o word of the day : CLEARING

Clearing a contract eliminates (clears) the bilateral counterparty risk when two parties enter into a contractual obligation. Clearing takes place through a Clearing House, an entity that takes the opposite side of every trade. The clearing house mechanism clears, settles, nets and guarantees all matched transactions in a given contract.

Here is a simple example to illustrate the benefits of clearing. I want to bet $1,000 on the big football game next week. But I don't want to bet with Johnny because I feel that if his team loses he's going to stiff me for the money. Johnny has a bad reputation for walking out on debts. In financial terms, he's a default risk and has a poor credit rating. In layman's terms, he's a Lehman. So Johnny and I will place our bets through Vinny our bookie (the clearing house). If I win my bet, I know I will get paid regardless of whether or not Johnny pays the bookie. The bookie charges a small fee for his service of taking on the counterparty risk. The other side of the bet may default on his $1,000 payment. Vinny may even ask Johnny to pay half the amount of the bet in cash upfront as a good faith deposit should Johnny lose (margining). If Johnny does not pay up in full, Vinny will make sure Johnny loses the ability to use his right thumb (trading operations are shut down). Both parties have eliminated the exposure that would be present in a bilateral transaction by using a third party intermediary.

Guess which type of derivatives have no clearing process set up to ensure the performance of the contracts. If you guessed Credit Default Swaps, you get a big fat shiny star on your forehead. Each counterparty to a trade is held directly accountable to the other company for the payment and performance of a credit default swap. A situation like this can lead to a domino effect where, for any given counterparty failing and defaulting, many others will be hurt financially. They may in turn default.