Clearing firms, also known as clearing corporations or clearing houses, handle the back-end operations behind making securities trades actually happen once a trade is submitted. Essentially, clearing firms make sure that your money and stocks make it to their intended destinations when you place trades by serving as the intermediary between your account and another buyer or seller’s account.
The Trade Clearing Process
What does this transaction look like, and what exactly is the role of the clearing firm? When a trade is initiated, the clearing firm pairs a buyer and seller and takes on the legal risk associated with the transaction. Because the clearing house is now invested in the success of the trade, it helps to ensure that the trade is completed successfully. In the event that the trade fails, the clearing firm is able to pay the remaining party out of its own capital and minimize the spread of risk throughout the market. Clearing firms are also responsible for regulating the delivery of securities and reporting data on the trades it mediates.
Clearing firms also play a major role in short selling. When traders borrow shares of a stock in order to short it, they are effectively borrowing from a clearing firm. This works because the clearing firm technically holds a vast number of the stock certificates for a given stock, and so it is able to seamlessly process the transaction internally. In the event of stocks that are relatively hard to borrow, brokerages may reach out to multiple clearing firms in order to ask which ones have volume of the stock in question that can be reserved for borrowing.
The clearing firm you choose may have a significant impact on the stocks you are able to short.
In some cases, brokerages can act as their own clearing firm rather than pass trades submitted to the brokerage to an external clearing firm for mediation. These self-clearing firms operate within a brokerage such that the brokerage is able to execute trades internally. Self-clearing firms are required to have a larger capital store than typical brokerages since they are taking on the risk for trades themselves.
Self-clearing firms can pass on the cost savings of not paying commissions to an external clearing house to its customers by way of lowering commissions, although this is not always the case. Instead, some self-clearing firms keep their commissions competitive with non-clearing firms in order to improve their margins.
Examples of Clearing Firms
Two examples of clearing firms are ETC – Electronic Transaction Clearing – and AXOS Clearing. Both of these firms operate as independent clearing houses supervised by the Financial Industry Regulatory Authority and serve as clearing firms for brokerages that do not have clearing capacity on their own.
Nearly all transactions in financial markets are handled by clearing firms – they are effectively the backbone of the major exchanges. Almost every trade placed with a brokerage is passed to a clearing firm, whether external or internal in the case of self-clearing firms. Although the work of clearing houses goes largely unseen, it is critical to understand them as a trader since they play an important role in limiting market-wide risk, directly determine the speed at which trades clear, play a major role in short selling, and impact the amount traders pay in commissions to their brokerages.