Two options traders walk into a bar, both hoping to get a little bit rich, but neither one knows the other. How do they make a deal?
No, that’s not the setup to a punch line. It’s more or less the problem that everyone in the derivatives market faces every single day: How do you make a deal with someone you don’t know?
It’s a problem which, while not unique to derivatives, certainly pervades this market. With stocks and bonds, the transaction is complete in and of itself. The buyer pays and the seller delivers as promised. Any problems happen at the point of sale.
Options, though, are long-term contracts. The buyer pays his premium trusting that the seller will keep her word at the expiration date. In the futures market, the seller writes contracts trusting that the buyer will follow through even on an unprofitable transaction. A little bit of bad faith could put the whole system in jeopardy. That’s where clearing houses come in.
Clearing houses such as the Options Clearing Corporation, act as third party intermediaries to every derivatives exchange. They provide a system which connects buyers with sellers, and are the good faith guarantors ensuring that all parties will get paid.
Here’s how it works.
Mark sells an options contract to Sarah. On the face of it, she pays him a premium and he trades a long position on GameCo.
What actually happens is that the clearing house takes title to Mark and Sarah’s contract, reviewing and confirming that both parties have the credit and assets necessary to uphold their end of the bargain. As counterparty, the clearing house takes legal responsibility for both sides of the transaction.
Ultimately, Mark sells a call option on GameCo to the clearing house, which then, in turn, sells an identical contract to Sarah. She pays her premium to the clearing house, which pays Mark the same amount.
The balance of obligations equals out and, as long as everything functions properly, Mark and Sarah barely notice the intermediary. The work of a clearing house happens silently in the background, and connecting these parties happens in a matter of seconds. In legal terms, this is called “novation,” when one party stands in another party’s shoes during a transaction.
But let’s say the expiration date arrives and Mark has gone bankrupt. He can no longer afford to buy the stocks to sell on to Sarah in accordance with their contract. Now the clearing house springs into action and fulfills the contract on his behalf.
Thus a clearing house provides much-needed stability in the marketplace. Although clearing houses do connect traders, their more important purpose is guaranteeing that both parties ultimately get paid.
In futures and options contracts there’s always the possibility of bankruptcy, confusion or simple bad faith. Most traders are strangers to each other, with no idea about the other’s creditworthiness, yet they enter long-term contracts. It’s the clearing house which gives all parties confidence that, one way or another, come the expiration date the assets will be there to execute this deal.
After all, if a stranger walked up on the street and said “give me $50 and I’ll sell you Microsoft stock in six months,” you wouldn’t likely give them more than a smack in the face. The third parties make that improbable system actually work.