A clearing house is a fundamental component of modern banking networks. The principle behind a clearing house is that a central agency deals with all contracts and transactions, instead of each pair of counterparties negotiating their own contract.
For example: consider 4 counterparties, each wants to trade with each other, both as buyer and seller. This gives 6 agreements for each counterparty, and 12 agreements in total. each line represents an agreement.
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A ___ B
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|| \// ||
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C ___ D
With a clearing house, this can be reduced to 8 agreements, and each counterparty only needs to sign 2.
A B
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CH
// \\
C D
Consider each new organisation that joins that wants to trade with all others. This requires 2*n new contracts, which grows larger as n grows larger. The number of agreements is order N squared.
The new organisation only needs 2 more with a clearing house - this is much less administrative hassle.
Clearing of cheques
If you were to ask most members of the public what function a clearing house provides, the answer would be to provide clearing of cheques.
If there were only one bank operating in a particular country (as is the case with most Communist countries), there is no need for a clearing house. In order for a bank to honour cheques drawn on accounts at other banks, there need to be reciprocal agreements with all the operating banks. Western countries and economic units usually have central clearing houses to deal with processing of cheques in a given currency.
A cheque arrives at the payee's bank, where the account is credited, and passed to the clearing house, whose job is to route all cheques to the drawer's bank, so that the drawer's account can be debited.
This is the normal state of affairs when there is sufficient funds in the account. When this is not the case, the cheque bounces, and the cheque is returned to the payee's bank.
If you talk to someone who works in the financial services or banking sector about a clearing house, they will be using the term to refer to a body that acts as a central counterparty for interbank trades, either exchange trades or OTC trades, be they trades of securities, commodities or derivatives.
The clearing house deals with all aspects of cash settlement, including risk management and collateral (margin). The idea is that the trade starts of as a deal between two counterparties A and B. Once the trade is approved - 'registered', cash transactions take place between A and the clearing house, and between B and the clearing house. The trade is thus split into two half trades.
What is the benefit of using a clearing house for over the counter transactions? A clearing house decouples the risk involved in a trade for counterparty A, from the risk involved in the trade for counterparty B. As the whole function of credit risk and collateral is centralised, it makes a more level playing field for all parties: members of the clearing house. The clearing house is responsible for defining the rules, and setting the margin rates, based on an assessment of risks.
When it comes to exchange traded transactions, the stock exchange usually appoint a designated clearing house as their agent for cash settlement. Once again, collection and reimbursement of margin is the responsibility of the clearing house.
Other
The principle of a central clearing house has other applications. In the United Kingdom, the National Health Service has a clearing house for settlement of payments between health providers (NHS trusts) and purchasers (Family Health Service Authorities). It is also used in processing of student applications to university in the UK
There is no reason why the principle could not be applied elsewhere:
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