FedNow: CBDC, not CBDC, or a “Trojan Horse for CBDC”? A brief overview of the Fed's instant payment system

The launch of FedNow stirred CBDC-related anxieties. Some critics argue that the Fed's interbank service is a testing ground for the digital version of the US dollar.

FedNow CBDC cash

FedNow is an instant payment system for interbank settlements rolled out by the Federal Reserve on July 20. The platform has stirred a lot of controversy, at least since March this year, when the Fed announced its launch date. The reason is the system's alleged similarity to the "notorious" central-bank digital currency (CBDC) concept. Last week, Coin Bureau put out a YouTube video calling FedNow a "Trojan horse for a CBDC."

Such opinions are widespread on crypto Twitter and other social media. Is the Fed's new service something Americans should worry about?

What is the FedNow instant payment system?

FedNow is not a recent invention. The project dates back to August 2019, when the Fed first shared its plans to develop a new interbank 24x7x365 real-time gross settlement (RTGS) service with integrated clearing functionality. The decision followed a policy analysis and a public comment period held in 2018. The declared goal of the initiative is to enable faster payments, allowing individuals and businesses to keep up with the digital transformation, and boost economic growth.

According to the release, FedNow aims "to facilitate nationwide reach of instant payment services by financial institutions — regardless of size or geographic location — around the clock, every day of the year." Thanks to FedNow, businesses and individuals will be able to send and receive money instantly through their depository accounts in their banks. The FED will provide access to FedNow through its FedLine network, which serves over 10,000 financial institutions directly or through their agents.

How is FedNow different from FedWire, Venmo, and PayPal?

The platform will help overcome some of the limitations of the current payment systems, such as delayed funds availability. This is especially the case with Automated Clearing House (ACH) transfers, which often take several business days to complete. The ACH has been in use for over 50 years, and, as an electronic funds-transfer system, it is falling behind real-time payment systems already adopted by tens of countries, including the European Union (RT1, available since November 2017).

Currently, there are several instant payment systems in the US, including Venmo, PayPal, and FedWire. However, the first two act as intermediaries between banks, and the latter is reserved for large-scale, corporate settlements, plus, it works only during business hours. Smaller banks typically connect to FedWire through larger entities, but they have to pay a fee for the service. On the other hand, FedNow works for everyone, providing access to real-time payments without time constraints.

FedNow key features and upcoming functionality

FedNow has been launched with several baseline features, but more functionality is planned for release in the future. The current version of the service includes:

- round-the-clock availability for processing domestic payments, accessible to all US banks,

- a liquidity management tool that allows FedNow participants to transfer funds among themselves,

- reporting capabilities to aid FedNow participants in transaction monitoring, reporting, and reconciliation,

- basic fraud prevention features, including transaction activity limit settings.

The upcoming features include:

- integration of alias-based payments through directories and APIs,

- alias payments based on the receiver's public identifiers like phone numbers or email addresses, enabling users to make payments without knowing the recipient's account number,

- improved fraud prevention tools, including centralized monitoring with pattern recognition capabilities.

- support for bulk payments and enhanced remittance information.

What is CBDC?

Central bank digital currency is a rapidly evolving concept in the financial world. At its core, CBDC is a digital form of a country's fiat currency issued and regulated by its central bank. Unlike cryptocurrencies such as Bitcoin, Ethereum, or SOL, CBDC is fundamentally linked to the traditional financial system as a government-controlled digital asset. On the other hand, most cryptocurrencies are decentralized "by nature," have no ties to government institutions, and, for the most part, are free from regulatory oversight.

What are key CBDC benefits?

CBDCs carry significant benefits for the economy, streamlining settlements and bringing efficiency to financial transactions. With CBDCs, consumers and businesses can transfer funds 24/7 at lightning speed compared to current standards without having to rely on intermediaries. Additionally, state-backed digital money provides unbanked or "underbanked" citizens with greater financial accessibility through digital wallets, allowing them to participate in the online economy.

What's wrong with CBDC?

This convenience comes at a price, though. CBDCs are a dream come true for central banks, which can reduce their dependence on intermediaries, such as commercial banks. At the same time, they increase consumers' dependence on central banks and the whims of institutions.

Theoretically, CBDCs provide respective governments with the ability to control citizens' financial activity, both in terms of thorough surveillance and limiting financial freedom, including restricting purchasing of certain types of products and services, increasing and decreasing balances, blocking access to funds, etc.

It's easy to imagine how CBDCs can be abused in authoritarian or totalitarian countries, like North Korea or China, especially when combined with the Social Credit System in the case of the latter country.

Is FedNow a CBDC? Key differences

The concise answer is: no, but… Both CBDCs and FedNow are solutions related to the domain of digital currencies and instant transactions, but they're different in several regards.

Money vs payment system

A CBDC is a digital form of a country's fiat currency issued by its central bank and regulated by the government. FedNow is a payment system operated by the Federal Reserve that facilitates faster interbank transactions but does not involve issuing or owning a new digital currency.

General availability vs limited availability

CBDCs, as a digital form of a national currency, are typically accessible to the general public and can be used for daily transactions. In contrast, FedNow is dedicated to financial institutions. Consequently, direct access to the platform is limited to banks and other authorized entities.

Money supply control vs money transfer oversight

CBDCs allow central banks to exert direct control over money supply and circulation. On the other hand, FedNow, being a payment system, doesn't directly impact monetary policy, nor does it introduce a new form of money supply. Still, it allows the Fed to exercise stricter oversight of money transfers.

New system vs current system beefed up

Unlike CBDCs that require substantial changes to the existing financial infrastructure, FedNow is integrated into the current payment ecosystem and coexists with other payment methods offered by private institutions.

Key FedNow/CBDC similarities

Key FedNow's advantages, like transfer speed and payment efficiency, imitate the benefits of cryptocurrencies but add a layer of governmental oversight over transactions. It's one of the reasons some argue that FedNow is a pathway to CBDCs, as it can lead to more people and businesses embracing state-backed digital currency in the future. Key similarities between CBDCs and FedNow include the following.

State-controlled enhanced payment system

Both FedNow and CBDCs are state-controlled and aim to leverage digital technology to enhance payment systems. Fed's service focuses on providing faster and more efficient interbank transactions, while CBDCs, as digital forms of fiat currencies, are available for the general public, plus, they offer the potential for immediate and cross-border payments.

FedNow as a testing ground for CBDC

The implementation of FedNow can serve as a testing ground for policymakers to help them understand the legal implications and technological challenges of a digital currency ecosystem. Ultimately, insights derived from the FedNow system can influence the decision-making process around CBDC adoption. FedNow itself may also contribute to broader acceptance and adoption of the CBDC.

Increased surveillance

Both FedNow and CBDCs, as digital payment systems, can create vast amounts of data on users' spending patterns, fueling concerns about potential privacy breaches and government monitoring of citizens' and businesses' financial activities. The collection and storage of such sensitive information can pose risks to financial freedom and freedom in general.

Financial exclusion

FedNow and CBDCs allow government(s) to exercise wider control over financial activity and may lead to the exclusion of certain individuals or businesses from the financial system on legal grounds and abuse thereof. While FedNow aims to enhance financial accessibility, its integration with CBDCs could potentially lead to locking out some individuals or organizations from the financial system in certain circumstances, such as legal action or institutional overreach.

Cybersecurity challenges

Both FedNow and CBDCs may face cybersecurity challenges. The transition to digital payment systems opens up vulnerabilities to cyber threats, such as hacking attempts, data breaches, and digital fraud.

Financial power concentration

Both FedNow and CBDCs allocate significant financial, economic, and to some extent legal power to central institutions, leading to increased reliance on government entities and potentially consolidating authority over the financial system,

Will FedNow replace cash?

Fortunately, the answer to this chilling question is an assured no-no. As clarified above, FedNow, not being a currency, has no capacity to substitute cash. The only scenario contradicting this assertion is when FedNow evolves to become or include CBDC, which – if not impossible – would entail becoming a different system.

Wrapping it up, both FedNow and CBDCs are hot topics in relation to financial freedom, meriting public attention and continuous critical inquiry. Hopefully, policymakers will address privacy and freedom-related concerns around digital money in a way that benefits "end users," i.e., citizens, rather than the government.