Those both supporting and opposing Federal Reserve action on faster payments now have their answer. The Fed announced that it will develop the FedNow real-time payment (RTP) system and explore expanding the operating hours of Fedwire Funds Service.
The decision isn’t likely to end the debate about how a Fed-operated system will compete with existing RTP systems from The Clearing House (TCH) and other private alternatives, but it does remove some uncertainty as to the Fed’s plans. Clear sides have been drawn. Larger banks tend to oppose a new system given their investment in the alternative TCH system while smaller banks, credit unions, and non-banks (FinTechs, retail, technology) tend to be more supportive.
The fundamental disagreement has overshadowed the fact that payments systems globally are moving toward faster payments with near-instantaneous access to funds. While arguments and real questions remain about global scale, availability and interoperability of alternative systems, US financial institutions need to make meaningful progress to prepare their organizations for change particularly with liquidity, cash buffers, and fraud management capabilities.
The FedNow service will be developed as an interbank real-time gross settlement system (RTGS) with immediate access to funds once a payment message is received. The system will settle payments by debiting and crediting an institution’s account(s) with the Federal Reserve Banks, similar to how Fedwire works to settle “high-value” interbank wires today. Judging from the initial transaction limit of $25,000, FedNow is more applicable to small business and retail payment needs, but expansion of the Fedwire operating window may enable payment innovation for high-value corporate payments.
Behind these changes lies an evolving liquidity environment. Excess reserve balances have been steadily declining, and banks have communicated a desire to decrease balances even further. But participating in a real-time payments system increases intraday liquidity needs as sufficient cash must be held to fund outbound payments before incoming payments settle. The accounts used to fund such systems are typically held at Federal Reserve Banks, so funds can be transferred only during normal operating hours. This produces an inherent challenge in which participants need to balance the risk of underfunding payment accounts and the inefficiency produced from overfunding accounts.
Banks will require sophisticated intraday liquidity management and cash flow forecasting capabilities to effectively operate in an environment of lower cash levels while trying to dynamically monetizing excess liquidity. Given this, the Fed, perhaps not surprisingly, communicated that the adequacy of a bank’s cash flow forecasting and intraday liquidity risk measurement practices would be among its liquidity focus areas for large bank supervision in 2019.
Clearly, the adoption of faster payments is an opportunity for banks and non-banks alike. Money movement services have become more commonplace as consumer and small businesses send, receive, and even store cash through retail and technology-operated platforms.
Whether adoption occurs via existing networks like the TCH RTP solution or FedNow’s RTGS system, a significant number of banks are operating payments infrastructure that’s not equipped to address evolving client payment needs. On one hand, increased faster payment volume will presumably mean lower cash and check volume, which would lower a bank’s overall payment processing costs. But there will be new demands on sophisticated cash management and intraday capabilities which banks can start to improve now.
Further, the potential for expanded operating hours for Fedwire may also open new revenue opportunities with corporate treasury clients seeking real-time settlements during non-standard working hours.
Banks that have to support multiple payment networks will likely put greater emphasis on the concept of payment hubs, which are designed to support both client and internal payment needs. Fully integrated management capabilities connecting business lines to internal treasury and risk management functions will be needed to balance creating a seamless client experience with sound risk management.
The notion of “faster payments” tends to stoke fears for “faster fraud.” As we have reviewed various readiness checklists across a number of real-time payment networks, fraud specific items dominate with particular focus on the use of real-time fraud engines. For example, Zelle justifies early preparation, noting that fraud rates are highest when institutions initially roll out real-time payments. Over time, however, as payment data is collected to help identify normal behaviors and effectiveness of existing controls, these rates go down.
So, for faster payments to reach sustainable, mass-scale adoption, fraud management capabilities will need to be enhanced. Similarly, opportunities for banks to provide corporates with real-time payment capabilities will be heavily influenced by the bank’s ability to help its clients detect, prevent, and manage fraud.
Overall, FedNow should be a win for the financial industry. In reviewing comments the Fed solicited, several technology companies, merchants and FinTechs requested to have direct access to the network, which could disintermediate banks and payment networks. The Fed arguably viewed this as too aggressive. This now provides a great opportunity for continued bank-led innovation where institutions can look to differentiate offerings to target and serve unique payment needs of FinTechs, merchants, and technology companies.
Many questions remain, particularly about the timing of the FedNow rollout, which is expected to be available in 2023 or 2024, interoperability with alternative systems both in the US and globally, and pricing. However, given the global momentum and consumer demand for faster payments, financial institutions should address their cash flow forecasting and intraday liquidity capabilities to meaningfully prepare for and participate in the ever changing payments landscape.