The Board of Governors of the US Federal Reserve announced in August 2019 that it will develop a new 24x7x365 real time gross settlement (RTGS) system called FedNow. The new system will allow near-instant settlement of transactions in final funds through debits and credits to member bank’s master accounts at Federal Reserve Banks. The Fed has said that it expects the system to be ready within five years, though it has hinted that development might be ahead of schedule.

FedNow will compete head-on with a similar service launched in 2017 by The Clearing House, a consortium of the largest US banks, called the RTP Network.

I. How will FedNow work?

The Fed still has significant decisions to make during FedNow’s multi-year build phase, but many of the most important features have been announced. Here is what we know:

• FedNow will handle only domestic credit transactions (“push payments”), not debit (“pull payment”) authorizations or cross-border payments.
• Only Fed member banks will participate directly, though they may designate a service provider or agent to submit or receive payment instructions on their behalf or settle funds to a correspondent bank.
• Non-bank fintechs will access FedNow indirectly through their financial institutions or an agent or service provider, similar to the current ACH system in the US.
• The initial per-transaction limit will be $25,000 (though participating banks could set a lower ceiling on payments they send).
• The interbank messages FedNow uses will conform to the ISO 20022 standard and will support non-value message types (like invoice details) and “request for payment” messages, in addition to the content needed for clearance.
• The Fed will likely make intraday credit available on a 24x7x365 basis to help participating banks maintain the continuous liquidity required for real-time settlement.
• Fees have not been announced but will likely include per-item charges, to be paid by sending and receiving banks, and a fixed fee for participation.
• Ancillary services the Fed is considering include: (1) either hosting a directory of public account identifiers or providing participating banks with a link to existing directory services to allow end-users to send funds without exchanging account info; and (2) including embedded fraud mitigation and identity authentication features.

II. Where does FedNow fit into the US faster payments landscape?

FedNow is intended to allow any deposit-account holder in the US to send a payment to any other deposit-account holder with real-time settlement in final funds. This is a welcome development. Today, US businesses and consumers have access to several retail payments services that appear instantaneous in that the recipient may access funds immediately. However, existing services typically have one or both of the following limitations.
 
First, they are not ubiquitous because they are “closed-loop”, meaning that both the sender and recipient must be signed up with the same service (and no single service reaches substantially all US accounts).

Second, today’s services often carry some degree of credit risk because funds are made available to the recipient before the actual interbank debits and credits necessary to fund the payment have occurred. This delay occurs because funds are still travelling over existing, slower rails (like ACH). As a result, transfers may be subject to clawback if final settlement and funding do not occur. That is the case with card payments (for which settlement takes one or more days), 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 unless the user pays for expedited transfer). 

The promise of FedNow is its potential to overcome both of these limitations. The Fed has existing relationships with nearly all of the roughly 12,000 US depository institutions, so it can offer nationwide scope. The hope is that, even if FedNow and the RTP Network are not interoperable, RTGS will still reach ubiquity because banks will make both services available to their customers. Unless ubiquity is achieved, RTGS will not be a significant improvement on faster payments solutions available today in the US. As for interbank and credit risk, they do not exist in an RTGS system because payment and settlement in final funds occur simultaneously.

The RTP Network, currently reaches about 51 percent of deposit accounts. Its reach comes not from the number of its participating banks, but from the large market share those banks hold. Historically, The Clearing House has lacked relationships with smaller institutions. This cast some doubt on The Clearing House’s ability to gain national reach on its own and increased support for the Fed’s entry into the market. However, the Clearing House announced in October 2019 that 15 small banks had joined the RTP Network. It is unclear how many smaller institutions will follow their lead in the near term. Many are not likely to be early adopters of RTGS, in part because they are not experiencing the same push from their customers as larger institutions. They may be content to wait for FedNow.

III. What will drive adoption of RTGS?

US tech companies and retailers hungry for an alternative to the card networks have welcomed the Fed’s greenlighting of its RTGS project. However, with respect to point-of-sale payments, it remains to be seen whether enough consumers will respond by ditching plastic cards for the new RTGS systems and new payment methods that ride their rails. Fintechs, or merchants using fintech payment solutions, may try to entice consumers to non-card payment methods powered by FedNow (or other real-time solution like The Clearing House’s RTP Network) by developing rewards programs to compete with the credit card rewards consumers in the United States have come to expect.

Small businesses, and those who send recurring bills, may be key adoption drivers for FedNow because they will benefit from the ability to send payment requests with attached invoices and receive payments in near-instant, final funds. This should mitigate cash flow management issues, which have been a significant drag on small business. Proponents of FedNow also expect consumers and gig workers to push adoption as they come to expect instant availability of paychecks and streamlined billing and payment for consumer-to-business, business-to-consumer, and person-to-person payments. Finally, large retailers have indicated that they expect significant benefits in the form of more efficient returns and refunds. 

IV. What does this mean for fintechs?

The Fed’s decision to deny non-bank financials direct participation in FedNow keeps banks in their traditional role of trusted gatekeepers of the US financial system. This is consistent with the Federal Reserve’s longstanding view that banks are the bedrock on which even the most innovative financial products are built. As Federal Reserve Board Governor Brainard said in a 2017 speech, “more often than not, there is a banking organization somewhere in the fintech stack.” 

Banks’ status as federally regulated entities is a major reason for this. There have been attempts to level the playing field for non-bank fintechs at both the federal level, with the controversial fintech charter advanced by the OCC, and at the state level, with the multi-state money transmitter licensing process under development by the Conference of State Bank Supervisors, and with the recent approval by the US Federal Deposit Insurance Corporation (FDIC) of industrial loan company charters for fintech companies Square Financial and Nelnet. For now, however, access to FedNow is another on the long list of functions and privileges that most fintechs have to obtain by either becoming a bank or partnering with one.

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