Clearing, and settlements, which are often used in the same sentence but refer to something different, are the building blocks of today's payment systems. Without bilateral clearing, everything from global trade to a personal bank or e-wallet transfer would not function efficiently.
In financial markets, clearing is necessary to facilitate all transactions, for example, ensuring sellers of an asset receive their funds and buyers get their asset. Bilateral clearing creates a smooth and efficient marketplace, faster transactions, and lower transaction costs. Besides providing examples of bilateral clearing, we will also highlight the difference between bilateral clearing vs. central clearing.
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Bilateral Clearing Explained
A bilateral clearing agreement can consist of the transmission, the reconciliation, the confirmation, and the establishment of final positions between two parties. The most defining aspect of bilateral clearing and why it is efficient is the inclusion of netting between parties, which we will explain with examples below. Bilateral clearing includes two parties, for example, two banks who skip the interbank market in favor of a bilateral clearing agreement. When more than two parties are involved, the term multilateral clearing applies.
Examples of Bilateral Clearing
An example of bilateral clearing will help understand how it works and illustrate its benefits. Then, we will evaluate the differences between bilateral clearing vs. central clearing.
Here is a bilateral clearing example:
- Assume two banks enter into a bilateral clearing agreement
- Bank A should send €50 million to Bank B
- Bank B should send €35 million to Bank A
- Without a bilateral clearing agreement, both banks will send the required funds, creating unnecessary transaction costs
- A bilateral clearing agreement includes the effect of netting
- Therefore, Bank A will send €15 million to Bank B, the difference between what Bank A should send to Bank B and what Bank B should send to Bank A
- Bank A has no transaction costs, as it will not engage in a fund transfer
Here is another bilateral clearing example:
- Assume you owe your friend $300
- You are selling your mobile phone for $250, and your friend wants to buy it from you
- Rather than sending $300 from your e-wallet to your friend, and your friend buying your phone on the auction site where you listed it, you send your friend $50 and the mobile phone
- Your transaction costs are lowered, as they are percentage-based on the amount you send
- Your friend has no transaction costs
- The bilateral clearing agreement settled two transactions simultaneously, and both parties are satisfied
The Difference Between Bilateral Clearing and Central Clearing
Bilateral clearing involves two parties, while a central clearing counterparty (CCP) conducts central clearing. A CCP is a financial institution that facilitates transactions between two parties, accepts the counterparty credit risk, provides clearing services, and handles settlement. A CCP may also offer accounting services, and it changes the overall links and risk exposures across the financial system.
Central clearing may offer a preferred method between two parties with trust issues or other obstacles. While Central clearing, which experiences a rise in demand globally, could lower the impact of small shocks on the financial system, it might magnify structural issues.
Here is a central clearing example, using the parameter from our bank bilateral clearing example above:
- With a CCP as the middleman, all transactions flow through it, and Bank A, and Bank B, have no interactions with each other
- A CCP can conduct netting services, asking Bank A to transfer the €15 million to the CCP
- The CCP will then transfer the funds to Bank B
- It includes two additional transactions, from Bank A to the CCP and from the CCP to Bank B, which add time and costs to the transaction, increasing fees for the end-user
A Clearing Member Trade Agreement Explained
A clearing member trade agreement outlines the relationship between a trader and a broker. The document allows a trader to take advantage of products and services available at multiple brokers before clearing all transactions with their broker at the end of the day. The process creates a smooth and efficient clearing process, reducing time, and lowering trading costs.
Bilateral Clearing Conclusion
Bilateral clearing between two parties who trust each other lowers transaction times and costs, creating an efficient flow of capital. It represents the cornerstone of today’s financial remittance system and eliminates unnecessary transactions which exist with central clearing.
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