Paradise FedNow? How the 2023 payment network will improve real-time payments (September Fintech Newsletter)

by James · September 22, 2022

This first appeared in the monthly a16z fintech newsletter. Subscribe to stay updated on the latest fintech news.

Paradise FedNow? How the payment network in 2023 will improve real-time payments

In late August, the US Federal Reserve announced that its real-time payments network, FedNow, would finally launch in May or June 2023. The highly anticipated new service, which will enable instant payments between accounts at participating banks at any time of the day, has been under consideration by the Fed and others for over 10 years. More than 120 banks, payment processors and gateways and others have since tried the service as part of a pilot program. Now that the launch is finally happening, what will it mean for real-time payments in the US?

We can all agree that faster real-time payments are better for a number of reasons, and the traditional methods have been imperfect. Real-time payments mean, for example, that salespeople can get paid without having to wait for the money to be paid, and employees can similarly get their pay faster. They should also eliminate the chargeback risk for a seller because the funds are immediately transferred and irrevocable. ACH, which is batch processed, can usually take several days, and will allow for same-day settlement at most. There is also the risk that the sender has insufficient funds and that the payment fails. Wires are instant, but only work during business hours, so if you miss the business hours window, you’ll have to wait to transfer. Zelle, Venmo, Mastercard Send and Visa Direct all offer instant payment options, but they cater more to consumers and generally have lower limits and only allow the transfer of smaller amounts. Of course, credit cards have a settlement period of a few days.

Of course, a real-time payment network is not an entirely new concept in the United States. Clearing House (TCH), a banking association and payments company owned and operated by a consortium of the 26 largest national banks, launched its own real-time payment (RTP) network in 2017. RTP also offers an immediate payment capability, but adoption has been slow and mostly among large, rather than small, banks. This is because smaller banks have been reluctant to work with a network created by the same large banks that have gobbled up market share and threatened their existence (although small banks and credit unions can access RTP through their relationships with large banks and third-party payment processors).

For further context, less than 1% of US transactions and expenses settled in real time last year. Contrast that with India, the world leader in real-time payments, as discussed above 30% of total payment volume in real time in 2021. Brazil is also quickly catching up – see below. Banks also do not often advertise RTP to their customers. The cynical view is that banks, as card issuers, earn fees on credit card interchange, among other things, so they may not be incentivized to promote RTP, even if they are integrated.

FedNow’s goal is to offer smaller banks access and offer a competitive rail to RTP. The service will be available to all banks in the Fed system, as opposed to only via TCH members. One of the key feedback from the pilot was the concern that only one option would create financial security issues if that one service was ever unavailable (and vice versa, large banks have lobbied against FedNow). FedNow will also use the international messaging standard ISO 20022, unlike ACH, which should make it interoperable with other payment systems, although FedNow’s data fields may not be organized as in other systems. The initial limit is likely up to $500,000, but the default will be $100,000. The settlement model is slightly different, but fungibly similar; FedNow will utilize participating banks’ existing main account with the Fed, while the RTP rail requires participants to have a separate pooled account for liquidity with The Clearing House.

So what does this mean for fintech? Overall, while a step in the right direction, FedNow is still only making a rail and it will require a number of steps to operationalize (especially for small banks). This is because even though the rails are built, applications still need a way to connect to the rails. Ideally, through the pilot process, when testing begins, there will be more clarity around this; very little has been revealed so far. An infrastructure layer is also needed to connect apps and services to send the payments over the rails: the so-called “last mile”.

Banks must also participate and integrate with FedNow to offer their customers access, and they must figure out their fraud controls. There is also the issue of multi-rail integration. Larger banks are likely to develop the connection between the two. But smaller banks may not have the resources to do so. Time will tell how this problem is solved. Consumers and businesses must also be made aware that it exists – something that RTP has struggled with to date. It also leaves a number of questions and potential opportunities around international transfers (FedNow is domestic only) or larger transfers in the future.

Lessons for FedNow from PIX

Coinciding with the FedNow announcement, we might see most successful adoption of a national real-time payment (RTP) system yet with the development of PIX in Brazil. While India holds the top spot for RTP volume and RTP share of all transactions (by a wide margin), PIX is the fastest growing national RTP system and currently processes 2x more real-time transactions per capita than India. Given the rapid growth, does PIX predict any lessons that could inform a significant shift in US payments in 2023 and beyond?

Launched in November 2020 and developed by the Central Bank of Brazil (Banco Central Do Brasil), the PIX network offers free and instant settlement of digital money transfers within two accounts registered with participating institutions. Less than two years since implementation, the rollout has exceeded expectations: PIX processes the vast majority of B2B payments, and over 75% of the adult population have either sent or received a payment via PIX. While initial adoption was largely driven by the replacement of wire transfers and cash payments in a B2B/P2P context, new features added in 2021 (e.g. payment in installments, scheduled payments, cashback, merchant initiation) and increasing merchant adoption have led to an accelerating use for P2B transactions. PIX now processes ~$250B in annual P2B payments, representing more than 40% of card volume and 20% of total spend.

Two important reasons for PIX’s success are 1) its strong proposal versus existing alternatives, and 2) a set of effective implementation decisions by Brazil’s central bank and market conditions.

PIX offers an all-in-one infrastructure that is significantly cheaper and more practical, and has thus generated widespread use in each of the different contexts. PIX is free and instant. Bank transfers and Boletos are expensive, only available during business hours, and take several days to be credited to the recipient’s account. Cash is less secure and more expensive to manage for merchants.
At the same time, rapid PIX adoption was aided by specific functionality and implementing decisions focused on widespread access, free participation and simplified user adoption. PIX requires any financial institution with 500,000+ users to offer PIX in their digital application at launch. PIX has also allowed fintechs to participate, to that point 85% of the ~780 active participants are indirect participants (institutions that are not regulated by the central bank). Furthermore, PIX payments must be offered free of charge for B2B and P2P transfers. And finally, PIX is focused on creating a simple and consistent experience across participants. For example, PIX allows easy, Zelle-like registration with keys like phone numbers or email, provides a consistent user experience across applications, and standardizes digital payment initiations for merchants (e.g., it replaces the one QR code needed per close loop wallet) .

So what might this mean for the outlook for FedNow?

First, it is important to note that the status quo payment solutions in the US are closer to what FedNow will offer in price and convenience compared to the improvement introduced by PIX. Major banks already use RTP for transfers (but have discretion to charge consumers); consumer adoption of free P2P digital payment solutions such as Zelle, Venmo or Cash App is high; and card networks have higher penetration.

Second, the limited information about FedNow released to date suggests that its implementation will differ significantly from PIX. FedNow may initially only be available to banks in the Fed system, participation will be voluntary, consumer fees will be discretionary, and additional functionality will be built by participants (as opposed to a central infrastructure in Brazil). While PIX evolved to be a “front-end” solution that is ubiquitous for Brazilian consumers, FedNow will launch as more of a back-end network available to banks at a low operating cost.

Finally, it is important to note that PIX adoption may have accelerated due to sponsorship from challenger neobanks. The growth of PIX has coincided with the acceleration of Nubank, Inter and other digital banks that do not have large profit pools in any of the disrupted service lines (transfer fees, ATMs, merchant acquiring) and have therefore been strong proponents of free service.

FedNow skeptics have noted that the US already has real-time settlement infrastructure in RTP and adoption has been slow (~97% lower volume processed than PIX), predict FedNow’s fate will be similar. However, this perspective may underestimate the compounding network effects of having a single system to handle all transactions (P2P, B2B, B2P, P2B), similar to PIX, which FedNow may one day evolve into – potentially enabling a new wave of fintech disruption . If consumers and businesses can affordably and easily send and receive all their payments with a single application, it can be a compelling value proposition.