What bankers need to know about FedNow

By John Adams, Kyle Campbell, Kate Fitzgerald

July 20, 2023 10:54 AM

The launch of FedNow, the Federal Reserve's instant-settlement system, raises many questions for banks, card networks and fintechs.

FedNow joins The Clearing House's RTP Network in supporting instant settlement in the U.S. In an email, David Watson, president and CEO of The Clearing House, said "The Clearing House which operates the RTP network, the instant payments system in the United States, welcomes FedNow to the real-time payments space. The launch draws more attention to how consumers and businesses are looking to send and receive money instantly between their accounts, which the RTP network has been enabling for millions of bank and credit union customers since 2017."

Any bank that's considering joining this new payment rail will have to consider the costs of processing and of any technology investment needed to properly route transactions to — or from — this new platform.

The use cases for banks include bringing more bill payments in house, speeding account funding and reducing back office complexity, according to Joshua Siegel, a partner at Capco. "It's really now a matter of banks prioritizing which uses should come first," Siegel said in an interview on Thursday.

Other important factors include interoperability with The Clearing House's existing RTP rail, the impact on an issuer's credit and debit card accounts, and even customer confusion over whether FedNow is a form of digital dollar.

Federal Reserve

FedNow, the Fed's instant payments system, is live

July 20, 2023 10:19 AM

"We are already talking with clients, As soon as FedNow launches, we're ready," said Jennifer Barker, global head of treasury services for BNY Mellon..

Here are the key issues American Banker analyzed in the lead-up to FedNow's launch.

Gabby Jones/Bloomberg

Who's on first?

There are 57 organizations on the Fed's early adopter list — and the roster includes several large banks and technology vendors that service thousands of institutions, creating an addressable market of millions of consumers and the potential for much broader adoption in the future.

The banks include JPMorgan Chase, BNY Mellon, Wells Fargo and U.S. Bancorp, and dozens of community and regional banks and credit unions. Service providers include FIS and Fiserv, which have thousands of financial institution clients. Adyen, a large Dutch payment processor that is aggressively expanding in the U.S, is on the early adopter list, as is Jack Henry, which sells transaction processing technology to thousands of financial institutions, primarily smaller ones.

Read more: FedNow's first participants include large banks, influential tech vendors

The Marriner S. Eccles Federal Reserve building in Washington on Feb. 19, 2021.

Samuel Corum/Bloomberg

What does it cost?

Last November, the Federal Reserve set the prices that banks pay for its new instant payment system.

For 2023, the 12 regional Federal Reserve banks will waive the monthly participation fee for banks. In 2024, banks will pay $25 per month per routing transit number to use the FedNow service.

Similarly, the reserve banks will waive the cost of up to 2,500 FedNow credit transfers per month this year and charge 4.5 cents per item after that. The reserve banks will also introduce a 1 cent per item request for payment fee and a $1 per transfer liquidity management fee.

The fee schedule determines how much the Fed must charge to recover the costs of the services it provides, along with other costs that it would have had to cover if it were a private service provider. This additional sum, also known as a private sector adjustment factor, or PSAF, was established by the Monetary Control Act of 1980 to prevent the Fed from undercutting the private sector.

Read more: Fed sets prices that banks will pay for FedNow

Przemek Klos - Adobe Stock

How it all works

The Fed's real-time payments system follows eight steps, according to FedNow's design. In the first step, a sender initiates the transaction by sending a payment message to their financial institution through an interface outside of the FedNow service. The sender's financial institution is responsible for screening the payment. In the second step, the sender's financial institution submits a payment message to the FedNow service.

Third, the FedNow service verifies the message-meets-message format specifications. Fourth, the FedNow service sends the contents of the payment message to the recipient's financial institution to confirm that the financial institution intends to accept the payment message. Fifth, the recipient's financial institution sends a positive response to the FedNow service, confirming that it intends to accept the payment message.

The fourth and fifth steps are designed to mitigate misdirected payments.

In the sixth step, the FedNow service debits and credits the designated master accounts of the sender's and recipient's financial institutions, or their correspondent financial institutions. Seventh, the FedNow service sends a payment message to the recipient's financial institution with an advice of credit and sends an acknowledgement to the sender's financial institution, notifying it that settlement is complete.

In the eighth and final step, the recipient's financial institution credits the recipient's account. As a term of the FedNow service, the Federal Reserve Banks expect the recipient's financial institution to make funds available to the receiver almost immediately after the seventh step. This credit to the recipient's account, and the debiting of the sender's account, happens outside the FedNow service.

Read more: How do real-time payments work?

Fast follower

FedNow's launch follows that of another real-time settlement system, The Clearing House's RTP rail, by over five years.

Ahead of FedNow's launch, TCH is focused on interoperability rather than competition. "We want to make sure they don't run into the same problems," said Rusiru Gunasena, head of the RTP network.

RTP has shared specifications with FedNow to ensure alignment between the two networks, and has engaged with FedNow on technical issues, according to Gunasena. Many banks and credit unions may be biding their time to see how the competition shapes up before adopting real-time payments, but consumers are already on board, Gunasena said.

"Banks that are in a wait-and-see mode with instant settlement will be surprised about how much consumers already know about real-time payments. They run the risk of these consumers going down the road to another provider," such as a standalone P2P app, Gunasena said.

Read more: The Clearing House prepares to share the stage with FedNow

Not a digital dollar

Federal Reserve Gov. Christopher Waller set the record straight about the central bank's instant payment system, during an April appearance at the University of Southern Florida's Sarasota campus.

Waller addressed some of the misconceptions about FedNow, which had been conflated with a central bank digital currency, or CBDC, by politicians and conspiracy theorists in recent weeks.

"It's just like ACH, Fedwire — these payment systems that we already have in place, both in the private sector and at the Fed," Waller said. "So, there's nothing nefarious about FedNow, it's just a payment rail that will clear things much faster."

The system will allow for money to move 24 hours a day, seven days a week and much quicker than the current most popular settlement system, the automated clearing house. Waller said transactions will be processed in as little as two seconds, instead of between one and three days for ACH.

Yet, while this marks a significant step up in the Fed's capabilities, Waller said, it does not require the development or issuance of a digital dollar, as some have asserted. He noted that The Clearing House's privately operated Real-Time Payments, or RTP, system, provides the same speed of service without a CBDC.

"These are just payment systems," he said. "They're just affecting the speed at which payment requests get made and settled and cleared."

Read more: Fed's Waller: 'Nothing nefarious about FedNow'

A concern for credit cards?

Though it won't happen overnight, the Federal Reserve's FedNow instant-payments rail is likely to displace certain types of credit and debit card transactions, according to a cross-section of payments industry experts.

Any shift away from card payments will be very gradual, because FedNow's rollout is taking place in stages for most providers. The first wave of bank users has just 57 participants.

One factor that could accelerate adoption of FedNow — and its potential to displace existing payment methods — is economic volatility, according to analysts.

"A tool that can immediately move funds from one organization or individual to another in real time, at a very low cost, should inevitably impact card usage going forward. It won't replace cards or other payment alternatives, but it will surely have an impact," said Thad Peterson, a strategic advisor with Datos Insights.

Instant-payment rails have already absorbed many new payment flows, with millions of businesses recently adopting The Clearing House's six-year-old RTP rail for bill payments and disbursements. Two of the fastest-growing payment categories for Early Warning Services' peer-to-peer payments network Zelle in 2022 were rent and disbursements.

FedNow's use cases and transaction modes are still evolving, Peterson said. But the economic forces driving lower-cost, faster payment cycles are destined to be a tailwind for these various faster-payment rails.

Read more: Should card issuers fear FedNow's impact on revenue?

Will it make bank runs worse?

Some worry the 24/7/365 nature of FedNow, which promises cleared transactions in 20 seconds or less, could supercharge future bank runs.

"You're working on a real-time payment system that's ripe for a problem like this with Twitter," Rep. Blaine Luetkemeyer, R-Missouri, told Fed Vice Chair for Supervision Michael Barr during a March 29 House Financial Services Committee hearing on the March 2023 bank crisis. Barr, the central bank's chief regulator, did not comment on FedNow, but said the nexus between banking, social media and technology is a "critical" topic of exploration. Other regulators have also noted the need for regulation to keep pace with technology.

"I don't think there's a way to put the genie back in the bottle," Consumer Financial Protection Bureau Director Rohit Chopra said during an April 11 webcast. "When it comes to 24/7, fast communication, it's a reality we must accept and incorporate accordingly."

Many of the specific requirements and best practices around FedNow will need to be worked out over time. The Fed expects adoption of the system to be gradual and it has signaled that it will adapt its policies and provisions around it over time.

Read more: Bank runs, fraud and faster payments: FedNow's impact on regulation

Not all payments will need the fast lane

It's widely expected that most transactions will not need to occur in real time. This creates an opportunity for technology to help determine when a specific payment needs to use the express lane — and pay the toll that comes along with it.

"Some businesses have higher margins and can use a higher-cost payment method. Some have lower margins and don't always need real-time payments," said Dave Glaser, president and COO of the payments company Dwolla.

The solution could be payments orchestration, or smart routing, which refers to a process of selecting how to route a transaction based on a mix of processing time, cost and user experience. Real-time payments adds another option, joining checks, wire transfers, P2P and B2B apps, cards and mobile wallets. Payment companies and banks are considering how to update their ability to choose the right processing option to attain the best outcome.

Real-time payments need technology that's more advanced than batch processing and banks may wish to right-size what parts of their payment business they update for real-time payments.

And the limits on real-time payments disqualify larger transactions, particularly for B2B payments. That will likely lead financial institutions to use real-time processing for specific-use cases, and set fees for real-time payments as a premium service.

Read more: How fintechs will decide which payments to route in real time