Clearinghouses and Custodians: Financial Intermediaries 101
Intermediaries are vital for a well-functioning financial system and allow their clients to solve the problems they face more efficiently than they could by themselves.
We find several types:
- Brokers, Exchanges, and Alternative trading systems
- Dealers and Securitizers
- Depository Institutions
- Insurance Companies
- Arbitrageurs, and
- Clearinghouses and Custodians
We shall now examine the last financial intermediary – clearinghouses and custodians.
What’s the Role of a Clearinghouse?
It acts as a mediator between the buyer and seller and seeks to ensure that the process from trade inception all the way to settlement goes smoothly. In acting as the middleman, a clearinghouse provides the security and efficiency integral for financial market stability. Its main goal is to assure that both parties will honor their contractual obligations. And so, the clearinghouse’s task is to mitigate the counterparty risk.
Clearinghouses also provide escrow services – that is the process of transferring cash and assets to the respective parties. What’s more, they act as a guarantee of contract completion and make sure that margin traders have adequate capital.
Illustrative Example of a Clearinghouse
Suppose that Melissa – a savvy trader – sells 10 shares of Apple for $1,000 on an exchange, while John buys 10 shares for $1,000. The two parties never meet or know they’ve been part of the same transaction. Instead, the clearinghouse collects $1,000 from John’s account and places it into Melissa’s account. At the same time, the intermediary makes sure that the 10 shares from Melissa are successfully transferred to John.
However, the clearinghouse takes on a significant risk that John won’t pay. The exposure increases further if he buys the securities on margin. To avoid taking any chances, it requires John to maintain a minimum account balance.
As you can imagine, with millions of trades every hour, it would be very difficult for a buyer and a seller to contact each other to settle the transaction on their own. That’s why we say that clearinghouses make financial markets stable and efficient.
What’s the Role of Custodians?
These are financial institutions that hold customers’ securities for safekeeping. Primarily, this prevents the loss of assets through fraud or natural disasters, but it also has a more practical purpose.
Because of the trading volume nowadays, it’s virtually impossible to keep track of the owners of every single security. Custodians mitigate this problem by holding the securities on behalf of the asset owners. In addition, they perform other securities-related services such as dividend collection and tax support.
Of course, nobody works for free. Custodians charge fees – usually a certain percentage of the securities they keep.
Clearinghouses vs. Custodians – What’s the Difference?
A clearinghouse is concerned with the process of securities transactions. It is a back-end activity that supports the transfer of securities from a broker to a dealer, and vice versa. A custodian, on the other hand, is a firm that physically holds an investor’s assets for the sake of security.
Taken together, clearinghouses, custodians, and the rest of the financial intermediaries operating across a variety of markets make up what we know as a financial system. Having financial systems in place means that trading and investing is a structured and well-regulated activity. So, to start building a successful portfolio, you need to be aware of the rules of the game and the most important players. With these out of the way, you can focus on more technical skills used to determine the value of companies and their stock. Sign onto our Introduction to Financial Ratio Analysis to gain a competitive edge in the world of investments, with a comprehensive induction to the most precise valuation metrics in use today.
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