Focus on Fintech: Federal Reserve Issues Final Rules Defining Legal Framework for FedNow | Eversheds Sutherland (US) LLP

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 in operation since 2017. The new FedNow rules will take effect on October 1, 2022 and will apply to all depositories 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 CFR Part 210), which governs the collection and return of checks and FedWire transfers. The new rules add a new subpart C to rule J to incorporate the FedNow service. The new subsection C does the following:

1. Specifies the terms and conditions under which Reserve Banks will process FedNow transactions;
2. Authorizes the Reserve Bank to issue an operating circular for the FedNow Service;
3. Provides official comments that constitute a board interpretation of the subsection; and
4. Make technical corrections to subpart A and clarifying changes to subpart B to reflect that the 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—which governs the rights and responsibilities of parties to remittances—to the extent they are consistent with Subpart C’s express provisions. Incorporation of UCC Article 4A provides important rights to financial institutions using the FedNow service, such as protection against consequential liability (unless provided by express written agreement) should a problem 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.

In addition, Subpart C provides that UCC Article 4A applies to all FedNow transfers, including those that potentially meet the definition of an “electronic funds transfer” under the Electronic Fund Transfer Act (EFTA). The EFTA provides certain protections with respect to “electronic funds transfers” on consumer accounts. Should an inconsistency arise between the requirements of EFTA and Chapter C, EFTA will take precedence to the extent of the inconsistency. For example, where a FedNow money transfer is subject to the EFTA (for example, an electronic money transfer that debits or credits a consumer’s account), the EFTA will govern the transfer and the bank’s obligations to the customer. So while UCC Article 4A (as incorporated in Subpart C) will allow the parties to a FedNow transaction to vary most of the provisions by agreement, banks must still comply with the applicable consumer protection requirements of the EFTA, which cannot be changed by agreement.

2.How will FedNow transfers work?

The rule establishes procedures to carry out the end-to-end transfer of funds in real time. An end user (eg, an individual or a business) initiates a payment by sending a payment message to their financial institution through an end user interface outside of the FedNow service. The end user’s financial institution or its service provider (a sender) then sends a payment message using the ISO 20022 standard for financial messaging to the FedNow service. The FedNow service validates the payment message and sends the content of the message to the recipient bank. The receiving bank must confirm that it intends to accept the payment notification. Upon confirmation, the FedNow service debits and credits the specified main accounts of the sender’s and recipient’s bank respectively. The FedNow services then send a payment message to the receiving bank with a credit message and a confirmation to the sender that the settlement has been completed. Payment is final and irrevocable at the first time when the amount for the payment order is credited to the recipient bank’s settlement account or when the Reserve Bank sends the recipient bank a corresponding payment order or notice of credit. The final rule sets the terms under which Reserve Banks will accept payment orders from banks acting as senders over 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. When the Reserve Bank accepts the payment order, a payment obligation arises. A remitter authorizes its reserve bank to receive payment for a payment order by debiting (or causing another reserve bank to debit) the order amount from the remitting bank’s settlement account. A sender is not entitled to an overdraft in its settlement account and must maintain 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 recipient 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 that clarify the term “immediately” as used in the 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 evolves, the Board decided to retain necessary flexibility by not defining the term in new subpart C. However, subpart C does not entitle the payee to to enforce the immediate availability requirement against the receiving bank.

3. What error prevention and resolution features are planned for FedNow?

To ensure that the FedNow service can complete real-time end-to-end transfers within seconds, the rule provides that a reserve bank may rely on the number (eg, an account number or routing number) in the payment order that identifies the payee’s bank or payee in accordance with UCC Article 4A. However, the Reserve Bank is entitled to rely on these identification numbers only if it is not aware 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 delay the processing of time-sensitive payments and introduce operational complexities. Instead, the Board determined that functionality that allows banks to request payment refunds after they identify an error would more effectively address erroneous or misdirected payments. The Board noted that where the EFTA applies to a consumer’s FedNow payment, the EFTA error resolution procedures will also apply.

The rule only provides additional time to decide whether to accept a payment order where the bank has reasonable grounds to believe that a recipient is not entitled or authorized to receive payment. To maintain 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 recipients may face operational challenges such as system maintenance needs or cybersecurity incidents, Subpart C allows participants to opt out of 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 integrated 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 that will include terms of service for them and additional fraud prevention tools. The Reserve Banks plan to expand the fraud prevention tools as the FedNow service matures.

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