What is compensation?
Clearing is the procedure by which financial transactions are settled; that is, the correct and timely transfer of funds to the seller and securities to the buyer. Often with compensation, a specialized body acts as an intermediary and assumes the role of tacit buyer and seller to reconcile orders between the parties to the transaction. Clearing is necessary for the matching of all buy and sell orders in the market. It provides smoother and more efficient markets because parties can make transfers to the clearinghouse rather than to each individual party they deal with.
Key points to remember
- Netting is the correct and timely transfer of funds to the seller and securities to the buyer.
- A specialized body often acts as an intermediary known as a clearing house and takes on the role of tacit buyer and seller to reconcile orders between the parties to the transaction.
- Clearing is necessary to match all buy and sell orders to ensure smoother and more efficient markets.
- When transactions are not cleared, the resulting transactions can lead to real monetary losses.
- The clearing process protects the parties involved in a transaction by recording details and validating the availability of funds.
How compensation works
Clearing is the process of reconciling the purchases and sales of various options, futures or securities, and the direct transfer of funds from one financial institution to another. The process validates the availability of appropriate funds, records the transfer and, in the case of securities, ensures delivery of the security to the buyer. Uncleared transactions can lead to settlement risk and, if the transactions are not cleared, accounting errors will occur and real money may be lost.
A foreign trade is a trade that cannot be placed because it was received by an exchange with conflicting information. The associated clearinghouse cannot settle the transaction because the data submitted by parties on both sides of the transaction is inconsistent or contradictory.
Stock exchanges, such as the New York Stock Exchange (NYSE) and NASDAQ, have clearing companies. They make sure that stock traders have enough money in their account, whether it’s using cash or a margin provided by the broker, to fund the trades they make. The clearing division of these exchanges acts as the middleman, helping to facilitate the smooth transfer of funds.
When an investor sells a stock they own, they want to know that the money will be returned to them. The clearinghouses make sure that happens. Likewise, when someone buys a stock, they must be able to afford it. The clearing company makes sure that the appropriate amount of funds are set aside for the settlement of trades when someone buys stocks.
The clearing can have different meanings depending on the instrument with which it is associated. In the case of check clearing, this is the process of transferring funds promised on the check to the recipient’s account. Some banks apply holdbacks on funds deposited by check, as the transfer is not instantaneous and may take time to process.
Federal reserve banks provide check collection services to depository institutions. When a depository institution receives a check drawn on another institution, it can send the check for collection to the institution directly, deliver the check to institutions through a local clearing house, or use the services of cashing of checks from a corresponding institution or from a Federal Reserve Bank.
Almost all checks that federal reserve banks process for collection are now received as electronic check images, and most checks are collected and settled within one business day.
For futures and options, a clearinghouse acts as an intermediary for the transaction, acting as an implied counterparty to both the buyer and the seller of the futures contract or option. This extends to the securities market, where the exchange validates trading in securities until settlement.
Clearing houses charge a fee for their services, called a clearing fee. When an investor pays a commission to the broker, these clearing fees are often already included in that commission amount. These fees support the centralization and reconciliation of transactions and facilitate the proper delivery of purchased investments.
When a clearinghouse encounters an out trade, it gives counterparties the opportunity to reconcile the deviation independently. If the parties manage to resolve the issue, they resubmit the transaction to the clearinghouse for proper settlement. But, if they cannot agree on the terms of trade, then the matter is sent to the appropriate trade committee for arbitration.
Automated clearing house
An Automated Clearing House (ACH) is an electronic system used for the transfer of funds between entities, often referred to as electronic funds transfer (EFT). The ACH acts as an intermediary by processing the sending / receiving of validated funds between institutions.
An ACH is often used for direct deposit of employee salaries and can be used to transfer funds between an individual and a business in exchange for goods and services. Traditionally, sending and receiving bank account information must be provided, including account and routing numbers, to facilitate the transaction. This process can also be thought of as an electronic check because it provides the same information as a written check.
Example of compensation
As a hypothetical example, suppose a trader buys an index futures contract. The initial margin required to hold this transaction overnight is $ 6,160. This amount is considered “good faith” assurance that the trader can afford to trade. This money is held by the clearing company, in the trader’s account, and cannot be used for other transactions. This helps to compensate for the losses that the trader may incur during a trade.
This process helps reduce the risk for individual traders. For example, if two people agree to negotiate and there is no one else to verify and support the transaction, it is possible that one of the parties will withdraw from the agreement or experience financial problems and be unable to produce the funds to maintain its end of the market. The clearing company takes this risk away from the individual trader. Every trader knows that the clearing company will raise enough funds from all trading parties, so they don’t have to worry about the credit risk or default of the person on the other side of the transaction. .
Clearing Bank FAQs
What is clearing in the banking system?
Clearing in the banking system is the process of settling transactions between banks. Millions of transactions occur every day, so bank clearing tries to minimize the amounts that change hands on any given day. For example, if bank A owes bank B $ 2 million in cleared checks, but bank B owes bank A $ 1 million, bank A only pays bank b $ 1 million.
Which banks are clearing banks in the United States?
The clearing banks in the United States are: Bank of America; West Bank; Barclays; the Bank of New York Mellon; BB&T; a capital letter; Citi; Citizens; Comería; German Bank; AG Consultants, Fifth Third Bank; HSBC; JPMorgan Chase; Key bank; M&T Bank; MUFG Union Bank; PNC; Bank of Regions; Santander; state street; SunTrust; TD Bank; UBS; American Bank; and Wells Fargo.
What is an example clearinghouse?
An example of a clearinghouse is the London Clearing House, which is the world’s largest derivatives clearinghouse, followed by the Chicago Mercantile Exchange. Clearing houses are usually large investment banks, such as JP Morgan, Deutsche Bank, and HSBC.
What is a compensation process?
Clearing is the process of reconciling a transaction in options, futures or securities or the direct transfer of funds from one financial institution to another. The process validates the availability of appropriate funds, records the transfer and, in the case of securities, ensures delivery of the security or funds to the buyer.
The bottom line
The clearing process ensures that the entities or parties involved in a financial transaction are protected, receive their amount due, and that the transaction runs smoothly. The clearinghouse acts as a third party or mediator for the transaction while the clearing process records the details of the transaction and validates the availability of funds.