Why Clearing Houses and Clearing Firms are so Important to the Stock Market

The clearing house is made up of broker dealer members whose main business is to be the clearing firm to other broker dealer and financial institutions in the Securities and Exchanges Market.  They act as part of the system of guarantees involving the individual trader, clearing firm/or clearing house and broker dealer, which ensures that the counter party does not default on any exchange-traded contracts. No individual traders can trade on an exchange without being associated with a clearing firm. The clearing firm holds the trader’s account on behalf of the broker and is responsible for the record-keeping and often provides the portal for post-trade reporting for the broker’s clients. The clearing firm is also responsible for calculating the collection of margins from individual traders, settling trade and cash transactions and holding the deposit funds on behalf of the broker’s clients.clearing house 1

One of the most important roles is that the clearing firms handle  the back office details of securities transactions between broker-dealers, thus smoothing out the settlement process and making it efficient. When you make a financial transaction, a clearing house ensures that your money is getting to the correct destination.  A clearing house is the common ground between two distinct financial institutions interest (the buyer and the seller) and hence is like a financial middle man.  The clearing house takes on the risk of a transaction between two parties and makes sure that it’s settled on both ends and provides confirmation of these transactions to the clients.  It therefore lowers the risk that one of the parties will fail in its obligation during a transaction.  This is why the stock brokers use clearing firms for settlement transactions to handle the most important aspects and practical details of buying and selling a trade.

The way clearing houses work is that once a trade is executed between two parties, the clearing house receives the post trade detail from the broker dealer trading system and matches the trade with the other clearing firm on the other side of each trade. This involves electronically requesting stock certificate to be deposited or transferred to the clearing firm via Depository Trust Company (DTCC) or with National Securities Clearing Corporation (NSCC) on behalf of its clients.  The DTCC is one of the world largest securities depositories which provides safekeeping through electronic recordkeeping of securities balances. The NSCC is a subsidiary of DTCC to provide clearing, settlement, risk on the equities, corporate and municipal debts, American depositary receipts, exchange-traded funds and unit investment trusts.  All US clearing firms use DTCC to facilitate settlement and clearing stocks in the market. The clearing firms takes on the legal counter-party on behalf of its clearing clients risk associated with the transaction and by doing so, ensures that the trade goes through since it is now responsible for it. The amount of time that this process takes is a matter of seconds via DTCC, with the exception of some transactions such as the OTC markets, where it can take days to settle.

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A clearing firm does not always have to be a third party.  Several large stock brokers have their own self-clearing firms, such as Interactive Brokers, Fidelity, Wells Fargo, E*Trade and others.  If the brokers are self-clearing they can cut costs and in turn offer customers lower transaction fees.  With that in mind, clearing houses should not be the most important factor when selecting a broker.  This is because brokers and other financial institutions can switch which clearing house they use. What is an important factor about the clearing house that a broker uses or self-clears is the availability and size of the short list which is available for the clients. It is the responsibility of the clearing firm to hold and maintenance the stocks that are available for shorting known as the Easy to Borrow list. This list is updated daily as new stocks become shortable are added or removed when restricted by the Exchanges and is normally provided early in the morning to the Broker’s trading system before the market opens.  Although many clearing firms maintain an extensive Easy to Borrow list, some brokers will request borrows from other clearing firms who will loan their short list to brokers who are not their clearing client. This type of borrow in put on a new list known as the Hard to Borrow list.

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You can tell if a stock is readily available for shorting on the DAS Trader PRO software by the letter “S” above the level 2 montage and entering the symbol Short List which is locate under the Trade menu option.  For more information on what it means to short a stock or go short in the market, please see our blog on our website covering this type of financial transaction at https://dastrader.com/blog/?p=179

It is also important to note that many brokers may have multiple clearing arrangement and may offer different commission rates and options based on the clearing house.