Standardization also facilitates the creation of a clearing and settlement operation. Clearing refers to the process by which the exchange verifies the execution of a transaction and records the participants’ identities. Settlement refers to the related process in which the exchange transfers money from one participant to the other or from a participant to the exchange or vice versa. This flow of money is a critical element of derivatives trading. Clearly, there would be no confidence in markets in which money is not efficiently collected and disbursed. Derivatives exchanges have done an excellent job of clearing and settlement, especially in comparison to securities exchanges. Derivatives exchanges clear and settle all contracts overnight, whereas most securities exchanges require two business days.

The clearing and settlement process of derivative transactions also provides a credit guarantee. If two parties engage in a derivative contract on an exchange, one party will ultimately make money and the other will lose money. Derivatives exchanges use their clearinghouses to provide a guarantee to the winning party that if the loser does not pay, the clearinghouse will pay the winning party. The clearinghouse is able to provide this credit guarantee by requiring a cash deposit, usually called the margin bond or performance bond, from the participants to the contract. Derivatives clearinghouses manage these deposits, occasionally requiring additional deposits, so effectively that they have never failed to pay in the nearly 100 years they have existed. We will say more about this process later and illustrate how it works.