Clearing Corporation & Example

What Is a Clearing Corporation?

A clearing corporation is an organization associated with an exchange to handle the confirmation, settlement, and delivery of transactions. Clearing corporations fulfill the main obligation of ensuring transactions are made in a prompt and efficient manner. Clearing corporations are also referred to as "clearing firms" or "clearing houses."

Understanding Clearing Corporations

In order to make certain that transactions run smoothly, clearing corporations become the buyer to every seller and the seller to every buyer. In other words, they take the offsetting position with a client in every transaction. For example, if two investors agree to the terms of a financial transaction, such as the purchase or sale of a corporate security, a clearing corporation will act as a middle man, facilitating the purchase on one end and the sale on the other end of the transaction.

Such transactions encompass futures, options contracts, stock and bond trades, and margin money. In addition, clearing corporations have a range of tasks including regulating the delivery of securities and reporting trading data.

Clearing Corporation and Futures Contracts

While clearing corporations may facilitate all forms of transactions, they are most helpful in more complex transactions, such as futures contracts. Futures are financial contracts that obligate a buyer to purchase an asset, such as a physical commodity like wheat, or a seller to sell an asset, at a predetermined future date and price.

For example, let’s assume that in October the current price for wheat is $4.00 per bushel and the futures price is $4.25. A wheat farmer is trying to secure a selling price for their next crop, while Domino's Pizza is trying to secure a buying price in order to determine how much to charge for a large pizza next year. The farmer and the corporation can enter into a futures contract requiring the delivery of five million bushels of wheat to Domino's in December at a price of $4.25 per bushel. The contract locks in a price for both parties. It is this contract, and not the actual, physical wheat, that can be subsequently bought and sold in the futures market.

Each futures exchange (such as the Chicago Mercantile Exchange) has its own clearing corporation. Members of these exchanges must clear their trades through the clearing corporation at the end of each trading session and deposit a sum of money based on the clearing corporation’s margin requirements to cover their debit balance. The clearing corporations help to keep markets operating in a timely and orderly manner. This, in turn, gives more entities confidence in entering futures trades to hedge their various exposures.