9 - What is a clearing house?

Clearing defines how banks and financial institutions guarantee the payment and delivery of securities between two parties to a transaction. When one buys financial products like shares, the order they placed is fixed and final. The clearing house will then handle or unwind the transaction.

[Man 1] William! William! How are you?
[Man 2] I'm fine. And you?
[Man 1] I wanted to get your help on something. I just bought some shares.
[Man 2] That's great! Congratulations!
[Man 1] Actually, it isn't. I bought them this morning. But look! They keep going up!
[Man 2] But that's fantastic!
[Man 1] No, it's not. If something goes wrong during the transaction, I'll never be able to get them back at that price.
[Man 2] Clearing house, my friend. If that's all you're worried about, you can relax. You'll get them at the price you paid for them, even if the seller no longer wants to sell them.
[Man 1] I don't get it.
[Man 2] When you buy financial products like shares, the order you placed is fixed and final. The clearing house will then handle or unwind the transaction. Clearing is how banks and financial institutions guarantee the payment and delivery of securities between two parties to a transaction.
[Man 1] Oh, but you see, I didn't go through one of these clearing houses.
[Man 2] You didn't, but the financial intermediary where you bought your shares did. When you buy your shares, the clearing house makes sure you get the right amount at the right price you paid for them. Clearing houses have virtually eliminated counterparty risks. In other words, even if the seller goes bankrupt, you'll still get your shares.
[Man 1] Okay, yeah, fine. But how does the clearing house guarantee that?
[Man 2] By standing in for the seller and making sure that buyers get their securities and vice versa.
[Man 1] But if my shares go up, then the clearinghouse loses money.
[Man 2] No, it won't, because as it unwinds the transaction, it will monitor any changes in the price. If there is a difference, say, because you bought the shares at €10 each, and now they're at €12 each, the clearinghouse will make what's called a margin call on the two-euro difference with the bank.
[Man 1] Oh, sure, yeah. A margin call… What is that?
[Man 2] Well, look, it's essentially a request for payment asking the seller's bank to pay the amount so that the clearing house can cover the two-euro difference.
[Man 1] But prices change all the time! That must cost millions every day!
[Man 2] You mean billions! That's the way it works. And it has to work that way for the markets to run smoothly.
[Man 1] Really? And what if there's an earthquake?
[Man 2] And what if you let me get on with my shopping.