My recent dive into the speech by Lael Brainard about FedNow has given rise to some interesting questions regarding its similarity to CBDCs. Specifically, FedNow is very similar to the infrastructure that was proposed for a potential Central Bank Digital Currency within the series of discussion papers written by a collaboration of the central banks of multiple developed nations as well as the BIS. Videos walking through these discussion papers in depth, as well as some other topics relevant to CBDCs, can be found within the playlist linked HERE. A letter online, written by the President and CEO of the Kansas City Fed Esther George in 2020, seems pertinent to this discussion, especially the discussion of how FedNow started, at least as an idea. The letter goes into some detail on the payment systems history of the Fed and the role that they played in the development of payment systems in the history of the United States monetary system.
The Fed’s participation in the US payments system
This participation started with the creation of the passing of the Federal Reserve act in 1913 where one of the functions of the Fed was to establish a national clearing house and to promote the collection of checks at par. This was a problem at the time due to the decentralization of reserves and the fact that the checks had to be physically transported to the transaction’s counterparty bank. The bank would require a fee to cover the costs of this transport and would just take it from the settlement of the check itself, much like a haircut off the top. With a central clearinghouse, at least within each region, the checks would not have to be transported to undergo settlement, so the need for this fee was negated.
The next innovation in the United States’ payments system was the advent of the wire transfer. Initially, this involved the use of morse code to relay transactions over large distances. This method is still used today for large-value transactions by the regional Reserve Banks with the system known as Fedwire.
In the 1960s, the magnetic ink character recognition system was developed, which allowed for the increased efficiency of the processing and clearing of checks because the computer could recognize the characters on the check even if they had been covered in signatures or bank stamps. A further development in the electronification of the check clearing processes occurred after 9/11 with the passage of the “Check Clearing for the 21st Century Act”. This legislation allowed for the conversion of checks into electronic images, thereby reducing the need for the physical transportation of check dramatically.
In the 1970s, the federal reserve supported the development of the ACH system, which stands for the automated clearinghouse. The system underwent improvements, including the advent of its same day clearing function which came to fruition in May of 2021.
The Development of FedNow
In August 2020, the federal reserve achieved a milestone in FedNow’s development. This coincided with the BIS papers on the development of digital bank currencies. The series of BIS papers was written by a collaboration of the central banks of some of the world’s most developed countries. These are the very same papers as alluded to in the beginning of this post with a YouTube playlist available for more information.
The timing was coincidental as the payment landscape was changing around this time and people’s behavior around payments was changing. They wanted things like contactless payments for instance which may have been a major catalyst for developing the sort of instant payments system we’re seeing now.
So, the decision to build and operate the FedNow instant payments infrastructure resulted not only from gathering and analyzing public comments but also from collaborative efforts throughout the 2010s. This goes back almost a full decade ago as of this writing and these efforts included initially consulting and subsequently announcing the federal reserve strategies for improving the US payment system and convening the faster payments task force. Ultimately one recommendation from the task force was for the Federal Reserve to develop and operate instant payments infrastructure.
The presence of multiple systems also provides competition which is one of the major selling points for implementing this kind of FedNow system because it’s an almost parallel system to what we already have, just more centralized via the federal reserve. They decided to do it themselves instead of letting the private sector do it.
What comes out of all the discussion documents and white papers is that the Federal Reserve wants to increase security around the system by introducing more redundancy. So, in having that parallel system, which is another reason for the analogy to central bank digital currencies, is that in the series of BIS papers within which the Fed’s board of governors was a participant, and co-authors, there are a lot of similarities between what’s said in that series of papers and what has been happening with the implementation of FedNow. The language used is similar in a way too, looking at it at face value at the moment.
Finally, the federal reserve service will be accessible to all banking organizations in all parts of the country, reaching over ten thousand diverse depository institutions and their customers.
And one of the things it seems that they’re pushing for, can be seen in the other sources as well, is that they’re really trying to provide it for all kinds of financial institutions, not just depository institutions. As the development of FedNow is underway, it will benefit from opportunities to learn from the “current” (2020) crisis, when considering when or how customers might use the service.
It really puts everything into perspective and the lessons from our current crisis could better inform not only the development of the FedNow service but also importantly, future services that will utilize the FedNow infrastructure to reach end users.
This is one thing that could be used for implementing Universal Basic Income (UBI) because it’s getting into how the processing of checks and the other modes of transfer that the government uses to transfer payments. They said that a significant portion of the funds that were delivered for those stimulus checks was spent immediately and that’s their argument for having an instant payment system. Essentially, these people are using it immediately, so we need to get it to them as soon as possible because they obviously need it. That seems to be their line of reasoning, at least in the way they say it. So, as is the case today, innovative solution providers can partner with banking organizations to bring their products to consumers’ computers, mobile phones, and even watches, to facilitate payment transactions through their banking relationships.
This is another concept that was discussed in relation to central bank digital currencies, as it seemed like they were really going to implement it in a tiered system, where the central bank took care of the actual currency part itself and even being a central clearinghouse for all transactions in a way. But they would outsource the major services and “innovation” to the private sector because there are certain things like customer service and other kinds of end-user interactions that they don’t have the necessary infrastructure for it.
To deal with that amount of throughput and volume of transactions and interactions with individual people, the Fed can leverage private sector infrastructure in a way.
There is a community around the FedNow implementation as well as an email list, but it is uncertain whether one can participate unless you are directly involved via one of the institutions.
FedNow is the next chapter in the building of the federal reserve’s payment services and is foundational to the future of payment services. With the alignment of goals, it seems that this is a test of the available infrastructure, to see if it can support a CBDC.
An amusing aside is that the public commentary on some of the documents available recommends the use of Ripple or “XRP”. No further discussion, just a bunch of crypto CEOs making the recommendation without any further supporting commentary.
References
“Policy Perspectives From The to FedNow: Payments Innovation and the Federal Reserve”, Esther George, December 18th, 2020. https://www.kansascityfed.org/research/policy-perspectives/payments-innovation-and-the-federal-reserve/
