All clearing arrangements are designed to help market participants manage various risks - operational, counterparty, settlement, market, and legal risks - between trade execution and settlement.

Currently, clearing most commonly means central counterparty clearing, where a CCP becomes the legal counterparty to each trading party, providing a guarantee that it will honour the terms of the original trade even if one of the parties defaults before the discharge of its obligations under the trade. This guarantee removes market risk, i.e. the exposure of the remaining party to adverse price movements if it had to replace the original trade at the prevailing market price.

The term clearing in financial markets has several other meanings, and its use may encompass several arrangements.

In many trading firms, clearing refers to the collective post-trade activities that ensure the firm meets its obligations to trading counterparties.

In organised markets such as stock exchanges, clearing could mean one or more of the following:

• The calculation of obligations between trading firms. Before CCPs were introduced, stock exchanges’ daily clearing process involved the tabulation of all buys and sells, advising trading firms of their obligations to each other so they could reconcile their records and prepare for settlement.
• A central delivery and receipt arrangement in which sellers deliver assets to a clearinghouse which then delivers them onward to the buyers. When share certificates had to be physically delivered, a clearinghouse was commonly used since it was more efficient and cost effective than each firm managing the process itself.
• Multilateral netting, whereby a party’s purchases and sales in the same asset with multiple trading parties are offset and reduced into one net amount. The net amount is delivered to or received from a clearinghouse (or electronic clearing account).
• Central counterparty (CCP) clearing, where trades are legally novated to a CCP. Most CCPs perform multilateral netting because it significantly reduces the value and number of obligations that require settlement, reduces operational risks and, combined with legal novation, reduces capital requirements.

Several well-known central securities depositories have the word "clear" in their names, although they perform settlement and not central counterparty clearing: for example, Clearstream, Euroclear, and Iberclear. Euroclear was the first international central securities depository (ICSD) established in the 1960's, before the introduction of CCPs, when the term clearing was generally used (as it sometimes is now) by trading firms to describe the collective post-trade activities that ensure they meet their obligations to trading counterparties.

The traditional description of a CCP as a "buyer to every seller and seller to every buyer" is based on the practice of a single CCP clearing for a trading venue. Now, a number of trading venues are in the process of appointing several CCPs to clear for them concurrently. The term "central" counterparty remains unchanged but centralisation now happens at the trading firm level rather than the trading venue level.

The use of a CCP ensures a safe and controlled post-trade process. In markets where an electronic order book matches buyers and sellers, the use of a CCP gives trading firms the assurance that they are protected regardless of which counterparty the electronic trading system matched them with. A CCP also facilitates preserving the anonymity of the trading parties vis-à-vis each other.

The CCP ensures that it can meet its obligations by collecting sufficient collateral from each trading party to be used to cover any losses incurred if the collateral-giving party defaulted and the CCP had to replace the trade at the prevailing market price. The CCP calculates collateral requirements based on each member’s exposures and open obligations.

A CCP centralises counterparty risk management. It protects all customers through contract; a CCP’s rulebook defines legally binding obligations and rights over all customers, and the procedures when there is a customer default. The customers of a CCP are usually referred to as participants or members to reflect the rule-based nature of the CCP service. In many jurisdictions, there is specific legislation that ensures a CCP can exercise its rights in order to give legal certainty to the centralised risk management.

A side benefit derived from CCPs is the facilitation of multilateral netting, whereby numerous sales and purchases of the same asset by the same party are netted down into a single obligation to settle against the CCP, instead of many obligations to settle against many different trading parties. CCPs thus help to increase liquidity in a market. In markets where settlement costs are high, market participants could consider the cost and operational benefits of multilateral netting to be one of the main values of a CCP.

Equity trading venues such as exchanges and multilateral trading facilities are typically required by their regulators to organise orderly post-trade processes for firms to complete their obligations arising from the trade. Trading venues decide whether or not executed trades should go through a CCP, and if so, which CCP.

In general, equities are typical of assets that can be safely cleared: they are standardised and regularly traded, with readily available current prices and liquidity. An equity trading venue may base its decision on whether to use a CCP on factors such as implementation cost, revenue opportunity, and its competitiveness with other trading venues that have a CCP.

An equity market without a CCP can shield trading firms from replacement cost risk in different ways. For example, it may impose a centrally administered levy on trading firms which grows over time into a pool of money that the market can use to cover replacement costs when a counterparty defaults. Another alternative to a CCP may involve each firm giving to the trading venue an amount of collateral that is proportionate to its open obligations on all trades and that would be used to compensate its trading counterparts if it defaulted.

An equity market that does not have a CCP can still centrally organise multilateral netting to reduce the number of settlements, which increases liquidity and reduces operational risk.

The governance of the trading venue determines the amount of influence users have in the introduction and appointment of CCPs.

There are 8 CCPs active in the equities markets in Europe. Each trading venue appoints a CCP based on its own commercial interests. Many users are required to connect to multiple CCPs, which is costly and operationally complex. They would like to be able to choose, if they wish, to concentrate their clearing with fewer CCPs or a single CCP of their choice. Users will be able to freely choose a CCP when there is full interoperability: that is, a trading venue will give its trade feed to a CCP that wants to clear its trades, and the incumbent CCP(s) will interoperate with a newcomer. If either condition is not fulfilled, users do not have free choice because which CCP is made available to them is determined by the trading venue and the incumbent CCP(s).

A CCP's primary function is to guarantee that obligations on a trade will be honoured regardless of what happens to the original counterparty. A user needs confidence that the CCP has robust risk management practices, a depth of experience and know-how, and a proven track record in successfully handling defaults without recourse to loss sharing.

A CCP's competence in risk management is critical - users do not want suddenly to discover they do not have the protection they thought they had. If insolvent, a CCP could no longer honour its guarantee on trades that have not yet settled. All CCPs have some form of loss sharing among customers (often via a central guarantee or default fund), invoked if a default results in losses that exceed the collateral collected from the defaulter plus other available resources. Even though some CCPs may be considered too important to fail, government bail-out is likely to occur only after all users' funds available for loss sharing have been exhausted.

Exposure to loss sharing gives user governance high value. As central risk manager, a CCP should inform and consult with users on matters that substantively affect the risks in the system. As potential loss-sharers, the users need to have influence over how risk mutualisation is achieved and what risk levels are acceptable. Users should pay attention to the level of risk the CCP is taking and what influence they have as paying customers over these decisions.

In addition, as a critical market infrastructure a CCP should have robust systems and processes; a good track record in delivering service implementations and enhancements on time, to specification and without defects; and have scalable capacity to handle surges in volumes. As a service provider it should be flexible and responsive to customer needs, but it should do so without compromising safety.

Value for money and pricing are also key considerations. Some users choose CCPs primarily on visible costs, including the level of clearing fees and the amount of collateral required. Invisible costs include penalty fees on settlement fails and spread retained by the CCP on cash collateral.