The Role of the Clearinghouse Associated with every futures exchange is a clearinghouse, which per-

The Role of the Clearinghouse Associated with every futures exchange is a clearinghouse, which per-

forms several functions. One of these functions is guaranteeing that the two parties to the transaction will perform. To see the importance of this function, consider potential problems in the futures transaction described earlier from the perspective of the two parties—Brent, the buyer and Susan, the seller. Each must be concerned with the other’s ability to fulfill the obligation at the settlement date. Suppose that at the settlement date the price of Asset X in the cash market is $40. Susan can buy Asset X for $40 and deliver it to Brent who, in turn, must pay her $60 (the futures price agreed upon when the two parties entered into the agreement). If Brent does not have the capacity to pay $60 or refuses to pay, however, Susan has lost the opportunity to realize a profit of $20. Suppose, instead, that the price of Asset X in the cash market is $90 at the settlement date. In this case, Brent is ready and willing to accept delivery of Asset X and pay the agreed-upon price of $60. If Susan does not have the ability or refuses to deliver Asset X, Brent has lost the opportunity to realize a profit of $30.

The clearinghouse exists to meet this problem. When a party takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract. Because of the clearinghouse, the parties to a futures contract need not worry about the financial strength and integrity of the other party that has

FOUNDATIONS

taken the opposite side of the contract (called the counterparty). After initial execution of an order, the relationship between the two parties ends. The clearinghouse interposes itself as the buyer for every sale and the seller for every purchase. Thus either party is free to liquidate a position without involving the counterparty in the original futures con- tract, and without worry that the counterparty may default. This is the reason why we define a futures contract as an agreement between a party and a clearinghouse associated with an exchange.

Besides its guarantee function, the clearinghouse makes it simple for parties to a futures contract to unwind their positions prior to the settle- ment date. Suppose that Brent wants to get out of his futures position. He will not have to seek out Susan and work out an agreement with her to terminate the original agreement. Instead, Brent can unwind his posi- tion by selling an identical futures contract. As far as the clearinghouse is concerned, its records will show that Brent has bought and sold an identical futures contract. At the settlement date, Susan will not deliver Asset X to Brent but will be instructed by the clearinghouse to deliver to someone who bought and still has an open futures position. In the same way, if Susan wants to unwind her position prior to the settlement date, she can buy an identical futures contract.