Clearing house plays an important role for clearing of derivatives trades to reduce credits risks involved in the trade. Clearing house provides clearing and settlement services for mainly derivatives and securities transactions. Clearing house helps to clear a trade for two clearing participants in order to reduce risk, especially Credit risk. Clearing house reduces risk of an OTC Derivatives trade by either using netting transactions between multiple counterparties or keeping collateral deposit.
Clearing by Clearing house can be done in two ways, which are principal clearing and agency clearing. In principal clearing, the party is itself a clearing participant and can directly approach clearing house for trade clearing. All investment banks are direct member of a clearing house, hence enjoy this benefit. In Agency clearing, party has to approach clearing house via a clearing agency or broker for trade clearing. This is a bit complex approach, as another trade needs to be booked between party 1 and clearing agency to transfer risk to clearing agency which can then be cleared with clearing house.
Once a transaction comes out of exchange with an agreement from both the parties, the CCP (Central Counterparty Clearing) or the clearinghouse comes in between and become seller to every buyer and buyer to every seller. This is usually called novation where any party of a trade is replaced by another party (either through step in or step out transaction).
The main responsibilities or task of clearinghouse/CCP are,
Clearinghouse maintains a record of all transactions, produces various reports, and processes the settlement of these transactions and interfaces with to complete trade cycle properly and on time. Since clearinghouse has its reserves support and it can also go back to its members as a final option to fulfill any outstanding dues, clearinghouse makes an attractive low-risk counterparties. Some Examples of popular CCP or Clearing Houses are, ICE Clearing, CME Clearing, Depository Trust Clearing Corporation (DTCC) and Euroclear etc.