What is a Clearing House?
Created on 09 Feb 2021
Wraps up in 5 Min
Read by 16.1k people
Updated on 20 Mar 2021
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 the transactions carried out daily.
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, liquidity, reduced the settlement and operational risks associated with the market transactions and has helped save the settlement costs.
In today's article, we will be discussing clearing houses, the process of clearing, and the risks involved in clearing houses.
Let's dive straight in.
What are Clearing houses?
Clearing corporations, commonly known as clearing houses or clearing firms, are entities that are associated with stock exchanges constituted to act as a designated mediator between a buyer and a seller in a financial market. The primary function of a clearing house is validation and finalization of the transaction by ensuring that both – 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.
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 person having clearing rights in any recognized clearing corporation is called a clearing member.
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 with the desire to purchase securities will place an order, and the seller with the desire to sell securities goes for the execution of the sale of securities.
- Clearing: The obligation of both the parties in terms of the funds and securities is determined in the process of clearing.
- Settlement: This is the final stage where 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 the parties in case of default.
Who all are 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: Custodians, as the name suggests, keep the securities in their 'custody' in a safe manner. The custodians hold the documentary proof of securities and have the securities' title in the holder's name.
Are there any risks involved with Clearing houses?
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. The replacement obligation is fulfilled by clearing houses 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 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 default 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 to every seller and vice-versa.
What are the steps involved in settlement of trade?
- Determination of obligations of buyers and sellers by the NSCCL that also is 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 to pass the required entries by the NSCCL once the pay-in obligations have been fulfilled.
- The NSCCL deploys 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
Clearing houses in the market come with a host of benefits. The settlement and operational risk are significantly reduced, and there are savings in settlement costs.
Clearing houses 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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