In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. Clearing of payments is necessary to turn the promise of payment (for example, in the form of a cheque or electronic payment request) into actual movement of money from one bank to another.
In trading, clearing is necessary because the speed of trades is much faster than the cycle time for completing the underlying transaction. It involves the management of post-trading, pre-settlement credit exposures to ensure that trades are settled in accordance with market rules, even if a buyer or seller should become insolvent prior to settlement. Processes included in clearing are reporting/monitoring, risk margining, netting of trades to single positions, tax handling, and failure handling.
Systemically Important Payment Systems (SIPS) are payment systems which have the characteristic that a failure of these systems could potentially endanger the operation of the whole economy. In general, these are the major payment clearing or Real Time Gross Settlement systems of individual countries, but in the case of Europe, there are certain pan-European payment systems. TARGET2 is a pan-European SIPS dealing with major inter-bank payments. STEP2, operated by the Euro Banking Association is a major pan-European clearing system for retail payments which has the potential to become a SIPS. The Federal Reserve System is a SIPS.
When cheques were invented in the 1600s in England, banks settled payments by direct courier to the issuing bank. Around 1770, they began meeting in a central location, and by the 1800s a dedicated space was established, known as a bankers' clearing house. The London clearing house used a method where each bank paid cash to and then was paid cash by an inspector at the end of each day. In 1853, the New York clearing house used a large oval table and two clerks from each bank. An outer ring of clerks would rotate at set intervals, settling payments in cash with each bank on a pairwise basis.
The Federal Reserve System was established in the United States in 1913 to act as a central, well-capitalized clearinghouse. This prevented occasional panics where banks would refuse to deposit cheques due to uncertainty about the solvency of the drawing bank. The Federal Reserve can physically accept and transport cheques.
As volume grew, more efficient sorting methods were needed. Approaching the 1940s, two popular methods were Sort-A-Matic and Top Tab Key. Sort-A-Matic involved a set of metal or leather dividers numbered 00 through 99. Checks would be sorted by hand according to the first two digits. The cheques would be removed, and each stack sorted into the same dividers by the third and fourth digits. The process was iterated until the cheques were completely sorted. Top Tab Key used a physical mechanism: holes were punched in the top of each cheque representing the values of various digits, and metal keys used to physically move them until sorted.
Magnetic ink character recognition was developed and commercialized in the 1950s. It enabled computers to reliably read routing and account numbers and made sorting of paper checks automated.
Cheque truncation was introduced in various countries, starting the 1990s. It allows physical cheques to be converted to electronic images and MICR data, for electronic clearance. (See Substitute check in United States for more details on clearance procedure.) These changes have made it possible for businesses and consumers to deposit checks without even delivering them to their own banks. In the procedure known as remote deposit, they take a picture of the physical cheque with a smartphone or other device, and use the image to make the deposit. The depositing bank uses the image in the normal electronic clearance process, though in this case MICR data is not available.
Though many debit cards are drawn against chequing accounts, direct deposit and point-of-purchase electronic payments are cleared through networks separate from the cheque clearing system (specifically the Federal Reserve's Automated Clearing House and the private Electronic Payments Network).
From the time the Amsterdam Stock Exchange was founded in 1602 there was a requirement to clear the trades as the speed of trades was much faster than the cycle time for completing the underlying transaction. This meant there was always a few days delay between the trade date and final settlement. Clearing was required to make sure payment had been received and the physical stock certificate delivered. To reduce the risk associated with failure to deliver on the trade on settlement date a clearing agent or clearing house often sat between the two counter-parties. The trading parties would deliver the physical stock certificate and the payment to the clearing house and they would make sure that the certificate was handed over when payment was complete. A process known as delivery versus payment.
During the 1700s the Amsterdam stock exchange had close links with the London stock exchange and they would often list each other's stocks. To clear the trades, time was required for the physical stock certificate or cash to move from Amsterdam to London and back. This led to standard settlement period of 14 days which was the time it usually took for a courier to make the journey on horse back and by ship. Most exchanges continued to use the same model over the next few hundred years. With the advent of new technology in the 1970s and 1980s there was a move to reduce settlement times and settlement dates in most exchanges reduced to three days (known as T+3 or Trade date plus three days).
With the advent of electronic settlement and the move to dematerialisation of securities, specific clearing systems were required as well as securities depositories, custodians and registrars. Up until this point many exchanges would act as their own clearing house. However the additional computer systems required to handle volumes and the opening up of financial markets in a number of countries in the 1980s, such as the 1986 big bang in the UK, led to a number of exchanges separating or contracting out the clearing and settlement functions to dedicated organisations.
In some specialist financial markets clearing had already been separate from trading. One example was the London Clearing House (later renamed LCH.Clearnet) which cleared derivatives and commodities for a number of the London exchanges since the 1950s. Another example was Euroclear that acted as the clearing house for the Eurobond market.
United States payment system
The United States payments system is the largest in the world. Each day, millions of transactions, valued in the trillions of dollars, are conducted between sellers and purchasers of goods, services, or financial assets. Most of the payments underlying those transactions flow between depository institutions, a large number of which maintain accounts with the Reserve Banks. The Federal Reserve therefore performs an important role as an intermediary in clearing and settling interbank payments. Banks settle payment transactions efficiently by debiting the accounts of the depository institutions making payments and by crediting the accounts of depository institutions receiving payments. Moreover, as the U.S. central bank, the Federal Reserve is immune from liquidity problems — not having sufficient funds to complete payment transactions — and credit problems that could disrupt its clearing and settlement activities.
The Fedwire Funds Service provides a real-time gross settlement system in which more than 9,500 participants are able to initiate electronic funds transfers that are immediate, final, and irrevocable. Depository institutions that maintain an account with a Reserve Bank are eligible to use the service to send payments directly to, or receive payments from, other participants. Depository institutions can also use a correspondent relationship with a Fedwire participant to make or receive transfers indirectly through the system. Participants generally use Fedwire to handle large-value, time-critical payments, such as payments to settle interbank purchases and sales of federal funds; to purchase, sell, or finance securities transactions; to disburse or repay large loans; and to settle real estate transactions. The Department of the Treasury, other federal agencies, and government-sponsored enterprises also use the Fedwire Funds Service to disburse and collect funds. In 2003, the Reserve Banks processed 123 million Fed-wire payments having a total value of $436.7 trillion.
The Fedwire Securities Service provides safekeeping, transfer, and settlement services for securities issued by the Treasury, federal agencies, government-sponsored enterprises, and certain international organizations. The Reserve Banks perform these services as fiscal agents for these entities. Securities are safekept in the form of electronic records of securities held in custody accounts. Securities are transferred according to instructions provided by parties with access to the system. Access to the Fed-wire Securities Service is limited to depository institutions that maintain accounts with a Reserve Bank, and a few other organizations, such as federal agencies, government-sponsored enterprises, and state government treasurer’s offices (which are designated by the U.S. Treasury to hold securities accounts). Other parties, specifically brokers and dealers, typically hold and transfer securities through depository institutions that are Fedwire participants and that provide specialized government securities clearing services. In 2003, the Fedwire Securities Service processed 20.4 million securities transfers with a value of $267.6 trillion.
The Automated Clearing House (ACH) is an electronic payment system, developed jointly by the private sector and the Federal Reserve in the early 1970s as a more-efficient alternative to checks. Since then, the ACH has evolved into a nationwide mechanism that processes credit and debit transfers electronically. ACH credit transfers are used to make direct deposit payroll payments and corporate payments to vendors. ACH debit transfers are used by consumers to authorize the payment of insurance premiums, mortgages, loans, and other bills from their account. The ACH is also used by businesses to concentrate funds at a primary bank and to make payments to other businesses. In 2003, the Reserve Banks processed 6.5 billion ACH payments with a value of $16.8 trillion.
- Cheque and Credit Clearing Company
- Central Counterparty Clearing
- Clearing house (finance)
- Payment system
- Clearstream scandal
- Understanding Derivatives: Markets and Infrastructure - Chapter 2, Central Counterparty Clearing by Robert Steigerwald (Federal Reserve Bank of Chicago)
- Clearing and Settlement of Exchange-Traded Derivatives by John McPartland (Federal Reserve Bank of Chicago)
- This article incorporates text from a publication now in the public domain: The Federal Reserve System: Purposes and Functions.