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Central Clearing

For those of my readers not familiar with the lingo of the financial world, let me begin with a definition of clearing and then of a clearinghouse.

Clearing is the process by which transactions are reconciled, that is, money matched to the product or service it is purchasing. An institution that "clears" a transaction is also the institution that, in the first instance, runs the risk of default. Simple example: I make some large purchase with a check. The seller accepts my check in payment. In that case, in a common arrangement my bank would be the clearing party, and would bear that initial risk of default.  It is the bank, not the seller, and not in the first instance me either, who will be "out" if my check is in excess of my deposit account.

In finance, then, a clearinghouse (sometimes written in two words as 'clearing house') is an institution that provides clearing and settlement services for commodities, derivatives, or securities transactions.

The issue of whether a transaction will take place on or off a listed exchange is not the same as whether the transaction will be centrally cleared. The trend since the global financial crisis of 2007-08  has been toward ever more central clearing, even in off-exchange, aka over the counter or OTC, transactions. One of the many 'takes' on the crisis was that the absence of central clearing was to blame, and the governments of various developed countries including the US have been working to build up clearinghouses in contexts in which they were not necessarily considered desirable pre-crisis.

Craig Pirrong, finance professor at Bauer College of Business, University of Houston, lists four distinct questions raised by this trend, especially with reference to derivatives trading, thus:

1) Do we want to favor central clearing over bilateral arrangements? There are arguments in favor of the trend, but some bilateralism will surely remain, and the right balance is not at all self-evident;

2) How do different clearing mechanisms affect the allocation of risks, including non-obvious risks and indirect allocations thereof?

3) How will the rules change the scale of derivatives trading?

4) Will the rules, in Pirrong's terms, "affect risk management by end-users and what is the implication of that for the allocation of risk in the economy?"

That is a good list. Here's the link to Pirrong's discussion.


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