What is compensation?
Clearing involves offsetting the value of several positions or payments to be exchanged between two or more parties. It can be used to determine which party owes compensation in a multi-party agreement. Clearing is a general concept that has a number of more specific uses, especially in the financial markets.
How the net works
Clearing used in trading, where an investor can clear a position in one security or currency with another position in the same or another security. The purpose of compensation is to compensate for losses in one position with gains in another. For example, if an investor is short 40 shares of one security and long 100 shares of the same security, it is long net 60 shares.
In addition, when a company files for bankruptcy, the parties tend to offset the balances owed to each other. This is also called a compensation clause or a compensation law. That is, a business doing business with a failed business will compensate any money it owes the failed business with the money it is owed. The rest represents the total amount owed by them or to them, which can be used in bankruptcy proceedings.
Businesses can also use compensation to simplify third-party invoices, ultimately reducing multiple invoices to one. For example, several divisions of a large transport company purchase paper supplies from a single supplier, but the paper supplier also uses the same transport company to ship products to others. By offsetting the amount each party owes to the other, a single invoice can be created for the business that has the overdue invoice. This technique can also be used when transferring funds between subsidiaries.
Clearing saves a lot of time by eliminating the need to process multiple transactions, thereby reducing the number of transactions to one.
Types of compensation
Here are the top four ways the net is used:
Lapse compensation occurs after default, when transactions between two parties compensate to arrive at a single amount for one party to pay the other.
Net by Novation
Novation clearing cancels clearing swaps and replaces them with new bonds.
Also known as payment clearing, settlement clearing consolidates the amount owed between the parties and distributes the cash flow into a single payment.
Multilateral compensation is compensation that involves more than two parties. In this case, a clearing house or a central office is often used.
Key points to remember
- Clearing compensates for the value of several positions or payments to be exchanged between two or more parties.
- Clearing is used in a number of contexts and jurisdictions – securities or currency trading, bankruptcy and business-to-business transactions, among others.
- Clearing can involve more than two parties, called multilateral clearing, and usually involves a central exchange or a clearing house.
Benefits of offsetting
Clearing saves businesses a lot of time and money by eliminating the need to process a large number of transactions per month and reducing the transactions required for a single payment. For banks making cross-border transfers, this limits the number of foreign exchange transactions as the number of flows decreases.
With currency clearing, businesses or banks can consolidate the number of currencies, and foreign exchange transactions integrate larger transactions, thereby reaping the benefits of improved prices. When companies have more organized deadlines and predictability in regulations, they can more accurately forecast their cash flows.
Example of compensation
Clearing is very common in the swap markets. For example, suppose two parties enter into a swap agreement on a particular security. At the end of the swap period, investor A should receive $ 100,000 from investor B. At the same time, investor B should receive $ 25,000 from investor A. Instead of investor B gives investor A $ 100,000 and investor A gives investor B $ 25,000, payments would be offset. Investor A would give Investor B $ 0, while Investor B would give Investor A $ 75,000.
This clearing process occurs on a wide variety of swaps, but there is a type of swap where clearing does not occur. With currency swaps, since the notional amounts are in different currencies, the notional amounts are exchanged in their respective currencies and all payments due are exchanged in full between two parties; no net occurs.