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How do clearing houses work?

Once a trade is executed between two parties, the clearing house steps in. The trade title is transferred to the firm using a process known as novation. This process means that the clearing house takes on the legal counter-party risk associated with the transaction. The clearing house can help ensure that the trade goes through since it is now responsible for it. If one of the parties fails, it's not as big a deal because the firm is now responsible.

A clearing house can help effectively isolate the negative effects from a failing market participant, and limit the spread of problems. If a firm fails, and a settlement failure is the result, the guarantee funds at the house can usually settle the transactions on behalf of the failing clearing firm. However, before the guarantee funds need to be used, clearing houses can often utilize default procedures against a failing clearing firm.

It sounds like the process is a long one, but in reality, it's possible for a clearing house to settle transactions in a matter of seconds. On highly liquid markets, these transactions take place in a fraction of a second. However, there are some transactions, especially in the OTC markets, that can take days to settle.

But clearing houses are also something to keep in the back of your mind when selecting a stock broker. Here's why.

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The magic of self-clearing

Many stock brokers and robo advisors — such as Betterment and Wealthfront— use Apex Clearing. Other clearing houses include Pershing LLC and the J.P. Morgan Clearing Corp.

However, the clearing house doesn't have to be a third party. In some cases, the big brokers have their own self-clearing firms. Fidelity is one that uses its own clearing house, National Financial Services LLC. Wells Fargo, TD Ameritrade, and E*TRADE are also self-clearing. Pay attention to the clearing house, and consider that as you choose a brokerage.

That's because by self-clearing, brokers can cut their costs and pass the savings along to you (read: lower transaction fees). But don't worry about this being risky — the SIPC (Securities Investor Protection Corporation) protects all clearing house transactions from loss.

To find out who uses which clearing house, check out this list.

Other functions of a clearing house

A clearing house doesn't just settle transactions, though. It can serve as an independent third party in other ways. Clearing houses can offer valuation services. They're designed to help limit wider market risk, and, in general, they do — as long as the parties trading use them.

Indeed, after the last decade's financial meltdown, many people pointed to the fact that credit default swaps weren't traded on exchanges and that clearing houses weren't used as one of the biggest issues. Since then, efforts have been put into place to make the process more transparent and to create an exchange. Additionally, at least one clearing house (Options Clearing Corporation) has begun backing equity derivatives as a way to prevent future problems.

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In conclusion

Now, keep in mind that the clearing house used shouldn't be the No. 1 reason why you select a particular broker. After all, brokers and other financial institutions can switch which clearing house they use. It's just something to keep in mind when comparing online brokers or robo advisors. (Hint: Here's what to look for).

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About the Author

Miranda Marquit

Miranda Marquit

Freelance Contributor

Miranda Marquit is a journalism-trained freelance writer and professional blogger specializing in personal finance.

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The content provided on Moneywise is information to help users become financially literate. It is neither tax nor legal advice, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional. We make no representation or warranty of any kind, either express or implied, with respect to the data provided, the timeliness thereof, the results to be obtained by the use thereof or any other matter.