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Clearing Houses Role

Clearing Houses Role

Clearing house is an exchange-associated body charged with the function of ensuring (guaranteeing) the financial integrity of each trade. Orders are cleared by means of the clearinghouse acting as the buyer to all sellers and the seller to all buyers. Clearing houses provide a range of services related to the guarantee of contracts, clearance and settlement of trades, and management of risk for their members and associated exchanges.

Clearing Houses Role

1 Role of Clearing Houses:

• It ensures adherence to the system and procedures for smooth trading.

• It minimises credit risks by being a counter party to all trades.

• It involves daily accounting of all gains or losses.

• It ensures delivery of payment for assets on the maturity dates for all outstanding

contracts.

• It monitors the maintenance of speculation margins.

2 Working:

The clearinghouse acts as the medium of transaction between the buyer and

the seller. Every contract between a buyer and a seller is substituted by two contracts so that clearing house becomes the buyer to every seller and the seller to every buyer. In a transaction where P sells futures to R, R is replaced by the clearinghouse and the risk taken by P becomes insignificant. Similarly, the credit risk of R is taken over by the clearing house; thus, the credit risk is now assumed by the clearing house rather than by individuals.

The credit risk of the clearing house is then minimised by employing some deposits as collaterals by both, buyers and sellers. These deposits, known as margins, are levied on each transaction depending upon the volatility of the instrument and adjusted everyday for price movements.

Clearing Houses Role

Margins, which normally are in form of cash or T-bills, can be categorised into the following types: –

Initial Margins on Securities: It is paid by purchasers and short sellers, generally function as a security for loan, and is similar to a down payment required for the purchase of a security.

Initial Margins on Derivatives: It refers to funds paid as guarantee to ensure that the party to the transaction will perform its obligation under the contract. Initial margin on derivatives is designed to cover future changes that may occur in the value.

Maintenance Margins: It refers to the value over and above the initial margin, which must be maintained in a margin account at all times after the initial margin requirement, if any, is satisfied.

Variation Margin: It refers to funds that are required to be deposited in, or paid out of, a margin account that reflects changes in the value of the relevant instrument.

Clearing Houses Role

3 Trading Procedures: Clients have to open an account with a member of the exchange. When they want to trade in futures, they instruct members to execute orders in their account. The trade details are reported to the clearing house. If a member of the exchange is also a member of clearing house, then he directly deposits the margins with the clearing house. If he is not a member then he should route all transactions through a clearing member for maintaining margins.

Clearing Houses Role

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Clearing Houses Role

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