The novelist and futurist Arthur C. Clarke once wrote, “Any sufficiently advanced technology is indistinguishable from magic.” In the financial services industry, achieving a customer-centric sense of wonder should be our goal. We want to wow customers by executing a fast, frictionless experience.
To do so, financial institutions must modernize their payments strategy to ensure security, speed and ubiquity. Real-time payments (RTP) further all three goals, leading banking executives to prioritize them second in CSI’s 2021 Banking Priorities Executive Report, just behind the related technology, P2P.
With the FedNow pilot program underway, the future is bright for real-time payments and the possibilities they could open. RTP will not likely replace existing payment processes in the short term but will become a critical leg for any customer-centric payment portfolio as the industry drives forward.
What Are Real-Time Payments?
Real-time payments have been called instant payments, immediate payments and real-time gross settlements. RTP adheres to ISO 20022, an international standard for financial business process communications. They utilize a separate network from same-day ACH and wire to enable customers and businesses to send and receive near-instant fund transfers, 24x7x365.
These data-rich payments occur on an open-loop system, with an inter-bank or account-to-account payment posted and confirmed to the originating account within a minute. And unlike closed-loop systems like PayPal and Venmo, RTP immediately moves actual funds from bank A to bank B. This is a game-changer for anyone who has eagerly waited for a paycheck to process in their account.
Pioneers like Japan, Switzerland, Turkey and Taiwan already have decades of use and data under their belts. Worldwide, over 50 billion real-time transactions took place in 2019. And despite numerous factors that caused the United States to lag, including competition and decentralized payment infrastructure, real-time payments are finally gaining steam in the United States.
Today, Celent reports that 59% of US banks have started their real-time payments journey and 88% of US banks now view RTP as an essential part of their payment toolkit.
Why Is the Federal Reserve Releasing the FedNow Service?
The Clearing House launched its RTP ® service in 2017, paving the way for immediate payments in the United States. But many smaller institutions have understandable reservations about using a service helmed by the nation’s largest banks.
So, in 2019, the Federal Reserve announced its intention to establish a nationwide infrastructure for instant payments. The Federal Reserve’s FedNow Service aims to provide secure, fast and ubiquitous payments for all financial institutions. In addition to encouraging competition and innovation, this development will also prevent a single point of failure.
When announcing the service, The Federal Reserve Board stated, “an operational role would allow the Federal Reserve to advance a number of important objectives, including establishing an accessible nationwide infrastructure, fostering stability in times of crisis, supporting resiliency through redundancy, and stimulating healthy competition for clearing and settling instant payments.”
The FedNow pilot program began in 2021, with many institutions and stakeholders weighing in on the service. As currently proposed, FedNow will offer uninterrupted 24x7x365 immediate payments by 2023, with security features to support payment integrity and data security.
How Will the FedNow Service Work?
At launch, FedNow will only support domestic credit transfers, and institutions must have adequate funds or available credit to settle each account. However, banks can leverage the FedNow Liquidity Management Transaction (LMT) to manage and transfer liquidity if they choose to do so.
The Federal Reserve’s FAQ states, “The first release of the FedNow Service will also include optional features: fraud prevention tools, the ability to join initially as a receive-only participant, request for payment capability, and tools to support participants in their handling of payment inquiries.”
In practice, payments undergo the same basic flow:
- A consumer initiates a payment.
- The sender’s bank screens the payment.
- The sender’s bank submits a payment message to the FedNow Service.
- FedNow validates the payment message.
- FedNow sends the contents of the payment message to the receiver’s bank.
- The receiver’s bank confirms or denies that it maintains the specified account.
- If approved, the FedNow Service debits and credits the appropriate master accounts.
- FedNow sends advice of credit to the receiver’s bank and an acknowledgment of completed settlement to the sender’s bank.
- The receiver’s bank immediately credits the receiver’s account.
This flow should all occur within moments. To consumers, it will appear as if they initiated a payment and were either approved or denied. Given the speed and convenience, real-time payments will also simplify B2B transactions, P2P, payroll, AR/AP processes, and more for businesses.
How Will Banks Manage Risks Associated With FedNow?
As with other forms of payment, there are some caveats and financial institutions should still take precautions. An enterprise fraud approach with a total view of the customer and their behaviors can help guide the screening process.
The instant nature of these payments makes them irrevocable once a settlement message is issued. In the event of an error, only a good faith request for those funds can resolve it, which damages credibility and the user experience. In other words, once a fraudulent transaction is authorized and processed, it’s probably too late.
However, real-time payments may also help you find faults in your system more quickly. It’s not necessarily that more fraud will occur, but that fraud will be evident faster, which will show you when you need to shore up defenses.
As security becomes more sophisticated, we may see more prevalent use of behavioral biometrics, passive resistance and other advanced security measures. But for now, institutions will need to do their due diligence and use FedNow’s optional fraud prevention tools or other fraud mitigation tools and techniques.
How Might FedNow Evolve in Future Phases?
The Federal Reserve is taking a phased approach to provide later features and functionality as it deems appropriate. Although it will first focus on the FedNow Service’s core functionality to ensure an efficient rollout, it seems likely that it will one day integrate alias-based payments into the service.
FedNow may not include directories at launch, but they could be a primary focus for future releases and elevating the customer experience. Traditionally, customers have been identified from their user ID, card credentials, account credentials, or token credentials. With a directory, customers don’t need to know specific account information to find someone and securely pay them. They can self-enroll and search for easily identifiable recipients by user ID, email, phone number, alias, name and picture.
Directories leverage APIs to transfer traditional payment credentials into more approachable “lookup criteria.” The process is nothing new to consumers who have used closed-loop directories through third-party P2P apps. However, it could revolutionize the user experience of paying through their financial institution’s digital banking solution.
At present, the Federal Reserve is weighing its options regarding alias-based payments, considering a host of legal, security and operational concerns. But its statements on alias-based payments are promising. The Fed has expressed interest in connecting one or more existing directories or building its own to facilitate nationwide reach. Its Directories Work Group focuses on directory options that:
- Facilitate ubiquity
- Provide open access
- Enable ease of entry
- Ensure safety and security
- Service all types of faster payments
- Support a multi-provider directory solution
In the meantime, the Federal Reserve has stated that participants “are not precluded from using alias-based payment services that are unaffiliated with the FedNow Service.”
Successfully Implementing Real-Time Payments
Effective incorporation of real-time payments into your payment portfolio will require a careful watch of the industry. FedNow may empower you to change the way you approach many backend processes. Additionally, competition may drive pricing dynamics, enabling you to choose the most cost-efficient RTP option.
Moving forward, real-time payments will continue to be supported and strengthened by innovations in core banking, digital technologies and security. If you haven’t already, consider and prepare for how it will exist alongside your existing payment portfolio.
To better grasp and meet the demands of today’s payments landscape, refer to CSI’s Digital Payment Trends White Paper.