The Fed is restructuring the US payments ecosystem with the FedNow service – what FIs need to know

The Federal Reserve’s long-awaited digital payments system, FedNow, will be deployed in phases, with the initial launch planned for July 2023.

FedNow is the first government-created system in the US for financial institutions to send and receive funds in near real-time online, with the primary goals of providing immediate access to funds and offering real-time and accurate views of account balances. FedNow promises to enable smoother operations by ensuring instant payment capabilities without any delays of a few business days, or during holidays or weekends.

In addition to money transfers, the system will allow bill payments and other consumer activities to move more rapidly -- decreasing transfer time from several days to just a few seconds -- and at a lower cost. 

The FedNow service will be a cloud-based solution available online 24/7 and open to depository institutions eligible to hold accounts with the Federal Reserve. Participating financial institutions will complete a training and certification process in early April, according to a Fed announcement. 

How does FedNow work?

FedNow acts as the clearing service for financial institutions’ transactions so they can provide immediate end-to-end payments to their customers. The Fed is working with credit unions and community banks specifically to prepare back-end operations for the new real-time payments rail to support bank readiness for instant payments. 

“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,” said Ken Montgomery, the program executive, and first vice president at the Boston Fed.

One of the ways the Fed is moving towards real-time payments is by leveraging the existing FedLine connection model. This allows electronic access to information services as well as critical payment services for FedNow connectivity. 

An instant payment system like FedNow will offer authorization, posting, or creating a record of the payment, settlement, and notification confirming whether the transaction was successful or failed, all in almost real-time.

More than 120 organizations including Square Financial Services, FIS, Jack Henry, Fiserv, Temenos, and Finastra have joined other banks, credit unions, and payments technology organizations to become a part of FedNow’s pilot program. These participants will support the development, testing, and adoption of the FedNow Service, as well as facilitate the development of services and use cases that leverage FedNow functionality.

Additionally, primary areas of pilot interest and feedback focus on onboarding, operational controls, documentation, and the ISO 20022 message format. ISO 20022 is a global standard for exchanging electronic messages between financial institutions.

What does it mean for the existing payment rails?

The initial iteration of the FedNow Service will provide baseline functionality for a range of use cases, including account-to-account (A2A) transfers and bill pay among B2B payments.

By using the FedNow service, bills from service providers will have an embedded link to make the payment that will automatically redirect to a payor's online banking portal where they can review the details and hit submit.

Small businesses can also leverage the network for faster bill pay capabilities in the same way, enabling them to respond to customer needs faster.

The key question however is -- how will FedNow impact other payment providers and whether the new system can co-exist with the existing payment rails in the space?

While the competition in the payments space has intensified, challenges will be tied to the ability of payment providers to deliver not only FedNow but other rails as well like Fedwire and SWIFT – especially as banks are looking to adopt and deliver multi-rail payment hubs, according to Michelle Bateman, director of product management at Finastra.

Many of the existing payment providers and fintechs are overlay services built on top of the ACH rail. These services give the perception of instant payments to the end customer but expose financial institutions and fintechs to credit risk.

“In the front end, it looks like the money has moved, but it still needs two days to process on the back end. It’s to their benefit to adopt real-time payments to lower their risk,” said Heman Daswani, principal consultant of the business solutions group at Temenos.

When it comes to the existing domestic payment rails, the Fed has an existing payments system in place, Fedwire. The primary difference between this service and FedNow is that FedNow will be online 24/7.

There is also the Real-Time Payments (RTP) network, a private service by The Clearing House launched in 2017 that is used by many larger financial institutions to transfer funds. 

Due to the existing widespread adoption of the RTP network, the initial release of FedNow will operate as an alternative to RTP as the two share similarities in their frameworks. This was a strategic move on the Federal Reserve’s part to mitigate the possibility of the new system failure by offering a model close to the system in play.

RTP is operated by a conglomerate of big banks, and FedNow is operated by the Federal Reserve Bank. When it comes to transaction amounts, the initial FedNow system will include a significantly lower transaction limit to support more financial institutions, including smaller community banks, capping transactions at $500,000 as opposed to RTP’s $1 million. Additionally, FedNow-participating banks can utilize their master account with the Federal Reserve, preventing separate funding requirements. 

Participating banks and credit unions that already use the RTP network can opt to use the FedNow system as well – introducing healthy competition into the space.

“I think two real-time payment systems can co-exist. From the perspective of a financial institution, participating in both payment systems enables their customers to send and receive transactions with banks participating in each of those payment systems,” added Bateman.