What is a clearing house?
- A “clearing house” acts as a middleman who secures the fulfillment of transactions between buyers and sellers within a stock market.
- To “clear” these transactions, they play the role of a buyer when facing a seller and vice versa while taking full responsibility for the completion of a deal.
- The clearing firm narrows the time gap when a product is sent to the buyer.
- A clearing house also auctions products, matching the highest bidding price to the lowest bidding price.
- Clearing houses earn money from the fees their members pay them for each transaction.
How a clearing house works
You may be wondering, “Why do we need middlemen if buyers and sellers can trade directly with each other?” While it’s practical to think that ditching intermediaries will reduce the money spent in a transaction, the dynamics within the stock market say otherwise. In a normal monetary trade, a seller gives a product to a buyer in exchange for cash. Then, the buyer obtains the product. The seller receives the money. They are both happy. However, in complicated transactions, there are many other factors to consider.
Most of the prominent brokers, mainly banks, operate with their own clearing house. Big name brokerages like Merrill Lynch function as both a bank and a broker, as well as its own clearinghouse. Vanguard, a well-known investment company, also operates the same way, and the online broker TD Ameritrade can clear trades with their own inhouse clearing agency.
Other brokers like Stockpile (who might that be? Hint hint it’s us), partner with a third-party clearing house. APEX Securities helps to clear our trades here at Stockpile.
Why does the market have a clearing house?
- To ensure and hasten the delivery time of products
One of the main reasons a clearinghouse exists is the facilitation of the products’ delivery time. Sometimes during a trade, the buyer’s money and the seller’s goods are not ready yet. Thus, both buyers and sellers could be trading off promises and good faith. It can take months before that promise is fulfilled. In that span of time, one party might break that promise. Either party could be on the losing end.
A clearing firm monitors the entire delivery process. A buyer will deposit an amount of money. After the down payment, the firm will immediately process the delivery. When the goods arrive, the buyer will pay in full. The supply of the product may come from several sellers. Because of this, there is a relative abundance of supply – leading to the next point.
- To secure transactions
A clearing house guarantees that the seller will receive enough money and the buyer will have enough supply of the goods he/she needs. This is very true for perishable goods and the financial derivatives that are traded for commodities. If you look at the more sophisticated financial trading, people will buy and sell future contracts of orange juice and pork belly. The house will “clear” these trades at a fee so that suppliers of these commodities may have enough capital and investors of these contracts will have their minds at ease due to the firms’ guarantee.
- To help sellers look for buyers
Clearing houses act as a market where buyers and sellers “meet.” However, the seller does not know where his/her product goes and the buyer does not know where his/her money goes. Individual traders face a clearing house for every deal.
Depending on the size, members can number thousands of traders. Sellers will never have a scarcity of buyers, thus no worries of looking for a customer for their goods.
- To report trading data
When the goods successfully arrive at the buyer, the clearing house reports data to both parties. It declares when a transaction is settled. The same data can be useful for the economy of nation states and the global market, especially in using research on how to make the financial strength of an economy better. Clearing market data can serve as a foundation of thought for the betterment of society.
Clearing house margins
It is important to note that buyers and sellers can only trade within the margin. It means that the clearing house sets specific limitations inside which people can buy or sell. Setting up margins protects the sustainability of the firm and its network of traders.
By knowing how vital a clearing house is to the economy, you can appreciate how resilient the financial markets are. Do not hesitate to start your investment journey, but before you trade, try to get to know your brokerage. You can ask any customer service representative of your brokerage who their clearing firm is, and a lot of information are available to the public through our trusted friend Google.