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FedNow: Are US Banks Ready For Real-Time Payments?

Forbes Technology Council
POST WRITTEN BY
Steve Hassett

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You might assume that the United States is on the cutting edge of money transfers. However, unlike other countries, the U.S. payment system lags in terms of real-time settlement.

While a pizza can be delivered in less than 30 minutes, a bank transfer can take days to show up in your account. The Federal Reserve intends to change that — and I believe consumers will demand it.

The Federal Reserve Board recently announced a plan for the Federal Reserve Banks to "develop a new round-the-clock real-time payment (RTP) and settlement service" called the FedNow Service. Estimated to arrive in 2023 or 2024, FedNow plans to revolutionize the American payment system to support faster RTP.

The flexibility of RTP is important for households on a tight budget that engage in expensive check-cashing services, high-cost borrowing or unnecessary overdraft fees. Small businesses will benefit from immediate access to their funds instead of resorting to short-term financing in a pinch.

Recipients have peace of mind that once their funds are received, they are secure and permanent. Unlike checks, RTP settlements cannot be recalled or bounced before final clearing, which seems like a win-win scenario for banks and users. So why is the U.S. taking so long to move toward RTPs?

Unfortunately, our current payment system process hails from the Fed's creation early in the 20th century, an era when checks were literally bundled together and sent to the Federal Reserve for clearing. In the early 1970s, when the number of paper checks exceeded what could be processed efficiently, the automated clearinghouse (ACH) was established. At first, the ACH system used magnetic tape and diskettes that had to be physically transported in order to exchange files. In 1994, the Fed mandated that all institutions send files electronically, but settlement still took a day or more.

Today, banks continue to rely heavily on mainframe and legacy applications to manage their growing businesses. In fact, according to research conducted by IBM (via Forbes), 92 of the top 100 banks use the mainframe to provide banking services to their customers.

Although mainframes are fantastic at computing millions of transactions in seconds, they struggle to communicate with modern systems. The banking industry's applications are decades old and designed for a batch world. Integrations between modern systems and mainframes that are written in older coding languages are complicated, time-consuming and costly. Moving from a batch structure to a real-time transfer system requires a complete transformation of the banking industry's IT structure.

Another risk for RTP is fraud. Under the current system, a check recipient is responsible for the financial risk of depositing a fraudulent check. Accounts are easily overdrawn due to depositing a bad check. A shift toward RTP puts the onus on the banks to spot fraud in real time. Banks have the financial liability associated with fraud without the days or weeks necessary to roll back a transaction.

To prevent fraud in real time, regulatory checks such as anti-money laundering (AML) and know your customer (KYC) — which normally take place over a series of days — would need to be done in seconds. An RTP means that once that payment is sent, it's gone instantly and can't be taken back.

Alternatively, services like Venmo and Zelle already operate in real time because they're closed systems. Venmo requires a Venmo-validated account. Zelle requires a validated bank account before any transfers can take place. Effectively, all AML, KYC and fraud checks take place prior to allowing any transaction.

Conversely, FedNow will act as an open system, working much like an instant check. Any person at any bank could send money to any other person at any other bank. To combat fraud, the bank's legacy applications would need to instantly communicate with third-party security vendors and verification services — something the legacy systems simply aren't designed to do.

Transforming banks doesn't require ripping and replacing the entire legacy application infrastructure. Application program interfaces (APIs) can securely access programs and data, acting as a bridge between legacy infrastructure and modern cloud applications. In fact, a Treasury Department report regarding the core principles of regulating the financial system mentions APIs 63 times.

Creating APIs involves time-consuming, complex code that can result in difficult-to-maintain, brittle connections between old and new. Coding is an efficient solution if there are only a few use cases that won't change over time. However, if the number of APIs swells into the 10s, 100s or more, manual coding becomes inefficient.

To gain efficiency, simple connectors can be used to expose the mainframe at a very granular level. While more efficient than manual coding, these connectors still require writing code for things like error checking, complicated data structure translations and embedded workflows.

From my experience, many companies with a large backlog of APIs and a rapid pace of change find that specialized tools can greatly increase team productivity. By using no-code, drag-and-drop graphical user interfaces, development teams can create APIs exponentially faster than other approaches. These tools can also enable legacy systems to make outbound calls to cloud applications for things like artificial intelligence-driven fraud detection.

I believe financial institutions looking to develop an API strategy have to look beyond today's needs to what the future demands, including required software maintenance, updates and enhancements. They'll need to assemble the right combination of people and tools in order to gain a competitive advantage. After all, the only sustainable advantage is the ability to innovate more quickly than the competition.

As consumers expect money to be accessible instantly, banks will continue to feel the pressure to change. Architects must build resilience into their solutions. Banks that do not support an open system of real-time payments like FedNow will find themselves at a huge disadvantage in the near future. Banks that lead change will continue to evolve and grow.

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