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By Brad Zigler

Last week, merger talks with the Chicago Mercantile Exchange (NYSE: CME) were extended ("Time's Expired For CME-NYMEX. No ... Wait!") until March 15 to allow the two bourses to work out niggling details. Questions, however, about the anti-competitiveness of a merged exchange's clearing operations may hold up the deal further.

No bother on NYMEX, though. Yesterday, the exchange and Europe's LCH.Clearnet Group announced a partnership that is slated to offer a double bill of transatlantic oil, and natural gas and electricity futures that can be cleared by either NYMEX in New York or by LCH.Clearnet in London.

These events have left many readers wondering about clearing. Just what IS clearing anyway?

Wonder no more.

At the time a futures trade is made, a financial obligation is created between the contract's buyer and seller. Sellers promise to make delivery of the commodity while buyers promise to take delivery. Trading is largely anonymous, so neither side likely knows the identity of its counterparty.

What assurance, then, does each party to the contract have that their counterparty will make good on its promise?

That's where the clearinghouse comes in. At the end of each trading day, the clearinghouse steps in to break the link between the contract parties, interposing itself as the buyer to every seller and the seller to every buyer. By doing so, market participants now look to the clearinghouse for performance on their contracts. And with that, there's no need to be concerned about the counterparty's identity. Ultimately, it's the clearinghouse on the other side of every trade, and the clearinghouse has substantial assets - obtained through fees and deposits made by member organizations, together with borrowing power - to meet its obligations.

To get the clearinghouse performance guaranty, though, futures trades must take place on the books of a clearing firm - a member of the clearinghouse. Not all exchange members are members of the clearinghouse. "Locals"- individuals trading for their own accounts - typically aren't clearing members. Instead, they contract with other firms to clear their trades.

To become a member of the clearinghouse, a substantial capital commitment is required as each clearing firm is obliged to post a guaranty deposit which may be tapped to cover defaults.

The clearinghouse also handles the flow of margin that secures each contract according to exchange rules.

Clearing can be a very profitable business. In years past, clearinghouse fees often skunked trading revenues earned by their associated exchanges.

Both the NYMEX and CME have captive clearinghouses that settle their respective trades. Privately held LCH.Clearnet is a third-party guarantor that was formed in the 2003 merger of the London Clearing House and Paris-based Clearnet.

Two of LCH.Clearnet's biggest clients - Euronext.liffe, a subsidiary of NYSE Euronext, and the IntercontinentalExchange (NYSE: ICE) - are reportedly recasting or severing their contracts as they work on launching their own clearing services.

Is all this clear now?

Source: NYMEX Clearing in the News Again