Clearing (finance)

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In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled (see settlement). Clearing is necessary because the speed of trades is much faster than the cycle time for completing the underlying transaction.

In its widest sense clearing involves the management of post-trading, pre-settlement credit exposures, to ensure that trades are settled in accordance with market rules, even if a buyer or seller should become insolvent prior to settlement.

Processes included in clearing are reporting/monitoring, risk margining, netting of trades to single positions, tax handling, and failure handling.

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[edit] Central counterparty

Clearing generally involves the use of a well capitalised financial institution known as a central counterparty (CCP). The CCP becomes a party to every trade, acting as buyer to market participant sellers, and seller to market participant buyers. In respect of unsettled trades, market participants therefore bear the standardised credit risk of the CCP, and not that of each other in a decentralised market. See Central Counterparty Clearing

In the United States, interbank clearing is done through the Automated Clearing House (ACH). Its rules and regulations are set by NACHA-The Electronic Payments Association, formerly the National Automated Clearing House Association, and the Federal Reserve. The ACH network acts as central clearing facility for all Electronic Funds Transfer (EFT) transactions. Interbank clearing of paper checks is done by correspondent banks and the Federal Reserve; they are ultimately settled between the 12 Federal Reserve Banks through the Interdistrict Settlement Fund.

[edit] Netting

The CCP can net its daily purchases and sales in like securities since each market participant has only one counterparty to its trades. Such netting is widely identified as the key benefit offered by the use of a CCP.

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