After six years of deliberation, the Federal Reserve announced on Monday that it will develop a new interbank real-time gross settlement (RTGS) system. The Fed expects the system, called FedNow, to be operational in 2023 or 2024. FedNow transactions will be settled in real time through debits and credits to member banks’ balances on account with Federal Reserve Banks. The Fed has said that it expects FedNow to serve as a neutral framework on which the private sector can build innovative, end-to-end services.
Although real-time settlement of large-dollar, wholesale transactions has been available for decades, FedNow aims to bring that functionality to the low-dollar, high-volume retail payments space. In doing so, the Fed will compete principally with a similar service launched in 2017 by The Clearing House (TCH), a consortium of the nation’s largest banks. The Clearing House service, called the RTP Network, currently reaches about 51% of deposit accounts and has a stated goal of 100% by 2020. That goal appears ambitious given TCH’s lack of relationships with small to mid-size institutions. Nonetheless, TCH has a significant head start on FedNow that will only widen during the Fed’s four- to five-year design and implementation timeframe.
FedNow and the RTP Network are attempting to offer a system that allows any deposit accountholder in the United States to send a payment to any other deposit accountholder with near-instantaneous settlement in final funds. Today, most retail payments that are processed outside of bank-owned consortiums like TCH and Zelle only appear instantaneous—the recipient may access the funds immediately, but the actual interbank debits and credits necessary to fund the payment occur sometime later. That is the case with card payments, ACH (including same-day ACH), and person-to person payment services (such as Venmo) in which payment funds are available immediately only within the platform.
In an RTGS system, however, payment and settlement in final funds occur simultaneously. This both eliminates interbank credit risk and increases liquidity demands on the banks, as a payment will fail if funds are not available in real time. To prevent this, the Fed has announced that it also plans to extend the hours of availability for FedWire and the National Settlement Service to allow banks more flexibility to move funds into their settlement accounts as needed.
In operating an RTGS system, the Federal Reserve belatedly joins the central banks of several other countries. The goal is essentially the same the world over—any-time, instantaneous payments between any two accounts. India has achieved this to an impressive degree through a standard, open application programming interface called UPI that allows third parties to build applications that plug into the country’s faster-payment rail. The central bank settles each transaction and runs a proxy server that generates universal virtual payment addresses tied to individual users’ bank account details.
The result is that an Indian accountholder can pay any other accountholder, consumer or business, from any bank account, using nothing more than a UPI-enabled application on their phone and the recipient’s virtual payment address. The system also has a built-in complaint feature, so the accountholder can initiate a dispute directly from the app, as well as two-factor authentication process, one half of which is handled by the central bank. India’s system has been so successful that credit and debit card usage have declined significantly there.
India’s real-time payment network is simple, ubiquitous, and has a proven ability to displace the card networks. As such, it has been seen as the gold standard for large US tech companies and retailers. The Fed’s decision to offer an RTGS payment system is one step in that direction. As a trusted intermediary with preexisting relationships with all US banks, the Federal Reserve can promise equitable access for small institutions, risk-free settlement with central bank money, and national scope.
However, the faster-payments landscape in the United States is developing under circumstances markedly different from those present in India and elsewhere. For one thing, the role of the Federal Reserve is more limited than the roles of central banks in India and most other countries. The Fed does not have authority over the US payments system and cannot mandate banks’ participation in RTGS or exercise enforcement authority over private-sector, real-time payment service providers. Instead, the Federal Reserve is attempting to exert its influence by competing with the private sector and thus ensuring equal access and preventing monopolistic behavior.
Additionally, ubiquity and interoperability will be significantly more elusive in the United States than elsewhere. The US banking sector is larger and more diverse than other countries’, meaning there are more depository institutions, and more types of institutions, to recruit. The difficulty of achieving near-universal adoption is matched only by its importance. Without it, any RTGS system will not be a significant improvement over bank and fintech services already available in the United States. As the Fed pointed out in Monday’s announcement, however, ubiquity can be achieved with multiple systems, even if those systems are not interoperable, as appears highly likely with FedNow and the RTP Network. Banks will simply have to incur the expense and complexity of membership in both systems.
There is precedent for this. Banks currently participate in multiple ACH networks, and they derive some benefit in terms of resiliency in the event one network is disabled. Whether banks will be willing to do the same with RTGS will depend in part on consumer demand, and this may also be more uncertain in the United States. The open, centrally issued API developed in India allows a rich variety of overlays and applications, such as social media components and messaging, that have increased adoption. This may be a harder sell in the United States, particularly with respect to consumer-to-business payments, where payment cards are more entrenched and offer valuable incentives.
Additionally, the Fed announcement was light on some important details, including the potential for a Fed-managed central directory of account identifiers and the data security features of the new system. Both are important components of India’s successful RTGS system.
Despite these obstacles, the Fed’s announcement has been welcomed by US tech companies and retailers hungry for an alternative to the card networks. They can, and undoubtedly will, develop their own loyalty and other incentive programs for customers who pay by RTGS. The question may be whether enough consumers respond by ditching the plastic, and, if not, whether demand for person-to-person payments is sufficient to drive adoption.
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