What is a Clearinghouse? A Simple Explanation for Investors

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The mobile brokerage Robinhood set off a firestorm among day traders and amateur investors last week when it halted - and then limited - purchase orders of GameStop (GMEand other heavily shorted stocks. The unprecedented maneuvers led to conspiracy theories about a cabal of powerful financial institutions intent on depriving retail investors of their gains.

The actual reason why Robinhood (and other brokerages) halted GameStop orders is considerably more boring: collateral demands from the Depository Trust & Clearing Corporation (DTCC), a mammoth SEC-regulated financial institution that provides clearing and settlement services for the financial services industry.

Indeed, Robinhood raised some $3.4 billion in capital to meet the daily collateral demands of the National Securities Clearing Corporation (NSCC), a subsidiary of the DTCC which provides clearing services for equities, bonds, and other financial instruments. This chain of events – and the cacophony surrounding them – sparked confusion over what clearinghouses are and how they work.

What is a Clearinghouse? 

At a 30,000-foot level, a clearinghouse is simply an intermediary, or “middleman,” between buyers and sellers of financial assets. The clearinghouse is responsible for validating all market transactions between buyers and sellers of securities, which range from stocks and bonds, to commodities and derivatives. Because financial markets are now electronic in nature and global in scope, buyers and sellers require a centralized authority to ensure that all market participants can fulfill their promise to buy or sell a given security.

Clearinghouses are especially important in futures markets, due to the high amount of leverage involved in those financial products. The high amount of lending and borrowing associated with futures contracts requires a stable third party that can settle and clear transactions, which is precisely where the clearinghouse comes into play.

What’s a Clearinghouse’s purpose?

A clearinghouse is designed to reduce market risk, and it accomplishes that goal by taking the opposite positions of trades. By doing so, clearinghouses reduce “counterparty risk” between buyers and sellers. Since clearinghouses are responsible for settling billions of trades in any given day, addressing counterparty risk at scale contributes to the overall reduction of systemic market risk. 

In the case of futures markets, counterparty risk mitigation involves additional layers of risk for clearinghouses. For example, if a large number of investors are suddenly buying call options on a particular stock whose price is continuing to go up, then the clearinghouse’s capital reserves are heavily exposed to movements in that stock’s price. That’s why clearinghouses often demand brokerages do something called "post margin," which essentially means putting down collateral.

As a case study, the GameStop saga illustrates how a clearinghouse’s margin requirements are tied up with market volatility and a brokerage’s policies. Robinhood’s clearinghouse demanded $3 billion in margin, but the firm’s CEO was able to negotiate a lower amount of $700 million after agreeing to limit trades in GameStop and other volatile stocks, according to the Financial Times. Other brokerages like Charles Schwab increased buyers’ margin requirements in those stocks for similar reasons.

Are Clearinghouses trustworthy?

Yes, because all U.S. clearinghouse services are SEC-registered organizations. In fact, different exchanges and markets have their own clearinghouses, built to meet the specific needs of each venue and group of securities. 

The aforementioned DTCC is responsible for settling most transactions of stocks, bonds, derivatives, and other financial instruments in the United States. The DTCC works with the clearing operations of exchanges, such as CME Group’s CME Clearing division. They also work with brokerages themselves; as mentioned, Robinhood raised capital as collateral for the DTCC subgroup, because clearing brokerages (Robinhood Securities) are “members” of the larger clearinghouse.

In sum, clearinghouses are an important part of the financial market infrastructure. As federal regulators deliberate over proposals to handle the next GameStop, the role of clearinghouses will continue featuring in the national discussion.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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John Hyatt

John Hyatt is a freelance journalist covering financial services, market structure, stocks and IPOs, and private equity. Prior to entering journalism, John worked in public relations for clients in financial services, investment management, fintech and cryptocurrency. John is currently receiving his M.A. in business and economic reporting from NYU as a Marjorie Deane fellow.

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