Technology companies in the payments space should pay close attention to the Federal Reserve’s (the Fed’s) upcoming launch of a long-awaited new payment system, the FedNow Service. The system will change the consumer payments landscape by providing a new instant payment alternative to existing retail payment rails.
It is rare for the U.S. central bank to build a wholly new payment rail, and importantly, the federal government has also announced its backing for instant payment systems. The FedNow Service promises to both pose challenges to fintech companies whose business models depend on activity over existing payments rails and offer key new opportunities to innovators in the space. These new drivers and risks will be important considerations for many players in the market and critical to their success.
The Fed’s Instant Payments Platform
An instant payment is a new type of payment from one bank account to another, where the recipient receives final funds in near real time, enabled by immediate interbank settlement of the payment. This means there is no buildup in interbank obligations, and end users can instantly send and receive money. This is an improvement to payments via credit or debit cards and automated clearinghouse (ACH), which come with higher costs or delays to receiving final funds.
FedNow, expected to launch between May and July of this year, will be the central bank’s new core instant payment infrastructure. It will process retail payments in real time, twenty-four hours a day, 365 days a year, with funds made available immediately for use by the payment recipient. Eligibility to participate in the new system will generally be limited to U.S. banks; these banks, in turn, would offer instant payment services to individuals and businesses. The new system is a much-needed upgrade to the national infrastructure for retail payments, which is currently closed on weekends and can at times take several days before funds are available. The Fed’s ultimate aim is to give consumers and merchants faster access to their funds and greater flexibility to manage cash flow, at low cost and with reduced payment risk.
A key milestone was the Fed’s October 2022 publication of the legal terms and conditions governing FedNow transfers, which contain granular legal details about the service. These terms reveal important shifts to the status quo and critical ways the FedNow Service will impact the competitive outlook for retail payments, especially for fintech companies.
Challenges and Opportunities for Technology Companies
The Fed’s launch of FedNow this year is significant because it will enable banks of any size to offer convenient instant payments with nationwide reach. This will alter the retail payments landscape in three critical ways:
FedNow will challenge some major players in the payments industry: Instant payment systems like FedNow may ultimately prompt companies that depend on revenue from activity over existing payment rails, such as fintechs and partner banks that rely on credit or debit card interchange fees, to rethink their business models. It will similarly impact established nonbank providers of peer-to-peer payment services, such as dominant fintech companies that offer alias-based payment services (which allow senders to more conveniently make payments using only the email address or cell phone number of the recipient, without having to know their bank account information). Understanding the relative strengths and limitations of instant payments will be critical for both types of entities to adapt.
In addition, emerging digital asset payment rails, such as stablecoins and cryptocurrencies, may appear risky compared to payments over FedNow. To address this problem, it will be even more critical for companies offering these digital asset-based products to adopt robust legal foundations, risk-based measures to ensure regulatory compliance, and appropriate controls to manage operational risk.
FedNow will offer a fast, low-cost payment rail for digital platforms: The Fed’s legal terms and conditions for FedNow generally limit eligibility to banks, but e-commerce merchants and other digital marketplaces that have accounts with banks participating in FedNow can also take advantage as recipients of instant payments. If these merchants and marketplaces enable an instant payment option that a customer can select when purchasing goods or services online, they would have a significantly lower-cost alternative to traditional credit and debit card rails.
Digital wallet companies and payment platforms could similarly leverage instant payments via FedNow to improve customer offerings. Consumers and businesses will be able to immediately fund and defund wallet balances at low cost. For example, they can instantly move funds sitting in a digital wallet to an interest-bearing or wealth management account to more efficiently manage money, or immediately fund the wallet to make an in-store purchase without a card.
Likewise, electronic billing and pay vendors should take note that bill pay is among the core use cases the Fed has pitched for FedNow. Instant settlement of bill payments means that consumers and businesses can conveniently move money immediately from their own accounts to biller accounts, at any time.
Fintech companies will have a new central bank platform to provide innovative consumer and enterprise services: The Fed’s approach to designing and growing FedNow is new and envisions an efficient, open platform for technology companies to innovate and create ancillary services, end-user interfaces, and back-end processing support. A range of fintech companies and service providers (such as payment processors, mobile and online banking platform providers, payment hubs and gateways, and bill pay service providers) can take advantage of this early opportunity to contribute to the Fed ecosystem’s development.
Why This Matters
Importantly, the U.S. Department of the Treasury has endorsed the adoption of instant payment systems in its recently issued report on “The Future of Money and Payments,” encouraging U.S. government agencies to use instant payment systems where appropriate. As history has shown with the growth of ACH payments, participation by U.S. government agencies in a payment system drastically amplifies that system’s ability to scale and reach ubiquity. While it may take time for consumers and businesses to change deep-rooted payments behavior, the government’s support makes FedNow and instant payments well worth watching—not just for banks that are eligible for the service, but also payment processors, end-user interface providers, and other fintech companies.
There is a critical role for technology companies in the growing U.S. instant payments space: by rolling out the end-user interfaces needed to make instant payments convenient and safe, by offering the processing services that many banks rely on, or by integrating instant payments into platforms and products that drive the digital economy. Fintech companies that intend to take advantage of the faster movement of money through this new national payment rail will need a solid understanding of the service’s key features, the areas available to innovate and offer tailored functionality within the bounds of FedNow’s legal terms, and, importantly, the regulatory compliance obligations and their interplay with payments law, such as the Uniform Commercial Code.
The Fed itself has recognized the importance of the contributions of highly motivated and engaged technology companies and service providers in its outreach campaigns. Among other things, the Fed has created an Ecosystem Accelerator Group to promote engagement with these service providers and a Service Provider Showcase to connect service providers with FedNow banks. ↑
Indeed, Treasury notes in its report: “In settings where appropriate, U.S. government agencies should consider and support the use of instant payment systems. The U.S. government sends and receives millions of payments per day. Use of instant payment systems by U.S. government agencies could promote the expedient distribution of disaster, emergency or other government-to-consumer payments, potentially providing more rapid support for underserved communities.” ↑