Credit Clearing and the Missing Middle, Part 2

Credit Clearing and the Missing Middle, Part 2:

The History of Clearing

Clearing, at its core, is about paying as many debts as possible with the minimum use of cash, resulting in more efficient trade at lower risk. While this sophistication may sound modern, versions of the practice can be traced back centuries.

The next two months’ newsletters serve to highlight that the foundations of what we are doing here at Local Loop Merseyside are deeply established. We’re building on centuries of innovation and learning, and adapting tools long used by the banking sector and corporations for our local business community.

This is only now possible thanks to the rise of digital accounting services, and through our Pilot we’ve established beyond doubt the feasibility of offering clearing to help small businesses reduce uncertainty around getting paid and improve their cashflow.

What’s more, we’ve discovered its wider benefits for local financial resilience and economic development, and will write about these topics in the future. But for now, we’re tracing clearing back to its mediaeval origins.

Origins in Mediaeval Merchant Fairs:

In large and complex trading networks, payment gridlocks (the domino effect of ‘I can’t pay because I haven’t been paid)’ are as inevitable as traffic jams. In fact, the livelier the economy, the worse the gridlocks will get! Even today, business communities have no reliable ways to get together to navigate and manage the chaos.

However, there are certain organisations - the banks - that have long had the knowledge, the motive, and the opportunity to get together and sort things out, at least for themselves. In fact, recognisably modern banks originated in the invention of sophisticated mechanisms (including clearing) to deal with the problem of how to manage and resolve complex debt relationships, even when the means to pay them (i.e. money) is in short supply.

Some of the earliest records of these mechanisms are from mediaeval trade fairs that took place across Europe, with Champagne in France hosting particularly famous ones. Following a yearly cycle, merchants would gather from far and wide, and over several weeks exchange textiles, furs, and spices to take back to their home countries and sell at high profits.

However, physical cash (gold and silver) was dangerous to travel with, and so the merchants would bring as little as they could. And yet, these fairs supported a huge volume of European trade for hundreds of years. How was this feat managed?

Firstly, merchants would buy and sell from each other on account - rather than paying each other on the spot for each trade, they would record them in their books - a lot like issuing an invoice. As the fair went on, an incredibly dense network of debts would build up. It was a very lively (and effectively closed) economy.

If there was no further coordination, then the resulting payment gridlocks would mean that the chances of anyone getting paid on time would be very, very small, and it’s unlikely anyone would choose to repeat the experience. Cross-European trade would have ground to a halt.

This is where an early form of clearing came in. Immediately after the trade fair, there would be a banking fair. The merchants would hand their books (containing records of all of their credits and debts) over to specialist money changers, who would then try to reduce the need for cash and payments as much as possible.

The first way they would do this was to look for pairs: if Merchant A owed 10 florins to Merchant B, and Merchant B owed 10 florins to Merchant A, then it was immediately possible to cancel everything out. If the amounts were different, then the two debts could be replaced with a single one equal to the larger amount minus the smaller. This is the simplest form of Loop Clearing.

Of course, these loops of two only accounted for a small fraction of the total debt, but it was a good start, and it meant that each merchant was reduced to being either a debtor or a creditor to every other merchant, rather than potentially both - a significant simplification.

The next step was to apply the same principle at scale - whether there were two, three, or ten merchants involved in a loop, it was always possible to deduct the smallest common amount right around the loop. The problem now was to find these longer loops, and what’s more, to find the ones that would clear as much debt as possible for everyone!

The way this was done was ingenious. The merchants would form physical circles, with debtors standing to their left and creditors to their right (remember that clearing the loops of two meant that the other merchants could be either of these, but not both). Detecting these loops meant that vastly more debt could be eliminated, all before any payments were needed.

A further step was then to reassign debts from one merchant to another - a debtor might pay one of their creditor’s creditors. This process was known as ‘scontration’ or ‘delegation’. Finally, any debts still outstanding were often rolled over to the next fair, in the expectation that they would probably be cleared next time around.

Any residual debts would be settled with money as a last resort, but records indicate that these clearing mechanisms were so effective that this was a small fraction of the total volume of trade. In fact, merchants were known to bring only enough cash to pay for food, drink, and entertainment - the trading network of the fair was so dense, and so closed, that almost everything could be cleared.

For centuries, the European economy was powered by these fairs, enabling a much larger and more active economy than the amount of physical money in circulation would otherwise have allowed.

Needless to say, organising all of this was highly specialist work (particularly when so few people were educated), and those who invented, refined, and coordinated these mechanisms had every reason to form organisations that could profit from providing these services at scale.

Although the mediaeval market fairs declined and disappeared with the rise of maritime trade, certain forms of clearing eventually became integrated into the first recognisably modern banking systems that developed in large port cities. For example, the Bank of Amsterdam (founded in 1609) began offering centralised ledgers for merchants, and in 1636 financier Philip Burlamachi proposed a formal clearing bank in London.

In the next part of this series, we’ll trace the rise and development of these institutions through to their place at the heart of the modern global financial system. Between now and then, follow us on LinkedIn to see the latest on our mission to build the most collaborative economy in the UK!