Exchanges-ClearingHard

3 min read · 496 words

What the seat actually does

An exchange runs the place where orders meet. A clearing house steps between the two sides once they have met, so that neither has to rely on the other. In many groups they are the same company, and they are two genuinely different businesses.

The clearing house is the interesting half. By novation it becomes the buyer to every seller and the seller to every buyer — which means it holds no market risk and enormous counterparty risk, and manages that with margin, a default fund and a written order for who absorbs a loss. It is the one institution in finance explicitly designed not to fail.

• Matching — the order book, its rules, and who may connect to it. See market microstructure.
• Market data, which is often the larger revenue line.
• Clearing — margin, netting and the default waterfall. See clearing and settlement.
• Listings and contract design, which decides what can be traded at all.

A day, and where it goes

• Margin calls, collected from every member before the market opens.
• Volumes and open interest, which are the revenue and the exposure respectively.
• Member risk — who is large, who is concentrated, and what a default would cost to close out.
• Incidents — an outage in a matching engine is a market-wide event.

What it is measured on

• Volume, open interest and data revenue, which is the commercial side.
• Whether margin covered the move — the clearing house's only real question.
• Availability. A venue that is down has no price, and everything referencing it stops.
• Default management, judged on the one occasion it is used.

What it touches on this site

• The mechanism — clearing and settlement, which carries the novation diagram, and margin and collateral.
• What trades there — futures, options and the rates market that is largely cleared.
• How a price is made — market microstructure and what happens when you press buy.
• When it goes wrong — 2022, where an exchange cancelled trades, and 2010.

How it goes wrong

• Margin models calibrated on calm. The move that matters is the one outside the sample.
• Concentration in one member, whose close-out is larger than the market can absorb.
• Cancelling trades. Reversing a print protects somebody and tells everybody that a price here is provisional.
• Procyclicality. Raising margin in a stress takes cash out of the market at the moment cash is scarcest.

Concepts to master

• Novation moves the risk rather than removing it — everybody now faces one institution instead of each other.
• Initial and variation margin answer different questions: what could be lost while closing out, and what has already been lost today.
• The waterfall is an order of loss — margin, the defaulter's contribution, the fund, then everybody else.
• Netting is why clearing is efficient, and why a clearing house's gross exposure is not the number to look at.