On June 6, 2022, the Federal Reserve Board issued a final rule governing funds transfers through the Fed’s new FedNow Service, an interbank 24x7x365 real-time gross settlement service with integrated clearing functionality to support instant payments. FedNow is expected to launch next year and will operate alongside The Clearing House’s Real Time Payments network, which has been operating since 2017. The new FedNow rules will take effect October 1, 2022 and will apply to all depository institutions that choose to participate in the FedNow Service, regardless of size.
1.What is the Legal Framework for FedNow?
The Federal Reserve’s final rule amends Regulation J (12 C.F.R. Part 210), which governs collection and return of checks and FedWire transfers. The new rules add a new Subpart C to Regulation J to incorporate the FedNow service. The new Subpart C does the following:
- Specifies the terms and conditions under which Reserve Banks will process FedNow transactions;
- Grants the Reserve Banks authority to issue an operating circular for the FedNow Service;
- Provides official commentary constituting a Board interpretation of the Subpart; and
- Makes technical corrections to Subpart A and clarifying amendments to Subpart B to reflect that Reserve Banks will operate a second funds transfer service in addition to the Fedwire Funds Service.
New Subpart C incorporates the provisions of UCC Article 4A—governing the rights and responsibilities of parties to funds transfers—to the extent they are consistent with Subpart C’s express provisions. Incorporating UCC Article 4A confers important rights upon financial institutions using the FedNow Service, such as protection from consequential damages liability (unless provided by express written agreement) should an issue with a transfer occur. The Board believes this protection will enable FedNow participants to offer instant payment services at lower costs and with greater speed.
Additionally, Subpart C provides that UCC Article 4A applies to all FedNow transfers, even those potentially meeting the definition of an “electronic fund transfer” under the Electronic Fund Transfer Act (EFTA). The EFTA provides certain protections with respect to “electronic fund transfers” on consumer accounts. Should any inconsistency arise between the requirements of the EFTA and Subpart C, the EFTA would prevail to the extent of any inconsistency. For example, where a FedNow funds transfer subject to EFTA (for example, an electronic fund transfer that debits or credits a consumer’s account) is initiated, the EFTA would govern the transfer and the bank’s obligations to its customer. So, while UCC Article 4A (as incorporated by Subpart C) would allow parties to a FedNow transaction to vary most of its provisions by agreement, banks must still comply with the applicable consumer protection requirements of the EFTA, which cannot be varied by agreement.
2.How Will FedNow Transfers Work?
The rule establishes procedures to effectuate real time, end-to-end fund transfer completion. An end-user (e.g., an individual or a business) initiates a payment by sending a payment message to its financial institution through an end-user interface outside the FedNow Service. The end-user’s financial institution or its service provider (a sender) then submits a payment message using the ISO 20022 financial messaging standard to the FedNow Service. The FedNow Service validates the payment message and sends the contents of the message to the receiving bank. The receiving bank must confirm that it intends to accept the payment message. Upon confirmation, the FedNow Service debits and credits the designated master accounts of the sender and the receiving bank, respectively. The FedNow Services then sends a payment message to the receiving bank with an advice of credit and an acknowledgement to the sender that settlement is complete. Payment is final and irrevocable at the earlier of the time when the amount of the payment order is credited to the receiving bank’s settlement account or when the Reserve Bank sends the receiving bank a conforming payment order or notice of credit. The final rule sets the terms under which Reserve Banks will accept payment orders from banks acting as sendersover the FedNow Service. First, a sender must make arrangements with its Reserve Bank before sending FedNow payment orders. A Reserve Bank may reject any payment order or impose conditions on acceptance. Once the Reserve Bank accepts the payment order, an obligation to pay arises. A sender authorizes its Reserve Bank to obtain payment for a payment order by debiting (or causing another Reserve Bank to debit) the order amount from the sending bank’s settlement account. A sender does not have a right to an overdraft in its settlement account and must ensure 24x7x365 liquidity sufficient to cover the amount of its FedNow transactions.
The Fed’s new rule requires the receiving bank to make funds available to the beneficiary of the FedNow payment immediately upon acceptance of the payment order over the service. After reviewing comments on whether the rule should specify time parameters clarifying the term “immediately” as used in the funds availability requirement, the Board decided not to adopt a time period in the final rule. Recognizing that the time period considered “immediate” may continue to evolve as the instant payment industry develops, the Board decided to retain necessary flexibility by not defining the term in new Subpart C. However, Subpart C does not entitle the beneficiary to enforce the immediate availability requirement against the receiving bank.
3. What Error Prevention and Resolution Features Are Planned for FedNow?
To ensure the FedNow Service can complete real time, end-to-end transfers in a matter of seconds, the rule provides that a Reserve Bank may rely on the number (e.g., an account number or routing number) in the payment order identifying the beneficiary’s bank or beneficiary consistent with UCC Article 4A. The Reserve Bank is, however, entitled to rely on these identifying numbers only if it is unaware of any inconsistency.
The Board found that requiring Reserve Banks to take additional steps to prevent erroneous payments when they identify potentially incorrect payment information would slow processing of time-sensitive payments and introduce operational complexities. Instead, the Board decided functionality allowing banks to request a return of payment after they identify an error would more effectively address erroneous or misdirected payments. The Board noted that, where EFTA applies to a consumer’s FedNow payment, EFTA’s error resolution procedures would also apply.
The rule only allows additional time to determine whether to accept a payment order where the bank has reasonable cause to believe a beneficiary is not entitled or permitted to receive payment. To preserve the end-to-end speed of the process, the Board rejected broader approaches that would allow additional time at a FedNow participant’s discretion or where a bank has “reasonable suspicion” rather than “reasonable cause.” Recognizing that FedNow participants who make funds immediately available to beneficiaries may face operational challenges such as system maintenance needs or cybersecurity incidents, Subpart C allows participants to sign off from the FedNow Service for limited periods, obviating the need for a broader approach.
4.What Fraud Prevention Features Are Planned for FedNow?
At launch, the FedNow Service’s incorporated fraud prevention tools will include optional negative lists and the ability to set lower credit transfer limits. Subpart C also authorizes Reserve Banks to issue operating circulars which would include service terms for these and additional fraud prevention tools. The Reserve Banks plan to augment fraud prevention tools as the FedNow Service matures.