Third-party clearing in Australia – what it is, how it works and why it’s important
Clearing is the second-last part of the trading process where a ‘clearing house’ acts as intermediary between buyers and sellers. During clearing, it’s confirmed that the seller of a financial instrument has the money to buy the assets they have agreed to buy, and that the seller actually owns the instruments they have sold. Once this has taken place the trade is ‘settled’ – the buyer receives the assets and the seller receives the cash.
Central clearing is a very important part of the plumbing of financial markets. Using a central counterparty reduces risk to both buyers and sellers who would otherwise be exposed to the potentially poor or fraudulent business dealings of their counterparties (see breakout box – How Clearing Works).
Clearing is not new to financial markets by any means. The first clearing house appeared in 1818 in Boston, opened by Suffolk Bank to net payments in commodity futures markets. For equities, exchanges began using clearing houses in the latter part of the 19th century – the Philadelphia Stock Exchange led the way in 1870.
Australia was very late indeed to this party. Up until 1987, there was no central clearing in this country. That year, as global stockmarkets melted down and Australian retail losses were exacerbated by the lack of central clearing and settlement, a national broker-to-broker system, BBS, was introduced. However, there was still no minimum requirement for the time between making a trade and receiving the cash or shares (settlement). It would be another five years before T+5 legislation was introduced, meaning trades must be settled on the fifth day after being made.
In September of 1994, Australia at last began to meet global market standards with the introduction of the Australian Clearing House (ACH), ASX Settlement and Transfer Corporation (ASTC), and Clearing House Electronic Sub-register System (CHESS) by the Australian Securities Exchange (ASX). Like all clearing houses, CHESS was now the intermediary for trades in the (initially limited) securities available within it. By August 1996, all 1600 ASX listed companied were available in CHESS and central clearing in Australia had begun.
What third party?
Registered market participants who wish to be direct counterparties to the central clearing house need to hold significant amounts of capital to be allowed to do so – this is to protect the central clearing house from default. In Australia, the amount required is $5 million. For big stockbrokers it makes sense – self-clearing, as this is known, is more cost effective when you are managing high volumes of trades.
But for smaller brokers, ring-fencing $5 million in capital, buying an expensive back-office system and hiring the people to run it is a prohibitively expensive process when you are only executing small numbers of trades for your clients. Enter the third-party clearer. For a fee, the third-party clearer acts as the counterparty in the broker’s place, holding the required capital and managing the processes between the making of the trade and the receipt of shares or cash.
A healthy third-party clearing landscape supports a healthy financial market overall, allowing for a thriving industry of boutique firms servicing retail investors. Without third-party clearers, many small and medium-sized brokers would be forced to close and investors would have very limited choices in investment management.