In financial markets, a clearinghouse is a designated intermediary between buyers and sellers who trade securities. The job of a clearinghouse is to validate and finalize transactions. This ensures that buyers and sellers honor any contractual obligation they may have. A designated clearinghouse handles this role in every financial market.
While clearinghouses serve different functions across different industries, we’ll examine what a financial clearinghouse is, how it works, and what types of transactions it may manage.
Definition and Examples of a Clearinghouse
Financial clearinghouses are intermediaries between those who buy and sell financial instruments. Clearinghouses can be made up of an agency or a separate corporation of a futures exchange and are registered with the Securities and Exchange Commission (SEC). A futures exchange can be responsible for things like settling stock trading accounts, collecting and maintaining margin monies, clearing trades, regulating delivery, and reporting trading data.
Financial clearinghouses take on a variety of responsibilities, including:
- Finalizing or "clearing" trades
- Settling trading accounts
- Overseeing the delivery of assets to the purchaser
- Reporting trading data
- Collecting margin payments
- Acting as third parties for options and futures contracts
Clearinghouses are essentially the middleman in an auction market.
In the U.S. two main clearinghouses take on this responsibility—the New York Stock Exchange (NYSE) and the Nasdaq. The NYSE acts as a clearinghouse by facilitating trades of financial entities such as bonds, mutual funds, stocks, derivatives, and exchange-traded funds (ETFs).
The NYSE makes it so investors and professional brokers can both buy and sell securities by matching the highest bidding price with the lowest selling price. Nasdaq serves a similar purpose but does not have a physical trading floor like the NYSE does.
- Alternate definition: Clearinghouses exist in several contexts, and all of them serve the same basic function as financial clearinghouses. For example, in the medical space, clearinghouses transmit electronic claims to insurance carriers.
How Financial Clearinghouses Work
A clearinghouse gets involved in a financial trade after the seller and buyer execute their trade. The clearinghouse finalizes and then validates the transaction. It is essentially a middleman that makes sure these trades are secure and efficient.
Clearinghouses play a key role in maintaining the stability of a financial market. They do this by taking on the opposing position for each trade. This reduces the risk, as well as the cost, that comes with settling multiple transactions across different parties.
There are laws in place that help regulate how clearinghouses work. The National Securities Clearing Corporation (NSCC), established in 1976, is a subsidiary of the Depository Trust Clearing Corporation (DTCC). The NSCC oversees the following responsibilities for most broker-to-broker trades that deal with corporate and municipal debt, equities, unit investment trusts, American depositary receipts, and ETFs:
- Risk management
- Central counterparty services
- Guarantee of completion for certain transactions
Let’s look at a common example of where a financial clearinghouse steps in to ensure a financial transaction is properly managed. Let’s say you sell shares of stock you own, and you need to ensure that the money you are supposed to receive from the sale is actually delivered to you. A financial clearinghouse will make sure that you do, in fact, receive the money you are owed from the sale. It does this by confirming that the stock trader purchasing the stocks actually has enough money in their account available to buy the stocks involved in the trade.
Types of Clearinghouse Transactions
There are two main types of financial clearinghouses: stock market and futures exchanges.
Stock Market Clearinghouses
Stock exchanges require a clearinghouse to make sure that the stock trader’s required funds are available in their account to complete the trade. By taking on this middleman role, the clearinghouse can smoothly facilitate the transfer of stocks and money between the two parties. The clearinghouse can give the investor who is selling the stocks peace of mind that they will be paid for their sale.
For example, the popular investing app Robinhood uses a clearinghouse. It takes two days for the clearinghouse to record the trade, transfer the stock to the buyer, and transfer the funds to the seller. This type of clearing and settling is known as “T+2”—the trade date plus two days to settle.
Futures Exchanges Clearinghouses
Financial products in the futures market are leveraged, and they greatly depend on the clearinghouse to act as a stable intermediary while money is borrowed in order to invest. All futures exchanges have their own clearinghouses, and the members of this exchange must clear their trades through the clearinghouse. This is done at the end of each trading session. Members then deposit money with the clearinghouse to cover their debit balance.
Clearinghouses vs. Exchanges
|An agency or corporation that oversees a marketplace for trading securities||A marketplace for trading securities|
|Helps execute trades that happen at the exchange||Where trades actually take place|
|May have a physical trading floor, but may also be strictly electronic||May have a physical trading floor, but may also be strictly electronic|
It’s easy to confuse clearinghouses and exchanges, but they do serve different purposes. A clearinghouse oversees marketplaces. An exchange is a central marketplace where buyers and sellers can meet to trade securities like futures and options contracts. Both can have a physical trading floor (such as the NYSE) or be strictly electronic (like the Nasdaq). The clearinghouse is the middleman that helps execute the trades between the buyers and sellers at the exchange.
There may be rules and regulations that businesses need to follow to be listed on the exchange. For example, a business must have 1.1 million publicly held shares to be listed on the NYSE.
- A clearinghouse in a financial market acts as an intermediary between buyers and sellers.
- Clearinghouses aim to keep financial markets stable by providing security and efficiency to buyers and sellers.
- Exchanges are often confused with clearinghouses, but exchanges are central marketplaces where you can trade securities like futures and options contracts.
- The NYSE and the Nasdaq are both exchanges and clearinghouses.