PDD#13: FedNow explained

Preface

The payment landscape is evolving at a rapid pace, with more and more options being presented to customers. Among these advancements stands the Federal Reserve's ambitious initiative, the FedNow Service, poised to revolutionize real-time payments in the United States. But will it?

In this article take a look at how payments flow over FedNow rails, see how it gets compared with ACH rails and why it might take some convincing before financial institutions adopt it on a scale.

Disclaimer: The information provided in this article is for general informational purposes only and should not be considered as professional advice. The content is based on my knowledge and research, and I have endeavored to ensure its accuracy. However, please note that information can change over time, and I cannot guarantee the accuracy, completeness, or relevance of the content at all times. The views expressed in this article are solely my own and do not necessarily reflect the views of any organizations I am affiliated with.

The FedNow Service is a new instant payment system developed by the US Federal Reserve that allows eligible depository institutions across the U.S. to provide instant payment services 24/7, including holidays

Forces that created FedNow

All good product builders and manager focus first on the WHY, before moving on to the HOW. That sets the context of the product. Even Marvel starts the superhero arc with his/her origin story! So let us understand what were the forces and needs that led to the FedNow being planned by Federal Reserve.

In 2010s, US Federal Reserve had come to the conclusion that U.S. payment system was undergoing a remarkable period of change, driven by rapid adoption of technology and evolving end-user expectations. They noted that the payment system was becoming more complex, comprised of incumbents (such as banks and processors), new entrants (such as nonbank innovators) and end users (individuals, corporations, and governments) - that were increasingly benefiting from innovations focused on their payment needs.

Fed saw it was their role as a central coordinating body to take steps to facilitate cooperation in addressing network and coordination challenges that would otherwise impede innovation, efficiency, and other public benefits. This led the to publish a Public Consultation paper on Payment System Improvement.

After these initial discussions, Fed followed by publishing "Strategies for Improving the U.S. Payment System" in 2015 which led to Fed discussing and taking inputs from hundreds of organizations and individuals. A faster payments task force was established in next few weeks itself which presented its Call to Action report in July 2017. The vision was set to have "a payment system in the United States that is faster, ubiquitous, broadly inclusive, safe, highly secure, and efficient by 2020."

The first steps from the discussions were then laid out in next publication "Strategies for Improving the U.S. Payment System - Federal Reserve Next Steps in the Payments Improvement Journey" that was published in Sep 2017. The core of the strategy was that Federal Reserve will focus on revamping the payment system and enhancing existing services with intended outcomes to achieve following 5 outcomes: Speed, Security, Efficiency, International (cross border payments) and Collaboration (with stakeholders).

In 2020, Lael Brainard announced the upcoming FedNow service that would provide "a neutral platform on which the private sector can build to offer safe, efficient instant payment services to users across the country". The webcast can be heard here.

The FedNow service went live in 2023, being the first common use real-time gross settlement (RTGS) system provided by the Federal Reserve that provides the instantaneous payment capabilities around the clock, every day of the year (FedWire that was launched in 1970 was the first system that had attributes of RTGS, but the Clearing House's RTP network, launched in 2017, was the first private-sector true RTGS payments system in the U.S. as we know them today).

Note: For the readers who earlier caught up on PDD#08: Unified Payments Interface (UPI) demystified, this above flow might seem to be rhyming with India's approach and journey, when they started working on Real Time Gross Settlement (RTGS) systems in 2008. See similar visual of India's journey on UPI that was covered in that article:

This rhyming is not a coincidence. Japan was the first to build RTGS with launch of 24X7 Zengin System in 1973 (yes that early!!) and South Korea's EBS that was launched in 2001 is considered as true first fast payment system in the world. By mid 2000s all major economies had realized that real time settlement is the need of financial services' future, and that the federal/central banks would either need to lead its framework or else the private sector would eventually build a system on its own, which could lead to a system that had a higher risk, low inclusion and fragmented. Hence many federal/central banks started working on these RTGS implementation proposals during that time. Below visual from Bank of International Settlements (BIS) during shows the spread of fast payment systems across the world.

Payment Flow in FedNow

Lets look at how the payment transaction flows through the FedNow system:

• Authorization: Before initiating any FedNow payment, an individual or entity must obtain authorization from the recipient to debit or credit their bank account. This consent is often obtained through signed agreements, online authorizations, or similar methods.
• Initiation: The sender (an individual or business) initiates a payment with using interface provided by their financial institution (Sender FI). The initiated request includes details such as the recipient's bank account information, the amount to be transferred, and the purpose of the payment. This step happens outside of the FedNow Service.
• Transmission phase 1: The Sender FI submits the payment message (in ISO 20022 format) to the FedNow Service which then validates the payment message — for example, by verifying that the message meets proper format specifications and complies with applicable controls.
• Transmission phase 2: The FedNow Service sends the contents of the payment message to the recipient’s FI to seek confirmation that the Receiver FI intends to accept the payment message. At this point, the Receiver FI will determine whether it maintains an account for the recipient and also how it will handle the message (accept, reject or accept without posting). For our flow, lets say Receiver FI sends a positive response of “accept” to the FedNow Service.
• Settlement and Clearing: The FedNow Service settles the payment, debiting and crediting the designated master accounts of the Sender FI and Receiver FI. The timeout is 20 seconds as of Jan 2024. The FedNow Service clears the sends an advice to the Receiver FI and an acknowledgement to the Sender FI, which marks execution of the payment order and settlement. As a term of participation in the FedNow Service, the Federal Reserve Banks require the Receiver FI to make funds available to the recipient immediately after settlement is communicated by FedNow.

The FedNow Service limits processing of messages to within 20 seconds and settles in this set amount of time or not at all. While most payment messages to settle within a few seconds, the payment timeout clock sets expectations for FIs that transactions submitted to the service are settled or rejected immediately.

Recap:

The flow within the FedNow Service ensures a swift and secure transaction from initiation to settlement. The FIs may settle using their own Federal Reserve Bank master account or may designate a correspondent for that purpose. Sender FI receives acknowledgement from the FedNow Service to notify its sending customer that the payment to the Receiver FI is complete.

This instant funds transfer and settlement is in contrast with ACH flow, where the payment messages were first stacked together by the FIs and then passed via a batch file. See the below flow that was explained in PDD#02: A Comprehensive Guide to the ACH Payment Rail edition:

Other Good Resources On FedNow

Here are some other good resources which you can refer to learn more about FedNow:

• FedNow's infographic on the use cases
• FedNow's comprehensive official guide that shares how the FedNow Service works, and ideas for gaining value from the service
• FedNow explained by Hua Li - She explained the difference between ACH (Automated Clearing House) and FedNow instant payment flow by taking a detailed example. (She is also a great knowledge resource to follow in general)

The Impact of FedNow

FedNow comes with government backing and hence the thousands of banks who are anyway currently using the Fed’s current, slower payments system may see FedNow as a safer RTGS/ fast pay option. As Forbes noted, Fed has already made clear that FedNow is not intended to kill or replace other money transfer options like Venmo, Cash App, PayPal or Zelle. Rather, it is meant to work alongside the current systems built by the private sector.

The FedNow transactions are final and irrevocable by the design. That brings up the flip side of these instant money movement capabilities that the scams and fraud can quickly go up affecting the especially the vulnerable population (as seen in UK). FedNow is looking to combat this threat by imposing Network-level transaction limits, Participant-level transaction limit and Participant-defined negative lists in addition to allowing participants to limit their access. For example, financial institutions may choose to support customer credit transfers, but elect not to support liquidity management transfers.

Conclusion

As the financial ecosystem adapts to a real-time, interconnected future, where payments happen across human and system entities, the FedNow Service can be key player in defining US payment infrastructure. But it would first need to convince users that the benefits of using this service outweigh the efforts and cost needed to move into it.

It remains an exciting time for the world of payments, and from the looks of it, the landscape is only going to spread wider and also deeper into the customer flows (aka embedded and rule based payments).

That is a wrap up for now. Your comments, opinions, and corrections are all much welcomed. If you enjoyed this article and think others will too, give this article a like below and share it. Thanks!