This article will cover some of the key features of FedNow and how it will be utilized by businesses and individuals as well as by financial service providers.
So, what is FedNow?
In essence, the FedNow service provides a structure to facilitate instant payments between entities. These entities can be businesses, financial institutions, or individuals. In a way, FedNow fulfills a similar role in terms of its messaging features, to the SWIFT payment system.
The service provides financial institutions (FIs) with a streamlined mechanism to instantly settle payments between participating FIs. This means that there is no build-up of interbank obligations and short-term risk.
What this means is that the Federal Reserve is offering banks the platform to make instant payments which allows the banks to come up with products to offer to their customers which the federal reserve will support as demand grows.
This appears, at least on the surface, to be an attempt by the Fed to set up the infrastructure for a bank CBDC.
So, let’s look at the core features of the FedNow service and compare them to the core features of a CBDC.
Initiate Payment Processes
This will be used by the financial institutions to send messages to each other that they would normally do to send money and then the FedNow service takes care of the back-end processes.
The FedNow service is going to be phased in over time from June or July 2023, with core functionality for a few use cases and once the system is working, it should be use-case agnostic. Effectively being used for any payment processor that the financial institutions dream up on a 24/7 basis. More on the intended use cases for the FedNow service can be found HERE.
Depending on whom you listen to, the description of exactly how the system works pops up with a few nuances.
For instance, there is some confusion over the timing of the end-of-business-day transactions as the FedNow system will still be operating after normal banking hours.
Flexibility
The system offers flexibility for correspondent relationships by offering participating FIs a master account to access the FedNow service.
Basically, having an account at the Fed would no longer be a perk exclusive only to depository institutions as with reserve accounts. With FedNow, all participating financial institutions would have one of these master accounts at the Federal Reserve.
Which is in essence the beginning structure of a CBDC.
Financial Institutions as Intermediaries
The financial institutions will still fulfill the function of an intermediary in the system and this falls in line with the descriptions from the BIS papers where they describe a tiered system involving the central bank with the current financial institutions providing the outsourced services that the Federal Reserve, for instance, would not provide or doesn’t have the experience of providing, like customer service.
So, this sounds like a settlement system where they can report transaction by transaction.
Liquidity Management
Another feature is liquidity management transfers and how this will be affected. They specifically refer to limits for liquidity transfers exceeding the customer credit transfer limit for participants to maintain adequate funds.
They also mention not requiring pre-funding for master accounts. Which is basically a reserve account structure that is keeping score in a ledger. This begs the question of what the limits are and whether they are there just to control the flow of funds.
With central bank digital currencies, they could put price caps or flow caps which only allow you to spend a certain amount in a given time. Both are concepts discussed freely in the series of BIS papers alluded to earlier. Videos going over said papers, as well as links to the papers themselves, can be found in the YouTube playlist linked below.
For more on Central Bank Digital Currencies:
https://youtube.com/playlist?list=PLi62lGg0Z1u48mEjPUO58FMQvmWGC_gw6
Fraud Prevention and Mitigation
There obviously must be fraud prevention or mitigation tools in place which is one of the selling points of a CBDC. And these fraud mitigation measures will include a blacklist where non-conforming institutions or people are kicked out of the system based on a set of specific criteria.
So, there’s a planned transaction limit of $500,000 and a default limit of $100,000 that the participants can adjust up or down. This is ostensible to prevent fraud of money laundering. But this begs the question, if you are going to commit fraud or launder money, are you really going to use FedNow to do it?
Redundancy
One of the explanations why the FedNow system is good is its redundancy factor. The hope is that it strengthens the whole system by having a process that runs in parallel.
Another feature is that you can request payment from any other participant whether a business or individual. They refer to the ISO20022 messages, where they support exception processes. FedNow is basically a messaging service in a way, at least part of it appears to be.
But FedNow sounds a lot like the infrastructure for a CBDC which we can see when we put the paper supplied by the BIS side-by-side with the FedNow documentation so that we can see and contrast and compare the relevant parts.
Participation Types
There are also a variety of participation types. You would be able to send and receive or just receive funds. There are settlement services for financial institutions which are designed to settle the transaction on behalf of respondents. Businesses and individuals will therefore outsource this service.
To see how the flow works there is a graphic provided that shows how FedNow works with the FedNow service in the middle and the sender and receiver institutions connected to it with the sender and receivers outside the FedNow system.
The individual sender sends a payment message to its individual financial institution through an end-user interface that is outside the FedNow service.
But how the individual components of the system work are still uncertain, which is why we will have to do more research on the mechanics of the system.
The FedNow system is going to be rolled out slowly to give the current monetary system and markets time to adjust and get an understanding of how they can innovate and build their side of things.
For more on FedNow:
The 7 Use Cases For FedNow : Utilizing Revolutionary Systems
How FedNow Started : The Commanding of The U.S. Payments System
