Commercial banks are considering setting up a clearing house-style system to reduce risks in foreign exchange settlement, according to a senior official at the Federal Reserve Bank of New York.

Speaking at the recent annual convention of the Bankers Association for Foreign Trade, New York Fed first vice president Ernest T. Patrikis said the proposed system would involve "creation of an entity which could take the form of a bank" where trading counterparties would maintain accounts.

"Payments would be made from - and paid to - those accounts in a continuous linked process designed to minimize the system's liquidity and collateral needs," Mr. Patrikis added.

The Fed official's remarks followed a warning from the G-10 group of central banks in March that current settlement practices expose banks to large potential losses for several days. Since then, a task force comprising 17 multinational banks, including J.P. Morgan & Co., Citicorp, Chase Manhattan Corp., and several major foreign banks, has been stepping up efforts to diminish settlement risk.

Mr. Patrikis said that the banks have so far explored two other possibilities as well, but both have shortcomings.

One would provide for a "double escrow arrangement" under which each counterparty would pay the amount it owed for a foreign exchange transaction into an escrow account. But this system was rejected as being inefficient and too complex, Mr. Patrikis said.

The other, involving net settlement of foreign exchange trades, would have required counterparties to post collateral.

"There was some concern that this (latter) system could give rise to liquidity pressures on some participants," Mr. Patrikis said.

Banks already use foreign exchange netting systems designed to reduce foreign exchange settlement risk. One such system, Exchange Clearing House Ltd., is run by 15 European banks. A second netting system, known as Multinet and owned by First Chicago NBD Corp., Chase, and Canada's six largest banks, is due to begin operating later this year.

Mr. Patrikis stressed that banks need to move quickly to improve back office payments processing, correspondent banking arrangements, netting capabilities, and risk management controls.

He added that the Fed itself did not favor any one solution over another. Regulators much prefer that the private sector find its own answer, he said.

"Foreign exchange risk can never be completely eliminated but it can be reduced," Mr. Patrikis said. "We believe that market participants are the ones best suited to define the ways to address foreign exchange settlement risk."

Mr. Patrikis also said he does not believe there is any need to impose a capital charge on banks to cover the risk from foreign exchange.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.