26 April 2021
Clearing services play a crucial role in the architecture of international financial markets. This architecture is a complex web of interconnected institutions and processes which have developed and evolved over decades. Taken together, it creates a robust framework that provides both stability and a means to generate profits.
While most attention is paid to the profit side of the equation, the managing of risk is a critical factor in ensuring that the whole process operates as smoothly as possible.
It is vital to understand how clearing services, safe custody and risk management are intertwined.
Whenever two interested parties come together to agree on a trade, it’s only the start of a successful transaction. As financial markets don’t involve tangible, physical goods that are transferred between owners, there are many ‘counterparty risks’ generated by this initial agreement. Managing these risks, reducing the chances of the transaction breaking down and either party failing to honour their commitments, is key to maintaining confidence in the market.
Clearinghouses manage this risk and look to guarantee contractual obligations. It does this by fulfilling the role of a central counterparty or CCP. Clearance and settlement services work by applying two clear principles to the trade. These are novation and collateral.
What is novation?
Novation is the technical term given to replace the existing contracts between the buyer and the seller with two new contracts. These are contracts between the CCP and the buyer’s clearing broker and the CCP and the seller’s clearing broker. By inserting itself into the trade, the CCP in effect becomes the only legal entity that both buyer and seller need to be concerned with. The CCP immediately reduces the risk of the trade collapsing.
What is collateral?
Collateral plays a crucial role in ensuring that clearing services operate smoothly. Throughout the duration of the contract, the buyer and seller post performance bonds on a daily basis as collateral. These help to reduce risk, reevaluating the overall value of the contract to reflect shifting market values. Custody banking or settlement banking facilitates the transfer of this collateral from the respective brokers to the CCP. As a result, they represent a vital link in the overall system.
Managing riskThere are inherent risks in financial market transactions that the clearinghouse looks to mitigate and manage. By doing so, it builds confidence in the system overall. Ensuring sufficient funds keep flowing between buyers and sellers is necessary if the entire financial system is not to be put in jeopardy. Because of the general efficiency of the clearing and custody services, post-trade actions can be taken for granted, but all parties to the trade must understand the processes involved and monitor risk in a controlled manner.
The type of risk that clearinghouses have developed mechanisms and resources to manage include:
Settlement bank risk
By being a stable intermediary, clearinghouses radically reduce risk and regulate and monitor their performance and regulatory compliance.
Safe Custody & Clearing services from GIS UK
Global Investment Strategy offers transparent and efficient post-trade, global clearing and prime services across multiple currencies. Over the past three years, Global Investment Strategy UK has administered 250,000 transactions with settlement values exceeding £50 billion. Our efficient, transparent and trustworthy services give you the time and confidence to focus on your key competencies.Back to News