After years of clamoring for enhancements of the Federal Reserve's net settlement services, payment service providers in the private sector are finally getting their wish.

The Fed plans to pilot test a service in the third quarter that would simplify the clearing and settlement of checks, automated clearing house payments, automated teller machine transactions, and other interbank payment obligations.

In effect, the service would be a boon to commercial banks' efforts to compete with the central bank because it accelerates the settlement and finality of payments.

Although a Federal Reserve System committee headed by Vice Chairman Alice Rivlin recently rejected the notion of privatizing the Fed's retail payment functions, it did endorse enhancements of its net settlement services.

"Development of this service hopefully will enhance the capability of the private sector," said Paul Bettge, assistant director at the Federal Reserve Board in Washington.

The Fed still provides the most payment services to the banking system. It earned about $1 billion of gross revenue in 1996, according to PSI Consulting Group, Tampa.

But the Rivlin report reflected the Fed's increasing recognition of the role the private sector plays in interbank settlements.

The Fed, which competes with banks in some areas even as it regulates them, first proposed an enhanced net settlement service last June. This would be another option among the settlement services it offers private clearing organizations.

Using the proposed service, clearing houses would electronically transmit account entries to the Fed, which in turn would post net debits first, then credits, to banks' reserve accounts. Settlements would be final as soon as all amounts were netted.

This would be an alternative to the paper-based settlement sheets primarily used for local check clearings. It would also offer a new way for some clearing houses that now use the Fed Wire to speed finality.

Settlement-sheet postings are not final until the next day, and are reversible. Fed Wire, the large-dollar funds transfer network, offers immediate finality, but it is subject to more stringent Federal Reserve approvals and can be cumbersome when settling payments for large numbers of banks in private clearing houses.

Gerard F. Milano, executive director at the California Bankers Clearing House, said an enhanced net settlement service would greatly help his business.

Mr. Milano, who has pushed for such a service for years, delivered persuasive testimony to Congress last year.

"If you are going to compete with the Fed in payment services, it would be helpful if you had something replicating the way the Fed settles," Mr. Milano said in an interview.

California Bankers Clearing House, San Bruno, clears checks for 150 banks, several of which straddle Federal Reserve districts.

"Fed Wire gives you operational risk in waiting for the last dime," Mr. Milano said. "The more participants there are, the more different things can go wrong."

Although there is wide agreement that a national net settlement service would benefit the payments industry, some officials were nonetheless miffed that it took so long for the Fed to act.

The New York Clearing House Association has been asking for a national net settlement service since 1992. Officials there noted that the Fed had endorsed enhanced net settlement only after it had completed a multiyear consolidation of its district services.

Indeed, the Fed has been accused of dragging its feet to improve its competitive position against private-sector alternatives.

The Fed's Mr. Bettge denied any stalling. "There is no intention of delaying this," he said of net settlement. "That was never a consideration.

"The Fed views competition as vital in any sort of payment arena, in order to ensure that it is done in an efficient way and a safe way."

Officials in the automated clearing house community scoffed at the notion of fair competition. They said the Fed unjustly charges fees for processing work that is done by the private sector.

The National Automated Clearing House Association raised that issue in a letter to the Fed just before release of the Rivlin report in mid-December.

Nacha not only repeated its request for an enhanced national net settlement service but also asked the Fed to reconsider its practice of double-charging banks that have ties to private ACH operators.

The Rivlin report made no mention of the double charge.

Despite their irritation, private-sector officials were nonetheless pleased that a net settlement service is near. They noted that it became possible only after the Fed ended its linkage of settlement policies with risk management issues.

The Fed is now contemplating a single, uniform risk policy for both large- and small-dollar netting systems. Comments on the proposal are due next month.

The Fed's risk policy statement would essentially say that controls for private clearing arrangements "should be commensurate with the risk," Mr. Bettge said.

In other words, banks that exchange checks at small clearing houses would not be required to maintain the same level of risk management required in larger clearing systems.

For example, the New York Clearing House Interbank Payments System, Chips, is a private-sector net settlement payment service that on a typical day processes electronic payments worth more than $2 trillion.

Chips, which ultimately settles with individual Fed Wire payments, has strict collateral obligations and other restrictions that would assure settlement, even if its largest bank participants failed. It has markedly different risk characteristics than the National Clearinghouse Association, a Columbus, Ohio-based alternative to the Fed's interdistrict check clearing services.

Rick Burke, an administrator at the National Clearinghouse Association, which clears about a billion checks annually, applauded the Fed's differentiating between national net settlement and settlement risk.

He said he is studying the proposed service and may recommend its use after the Fed clarifies the service's pricing.

"It would be easier for us to just present a file to the Fed and just post transactions," he said.

Furthermore, with more banks exchanging transactions on a bilateral basis, Mr. Burke said, enhanced net settlement could offer banks a "tremendous opportunity" to reduce operating costs.

Ralph Joy, senior vice president for ACH services at Visa U.S.A., a Fed competitor, said he too is considering the national net settlement service for the Private Sector Automated Clearing House Exchange, or Pax.

Pax enables direct exchanges of ACH payments among private-sector operators.

Pax, which relies on Visa's Fed Wire-based net settlement system, has more than 500 financial institutions participating. Its burdensome settlement process has hindered volume growth.

"There are certainly some advantages in the sense that you no longer have to send a wire," Mr. Joy said of the new proposal. But he added, "The devil is in the details."

"I think we are all looking forward to the service," said Holly Merrill, president of the Arizona Clearing House Association, a check clearing house and another private automated clearing house processor.

"It is long overdue," she added. "I think it will help the payments industry as a whole."

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