In response to the demand for faster and more convenient payment options, the Federal Reserve has launched a plan to modernize the US payment system, including the implementation of real-time payments.
The idea for this innovative payment service has been in the works for over a decade. Its implementation is expected to revolutionize the banking industry by providing customers with a more efficient and seamless payment experience.
FedNow is expected to revolutionize the way transactions are conducted in the US, making it easier and quicker for businesses and individuals to transfer funds.
But, what is the new Federal Reserve Payment System, how will it affect the Fintech industry, who can participate in the FedNow Pilot program, and when will FedNow be available? These questions and more will be answered by our Finance expert in this handy guide.
Real-Time Payments vs ACH
Before we jump to the FedNow payment system, it’s important to take a look back at what the Federal Reserve has been using and continues to use (for now) to transfer money between bank accounts.
For almost half a century, banks in the United States have been using the Automated Clearing House (ACH) as the primary payment rail for electronic money transfers between bank accounts.
ACH Fed Payment is a batch processing system that facilitates electronic transactions between bank accounts, including direct deposit of paychecks, bill payments, and other types of transfers. However, ACH transactions typically take one or two business days to complete, which can cause delays and inconvenience for customers who need to make or receive payments quickly.
While other countries have embraced instant services and real-time payments (RTP) - which we will explain more about soon - ACH providers in the US have lagged behind, limiting the speed and efficiency of transactions.
There is now a move towards change, spearheaded by the Federal Reserve.With the launch of FedNow real time payments, the Federal Reserve aims to provide a faster, more convenient alternative to ACH that will benefit both individuals and businesses.
What are Real-Time Payments?
Real-time payments (RTP) allow for instantaneous transfers, which means that funds are available in the recipient's account within seconds, as opposed to the traditional ACH system, which can take up to several days. This is a major step towards modernizing the US payment system, bringing it in line with other advanced economies.
RTP rails are networks or platforms that allow digital money to move from one person to another regardless of the method, currency, or country. Once adopted by the Federal Reserve, RTP would allow domestic US payments to be processed 24/7 and all year round with immediate settlement and instant funds availability.
Real-time payments are not a new concept. In the 1970s, Japan was one of the first to develop an RTP system, and countries such as the UK, India, and China followed suit in the 2000s. There are an estimated 54 countries that have already set up real-time payment systems.
What are the Benefits of Real-Time Payments?
RTPs make payments frictionless for customers since they are initiated, cleared, and settled within seconds of a purchase. To make payments in real-time, the bank's backend system must be available 24/7, keeping both users and the bank secure and protected from fraud. RTPs ensure that customers will have speed in payments, instant financial and settlements, and easy access to their money whenever they need it.
Building payment rails will support better end-to-end communication, and it will be a significant change compared to one-way communication (payer to payee). Their lean and open architecture will simplify the setup and operating costs and will make business processes and communication around payments much more efficient.
Learn more about the challenges and benefits of Real-time payments.
What is FedNow?
FedNow, the Federal Reserve's payment system, will facilitate real-time transactions for financial institutions of any size, 24 hours a day, 365 days a year.
By utilizing clearing functions, banks can instantly exchange the required information to debit or credit their customers' accounts during payment settlements. Plus, with the implementation of FedNow, banks can now provide better notifications to their end-users regarding payment acceptance or failure.
In contrast to RTP, FedNow will service all federal reserve banks through the FedLine network, providing payment and information services, including secure electronic messaging systems and IP-based solutions, to over 10,000 financial institutions.
How Will FedNow Work?
To ensure the effectiveness of real-time payment systems, simplicity for users and robust security measures are crucial factors.
Users of the FedNow Service are unlikely to notice any significant differences from other real-time payment systems. They will continue to log in to their bank account to initiate payments, and financial institutions will continue to provide security measures, screen payments, and manage account changes and reconciliations.
However, the primary difference with FedNow is the payment transfer process between financial institutions. FedNow will act as an intermediary between the sender's and receiver's financial institutions, validating payment messages, and debiting and crediting the appropriate accounts, all within seconds.
Yuriy Kropelytsky, Softjourn’s Payment Expert, compares the direct access to customers' accounts provided by the FedNow Service to a "smart contract on the blockchain," as it will enable smoother and quicker transactions between participants. “However,” he said, “the increased control and centralization of the system may result in higher costs for users.”
Kropelynystky noted, “While the FedNow service is designed to maintain high levels of security, the need for increased security measures may also be attributed to the costs of using the system.”
FedNow has been designed to operate alongside other real-time payment systems and will utilize the ISO20022 standard. Initially, it will only cover domestic payments.
What is ISO 20022?
ISO 20022 is a globally recognized payment messaging standard that offers richer and more structured data during the payment process.
Compared to other standards, ISO 20022 allows for about 10 times more data to be sent per payment. This additional data may include information about the payment's purpose, source, and ultimate beneficiary. This enhances the payment system's data structure, creating a common language and model for payment data worldwide.
However, building a new real-time product that meets all these requirements is complex as it involves modernizing legacy systems. The US adoption of ISO 20022 has brought more focus on messaging and data for real-time payments within an international financial framework.
What is the FedNow Launch Date?
This month (March 2023), the Federal Reserve has revealed that the FedNow Service is set to commence its operations in July. In April, the Federal Reserve will welcome those who wish to be early adopters to initiate a customer testing and certification program.
Who Can Use FedNow?
FedNow will be accessible to both individuals and businesses. For the initial launch, the Federal Reserve intends to set a transaction limit of $25,000. As a result of this cap, small businesses and retail payments made by individuals will benefit more from FedNow until the Federal Reserve increases the transaction limit.
Starting from the first week of April, the Federal Reserve will initiate a formal certification process for participating banks who wish to use the service. Early adopters will undertake a customer testing and certification program, which will be guided by feedback received from the FedNow Pilot Program, to prepare for live transactions via the system.
The FedNow Pilot Program involved over 100 participants from different credit unions and depository institutions. In June, the Federal Reserve and certified participants will conduct production validation activities to ensure that they are fully prepared for the July launch.
Once financial institutions participate in the FedNow Service, both businesses and individuals will be able to send and receive instant payments at any time of day, and the recipients will have full access to the funds immediately.
What are the Benefits of FedNow Payments?
The Federal Reserve's initiative to modernize the payment system is expected to bring numerous benefits, including greater efficiency, lower costs, increased competition, and improved customer experience. It is also likely to encourage innovation in the payment industry, leading to the development of new payment services and products.
Softjourn’s Payments Expert, Yuriy Kropelnytsky, said “the use of FedNow in wire transfers between banks as an intermediary can increase fees of transactions.” He continued, “Despite these costs, the use of intermediaries in bank transactions can improve the process of Anti-Money Laundering (AML) and Office of Foreign Assets Control (OFAC) checking.”
For example, FedNow can play a role in ensuring compliance with AML and OFAC regulations by conducting due diligence on the parties involved in transactions and review the transactions for any suspicious activity.
The benefits of instant payments aren't limited to fintech companies and banks. The elimination of chargeback risks that merchants currently face could lead to greater user satisfaction, and instant payments could make banking and payment processing more accessible to underbanked and unbanked communities.
The implementation of real-time payments can allow employees to receive their wages promptly, and merchants to receive payment without the waiting period for funds to settle.
What Does FedNow Mean for Fintechs in 2023?
The FedNow program is currently only accessible to licensed banks, which limits the benefits that non-bank financial institutions can enjoy.
Fintechs, in particular, could benefit greatly from the program, as it would allow them to expedite payments at a lower cost to consumers. From depositing checks to paying bills, instant payments could be a game-changer for fintech giants, like Stripe and Wise, and could lead to greater innovation in the banking industry.
The Financial Technology Association (FTA), which represents a range of fintech companies, has called for "broader entity access" to the program. If Fintechs are eventually granted access, it could open up a world of possibilities for faster and more convenient banking and payment processing.
For example, real-time payments could enable suppliers to be paid instantly, mortgage payments to be processed more quickly, and contract work to be paid out on the day it is completed.
Despite the potential benefits, it remains unclear when non-bank financial institutions will be granted access to the FedNow program. Softjourn’s Payment Expert, Yuriy Kropelnytsky, finds that “tighter governmental control and legislation surrounding nonbank lenders may be necessary to ensure that they can comply with FedNow’s increased consumer protection and fraud prevention”.
In the meantime, we suggest fintech companies continue to work on overlaying their technology onto existing bank systems, which could still provide significant improvements in the speed and convenience of banking and payment processing.
Don't let your fintech business get left behind in this rapidly changing industry. Softjourn has deep experience in helping fintechs digitally transform their business to keep up with the most powerful emerging technologies, such as integrating with existing payment gateways or building their own payment gateways.
Our fintech advisors, with almost two decades of experience, can help you navigate the digital-first approach and overcome any challenges that arise. We will help you understand the benefits and drawbacks of real-time payments, develop a plan to integrate it into your system, and ensure compliance with regulatory requirements.
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How Will Fraud be Tackled with Instant Payments?
Instant payments and fraud are often discussed together, with the assumption that faster payments lead to more fraud. However, according to Jim Colassano, the Senior Vice President of RTP product management at The Clearing House, this is not necessarily the case for credit 'push' transactions, which are inherently safer than direct debit transactions.
While some people worry about the potential irreversibility of instant payments, the transactions are actually processed through secure bank rails, which are among the most secure payment channels in the world.
With real-time payments changing the game, banks must educate customers to think of instant payments like cash payments and act accordingly. To ensure even greater safety, some fintech companies are developing standard APIs to help financial institutions integrate with fraud providers.
Ultimately, banks and networks have an obligation to protect their clients, which includes educating them and providing additional layers of security.
Does FedNow Use Blockchain and Will There be a Federal Reserve Cryptocurrency?
Though FedNow does not use cryptocurrency or distributed ledger technology, it has been advanced as a complement to central bank digital currencies (CBDC). There is no plan for the Federal Reserve to use a FedNow Digital Currency as well.
It is uncertain whether a CBDC or "digital dollar" will ever exist in the US. Whether or not the US government will launch a cryptocurrency, we do know that Fed Now will precede a CBDC or similar projects by months or even years.
How Will FedNow Impact Other Real-Time Payment Products?
You may have seen the recent news about the FedNow Ripple controversy. Ripple offers similar technology to FedNow, except it uses blockchain-based solutions. Ripple has been gaining popularity for offering cheap cross-border payments using XRP - a token used for representing the transfer of value across the Ripple Network. However, Ripple has an ongoing case with the SEC over whether XRP is an unregistered security.
FedNow strives to provide a safer alternative to Ripple and other similar real-time, cross-border payment solutions in the US, for banks to move funds within the US financial system.
Jim Colassano, the Senior Vice President of Real-Time Payments product management at The Clearing House (THC), said the following about the launch of FedNow:
There’s a massive amount of upside in this space, and I welcome the introduction of FedNow. FedNow and TCH have worked to make sure that there are no technical issues for any originator who would want to use both networks.
Colassano believes that over time, FedNow, TCH, and other real-time providers will have healthy competition. “Over time,” he said, “we’re going to be competitive partners and we will learn to differentiate our services such that we can gain competitive advantages… This will be healthy for the industry, and will improve the services that we’re providing to our clients.”
Real-Time Payments Use Case: What FedNow can Learn from PIX
PIX, the national real-time payment (RTP) system developed by Brazil's central bank, has achieved remarkable success in adoption.
Although India is the leader in RTP volume and share of all transactions, PIX has emerged as the fastest-growing national RTP system, processing twice as many real-time transactions per capita as India.
PIX offers free and instant settlement of digital money transfers, resulting in its success as a cheaper and more convenient all-in-one infrastructure compared to existing alternatives, which has generated widespread adoption across different contexts.
The key reasons for its success are its strong proposition and effective implementation decisions, such as requiring financial institutions with 500k+ users to offer PIX within their digital application at launch, allowing fintechs to participate, and standardizing digital payment initiations for merchants.
FedNow may differ from PIX in implementation and accessibility to banks in the Fed System, with voluntary participation and discretionary consumer fees. PIX adoption may have also accelerated due to sponsorship by challenger neobanks, which may not have large profit pools in some disrupted service lines and have therefore been strong advocates of the free service.
Similarly to PIX, FedNow has the potential to enable a new wave of fintech disruption.
Looking Ahead
We predict that instant payments will scale since there will be such high demand for this functionality in the near future. In fact, it is likely that providers will lose customers if they don’t offer that functionality.
Dan Baum, FedNow’s head of payments product, said 90% of businesses have reported that the availability of instant payments will be an important part of their banking decision-making.
This isn’t so surprising when we consider that up to 80% of consumers are actively using faster payment solutions, while another 70% of users say that they consider faster payments as a major factor in whether they are satisfied with their financial services providers.1
Overall, the move towards real-time payments is a positive step for the US payment industry, and one that is likely to have a significant impact on the way transactions are conducted in the country.
Don't miss out on the opportunities that real-time payments offer! By incorporating new services into your business, you can unlock new business models, expand customer relationships, and boost profitability.
Now is the time to start contemplating the integration of FedNow and envisioning the future of real-time payments in the long term. Our experts can provide valuable insights to help you prepare for this exciting shift in the payments landscape. Don’t hesitate to reach out and get started!
