Since 2017, many financial institutions in the United States have been using the Automated Clearing House (ACH) or The Clearing House (TCH) Real-Time Payment Network for their payments. However, some companies have been cautious about using this instant payment service because TCH is owned by some of the world’s largest banks.
Moreover, integrating instant payment services into their existing technology systems can be expensive and time-consuming, which has deterred many of US-based financial institutions from making the switch. This has led to a standstill in the industry because both parties in a transaction need the same technology to benefit from instant payments. Consequently, real-time payments accounted for only 1% of all payments in the US in 2022.
In July 2023, the US Federal Reserve introduced an alternative payment service for financial institutions. Since its launch, Forbes has described it as a potential game-changer and “a secure and faster option with government support.”
One of the main reasons American consumers embrace new FinTech tools is the speed and convenience they offer. Recent advancements in payment options, such as peer-to-peer (P2P) payment apps and autopay, have emerged to cater to these preferences.
FedNow is the most recent addition to this lineup, aiming to provide even more speed, convenience, and choices. As a result, it is anticipated that FedNow will expand the availability of instant payments and make them more popular among users.
What is FedNow?
FedNow is an innovative payment system introduced by the Federal Reserve, the central bank of the United States. It enables instant money transfers at any time, day or night. This development promises to align the speed of payments in the U.S., significantly speeding it up, after taking five years to create. It aims to bring the country in line with other advanced economies like the United Kingdom, European Union, India, and Brazil, all renowned for their sophisticated payment infrastructure.
The primary purpose of FedNow is to facilitate immediate retail payments, even during weekends and nighttime hours, setting it apart from other payment networks. While FedNow offers unique advantages, it shares similarities with other payment systems.
For example, like the Automated Clearing House (ACH) and Fedwire, FedNow operates as an interbank mechanism. However, unlike ACH, FedNow utilizes a real-time gross settlement (RTGS) approach, similar to Fedwire.
ACH is an electronic payment system for processing batch-processed fund transfers in the United States. At the same time, Fedwire serves as an RTGS system for immediate and high-value fund transfers within the country. Unlike netting or grouping multiple transactions, the RTGS system processes each transaction individually and settles it immediately.
FedNow vs Fedwire
So, you might wonder why FedNow is necessary when banks can already use Fedwire, which works with the Clearing House Interbank Payments System (CHIPS), Fedwire is the primary U.S. network for large-value or time-critical domestic and international payments. The reason lies in the limitations of existing interbank payment systems like Fedwire, which need to be better suited for facilitating immediate retail payments.
For example, Fedwire operates during set business hours, from Monday to Friday, excluding holidays, starting at 9:00 pm ET the night before and ending at 7:00 pm ET. Additionally, third-party transfers must be initiated daily at 6:00 pm ET.
An instant retail payment system like FedNow aims to enable customers and businesses to send money instantly, anytime, from anywhere, ensuring that the recipient receives it without delay.
The FedNow Service has already been launched in several stages, starting with its primary launch on July 20, 2023. This initial release offers essential features to cater to various market needs, addressing the increasing demand for account-to-account (A2A) transfers and bill payments.
So, who can benefit from FedNow? FedNow’s design allows for potential use in various consumer, commercial, and governmental situations. It assists businesses by simplifying payments to clients, customers, and employees while expediting business-to-business (B2B) transactions.
The faster payments facilitated by FedNow bring several advantages to consumers, making it more convenient for them to pay bills and send money to friends and family. Furthermore, the government can leverage FedNow to transform the financial landscape in the United States, potentially expediting processes like tax returns to a remarkable degree.
How Does FedNow Work?
FedNow operates as a faster payment system with three key characteristics: instant transaction settlement, continuous availability 24/7/365, and immediate sender and recipient confirmation.
These faster payments can function within two systems: “closed loop” and “open loop.” In closed-loop systems, transactions are handled only by a single provider, meaning the sender and receiver must have accounts with that specific provider. Popular examples of closed-loop systems include apps like Venmo, Cash App, and Paypal.
In contrast, open-loop systems allow transactions between accounts held at different banks, eliminating the need for participants to have accounts with specific apps or financial institutions (FIs). Open loop payments operate through shared networks, such as FedNow, the RTP Network, and Zelle, which route and settle payments for FIs that are part of that network.
With this new infrastructure, individuals and small businesses can conduct real-time transactions using reserve bank accounts held by participating banks. It’s important to note that transactions can only occur between banks in the FedNow network. The goal is to encourage more local banks to adopt FedNow, ensuring more people have equitable access to this service.
The question remains how quickly financial institutions will embrace FedNow and how long the rollout phase will take.
FedNow Difference From ACH and Other Traditional Payment Systems
Processing (Batch vs. Transaction)
Traditional payment systems like ACH rely on batch processing, where financial institutions gather and bundle ACH transactions before sending them in bulk to a clearing house. This batching approach makes sense due to the large volume of ACH payments processed regularly.
However, it leads to delays. In contrast, FedNow employs transaction processing, handling payment files in real-time on a per-transaction basis. This significantly speeds up the movement of money, with each payment going through initiation, authorization, transmission, acceptance, and receipt nearly instantly.
This shift can affect how transactions are recorded and pose new challenges for compliance programs, necessitating improved controls, risk assessment for counterparties, and transaction monitoring.
With ACH, clearing using traditional bank rails occurs at scheduled intervals. In contrast, faster payments like FedNow clear transactions one by one per ISO20022 standards. This messaging frequency, along with agreements between financial institutions, allows for real-time crediting of payments.
ACH employs deferred settlement, where settlements occur at specified times or on a predetermined schedule. FedNow, on the other hand, employs real-time settlement, settling transactions individually almost simultaneously with clearing.
This is known as gross settlement and is significantly faster than the net settlement used in ACH. The difference has implications for liquidity and credit risk.
Finality vs. Reversibility
ACH transactions can be reversed or returned, whereas transactions on faster payment rails are final, guaranteeing the transfer of funds. Given that most FedNow payments are likely to be credit (or push) payments, there is assurance that a payer can only initiate payment if they have sufficient funds, offering protection against chargebacks due to issues like insufficient funds.
For request-for-payment (RFP) transactions, having comprehensive data and predefined parameters reduces the likelihood of errors. In the case of ACH, similar errors might necessitate a reversal. However, for FedNow, the “amount due” will be a required field in all RFPs, reducing the chances of mistakes.
How Much Does FedNow Cost?
In early 2022, the Federal Reserve disclosed the pricing and fees associated with their real-time settlement network, FedNow. Since FedNow is government-operated, it’s required to cover its operational costs without making a profit. This unique aspect may result in more competitive pricing than other payment systems, potentially accelerating its adoption.
The expected fees include:
1. A monthly participation fee of $25 for each routing transit number (RTN) that receives credit transfers.
2. A sender-paid fee of $0.045 per credit transfer also covers returns.
3. A fee of $0.01 for request-for-payment (RfP) messages, payable by the requestors. This fee applies to both new payment messages and returns.
4. Initially, there is a default credit transfer limit of $100,000. However, financial institutions (FIs) can adjust their credit transfer limit, either lower or higher, up to $500,000. The Federal Reserve will continuously assess and modify the credit transfer limit.
What Does a FedNow Payment Process Look Like?
A FedNow payment process resembles the flow of any other instant payment involving key participants: a payer, the payer’s bank, the FedNow network, a payee, and the payee’s bank.
Here’s a step-by-step overview:
1. The payer initiates a payment using an end-user interface outside the FedNow Service to send a payment message to their bank.
2. The payer’s bank receives the payment instructions and, assuming the payer has sufficient funds, authorizes the transaction.
3. The payer’s bank forwards the payment message to the FedNow Service.
4. The FedNow Service checks and validates the payment message, then passes its contents to the payee’s bank for approval or rejection.
5. The payee’s bank responds to the FedNow Service, accepting or rejecting the payment message. If the payee’s bank rejects the message, the FedNow Service notifies the payer’s bank about the payment failure. If accepted, the FedNow Service deducts funds from the payer’s account and credits them to the payee’s account.
6. The FedNow Service informs all parties involved of the successful funds transfer, marking the completion of the transaction.
What are the Advantages of FedNow
FedNow offers several advantages, including:
Real-Time Payments and Reduced Costs
FedNow enables instant fund transfers, ensuring recipients receive their money promptly. This speeds up cash flow and simplifies financial transactions. It also helps businesses and individuals save on expensive sped up payment methods.
24/7 Availability and Government Efficiency
FedNow operates 24/7, including weekends and holidays, providing uninterrupted payment services. Additionally, government adoption of FedNow could lead to more efficient financial operations, expediting processes like tax returns and government payments.
Enhanced Financial Inclusion
FedNow can potentially extend its benefits to underserved populations, promoting financial inclusion. Furthermore, it offers affordable access to real-time payment infrastructure for smaller financial institutions.
Streamlined Business Operations
Organizations can use FedNow to streamline payment processes, making invoice settlement easier, managing cash flow, and facilitating faster, more secure B2B transactions.
Competition and Innovation
The introduction of FedNow into the payment ecosystem may encourage financial service providers to compete more vigorously and innovate, leading to improved products and services.
Cons of FedNow
While FedNow offers various benefits, there are some drawbacks to consider:
FedNow payments cannot be reversed once completed. This could pose challenges when mistakes are made during transactions. For instance, if someone sends the wrong amount, they won’t be able to cancel the payment. Proper customer education by institutions will be crucial to avoid such issues.
The irreversibility of FedNow payments may also raise concerns regarding fraudulent transactions. While there are built-in fraud prevention measures, such as blocking certain accounts or setting transaction limits based on risk, institutions may need to invest more in anti-fraud measures like identity verification to enhance protection against fraud.
Financial institutions (FIs) must establish a FedLine connection to access and configure their participant profile and send FedNow messages using the ISO 20022 format. Additionally, FIs need to manage liquidity effectively and potentially make adjustments to support 24/7 payment activity, which can be complex.
The success of FedNow depends on how many FIs adopt it and how quickly they do so. Banks can enable users to send funds using FedNow or only receive them. This flexibility could slow down the widespread adoption of the system.
FedNow represents a significant advancement in financial payments, offering numerous benefits such as real-time transactions, 24/7 availability, enhanced financial inclusion, streamlined operations, and the potential for increased competition and innovation within the industry.
However, it’s essential to acknowledge its limitations, including irreversible payments, potential fraud risks, implementation requirements, and uncertainties regarding widespread adoption.
Financial institutions and individuals must weigh the advantages and disadvantages of FedNow as they consider its integration into their payment processes. While it promises to revolutionize how we handle transactions, it also demands careful consideration and adaptation to navigate its unique features and challenges effectively.
The successful implementation of FedNow will depend on how well these issues are managed and the extent to which it meets the evolving needs of the financial ecosystem.