exchange and clearinghouse risk

In short

A friend of mine once asked who stands behind an options trade when the other side goes broke. It is a fair question, and a good one to ask before a single dollar goes in. If you hold a listed option, a clearinghouse steps between you and the other trader, so you face the clearinghouse and not a stranger. That lowers the risk of a counterparty failing. It does not remove every risk. Your broker can still fail, and the clearinghouse can still have a bad day when markets panic. Ask your broker how it holds customer assets and where those assets are kept, and read what the clearinghouse publishes about its own financial backing. Then size every position so a surprise cannot sink you.

The whole of it

What it is

I once watched a neighbor sell a used truck to a man he had never met. They did it at a bank, with a teller holding the money and the title until both sides were satisfied. Neither man had to trust the other. They only had to trust the bank. A clearinghouse does much the same work for options and futures.

An exchange is the marketplace where buyers and sellers meet and agree on a price. The clearinghouse is a separate body that sits behind the exchange. After two traders agree, it becomes the buyer to every seller and the seller to every buyer. Lawyers call this step novation, which just means the first deal is swapped out for two new ones. Each trader now holds a contract with the clearinghouse, not with the person on the other side.

For listed stock options in the United States, that body is the Options Clearing Corporation, often called the OCC. Its own website describes it as the clearinghouse for listed options. The Securities and Exchange Commission and the Commodity Futures Trading Commission oversee clearing agencies and clearing organizations in their own areas. Futures work the same way. Each futures exchange has its own clearinghouse or uses a shared one.

How it works

If you are holding a call option, you have probably wondered what happens when the seller cannot pay. Here is the answer. The clearinghouse owes you, and it does not care a whit about the original seller's mood or bank balance. Its whole job is to make sure the contract is honored.

To pull that off, it asks for money up front. Every member firm has to post collateral, which is cash or safe securities set aside as a guarantee. This is called margin. The clearinghouse also marks positions to market, meaning it recalculates gains and losses every single day. A firm that lost money must pay in more collateral, often by the next morning. Small losses never get the chance to pile up into one giant one.

The clearinghouse also keeps a shared pool called a guaranty fund, which members pay into. When one member defaults, the clearinghouse can draw on that member's collateral and on the shared pool. The order of those steps differs from one clearinghouse to the next. The exact order sits in each one's published rulebook. The OCC describes its own steps in its rules and in its Clearing Fund disclosures.

Notice who the clearinghouse actually deals with. It deals with clearing members, which are large firms. A customer deals with a broker. That broker is either a clearing member itself or it uses another firm that is one. When the broker is a clearing member, the chain has three links: the customer, the broker, and the clearinghouse. When the broker uses another firm, the chain has four links, with the clearing member added between the broker and the clearinghouse. Which chain a person sits in depends on the broker. A break in any link matters.

The numbers, and where to find yours

I like to know the size of a thing before I lean on it. So here is where to look.

The OCC publishes its financial safeguards, its rules, and its annual report on its website. It also publishes disclosures under the Principles for Financial Market Infrastructures, an international standard that clearinghouses report against. Those documents tell a reader how large the guaranty fund is and how margin is set. Futures clearinghouses such as CME Clearing publish similar material.

Your broker is the other half. A brokerage that holds your stocks and options is a member of the Securities Investor Protection Corporation, known as SIPC. SIPC protects customers up to the current figure, which the official source publishes each year if a member firm fails and assets are missing. It does not protect against market losses. Futures accounts are different, because SIPC does not cover futures. Ask your broker whether your account holds securities, futures, or both, and what protection applies to each.

For your own account, find three things. The first is the name of your broker's clearing firm, which appears in the account agreement. The second is the set of margin rules your broker applies, which may be stricter than the clearinghouse's. The third is the options disclosure document, titled Characteristics and Risks of Standardized Options, which the OCC makes available and which brokers must provide.

A worked example

A woman I will call Maria opened an options account with $12,000. She bought 10 call contracts on a stock, paying $2.50 per share. Each contract covers 100 shares. So 10 contracts times 100 shares times $2.50 is $2,500. She paid $2,500, and the other $9,500 stayed in the account as cash.

Her trade cleared through the OCC. Say the person who sold her those calls was a trader whose firm later ran into trouble. Maria still held her contracts, because the OCC stood in as the seller. Her risk was no longer that one trader's firm might fail. Good news.

Now suppose the stock rose and the calls became worth $4.50 per share. Her position was worth 10 times 100 times $4.50, which is $4,500. Her gain was $4,500 minus $2,500, or $2,000. She could sell the contracts and collect that gain, and the clearinghouse made sure the buyer on the other side of her sale was good for it.

Here is the part that is easy to miss. Suppose Maria's own broker had failed that same week. Her contracts were still valid at the clearinghouse. But her account sat at the broker, and moving an account to a new firm could take time. During that window she might not be able to sell or exercise, and a real gain of $2,000 could sit frozen while the stock slid back down. That is a delay risk. It comes from the broker link, not from the clearinghouse.

Where it goes wrong

I have seen smart people get comfortable too fast, and it costs them. A clearinghouse lowers one risk. It does not erase risk.

It can fail, though rarely. The 1987 market crash strained clearing systems, and after the 2008 crisis regulators pushed more trades through clearinghouses. That push also made clearinghouses bigger and more important, which gathers risk in fewer places. Regulators and the Financial Stability Board have written about this very concern. A clearinghouse that fails would hurt many people at once.

Margin calls can hurt a seller directly. If you sell options, the clearinghouse and your broker can demand more collateral fast, sometimes within a day. A seller who cannot pay may have positions closed out at a bad price. The loss on a sold call can run far larger than the money first set aside. That is no small thing.

Contracts outside the exchange carry more danger. Over the counter options are private deals, and some have no clearinghouse at all. In those, the other party can simply fail to pay. Always ask whether a trade is listed and cleared.

And exercise and assignment can catch a person off guard. When a buyer exercises a listed option, the clearinghouse assigns the duty to a seller, either at random or in some cases by order of position. The assigned seller must then deliver the shares or buy them in the market to cover. It may happen overnight, with no phone call first. Know the rules before you sell anything.

Questions to answer before you leave this page

Do you know whether the options you hold are listed and cleared, or traded privately with no clearinghouse behind them? Have you found the name of your broker's clearing firm in your account paperwork? Do you know what would protect your account if your broker failed, and have you read what SIPC does and does not cover? Have you read the options disclosure document your broker gave you, and does it match what you think you own? If you sell options, can you pay a margin call tomorrow morning without selling something you would rather keep? And if your account were frozen for two weeks, could you live with that?