The Federal Reserve announces July launch for the FedNow Service. What is FedNow?

March 16, 2023 - The Federal Reserve has announced that its groundbreaking 'FedNow' Service will start operating in July and has provided details on preparations for launch.

From the official press release yesterday, the Fed announced,  "In the first week of April, the Federal Reserve will begin the formal certification of participants for launch of the service. Early adopters will complete a customer testing and certification program, informed by feedback from the FedNow Pilot Program, to prepare for sending live transactions through the system.

Certification encompasses a comprehensive testing curriculum with defined expectations for operational readiness and network experience. In June, the Federal Reserve and certified participants will conduct production validation activities to confirm readiness for the July launch.

"We couldn't be more excited about the forthcoming FedNow launch, which will enable every participating financial institution, the smallest to the largest and from all corners of the country, to offer a modern instant payment solution," said Ken Montgomery, first vice president of the Federal Reserve Bank of Boston and FedNow program executive. "With the launch drawing near, we urge financial institutions and their industry partners to move full steam ahead with preparations to join the FedNow Service."

Many early adopters have declared their intent to begin using the service in July, including a diverse mix of financial institutions of all sizes, the largest processors, and the U.S. Treasury.

In addition to preparing early adopters for the July launch, the Federal Reserve continues to engage a range of financial institutions and service providers to complete the testing and certification program and implement the service throughout 2023 and beyond. Montgomery noted that availability of the service is just the beginning, and growing the network of participating financial institutions will be key to increasing the availability of instant payments for consumers and businesses across the country.

The FedNow Service will launch with a robust set of core clearing and settlement functionality and value-added features. More features and enhancements will be added in future releases to continue supporting safety, resiliency and innovation in the industry as the FedNow network expands in the coming years.

"With the FedNow Service, the Federal Reserve is creating a leading-edge payments system that is resilient, adaptive, and accessible," said Tom Barkin, president of the Federal Reserve Bank of Richmond and FedNow Program executive sponsor. "The launch reflects an important milestone in the journey to help financial institutions serve customer needs for instant payments to better support nearly every aspect of our economy."

What is FedNow?

You could be forgiven for thinking that FedNow is a new innovation from PayPal, based on the similarity, (in colour at least) of their logos:

Fintech apps like PayPal, CashApp, and Venmo, already transfer money from one party to another instantly. The current Fed system has been too slow compared to these fintechs and has been working to speed up the time it takes to process money through the banking system. The Fed is playing catch-up.

The big difference between the payment fintechs and the what the Fed is aiming at is that currently the fintech apps can instantly transfer between apps, but not into a user's bank account. 

The FedNow service, which was announced in 2019, offers instantaneous payments to individuals and businesses bank accounts. It is a real-time gross settlement (RTGS) system, developed by the Federal Reserve, designed to facilitate instant and continuous payment services, enabling banks and other financial institutions to offer round-the-clock fund transfers to customers. The platform supports real-time, interbank settlement of individual payments, providing a more efficient and secure alternative to existing methods.

How Does FedNow Work?

FedNow will operate on a 24x7x365 basis, allowing financial institutions to process and settle transactions at any time. When a user initiates a transaction, the sending bank submits a payment message to FedNow. The system then verifies the details of the transaction, including the recipient's account information, and immediately settles the funds between the sender's and recipient's banks. Once settlement is complete, the recipient's bank sends a notification to the recipient, confirming the deposit of funds.

Payment Flow

The figure below illustrates a completed payment over the FedNow Service in its simplest form.
(Source: https://www.frbservices.org/financial-services/fednow/about.html)

1. In step 1, a sender (i.e., an individual or business) initiates a payment by sending a payment message to its financial institution through an end-user interface outside the FedNow Service. The sender’s financial institution is responsible for screening the payment according to its internal processes and requirements.
2. In step 2, the sender’s financial institution submits a payment message to the FedNow Service.
3. In step 3, the FedNow Service validates the payment message, for example, by verifying that the message meets message format specifications.
4. In step 4, the FedNow Service sends the contents of the payment message to the receiver’s financial institution to seek confirmation that the receiver’s financial institution intends to accept the payment message. At this point, the receiver’s financial institution will have the opportunity to confirm or deny that it maintains the specified account.
5. In step 5, the receiver’s financial institution sends a positive response to the FedNow Service, confirming that it intends to accept the payment message. Steps 4 and 5 are intended to reduce the number of misdirected payments and resulting exception cases that can occur in high-volume systems.
6. In step 6, the FedNow Service debits and credits the designated master accounts of the sender’s and receiver’s financial institutions (or their correspondent financial institutions), respectively.
7. In step 7, the FedNow Service sends a payment message forward to the receiver’s financial institution with an advice of credit and in parallel sends an acknowledgement to the sender’s financial institution, notifying it that settlement is complete.
8. In step 8, the receiver’s financial institution credits the receiver’s account. As a term of the FedNow Service, the Federal Reserve Banks anticipate requiring the receiver’s financial institution to make funds available to the receiver almost immediately after step 7. This crediting to the receiver’s account as well as the debiting of the sender’s account by their respective financial institutions happens outside the FedNow Service.

The Potential Impact on the Financial Industry

The introduction of the FedNow Service could have a significant impact on the financial industry, some of which could be:

Increased Competition: FedNow has the potential to introduce a new level of competition in the real-time payments market, which was previously dominated by private-sector players like The Clearing House (TCH). This competition should lead to improved services and lower costs for both consumers and businesses.

Enhanced Customer Experience: FedNow has been designed to revolutionise the way individuals and businesses make payments, enabling them to transfer funds instantly, securely, and conveniently. This enhanced customer experience should raise the bar for payment services across the board.

Opportunities for Innovation: FedNow's real-time settlement capabilities should open the door for financial institutions to develop new products and services that leverage the benefits of instant payments and could include new lending products, cash management services, and fraud prevention tools.

Financial Inclusion: The FedNow Service may promote financial inclusion by providing affordable and accessible payment options to unbanked and underbanked populations. By offering low-cost, real-time payment services, financial institutions could reach a broader customer base, including those who may have been excluded from traditional banking services.
 

As the service matures and evolves, it is also crucial to consider the potential challenges that may arise. Key areas of focus will be maintaining the platform's security and resilience, ensuring the interoperability of various payment systems, and addressing potential privacy concerns. In addition, regulators and policymakers will need to ensure a fair and competitive landscape while safeguarding the interests of consumers and businesses.

Why doesn't FedNow use blockchain or distributed ledger technology (DLT)?

Despite some early rumours amongst crypto-enthusiasts, especially in the Ripple (XRP) community, FedNow is not based on any blockchain or distributed ledger technology. There are several reasons for this:

1. Scalability: One of the critical challenges faced by blockchain technology is its limited scalability. Blockchain-based systems, like Bitcoin or Ethereum, or distributed ledger technology like Ripple, can only process a limited number of transactions per second. The FedNow Service, on the other hand, is designed to handle high transaction volumes, which requires a faster and more scalable system. Implementing blockchain technology might have resulted in slower transaction times and reduced efficiency.
2. Maturity of technology: Blockchain technology, although it has made significant progress over the past few years, is still relatively new and untested on a large scale. The Federal Reserve needed a robust and reliable solution to build a real-time gross settlement (RTGS) system that could handle the entire country's payment needs. At this stage, blockchain does not yet have the maturity and proven track record required for such a critical financial infrastructure.
3. Centralisation vs. Decentralisation: Blockchain technology is built around the concept of decentralisation, meaning that no single entity has control over the system. However, the Federal Reserve, as a central bank, is responsible for maintaining the stability and integrity of the U.S. financial system. Therefore, it needs a certain level of control and oversight over the FedNow Service, which may not align with the decentralised nature of blockchain technology.
4. Privacy and Security: While blockchain can offer a high level of security through cryptography, it may not provide the desired privacy for users. Most blockchain networks are designed to be transparent, with transaction details being publicly available on a distributed ledger. In contrast, the FedNow Service needs to ensure the privacy and confidentiality of user transactions, which may not be easily achievable with blockchain technology.
5. Interoperability: The FedNow Settlement Service is designed to work seamlessly with existing payment systems and financial institutions. Integrating a blockchain-based system might have presented significant challenges in terms of interoperability with other systems and could have complicated the adoption process for banks and financial institutions.
   
   This is not to say that blockchain and DLT systems will not work with FedNow in future. Banks and fintech companies could build applications or services that use blockchain for specific use cases, such as cross-border payments, supply chain financing, or digital identity management, while still utilising the instant settlement capabilities of FedNow.

As crypto services mature and become more widely adopted, it is possible that the Fed may consider exploring partnerships or integrations with blockchain/DLT-based services. However, this would depend on such things as regulatory and compliance requirements, technology maturity, and the potential benefits that such integrations would bring to the overall financial system. These collaborations could be established by developing APIs or integration layers that allow blockchain-based systems to interact with the FedNow Service, enabling a hybrid approach that combines the strengths of both centralised and decentralised systems, the best of both worlds.

FedNow have published the charges for using the system (https://www.frbservices.org/resources/fees/fedcomplete-2023) but is not a given that it will be able to compete with entrenched services with critical mass such as Visa.

Recommened reading: https://www.paymentsdive.com/news/Visa-CFO-Fednow-realtime-payments-competition-credit-legislation/631047/