The Clearing House System

There is much more to the international financial system than what meets the eye. For instance, if you were to ask an average person about the parties involved in making a payment, very few will come up with the term clearinghouse. This is because they think about payers, payees, and even intermediaries. However, the concept of a clearinghouse is alien to them.

Clearinghouses are not known to the common man, yet they play an important part in their lives. Every payment which is routed via a bank or via a financial intermediary ends up being routed via a clearing house. 100% of check payments are routed via clearinghouses. Yet, people know so little about them!

In this article, we will understand what a clearinghouse is and how it facilitates a smooth flow of financial payments across the world.

How are Payments Made?

From a layman point of view, when we write a check, we just know that the counterparty will get paid. We also know that check clearing is a lengthy process that involves several days. However, most people do not know the details of that process and why it takes as long as it does.

When we write a check, the receiver of the check deposits it into their account. If the issuing and the receiving bank are the same, then the bank can transfer the money directly within its own accounts.

However, if the sending and receiving banks are different, then the check has to be routed to a clearing agency. The receiving bank sends this check to a centralized agency. This centralized agency then connects with the bank on which the check was drawn in order to verify whether there are sufficient funds in the account on which the check was drawn. The centralized agency ensures that the funds are transferred from the bank of the issuing party to the bank of the receiving party.

This intermediary, which allows for the clearing of payments between two banks, is called a clearinghouse.

What is a Clearing House?

In simple words, a clearinghouse is a financial intermediary which connects several individual banks. It is because of the clearinghouse that all the individual banks appear to be one single system to external parties.

Clearinghouses enable checks drawn on one bank to be credited to an account held in a different bank. A clearinghouse is a central agency where all banks can meet. In the absence of a clearinghouse, all banks will have to set up connections with all other banks leading to duplication of effort and wastage of resources, which would result from having different setups to clear multiple transactions between multiple parties. Hence, every time a person writes a check, they are employing the services of a clearinghouse! The problem is that most people are not aware of this process or this institution.

In most countries, there is only one clearinghouse. Generally, this clearinghouse is a non-profit organization which is controlled either by banks or their associations. Multiple clearinghouses would complicate the process. This is the reason why a monopoly is preferred. Also, the charges taken by the clearinghouse are nominal.

What are the Responsibilities of a Clearing House?

Generally, a clearinghouse has many distinct responsibilities. Some of these have been mentioned below:

• The clearinghouse is responsible for matching the payer and payee transactions. This means that it is the responsibility of the clearinghouse to set up a process which ensures that payments are always credited to the correct beneficiary without fail

• Clearinghouses consolidate all transactions between banks. Instead of asking for several small payments, clearinghouses provide the banks with one statement. The details of the debits and credits are listed as line items on that statement. This simplifies the record-keeping process and makes it easier for the banks.

• Payments in the clearinghouse are often netted. This means that if bank A owes bank B $100, whereas bank B owes bank A $150, then bank B pays bank A $50, and all the transactions are considered to be cleared. This process is called netting. Although this may seem simple and obvious, when the number of transactions and the number of parties involved is high, then the complications can also increase quickly.

• There are several types of transactions in which the clearinghouses take counterparty positions. This means that instead of dealing with one another, both parties are often dealing with the clearinghouse.

• Clearinghouses also perform other tasks such as collection and dissemination of information, which helps in conducting analyses of the trades which have happened.

• In the case of derivatives, clearinghouses play an even more important role. This is because of the co-ordinate the margin payments, which are due to various brokers. The clearinghouse is responsible for issuing margin calls and ensuring that the trades remain in the money at all times.

Clearinghouses have been in existence for hundreds of years. Over a period of time, they have evolved to meet the growing needs of the business. This evolution has been discussed in detail in subsequent articles.