May 28, 2023
By Keegan Ferguson, Capstone Financial Services Analyst
In July, the Federal Reserve is expected to launch its long-awaited FedNow service after piloting the program for months with more than 100 participating financial institutions. The service sets the stage for the long-term disruption of several financial services, including existing card networks through the expansion of account-to-account payments, with implications for industries as diverse as retail and banking. However, both industry and investors are only beginning to grapple with both the promise and the perils of long-term, widespread adoption.
FedNow will support real-time payments and represents the federal government’s first foray into instant payments after dozens of countries have debuted systems in recent years.
While proponents of broader adoption of real-time payments and the federal government’s entry into the instant payment landscape tout the development as a possible revolution for the U.S. payment system, there are still significant hurdles to widespread adoption and realization of the potential benefits.
Real-time payments will help small businesses and low-income consumers.
Supporters of real-time payments argue that the faster movement of funds between accounts and real-time settlement carries outsize benefits for small businesses and low-income consumers. In announcing the development of FedNow in 2019, the Federal Reserve argued that real-time payments are specifically beneficial for individuals “facing financial constraints or in times of crisis” who need to move and access funds quickly. Proponents suggest fees that disproportionately impact low-income populations—like overdraft fees, insufficient fund fees, and check cashing fees—could be significantly reduced if money could be moved in real-time and consumers had greater awareness of fund balances. A recent MIT study found that shortening check deposit times significantly reduced the use of check-cashing services, saving consumers high check-cashing fees and underlining the demand and cost-savings associated with rapid fund access. Similarly, proponents argue that small business treasury management and cash flow would benefit from more immediate options for making and receiving payments.
The commercial implications vary significantly for stakeholders across the payments ecosystem. The FedNow system will be less expensive than more traditional debit and credit transactions. The fee per transaction, paid by the sender, will be $0.045, and a request for payment will cost $0.01, paid by the requestor, according to the Fed. That cost per transaction is much lower than the interchange fees charged for debit and credit transactions. Per the Fed’s most recent debit interchange data, the average dual-message debit transaction cost $0.39 and the average single-message transaction cost $0.25. The significantly reduced transaction costs associated with FedNow (and RTP) pose risks to the interchange revenue generated by card networks and banks should the solution reach scale. Alternatively, merchants are reportedly interested in pushing the adoption of real-time payments at the point-of-sale to reduce their interchange exposure. At a recent Faster Payments Council meeting this spring, retailers like Walmart and Kroger threw their support behind the adoption of instant payments via FedNow.
Hurdles exist for international payments, fintechs, and more.
But while we believe that FedNow represents an exciting new payments option, we do not anticipate immediate widespread adoption and displacement of currently dominant payment mechanisms. Although real-time payments have been available in the United States via the RTP network since 2017, the payments landscape has not shifted significantly. While FedNow will support a larger number of financial institutions than RTP – all depository institutions in the United States will be eligible to join – not all institutions are required to join, and banks can choose to participate in a “receive only” capacity. RTP total transactions have grown steadily since 2020, growing from less than 10 million transactions and $5M in volume in Q1 2020 to 52 million transactions and $52M in volume by Q1 2023. That volume, however, is dwarfed by the number and size of transactions being routed through debit and credit card networks. In 2021, there were ~157B credit and debit card transactions totaling more than $9T in overall spending. While consumers are comfortable using peer-to-peer (P2P) tools to exchange funds, changing consumer behavior at the point of sale, and equipping merchants to support FedNow will take additional time. Unlike other countries, which largely bypassed the use of credit and debit cards – jumping straight from cash use to account-to-account payment systems – consumers in the U.S. are accustomed to using credit and debit cards and may not be acutely aware of the possible benefits of faster payments. Moreover, rewards programs for credit cards disincentivize shifting to alternative payment methods – programs that individual retailers and retailer collectives have struggled to replicate.
Beyond challenges with spreading awareness and changing consumer behavior, the initial version of FedNow will not yet support cross-border payments or allow non-banks to directly access the system. Though likely a priority in the future, the inability of the FedNow platform to support cross-border payments will eliminate key use cases. Businesses that might have otherwise been inclined to utilize the tool might be discouraged from wider adoption until they can transact across borders. Similarly, the platform’s inability to support remittance payments closes off a possible use case that could drive adoption. However, we believe these functionalities may exist in the future as FedNow continues to develop.
The platform, in July and for the foreseeable future, will not support direct access from non-banks. While fintechs and other bank partners will undoubtedly be able to facilitate payments on FedNow via banking partners, they will be unable to directly access the FedNow platform. Given the mixed incentives for offering or expanding real-time payments for banks – the need to balance the loss of interchange income against consumer or business demand for the service – the lack of direct competition from non-banks could slow overall growth.
An instant payments system also creates new fraud concerns. The immediate and irreversible nature of transactions makes it nearly impossible to correct an error before a payment is processed. The speed of the transaction also allows potential fraudsters to more rapidly move or withdraw funds without detection. As retailers and financial institutions explore FedNow usage, the ability to detect and prevent fraud will likely impact the pace of adoption.
Broadly, we view FedNow’s debut as a promising expansion of real-time payments but do not foresee an immediate sea change in the payments industry. There are legitimate technical hurdles to bank adoption, we do not expect that all financial institutions will immediately offer the service to consumers and expect that changing consumer behaviors will take time.
The Fed may have the authority, however, to speed the pace of the transition towards real-time payments, if they choose. Under the Expedited Funds Availability Act, the Fed has the authority to push financial institutions to recognize funds in real time. Passed in 1984, and implemented through Regulation CC, the law states that Fed shall “by regulation, reduce the time period” for a variety of check, cash deposit, and wire transfer types to “as short a time as possible.” Senator Van Hollen (D-MD) and Senator Warren (D-MA) have previously introduced the Payments Modernization Act – a piece of legislation that would update the Expedited Funds Availability act and required real time funds recognition. Legislation or rulemaking from the Fed could compel faster funds recognition and help drive traffic to FedNow or RTP.
But make no mistake, in the long run we believe that FedNow will have significant underappreciated implications for multiple industries. Faster direct payments could eventually erode the market dominance of card networks and create cost savings for merchants. Low-cost, rapid cross-border payments – once that functionality is enabled – present new opportunities and risks for remittance businesses. Business-to-business payment could be accelerated, and new market entrants could develop models offering lower-cost payment methods. That’s just the start.
Despite the hurdles ahead, we believe the service is promising. Companies and investors should begin positioning themselves to capitalize on the eventual benefits and gird against the inevitable downside risks. Capstone will continue to cover the rules governing the nascent system and the incentives for payments stakeholders, and help our clients navigate the roll-out and commercial opportunities that the system represents.
Keegan Ferguson, Capstone Financial Services Analyst
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