Clearing refers to the process each financial transaction undergoes. In banking, it is the transfer of funds from one account to another via a clearing bank. In finance, clearing is the exchange of capital for securities through a clearing house or clearing broker.
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Clearing ensures the seller has the securities and receives funds, and the buyer has sufficient funds and receives the purchased securities.
Clearing remains necessary to match all buy and sell orders and ensures efficient markets, as market participants deal with one clearing institution instead of clearing and settling between each other.
Given the fast-paced nature of trading and financial transactions, a trusted intermediary, the clearing institutions, step in and process clearing, while settlement can take several days, usually two business days for financial transactions, up to five business days for domestic bank transactions, and ten business days for international transfers.
What is the Clearing Definition?
Once a trader places an order, the broker deducts the funds and adds the purchased assets to the account in real-time, unless it requires more time to fill the order. The trader does not see the clearing and settlement of the transaction handled by a sophisticated clearing system. The same applies to one bank customer sending a payment to another bank. While the account balance remains deducted immediately, the counterparty to the transaction must wait until funds arrive, known as settlement.
What happens during the clearing process?
During the clearing process, network operators validate the clearing instructions, ensuring they are valid and match the available information at the initiating and receiving financial institution. It also triggers obligations among the financial institutions to settle the transaction between each other and their customers.
Clearing institutions ensure the following:
- Both parties are members of the clearing network
- Data in the clearing instructions match records at both financial institutions
- Funds are available in a client account at the initiating financial institution
- Securities are available at the receiving financial institution
- The buyer receives the purchased securities, and the seller the funds
Clearing involves a clearing fee added to each transaction. Given the volume, those extra charges could be a few cents in clearing finance transactions, a few dollars for bank transfers, or a percentage of the transaction volume for payment processors.
Clearing and Settlement in Finance and Banking
Clearing and settlement ensure smooth financial transactions. They occur in the background, and while users never notice them, they must understand the clearing house meaning in finance and banking, as it explains additional costs via a clearing fee, delays in receiving funds, and knowledge of potential clearing risk. Without clearing and settlement via a trusted clearing house function, the clearing payment process becomes inefficient and financial markets dysfunctional.
The clearing and settlement process protects both parties. Besides enduring that the buyer has the necessary funds, it records the clearing instructions, investigates potential discrepancies, and validates records, including the availability of securities. Once the clearing firm confirms all details, it releases the funds and securities, ensuring swift settlement.
An Example of Clearing
Assume a trader wants to purchase 5,000 shares in Company ABC at $12 for a total of $60,000 but uses 1:20 leverage, resulting in a margin requirement of $3,000, borrowing the remaining $57,000 from their broker. The broker deducts the $3,000 from the account balance and adds 5,000 shares in Company ABC, assuming it found a counterparty willing to sell at $12.
Here is an example of clearing:
- The clearing house ensures the broker has the $60,000 required for the purchase of 5,000 shares at $12 and that the trader does not use the $3,000 margin requirement to maintain the position
- It also makes sure the seller has 5,000 shares available and willing to sell at $12
- After the clearing house verifies all clearing instructions, it releases the funds to the seller and the shares to the buyer, avoiding an out-trade, which results in a failed transaction
- The clearing house ensures all parties fulfill their obligations, creating a trustworthy, smooth, and efficient financial flow
Four Elements of Clearing Every Trader Must Know
Traders and consumers must understand the clearing definition and differentiate between the four primary elements of the clearing infrastructure.
- Clearing Bank - It facilitates transactions between banks, ensures clearing instructions match bank records, and that banks settle payments between each other and their customers
- Clearing House - Acts as the direct counterparty and intermediary between itself and buyers and itself and sellers, collects a clearing fee, handles clearing FX transactions, and ensures the settlement of transactions
- Clearing Broker - An exchange member acting as the intermediary between traders and the clearing house, ensuring a smooth order flow, often engaged by smaller brokers, and keeps records of clearing instructions for future reference
- Clearing Instruction - Includes all relevant information to complete an order, validated by a clearing firm, which then proceeds with the settlement process
How to Avoid Clearing Risk?
A clearing system mitigates risk but cannot eliminate it. Each clearing institution deploys internal risk management protocols to reduce avoidable risk as much as possible.
It is impossible to avoid clearing risk, but traders, consumers, and financial institutions can decrease it to acceptable levels.
How can traders mitigate clearing risk?
- Trade with well-established brokers
- Ensure they maintain sufficient capital in trading accounts, especially when using leverage
- Transact in liquid securities
What are some steps clearing institutions take to decrease clearing risk?
- Manage wholesale payments throughout the day
- Avoid late-day concentration of payments
- Optimize operating protocols for clearing payment
- Intraday reconciliation of payment activity
- Identify and prioritize time-sensitive transactions
- Maintains an IT infrastructure able to facilitate daily operating requirements, including efficient real-time transactional and intraday liquidity monitoring and reconciliation
- Frequent stress testing to ensure the capacity, durability, and redundancy of the payment infrastructure
- Minimize manual intervention in the payment process
- Use a bilateral netting payment process with counterparties to improve settlement
- Efficiency
- Ensure settlement as soon as practicable possible, decreasing undue risks consisting of credit, operational, and liquidity risks
- Reduce failed transaction risk, especially during late-day settlements
Clearing Conclusion
Clearing remains an essential background component ensuring efficient clearing payment flow in finance and banking. A clearing house handles the process, verifies funds and availability of securities, matches buy and sell orders, and ensures clearing instructions match records, resulting in an orderly execution. A clearing house also acts as a mediator in case of disputes and records transaction details, available for future reference.
FAQs
Is clearing the same as settlement?
Clearing and settlement are different and form the two components of a transaction. Clearing refers to the first step, where financial institutions send payment messages through the payment system with all relevant information. Settlement is the second step, where financial institutions fulfill their commitments to act on the received instructions.
What comes first, clearing or settlement?
Clearing is the first step of a financial transaction, followed by settlement.
Who is involved in the clearing process?
It requires at least two financial institutions and one clearing institution. Should one of the financial institutions has no direct access to the necessary payment system, a correspondent financial institution is required. In rare cases, it can take up to four financial institutions to complete a transaction.