Clearing houses are a vital part of derivative exchanges and they form the core foundation upon which the exchanges stand.
Every exchange has an affiliated clearing house, which is a separate legal entity from the exchange through overlapping memberships is not unusual.
National Securities Clearing Corporation Limited (NSCCL) acts as the clearing house for deals done on NSE.
In a traded futures contract, the clearing house of the exchange interposes itself between the buyer (the long position) and the seller (the short position).
This means that the clearing house becomes the seller to the buyer and the buyer to the seller, as shown in figure 5.3.
Because the clearing house is obligated to perform on its side of each contract, it is the only party that can be hurt if any trader fails to fulfill his obligation.
The clearing house protects its interest by imposing margin requirements on traders and by marking-to-market explained below.
Once the deal is concluded, clearing house becomes/acts as a legal counterparty to both buyers as well as sellers.
As a consequence, the original parties to the transaction will have to deal only with the clearing house, which is usually a high creditworthy institution, resulting in negligible counterparty risk/credit risk for the traders.
For example, A believes that the central government’s thrust on infrastructure is going to give a big boost to the steel and cement companies.
With hopes of profiting from this expectation, suppose A decides to take a long position in a September Tisco futures contract and instructs his broker to buy one September futures contract listed on the NSE (one contract calls for the purchase of 675 shares of Tisco).
The NEAT system finds a suitable sell order and matches with that of B at a price of ₹400 per share. In terms of futures positions, A would have a long position in which he agrees to buy Tisco shares from B at ₹400 on the delivery date in September, and B would have a short position.
But once A and B’s trade is concluded, the Clearing House (CH) would come in and become the effective seller on A’s long position and the effective buyer on B’s short position.
Once the clearing house has broken up the contracts, then A’s and B’s contacts would be with the clearing house, as shown in figure 5.5.
The primary role of the clearing house is to guarantee the performance of the contracts. The nature of this guarantee can be on a net or gross basis.
If the guarantee is on a net basis, then the clearing house will provide assurance on the net position held by each clearing member.
Gross clearing strictly involves providing a guarantee to all the contracts done by its clearing members and their clients.
Apart from guaranteeing the contracts, clearing house has the responsibility of recording the transactions, working out the open positions of the trading members.