contracts
Basically, clearing corporations have the capacity to facilitate all types of transactions. However, they are more useful where complex transactions are involved. A good example is futures contracts. Futures are financial contracts where a seller is compelled to sell an asset, or a buyer to buy an asset at a predetermined price and date. For instance, lets assume that the current price of wheat per bushel is $5.00 in August, and the futures price is $5.50. So, here is a wheat farmer who wants to secure a selling price for his crop in the next harvest. On the other hand, there is Johnnie, who wants to secure a buying price so that he is able to determine the charges for his pizza in the coming year. In this case, the farmer and the clearing corporation can have a futures contract that requires the delivery of 4 million bushels of wheat to Johnnie, in November going at $50.50 per bushel. After negotiations, the two parties are able to lock a contract at a price. Note that in the futures market, only the selling and buying of this contract will happen and not the real wheat. Generally, each futures exchange has its own clearing corporation. Chicago Mercantile Exchange is a good example. It has its own clearing corporation, and it is mandatory for its members to clear their trades through it. Members are also required to deposit some amount of money, as per the requirements set by the clearing corporation. The money is for covering their debit balance.