Clearing houses play an important role in the global financial sector but in order to understand a clearing house’s role in the global financial sector it’s important to start with the basics. Clearing houses are essential to manage and reduce systemic risk in the Derivatives market.
What is a Derivative?
A derivative is a contract between two parties and the value is determined on the fluctuations in the value of the asset – the underlier. Examples of underliers could be Interest rate derivatives, stocks, currencies or goods while the most common type of derivative contracts are forwards, futures and Interest rate swap claims.
The benefit of a derivatives contract is that they help improve the risks involved in transactions. The interest rate derivatives market is responsible for the vast majority of the other-the-counter market.
Counterparty Systematic Risks
Even when a derivative is performed correctly, the contract leaves its two counter-parties at risk for a potential loss in two primary ways:
- Performance of underlying asset: In some derivatives contract, when one party loses, the other one gains depending on the agreed upon asset.
- The default of the counter-party: a systematic risk is that the counter-party on the trade will not meet its obligations of the contract by defaulting.
The amount risk can be assumed by the counter-parties depends on the structure of the Interest rate swap or trade. The derivative can be bilaterally negotiated, known as other-the-counter trades between the buyer and seller or it can exchanged through a centralized facility. The over-the-counter trades often expose the counter-parties to more risks of defaults than trades through the exchange. However, the other-the-counter trades are able to be customised to meet the specific needs of the counterparties. One way that parties decrease risk through the other-the-counter trade or exchanges is by clearing the trade through a clearing house.
The Role of the Clearing house
Clearing houses are a third party institution that acts as the middleman between the two original counter-parties. The clearing house assumes the obligations of both parties and acts as both the buyer and seller. The clearing house offers several benefits to the parties including improved risk management and improved transparency. Through its procedures the clearing house reduces the systemic risk with derivative contracts. The clearing house will assume responsibility of both parties and therefore assumes the risk. The clearing house also simplifies the management of collateral for all members to help improve risk-management.