FedNow: How is it Going to Change the Payment Landscape in the US?

The conventional US payment system has existed for nearly four decades. The early adoption of electronic payments in the US can be credited to greater technological acceptance in the past. However, incorporating the latest payment technologies in the last decade has been challenging for the US.

Despite safety features and credit card monitoring services, Americans felt vulnerable to fraud and security risks associated with plastic money.  Trusting a digital payment system seems like a long shot, requiring more sophisticated cybersecurity measures. The widespread adoption of real-time payments (RTPs) was further impeded by the stringent regulatory environment.

Secondly, the existing banking infrastructure in the US is decades old. Most financial institutions in the US still use legacy systems, with more than 40% of banks using COBOL, which dates back to (wait for it) the late 1950s! Replacing these entails colossal investments. Further, adopting RTPs requires businesses and financial institutions to adjust their internal processes and workflows to align with the new system, which is extremely time-consuming.

Thirdly, the US financial system is highly fragmented, with multiple banks, credit unions, and financial institutions using different systems and standards. Coordinating and standardizing RTP implementation across this diverse landscape is hugely challenging.

While the US struggles with these impediments, their European and Asian counterparts have been busy developing nimble technologies and educating their citizens about RTPs in recent years. It has been easier for emerging economies to adopt faster payments as many of them are developing digital payment infrastructure for the first time. As per Grand View Research, the global RTP market is projected to generate a 35.5% CAGR between 2023 and 2030.

In the US, the share of RTP is a dismal 2% of the global volume. A primary reason could be the fact that the existing TCH (The Clearing House) RTP system in the US is a private payment system built and maintained by large banks that prioritize ease of adoption and speed. But the US still had certain hurdles to overcome, such as seamless cross-border payments and peer-to-peer (P2P) transfers, before embracing payment modernization globally. The reach of TCH RTP was also limited to approximately 65% of demand deposit accounts (DDAs). This underwhelming reach, despite banks holding 90% of the DDAs, is because TCH RTP was never mandatory. Moreover, smaller FIs (financial institutions) were apprehensive about joining private payment rails that required significant investments.

Being another voluntary system, FedNow created a public payment rail that hopes to put the US on a solid competitive footing through trusted and utility-based adoption. It emphasizes “richer payments” rather than merely “faster payments.” The benefits to individuals and businesses will come from the enhanced data capabilities of FedNow’s liquidity management tool to enable instant payment transfers between system participants.

Let us deep dive into the benefits of FedNow to understand its positioning in the American financial system.

Reduced Costs of Instant Payments

Depository institutions carrying out these settlement services are foundational to legacy payment systems. These act as middlemen because a digital payment provider must partner with a depository institution to take advantage of the Federal Reserve payment system. This additional layer of complexity results in costlier payments, with consumers and businesses often bearing the expense. FedNow offers an instant gross settlement service with integrated clearing functionality to overcome the hurdles of legacy systems. Digital banks and PSPs can now settle real-time payments without paying the depository institution’s commission. Any bank, business, or individual will not have to bear the cost of delayed payments, given the functionality of instant payments.

Beyond these consumer and business use cases, the switching costs associated with investment accounts (funding, withdrawing, and transferring funds) can also be reduced with instant payment rails. This will help the financial services industry become more competitive and allow investors to realize efficiency gains. 

Increased Operational Efficiency

As per a Cornerstone Advisors study cited in Forbes, digital banks and FinTechs account for nearly half (47%) of new checking accounts opened by Americans, demonstrating that these consumers expect flexibility, personalization, and easy money movement in the digital age.

Given the rapid adoption of digital financial services, limiting access to federal banking services doesn’t make sense. With FinTechs having direct access to FedNow rails, they can now transact on behalf of customers for a better payment experience.

Businesses can also use these near real-time payments to better manage cash flow through automated just-in-time payments, striking a balance between the opportunity cost of early payments and late payment incidents. They can also improve their working capital and accounts receivable (AR) management by instantly receiving payments. Employees will also benefit from instant payments, as businesses will be able to pay wages at the end of their shift, giving them access to the funds almost immediately.

The use cases for banks include bringing more bill payments in-house with integrated invoice generation and instant settlement capabilities. Even the account funding process will be faster, reducing back-office complexity. However, more use cases need to develop faster for the greater FI adoption to allow FedNow to become mainstream, unlike its predecessor, the RTP system.

Building a Competitive Open Banking System

The fragmented financial system of the US is both a boon and a bane; the former because it allows choices for users and customers, and the latter because it restricts the pace of innovation. Multiple payment systems coexist in the country, which calls for deliberate harmonization to prevent risks arising from shifts in payment trends.

With non-cash transactions on the rise globally, ACH transfers accounted for over 90% of these transactions. Two of the top banks were originators of nearly 50% of US ACH transactions in 2021, which increases concentration risk and leads to a less competitive banking system overall, in spite of these ACH transfers being slower than instant payments. Although TCH achieved some admirable milestones on its RTP platform, the transaction volume remained sparse enough to prevent the alleviation of concentration risk in electronic payments. These will now compete with the potential use cases for merchant payments offered by FedNow. But this is not something to be wary of. Instead, it should be openly welcomed, as, above all, these payment rails are geared to make instant account-to-account (A2A) payments ubiquitous in the country. By inviting smaller FIs into FedNow, the race for broader participation has just begun.

Facilitating a diverse set of financial institutions to participate in the federal payments network would maximize the benefits of faster payments and allow diverse business models to keep pace with a changing global landscape.

If you want your business to join the Federal Reserve’s payment modernization drive  and reap the benefits of instant payments, contact us now.