What is a Clearing House?

The Indian stocks and securities market has seen considerable changes over the last few years. Fintech for financial inclusion has played a significant role in improving the efficiency of daily transactions.

Gone are the days when trades were settled by an account period settlement system. The trade obligations, which earlier took at least a week to clear, are now settled within three working days. 

The introduction of clearing houses has helped improve market efficiency, transparency, and liquidity, reduce the settlement and operational risks associated with market transactions and save settlement costs.

In today's article, we will discuss clearing houses, the clearing process, and the risks involved in clearing houses.

Let's dive straight in.

What is Clearinghouses?

Clearing corporations, commonly known as clearing houses or clearing firms, are entities associated with stock exchanges that act as designated mediators between buyers and sellers in a financial market. The primary function of a clearing house is to validate and finalize the transaction by ensuring that both parties—the seller and the buyer—honour their contractual obligations.

Clearing houses are essential for the successful completion of trades through their association with the stock exchanges. They handle confirmations, settlements, and transaction deliveries.

Statutory Definitions

Let us look into the definition provided in the Securities Contract (Regulation) (Stock Exchange and Clearing Corporation) Regulations, 2018:

• Section 2(d) -  Entity that is established to undertake the activity of clearing and settlement of trades in securities or other instruments or products that are dealt with or traded on a recognized stock exchange and includes a clearing house.
• Section 2(e) - A clearing member is a person with clearing rights in any recognized clearing corporation.

What do you mean by clearing and settlement?

The Settlement Process

Three processes constitute the successful completion of the trade. They are:

• Trading: In the trading process, the buyer who desires to purchase securities places an order, and the seller who desires to sell securities executes the sale.
•  Clearing: The obligation of both parties regarding funds and securities is determined in the process of clearing.
• Settlement: This is the final stage, in which NSCCL (National Securities Clearing Corporation Limited) is the counterparty between the buyer and the seller. The NSCCL guarantees both parties that it will take action against both parties in case of default.

Who is involved in the clearing process?

The following parties are mainly involved in the clearing process:

• Depositories: The primary function of depositories is to ensure the electronic transfer of securities in a dematerialized form.
• Clearing banks: The clearing banks are essentially a link between clearing members and the NSCCL in the settlement process.
• Clearing members: Clearing members settle the trades carried out across all the counters.
• Custodians: As the name suggests, custodians keep the securities in safe custody. They hold the documentary proof of securities and have the securities' title in the holder's name.

Are there any risks involved with Clearinghouses?

No entity involved in the securities transactions is risk-free. Clearing houses come with the following risks:

• The Replacement Cost Risk: Clearing houses become liable to pay the replacement costs when a clearing member defaults. They fulfil the replacement obligation when they purchase/sell contracts identical to those on which the clearing member defaulted.
• The Liquidity Risk: Clearing houses assume a liquidity risk when they substitute themselves for clearing members as a counterparty. They fulfil scheduled payment obligations to the non-defaulting members. Whenever a member defaults, the clearing houses look into its assets and financials to raise the necessary funds.
• The Delivery Risk: Clearing houses encounter the most significant risk in the form of delivery risk. Delivery risk is incurred when a contract expires, and the settlement is through delivery as opposed to a payment that is not received. Delivery risks can arise out of either of the following two circumstances:
  • When the securities are delivered to the buyer before he makes any payment to the seller, the seller runs a default risk in payment.
  • When the payment is made prior to the delivery of securities to the buyer.
• The Counterparty Risk: Clearing houses encounter counterparty risk when either party to a transaction defaults in their obligations.
• Principal Risk: Principal risk arises when both parties (buyer and seller) fulfil their obligations to make payments and deliver shares but do not receive the delivery of shares or the money. In such circumstances, NSCCL (which is the counterparty) becomes the buyer for every seller and vice versa.

What are the steps involved in the settlement of trade?

• Determination of obligations of buyers and sellers by the NSCCL as the counterparty to the members.
• Members make available the requisite funds once they're aware of their respective obligations.
• Electronic instructions are sent out to the clearing banks so they can pass the required entries by the NSCCL once the pay-in obligations have been fulfilled.
• The NSCCL deploys a comprehensive risk management and surveillance system to monitor and minimize the potential default risks. We say potential risks because there is a considerable time gap between trade settlement and execution.

Clearing houses in India – Clearing Corporation of India Limited

Introduced in April 2001, under the ministry of central counterparty, the Clearing Corporation of India was established with the primary objective of providing clearing and settlement for transactions in foreign exchange, government securities, and other money market instruments in the economy. Following are some of the clearing corporations in India:

• Indian International Clearing Corporation (IFSC) Limited
• Indian Clearing Corporation
• Metropolitan Clearing Corporation of India Limited
• Multi Commodity Exchange Clearing Corporation Limited
• National Commodity Clearing Corporation Limited
• National Securities Clearing Corporation Limited (NSCCL)
• NSE IFSC Clearing Corporation Limited

Closing Remarks

Clearing houses in the market offer a host of benefits. Settlement and operational risk are significantly reduced, and settlement costs are saved. 

Clearing houses have become the hub of various platforms for electronic deal execution in varied market segments. We conclude by saying that a clearing corporation is no less than a protective guide for all transactions in the secondary markets with robust risk management systems.

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Happy Investing.