Federal Reserve Launches FedNow, Steps From CDBC

The Fed’s early solution to Central Bank Digital Currencies has already arrived. FedNow, the recently announced program for nationwide, instant payments between financial institutions, will launch in July offering greater flexibility with time-sensitive payments. In fact, hundreds of banks, including some of the country's largest institutions, have been piloting the Federal Reserve's real-time payments system, FedNow, for months.

"The launch reflects an important milestone in the journey to help financial institutions serve customer needs for instant payments to support nearly every aspect of our economy better,” said Tom Barkin, president of the Federal Reserve Bank of Richmond, executive sponsor of the FedNow Program.

This program has the potential to reshuffle the person-to-person (P2P) transaction market by providing immediate and certain fund transfers with less friction on the interbank network. The system should also have a much broader reach and accessibility since customers avoid the hassle of having multiple stored-value accounts. In effect, FedNow centralizes all taxpayer accounts between banks, making the financial institution a custodian for a shared wallet.

The system is based on Brazil's own interbank transfer program called Pix. When Brazil first launched Pix, consumers were overly hesitant about using it, citing concerns that their money and data would not be secure within the service. The steep increase in instant payments adoption that Brazil has seen since launching Pix came down to three components that financial institutions emphasized to enhance consumers' experience with it: security, convenience and user experience. Like cryptocurrency wallets, Pix wallets have unique identifiers. But unlike crypto, all user data is stored in a central database called the "Transaction Accounts Identifier Directory" (DICT), which links Pix keys/aliases and the users' transactional account information.

P2P Growth

According to the San Francisco FED survey, the P2P market has been growing, with a noticeable increase in mobile app payments that reached 29% of P2P transactions in 2021.

The trend is also evident from PayPal's latest earnings results, as its brands PayPal, Venmo, and Xoom achieved P2P volume exceeding $91b in Q1 2023 and represented 26% of the total payment volume (TPV).

While P2P service providers might use ACH debit or credit cards to pull money out of financial institutions – those funds often remain in a closed-loop network. For example, a person sending money via PayPal to someone else, spending them on a Paypal-accepting vendor. The result is significant payment volume bypassing traditional financial institutions beyond the banks used for delayed settlement and escrow accounts.

P2P transfers were typical for the gambling & entertainment industry, with the poker community developing an honor-based network. Yet, large poker sites like Party Poker even responded by banning P2P transfers. Such communities circumvented payment services, and regulators tried prohibiting such arrangements.

Tax Evasion

Between 2016 and 2021, McKinsey's estimates show a 31% growth of self-employed Americans, that form an independent workforce of 58 million. According to Statista, this number could grow to over 90 million by 2028.

Research by Warthon showed that total underreported income for 2018 reached $1.3tn, or 6.3% of GDP. Considering many small and mid-sized businesses are highly dependent on contractors and handle payments via cash, there is a significant part of the economy that relies on instantaneous payments.

Still, the economy is becoming increasingly cashless, as the San Francisco FED's data shows, although the COVID-19 pandemic temporarily halted this transition. Cash payments still fell 26% in 2021 compared to 2019.

For gig workers, services like FedNow would force a means of receiving instantaneous income without underreporting it to the IRS.

System Upgrade

A move toward the faster digital payment system raised new questions about a physical money phase-out, prompting a response from the Fed.

In a statement, officials denied the service's relation to digital currency in any form, stating it is “neither a form of currency nor a step toward eliminating any form of payment, including cash.“

Aaron Klein, a senior fellow in economic studies at the Brookings Institution, shares this opinion.

“FedNow has nothing to do with replacing cash. It is an upgrade to the decades-old payment system,” said Klein, adding that such a service would make payments faster, resulting in fewer overdraft fees, late fees, and visits to check cashers.