“Clearing” is a process that occurs between the moment a trade is agreed upon and the time the trade is settled.
It involves the confirmation of the details of a trade, the netting of trades by parties, and a guarantee of the trade’s performance.
Here are the key components of clearing:
- Trade Confirmation: After a trade is executed, both parties to the transaction receive a confirmation that specifies the details of the trade, including the price, size, and terms of the transaction.
- Netting of Trades: Clearing also involves netting, which consolidates or aggregates all buy and sell orders of a party to simplify the obligations of the party. For instance, if a trader has made 50 trades in a day (some buys, some sells), netting would consolidate these transactions into a single sum that the trader owes or is owed.
- Guarantee of Performance: A crucial role in the clearing process is played by clearing houses. These entities serve as the middleman in trades, standing between the buyer and seller. The clearing house ensures each party meets its obligations. If one party defaults or is unable to uphold the terms of the trade, the clearing house steps in and absorbs the loss, thereby reducing the risk to the other party.