Clearing is a vital process in the financial markets that facilitates the settlement of transactions and helps mitigate counterparty risk. In simple terms, clearing is the process of transmitting, reconciling and, in some cases, confirming payment orders before settlement. This allows the parties involved to reduce their settlement risk and lock in the trade.

Clearing services play a crucial role in the world’s major securities and derivatives markets. They are usually provided by dedicated clearing houses or central counterparties (CCPs). Some of the most well-known clearing organizations globally include the Options Clearing Corporation (OCC), LCH Clearnet, and the Chicago Mercantile Exchange (CME) Group.

Section 1. Clearing and Settlement

Clearing and settlement are two distinct steps in the processing of securities transactions. It is important to understand the difference between these two concepts.

1.1 Definition of Clearing

Clearing is the process of transmitting, reconciling, and confirming payment orders or security transfer instructions prior to settlement, potentially including the netting of instructions and the establishment of final positions for settlement.

In other words, clearing facilitates the exchange of obligations in order to determine a net cash flow and establish which securities need to be delivered. The key purpose is to reduce risks and ensure the smooth functioning of the settlement process.

Clearing may be performed by individual institutions, but it is most commonly handled by a centralized clearing house or central counterparty (CCP).

1.2 Difference Between Clearing and Settlement

While clearing establishes the payment obligations, settlement refers to the actual exchange of assets or financial instruments. Settlement represents the physical act of transferring cash and securities to fulfill the contractual obligations of a trade.

Settlement typically occurs one or two days after the trade date (T+1 or T+2). It completes the exchange of value between the trading parties and achieves the final discharge of obligations.

In short:

  • Clearing = determining what counterparties owe each other
  • Settlement = exchanging the cash and securities to fulfill those obligations

1.3 Importance of Clearing Prior to Settlement

By ensuring the terms of the transaction match and establishing the net cash and asset settlement positions, clearing minimizes the settlement risks for all parties involved. Specifically, the key benefits of clearing are:

  • Counterparty risk reduction – clearing mitigates counterparty credit risks and the potential for defaults that can cause disruptions on settlement day.
  • Netting efficiencies – clearing allows for netting of offsetting transactions to reduce settlement volumes and costs.
  • Market integrity – the standardized clearing process promotes transparency and integrity across markets.
  • Operational efficiency – clearing facilitates straight-through processing and smooth functioning of markets.
  • Risk management – robust collateral requirements improve risk management.

Overall, clearing promotes financial stability and allows markets to run more smoothly. By validating the transaction details and determining settlement requirements in advance, clearing reduces uncertainty during final settlement. In many regulated markets, securities transactions are required to be cleared prior to settlement.

Section 2. Types of Clearing

There are several important models and structures for how clearing services are provided:

2.1 Exchange Trading vs Over-The-Counter Clearing

In exchange-traded markets such as futures, options, and listed equities, clearing is generally required under exchange rules. Standardized contracts traded on an exchange are centrally cleared by the exchange’s clearing house.

Over-the-counter (OTC) transactions like swaps and forwards directly between counterparties do not automatically come under a clearing mandate. However, efforts have been made by regulators worldwide to promote central clearing for standardized OTC derivatives to reduce systemic risks.

2.2 Central Counterparty Clearing

Under the central counterparty (CCP) clearing model, the clearing house effectively becomes the buyer for every seller, and the seller for every buyer. It assumes the counterparty risk on all cleared transactions.

The original counterparties no longer have credit exposures to each other – their positions are against the CCP instead. By interposing itself as the counterparty, the CCP mutualizes risk among all participants and facilitates anonymous trading.

2.3 Bilateral Clearing

In certain markets like FX and commodities trading, bilateral clearing may be performed between the counterparties themselves or through prime brokers. This does not transfer counterparty risk to a central utility but can still enable netting and settlement efficiencies.

Section 3. Clearing Models

There are two primary models for how clearing services are facilitated:

3.1 Principal-to-Principal Clearing

In principal-to-principal clearing, transactions are between market participants. The CCP is not a principal to the trades, but stands between the parties to assume counterparty risk. Also known as non-guaranteed clearing.

3.2 Agency Clearing

Under the agency clearing model, the clearing members and their clients enter into trades as agents for the CCP as the central counterparty principal. The clearing house becomes the counterparty to all open positions. Also referred to as guaranteed clearing.

3.3 Direct and Indirect Clearing

Direct clearing means the market participant clears its trades directly through the CCP by becoming a member. Indirect clearing is where other firms clear on behalf of clients through their CCP membership. This may involve intermediaries like clearing brokers or clients of direct members.

Section 4. Clearing Process and Steps

The clearing process involves the following key steps:

4.1 Trade Execution

This is the first step where a buyer and seller enter into a bilateral contract or execute a trade on an exchange. Details like security name, quantity, price, settlement date are agreed.

4.2 Trade Capture

Once executed, trade details are submitted to the clearing house. This is typically done automatically via electronic feeds from the trading venues in real-time.

4.3 Netting and Novation

CCPs net offsetting positions and payments among participants to determine net settlement obligations. Through novation, the original trade is terminated and the CCP legally assumes the counterparty risk.

4.4 Margining

The CCP collects initial margin upfront from all participants to cover potential losses in case of defaults. During the life of the contracts, variation margin is exchanged daily to account for changes in positions.

4.5 Settlement

On settlement date, the clearing house coordinates the final exchange of securities and payments to complete delivery obligations. This discharges the cleared transactions.

Section 5. Central Counterparties (CCPs)

Central clearing has been facilitated by the establishment of CCPs worldwide that specialize in providing clearing services:

5.1 Role of CCPs

The main functions provided by CCPs are:

  • Novation and counterparty substitution
  • Multilateral netting of trades
  • Collateral management and margining
  • Settlement coordination and monitoring
  • Risk management through member requirements
  • Default management through loss allocation rules

By centralizing these core clearing functions, CCPs generate multiple risk and efficiency benefits for the markets they serve.

5.2 Risk Management by CCPs

To mitigate their own risks as the counterparty, CCPs have extensive risk management protections in place, including:

Membership requirements – stringent criteria for clearing members

Margin collection – collecting upfront margin and daily mark-to-market variation margin

Default fund contributions – all members must contribute to a pooled default fund

Collateral haircuts – applying valuations haircuts to collected collateral

Daily stress testing – running daily default simulations across portfolios

Default waterfall – sequenced lines of defense to cover losses

These measures allow CCPs to mutualize risk, maintain high financial resources, and continue operations during periods of market stress.

5.3 Default Procedures

If a clearing member defaults and CCP initial margins are insufficient, the following steps may be taken by the CCP:

  • Use defaulter’s contributions to default fund
  • Apply its own capital contribution
  • Require additional payments from surviving members
  • Tear up remaining contracts with defaulter
  • Hedge or auction off defaulter’s portfolio
  • Spread remaining losses through variation margin
  • Cash calls, assessments, or loss allocation to members

The goal is to contain the default losses and prevent them from spreading through strict membership rules, collateral requirements, and mutualized loss allocation.

5.4 Interoperability Between CCPs

Cooperation between CCPs is growing through interoperability arrangements that allow cross-margining. This links CCPs to more efficiently manage collateral, netting, and settlement across markets. Interoperability can enhance efficiencies and risk management across CCPs. But it needs to be supported by robust risk controls.

Section 6. Clearing Technology and Infrastructure

Modern clearing relies on advanced technology infrastructure:

6.1 High-Performance Technologies

  • Low latency – High-speed automated systems for rapid clearing and settlement.
  • Huge capacity – Ability to reliably handle massive daily volumes and peak loads.
  • Workflow automation – Straight-through processing with minimal manual intervention.

6.2 Interoperability and Standardization

  • Interfaces between trading, clearing, settlement systems – Smooth linking of trade execution, clearing calculation, settlement activities.
  • Industry data standards like FIX, FpML, ISO – Formats that support interoperability across diverse systems.

6.3 Cyber Risk Management

  • Resilience architecture – Systems engineered for high availability and fast recovery.
  • Access controls – Multifactor authentication, role-based system access, and privileged access management.
  • Network security – Multilayered perimeter defenses, monitoring, and attack protection.
  • Data protections – Encryption, integrity checking, secure code development protocols.

As financial infrastructure, CCPs rely on cutting-edge IT capabilities to promote stability, speed, resilience, and interoperability across the interconnected clearing ecosystem.

Section 7. Clearing Services

While clearing principles are consistent across products, clearing services are highly customized by asset class based on specific contract terms, risk profiles, and market nuances. Key clearing segments include:

7.1 Listed Derivatives Clearing

Futures – Standardized futures contracts on commodities, indexes, currencies listed on exchanges.

Options – Exchange-traded options contracts on equities, indexes, futures.

Highly regulated markets with mandatory central clearing requirements.

7.2 OTC Derivatives Clearing

Swaps – Interest rate, credit default, commodity, equity swaps between banks and institutional clients.

Forwards – FX forwards between banks are also increasingly centrally cleared.

Reforms are expanding OTC derivatives clearing through trade repositories, execution venues, and CCPs.

7.3 Securities Financing Transactions Clearing

Repos, reverse repos, securities lending agreements – large short-term collateralized funding markets between banks, funds and broker-dealers.

Reforms are promoting central clearing of standardized SFTs to improve transparency.

7.4 Securities Clearing

Listed shares – equity securities trading on primary exchanges.

Corporate and government bonds – clearing of OTC-traded fixed income securities is also increasing.

Stock exchanges generally provide integrated trading, clearing and settlement services.

Section 8. Central Bank Clearing and Settlement

Central banks play pivotal roles in financial market clearing and settlement:

8.1 Role of Central Banks

  • Overseeing smooth functioning of clearing and settlement systems.
  • Mitigating and containing settlement risks.
  • Providing settlement accounts and collateral management services.
  • Acting as settlement agent for large-value payments.
  • Providing liquidity through repos or credit for resolution actions.
  • Developing market infrastructure and high-value payment systems.

8.2 Implications for Monetary Policy

  • Central bank actions influence collateral availability.
  • Open market operations interact with settlement flows.
  • Targeted longer-term operations supply liquidity against collateral.
  • Reserve requirements affect settlement liquidity.
  • Interest rate changes impact incentives around clearing.

8.3 Financial Stability Considerations

  • Oversight and regulation of clearing/settlement systems.
  • Managing concentration risks with dominant clearers.
  • Understanding links between CCP exposures and banks.
  • Monitoring collateral adequacy, liquidity risks.
  • Readiness for emergency liquidity support and resolution.

The interactions between central bank functions, market infrastructures, and clearing flows are multilayered. This can create complex trade-offs to consider between policy aims around monetary control, financial stability, market functioning, and risk mitigation.

Section 9. Clearing Reforms Since 2008

Regulatory reforms after the global financial crisis specifically targeted OTC derivatives clearing and CCP resiliency:

9.1 G20 Clearing Mandates

At the 2009 Pittsburgh Summit, G20 leaders agreed that:

“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

This spurred a comprehensive set of clearing mandates and transparency requirements across major jurisdictions.

9.2 European Market Infrastructure Regulation (EMIR)

EMIR entered force in Europe in 2012 requiring central clearing and risk mitigation for OTC derivatives. Specific regulations cover:

  • Central clearing for standardized OTC derivatives
  • Margin and collateral requirements
  • Strict prudential requirements for CCPs
  • Trade reporting to repositories
  • Rules to improve transparency and strengthen oversight

9.3 Dodd-Frank Act Title VII Rules

In the US, the Dodd-Frank Wall Street Reform Act Title VII measures:

  • Mandated central clearing of swaps traded between financial firms
  • Established rigorous standards for risk management at CCPs
  • Enhanced data reporting requirements to regulators
  • Moved trading of swaps onto regulated venues
  • Increased swap dealer registration and business conduct rules
  • Required banks to move swap trading units to affiliates

Globally, these coordinated regulatory reforms have led to a significant shift towards central clearing of standardized OTC derivatives by regulated CCPs, along with greater transparency through trade reporting. The proportion of interest rate swaps cleared globally rose from around 20% in 2007 to over 80% by 2018. While clearing mandates were not universally applied across all jurisdictions, the extensive adoption of central clearing is seen as reducing systemic risks and enhancing the resilience of derivatives markets. However, this has also led to a concentration of risks in CCPs that are now systemically important financial market infrastructures.

Looking ahead, key directions in the evolution of clearing include:

10.1 Continued Growth of Central Clearing

  • Expanding into new OTC derivatives asset classes.
  • Increasing use for securities financing transactions.
  • Exploring clearing for other instruments like corporate bonds, FX, and crypto-assets.
  • Further adoption across jurisdictions.
  • Rising volumes leading to greater concentration in dominant global CCPs.

10.2 Cross-Border Harmonization

  • Common CPMI-IOSCO risk management standards across CCPs globally.
  • Cooperation agreements for regulatory oversight of cross-border
  • Addressing extra-territoriality issues in oversight of global clearers.
  • Progress towards recognition frameworks enabling international activity.
  • Need for robust cooperation in crisis management planning.

10.3 Fintech Innovations

  • DLT integration with post-trade systems and settlement flows.
  • Smart contracts to embed clearing terms and automate processing.
  • Cloud enablement for flexibility, resiliency, and economies of scale.
  • Leveraging AI, ML, advanced analytics for risk monitoring.
  • APIs and microservices facilitating interoperability.
  • User interface modernization – mobile, web, accessibility.

10.4 Focus on Operational Resilience

  • Business continuity planning, crisis preparedness, default fire drills.
  • Holistic cyber risk management across interconnected ecosystem.
  • Analysis of clearing interdependencies and concentration risks.
  • Reviewing adequacy of financial resources and liquidity preparedness.
  • Upgrading risk governance, compliance, and operational controls.
  • Ongoing monitoring of resiliency through stress testing.

Clearing underpins the world’s financial markets and mitigates systemic risks. As reforms expand central clearing and concentrate risks in CCPs, operational excellence is crucial. With technology advancements and global coordination, clearing systems aim to maintain stability and foster financial market integration into the future.

Conclusion

Clearing plays a vital role in reducing risks and promoting the efficient functioning of securities and derivatives markets. By validating and matching trades, calculating net obligations, securing collateral, and coordinating settlement, clearing facilitates orderly exchanges between counterparties.

Modern clearing is facilitated through specialized central counterparties with robust risk protections. Clearing reforms enacted after 2008 have significantly expanded central clearing across major asset classes like OTC derivatives to reduce systemic risks. However, this has concentrated risks in systemically important clearing houses.

With clearing volumes continuing to rise, ongoing international coordination, technological innovation, and vigilant risk management remains crucial to ensuring clearing systems maintain high operational standards and financial stability.