December 05, 2019

Hot Topic: The Fed’s Proposed Entry into Real-Time Payments Through the FedNow Service

Judy Mok

By now, most of us in the payments world are likely aware of the Federal Reserve Board’s (the “Fed’s”) proposed foray into real-time payments (“RTPs”). On August 5, 2019, the Fed announced that the Federal Reserve Banks would develop a new round-the-clock real-time payment and settlement service, called the FedNowSM Service (“FedNow”), to support faster payments in the United States. On August 15, 2019, the Fed announced the appointment of Kenneth Montgomery, vice president and chief operating officer of the Federal Reserve Bank of Boston, to lead FedNow’s development.

What Is FedNow?

FedNow is a real-time payment and settlement service that will incorporate clearing functionality into the process of settling each payment. This will allow financial institutions to exchange the information needed to make debits and credits to customer accounts and notify customers of completed or failed payments. FedNow will provide access through the Fed’s FedLine® network, which currently provides Federal Reserve Bank payment and information services to more than 10,000 financial institutions, both directly and through their agents.

FedNow is expected to launch in 2023 or 2024, and it will exist independently of the existing RTP network that was established by The Clearing House in 2017. There has been industry criticism that this timeframe is too long and that FedNow should instead be called “Fed Five Years From Now.”

Why Is this Announcement Significant?

FedNow will be the first new payment rail in the United States since the introduction of the Automated Clearing House (“ACH”) in the early 1970s. As we all know, the payments industry looks very different today than it did 50 years ago. Today, RTPs compete in a complex ecosystem with a host of new players and initiatives, such as Same Day ACH and Zelle, as well as other services from banks, non-banks, fintechs, and technology giants, such as Apple and Amazon.

There have been many industry discussions around what the Fed’s entry into RTPs would mean for all participants in the payments ecosystem, including the impact on the existing private sector RTP network that was established by The Clearing House—a payments consortium of 25 of the world’s largest banks and various technology companies.

What is an RTP?

Many consumers and small businesses may think they are already making real-time payments when they use their credit cards or debit cards for in-store or online purchases. Digital wallets and mobile peer-to-peer (“P2P”) payment services such as Zelle and Venmo may also seem like real-time transfers. However, these are not RTPs. Credit card transactions are structured loan products, and they are settled by the payers each month. Debit payments are linked directly to the payer’s bank account but are also not settled in real time. In fact, even the standard services offered by payment service providers such as PayPal and Venmo are not real-time payments because the only immediate transfer is between funds held in those wallets. If you try to move the cash from your Venmo account back to your bank or to a different P2P wallet, you’re back to using multiday ACH.

A true RTP is one where money moves almost instantaneously from one bank account to another, 24 hours a day, 7 days a week, and 365 days a year. These transactions are designed to allow recipients to receive payment within seconds of the sending bank initiating the transaction. The receiving bank is required to make funds available immediately, except where necessary for risk management or legal compliance purposes. There has to be payment certainty in that the sending bank will not be able to revoke or recall a payment once it has been authorized and submitted to the network. However, with the existing RTP network, there is a process to facilitate bank-to-bank communication around the return of funds when the funds are sent in error.

These transactions are ubiquitous—all federally insured depository institutions can be RTP participants today, regardless of their size. RTPs are convenient for customers, as customers are able to initiate payments from their existing accounts. RTPs also offer cash flow control for customers because they have the ability to send and receive immediate payments, which may be particularly important for cash-constrained small businesses and consumers.

RTP Today

On November 13, 2017, RTP became a reality in the United States when The Clearing House launched the RTP network. So far, many smaller banks and credit unions have chosen not to participate in the RTP network, holding out hope that the Fed would build a competing service—a hope that has now materialized.

Although RTP is relatively new in the United States, it already exists in more than 20 countries worldwide, including the UK, Thailand, and Singapore. In the United States, the RTP network currently reaches more than 50 percent of U.S. demand deposit accounts, but that is largely because the country’s biggest banks have such a significant market share. Like FedNow, the RTP network is open to all federally insured U.S. depository institutions. The RTP network is designed to address customer needs across all customer segments, including consumers, businesses, and the government. There is a credit transfer limit of $25,000 with the RTP network.

RTP Network vs. FedNow

FedNow shares many similarities with the existing RTP network, in part because both solutions were designed to reflect the recommendations of the Federal Reserve’s Faster Payments Task Force. For example, things such as permitted participants, transaction limits, operating hours, transfer types, and finality of transfers are very similar between the two networks.

There will be some differences as well, and as of right now, it appears that FedNow participants will be permitted to use their master accounts, with the funds in those accounts earning interest and counting toward reserve requirements. RTP network participants, on the other hand, prefund amounts into a joint account that does not earn interest or count toward reserve requirements. The pre-funding required of RTP network participants may also have the effect of removing liquidity from their master accounts.

What Is the Impact of the FedNow Announcement on RTPs?

The answer may depend on who you are. From the large banks’ perspective, they have just invested more than $1 billion into The Clearing House’s RTP network, and they could view the Fed’s entry as an impediment to innovation. Smaller banks that may have considered joining the RTP network may now take a wait-and-see approach and make a determination after the Fed rolls out FedNow in four to five years.

There is also the question of whether FedNow would be interoperable with other RTP systems and how a lack of interoperability could affect the payments market and operating costs of competing networks that do not work together. Although the Fed has stated that interoperability is desirable, it has also admitted that interoperability would be difficult to achieve, especially early on.

From the consumer’s standpoint, consumers expect to send and receive payments instantly, and they want an easy, fast, and reliable system that works 100 percent of the time.

As for merchants, they care about their customers’ experiences and want to make sure their customers can make payments at any time. Merchants are generally in favor of FedNow, in part because they see that the best defense to inevitable system failures is to provide redundant and diversified paths to consumer accounts so that payment can be completed. Merchants and their customers depend on payments processing regardless of the circumstances. They believe that system redundancy will ensure that payments will continue to process despite unplanned outages or disastrous events.

The Fed is one of the few institutions that has the ability to reach every depository account in the country, and some argue that this makes its involvement as an RTP operator necessary. The question now is how the market can balance the agenda and incentives for private sector organizations, such as The Clearing House, with the goals of the Fed and FedNow. In order for RTPs to succeed in the United States, The Clearing House and the Fed need to find a way to work together to ensure that their systems are interoperable.

 

Judy Mok

Judy Mok is Of Counsel at Ballard Spahr LLP in the New York office. Judy has extensive experience negotiating complex payments transactions for some of the world's largest retailers and financial institutions. Judy is currently Chair of the Membership Subcommittee of the Consumer Financial Services Committee in the American Bar Association Business Law Section.