In searching for articles to review this week, I visited one of my favorite pure browsing sites. Though not a site you might first consider for an International Economics course, I wandered over to www.uspto.gov to see what I could find. This is the web site for the United States Patent & Trademark Office. The search feature of the site is pretty powerful allowing you to search by inventor’s name, patent number, or keyword(s). I’ve used the site for work and (almost!) pleasure but to date I’ve never used it as a source of an article review. Nonetheless, the complete patent filings are an interesting place to fish for ideas so I thought I’d try it for this week’s article review.
At the Boolean search box for the patent database, I entered “currency” and ‘trading’ and of the 53 patents returned, one of them was titled “Foreign Exchange Transaction System.” Invented by S. Rosen, awarded on November 2, 1999 and assigned to Citibank, the 26 page document sets out the basis for a real-time multilateral foreign exchange settlement system designed to eliminate foreign exchange settlement risk.
Foreign exchange settlement risk or Herstatt risk as it is sometimes referred to, describes the “risk of failure by any of the participants” in a foreign exchange trading transaction during the time lag between the trade commitment and the settlement date. The problem behind this risk was “demonstrated in 1974 when the Herstatt Bank in Germany was declared insolvent at the end of the banking day” leaving any pending trades in the lurch.
Because “foreign exchange trading is by convention settled two business days following the trading day” if the “counterparty to the Herstatt Bank had paid his marks and had not received his dollars” prior to the insolvency announcement, then said party’s German marks could be forever lost. Given the settlement timing gap, further exacerbated by the fact that Germany is seven-ten hours ahead of the US banks, there is a definite opportunity for risk to come into play and this “has the central banks of the major economies concerned.”
What the patent purports to enable is the development of a real-time exchange of currencies via a form of electronic money which can be denominated in multiple monetary units via a secure electronic network. Such an approach could eliminate the risk as opposed to merely reducing the risk as suggested by various industry studies touting “solutions incorporating extended banking hours, coordinating central bank accounting systems, and setting up multi-currency clearing banks.” Such a technology driven solution, if secure, could work as it solves the problem by attacking at the root cause and eliminating the time lag of the current systems.
The text walks through the basics of foreign exchange trading describing the existing systems, including some of the inherent risk points. Additionally, the NY Times article I posted earlier today exposed a related risk factor due to the lack of real time information in trading systems today. When combined with the text’s explanation of triangular arbitrage, I found myself drawn to this patent as means to improve upon the trading process in its entirety via a real-time system. As is usually the case, information is the key to success. This is especially so in the trading arena where timely availability of that information can produce fortunes or loss.
This patent application offers an interesting means of outlining the need for change in the manner in which foreign currency exchanges occur. While obviously beneficial to Citibank given the protection of the patent process, the benefit to the market and its participants in providing more timely and thus more perfect information could raise the efficiency of the market at large.
Though it may be highly unusual to attempt to tie together an economics text, a NY Times article, and a US Patent, I enjoyed the challenge and found it to be quite interesting!
US Patent & Trademark Office. 2 November, 1999. http://www.uspto.gov. Rosen, S. “Foreign exchange transaction system.”
Hulbert, M. Monitoring Trade for the Good of a Fund [Online]. http://www.nytimes.com/library/financial/Sunday/040900mutfund-strategies.html
Pugel, T. A., & Lindert, P. H. (2000). International Economics. New York: Irwin McGraw-Hill.