Market Clearinghouse Research Paper

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A clearinghouse is a third-party establishment that operates with stock exchanges to clear trades, collect and maintain margin monies, regulate delivery, and report trading data. All trades on an exchange go through the clearinghouse. Three million contracts trade each day on the Chicago Mercantile Exchange, and 1.5 billion shares change hands each day on the New York Stock Exchange (NYSE). If an exchange clearinghouse were to fail it would trigger a financial meltdown. When the stock market crashed in 1987 the Federal Reserve moved quickly to provide access to liquidity for exchange clearinghouses, and none failed.

The clearinghouse performs two principal functions: (1) accounting; and (2) contract guarantee. Accounting is a necessity, but it can be outsourced. The fundamental economic function of the clearinghouse is the contract guarantee, which makes large-scale anonymous trading feasible.

The accounting function is easy to understand and mechanically hard to complete. The clearinghouse keeps the books. At the end of the trading day (or on rare occasions during the trading day) the clearinghouse requires that traders balance their account. The guarantee function is harder to understand, but it is the reason for the clearinghouse. In any transaction a seller agrees to deliver at a price and a buyer agrees to take delivery at that price. But for transactions separated in time or space, payment and delivery are uncertain. The clearinghouse puts itself in the middle of each transaction. Technically, buyers buy from the clearinghouse and sellers sell to the clearinghouse. If the seller fails to deliver, he or she defaults to the clearinghouse. The clearinghouse delivers to the buyer. Traders on organized exchanges do not concern themselves with the creditworthiness of their trading partner because their trading partner is the clearinghouse.

In over-the-counter markets traders trade directly with other traders—there is no clearinghouse in the middle. In most over-the-counter markets trades take place only among principals (large financial institutions) that know each other very well.

The clearinghouse guarantee exposes the clearinghouse to default risk. Most traders operate on credit. The clearinghouse requires traders to post margins (collateral) on their accounts so that they have an incentive to perform, and if they do not perform the clearinghouse has immediate access to the collateral. Setting the correct margin involves walking a fine line: a margin too high pushes traders off organized exchanges, and a margin too low exposes the clearinghouse to excess risk.

eBay is an Internet auction site that bills itself as “The World’s Online Marketplace.” Traders meet virtually to agree on the terms of a trade for virtually any item. A big problem for eBay is that a few sellers do not deliver and a few buyers do not pay. If potential eBay traders do not have confidence in the performance of their trading partner, then they will not go to eBay for trades, and the exchange dies. eBay works hard to assure traders that their transactions will be consummated.

eBay bought PayPal, an electronic payments system, in 2002. Through PayPal, one can authorize credit card payments or electronic check transfers. PayPal provides eBay with an electronic accounting system, the first function of a clearinghouse. In addition, PayPal has begun to guarantee transactions. If one buys from a PayPal authorized seller using the electronic check payment method, then PayPal guarantees delivery of items that cost less than $1,000. PayPal also guarantees that the seller will receive payment.

In conclusion, exchanges provide an anonymous marketplace for traders in modern economies. Clearinghouses provide the assurance that delivery and payment occurs.

Bibliography:

  1. The Chicago Mercantile Exchange Education Center. https://www.cmegroup.com/education.html
  2. Craine, Roger, and David B 1999. Valuing the Futures Market Clearinghouse’s Default Exposure During the 1987 Crash. Journal of Money, Credit, and Banking 31: 248–272.
  3. Hull, John 2006. Options, Futures, and Other Derivatives. 6th ed. Upper Saddle River, NJ: Prentice Hall.

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