Where now FedNow?

Earlier this month the Federal Reserve introduced its new instant retail payments system, FedNow. This is actually the U.S.'s second real-time retail settlement system. The first, The Clearing House's Real Time Payments Network, or RTP, opened for business back in 2017.

As FedNow and RTP develop over the next few years, a good way to gauge their performance will be to look to the UK, which provides a useful blueprint of a successful rollout of real-time retail payments, one that the U.S. would surely like to emulate. 

The UK introduced its Faster Payments real-time system in 2008, almost ten years ahead of the American roll-out of RTP. Prior to 2008, payments made by U.K. retail bank customers entirely relied on a piece of infrastructure called Bacs, built back in 1968 and originally dubbed the Bankers’ Automated Clearing System. Much like the automated clearing house (ACH) payments, the go-to U.S. option for retail payments, Bacs payments are not immediate, often taking several days to settle.

Below is a chart of the total value of payments processed by Faster Payments and Bacs over time:

As you can see, the value of Bacs payments was advancing at a brisk 10% pace until Faster Payments landed in 2008, at which point they immediately slowed to a lethargic 2-3%, in some years not growing at all. The Faster Payments scheme, which is currently expanding at a healthy clip of 15-20% each year, is set to surpass Bacs by 2025 or 2026.

A steady eclipsing of the slower network is what should ideally happen in the U.S. as consumers switch from ACH over to useful (and often crucial) real-time FedNow or RTP payments. Mind you, we shouldn't expect ACH to be entirely replaced. It's still more efficient to use slower systems to settle non-time sensitive payments.

Unfortunately, the U.S. is already far behind the timetable set by the UK, and is unlikely to catch up.

Let's take a look at RTP, which is now in its seventh year of operations. When the UK's Faster Payments system was in its seventh year, it was already processing around £225 billion worth of payments per quarter, a hefty 20% of the value then flowing through Bacs. Alas, as the chart below illustrates, the blazing-fast RTP network processed $25 billion worth of payments in the first quarter of 2023, just 0.1% of the $19.7 trillion load processed by U.S.'s ACH network. That's next to nothing.

Source: The Clearing House

I don't see why FedNow will prove anymore successful than RTP in driving real-time payments, since it offers no real advantages over its competitor. (In fact, the second network may even slow down the overall growth rate of real-time payments, as I'll show further down.)

I count two reasons why the uptake of real-time payments in the U.S. has lagged U.K., and why this under-performance will only continue, even with FedNow's introduction.

1. The U.S. has over 9,000 banks, thrifts, and credit unions. By contrast, the UK has only 357 banks and building societies. Not only are there fewer UK banks, the UK's top-5 banks are more concentrated, controlling around 60% of all banking assets compared to the U.S. top-5, which control just 50%.

The advantage of having fewer, more concentrated banks is that it makes it easier for the banking system to coordinate a shift onto a new network. When Faster Payments started, for instance, it enjoyed a huge vanguard group with all of the UK's biggest banks participating, including NatWest, Barclays, Lloyds, and HSBC. Not so with FedNow, which has only signed up 41 of America's 9,000 financial institutions, and is missing top-10 banks like Bank of America, PNC, Truist and TD.

(Those with long memories will recall that this vanguard group problem is also why Canada's e-Transfer service has grown so much faster than U.S.'s Zelle.)

2. Further complicating adoption is that fact that while the UK had just one instant network, Faster Payments, the U.S. has two real-time networks, FedNow and RTP. These two networks are not interoperable with each other. A bank that wants to offer real-time payments to its customers may choose to delay incurring the set-up costs of joining either of the two networks, until a definite favorite has emerged. But this collective hesitation will prevent real-time payments from ever being adopted in the first place.

To sum up, the road to real-time settlement systems in the U.S. has been a long one. Whereas the UK introduced Faster Payments in 2008, it took another decade for RTP to be built, and five years on top of that for FedNow. Alas, the path to actual usage of these new real-time systems will be even slower, given the diffuse nature of the U.S. banking system and the hesitation effect that comes with having two competing networks.

Elon Musk's understanding of payments dates back to his PayPal days. It needs an update

[This is a republication of my most recent CoinDesk opinion piece.]

You've heard the script before. Migrants need to make payments back home to their family, but cross-border payments are achingly slow, taking days to process. Luckily, revolutionary new technologies like blockchains, stablecoins, and central bank digital currency (CBDC) are on the verge of speeding things up, or so their advocates claim.

Even Elon Musk has joined in. In an interview last month, Musk says that the banking system is "still not real-time" and "quite inefficient," and suggests that his social network, Twitter, may be able to do something about this. His subsidiary, Twitter Payments LLC, just got its first money transmitter license yesterday from the state of New Hampshire, suggesting that he means business. [Note: Twitter Payments now has three more licenses, as illustrated below.]

Twitter Payments LLC's money transmitter licenses, via NMLS

Alas, the script is based on dubious assumptions, and money transfer company Wise (previously Transferwise) is a great example of why. Wise, based in London, now processes 55% of its customers' cross-border payments instantly, up from under 10% back in 2018. Wise doesn't rely on blockchains, stablecoins, or CBDC to get up to speed. It uses boring already-existing architecture.

The Wise example suggests that would-be challengers like Elon Musk's Twitter and advocates of blockchains, stablecoins and CBDCs may need to update their views on the incumbent infrastructure they are looking to displace.

Take Elon, for example, who helped found PayPal in 1999 and therefore knows a little bit about the payments system. In his recent interview, he describes the financial system as a heterogeneous set of databases that "slowly engage in batch processing."

Having subsequently switched his focus from retail payments to rockets and cars in 2000, what Musk seems to have missed is that batch processing of retail payments has been increasingly displaced by real-time processing. Under the older batching systems that prevailed when Elon was still at PayPal, streams of retail payment instructions would be accumulated over the course of the day into a big batch. Come evening-time or the following day that entire mass of payments was cleared and settled. Only then would the money be made available to the recipient.

Batching was efficient, but slug-like.

But then the global payments landscape entered into an era of transformation. Central banks began to build a new generation of payments infrastructure: real-time retail payments systems.

Real-time payments

These new retail payments systems process incoming retail payments on a first-come first-serve basis, and do so instantly. The central banks that offer these systems keep them open through the night and during weekends. Banks and fintechs can in turn plug into these new pieces of public infrastructure in order to offer their customers 24/7 instant payments.

The world's first real-time retail system, Zengin, was built in 1973 by the Bank of Japan, but the movement really only hit its stride in the 2000s as Korea, Mexico, and the UK sped up their capabilities. India and China went real-time in the early 2010s. The U.S. finally got its first instant retail payments system in 2017, with the debut of the Real-Time Payments network, run by privately-owned The Clearing House. It will get its second such system this summer as the Fed introduces its FedNow payments network.

According to a 2021 BIS report, over 60 jurisdictions currently now have real-time retail systems in place running alongside their older batch retail systems. This is up from almost none back when Elon was working in the payments sector.

This new generation of real-time retail payments systems is a big part of why Wise can move 55% of its customers cross-border payments instantly. Here's how it works.

Say a Wise customer in Ireland wants to send 500 euros to a family member in India. First, the money must be moved from the customer's Irish bank account to Wise's account at another Irish bank. In the old days of batch processing, this leg of the remittance would have taken a day or two. Thanks to the European Central Bank's TARGET instant payment settlement (TIPS) system, introduced in 2018, a flow like this can now occur in just a few moments.

Having received its customer’s 500 euros, Wise can now proceed to the next stage: paying out 44,000 rupees to the recipient in India. To do so it will have to transfer funds from its account at an Indian bank to the recipient's bank. In the days of batch processing, that meant adding another day or two of waiting. Nowadays, courtesy of India's Immediate Payment Service (IMPS), when Wise sends 44,000 rupees to the family member's bank account the payment can be processed in a second or two.

In sum, the Irish and Indian legs of a modern remittance can be processed in a few heart beats, much faster than the multiple day lags that dominated 20 years ago.

As more and more countries install real-time payments systems, and as Wise integrates itself with them, the proportion of Wise remittances settled in real-time will move ever closer to 100%.

But blockchain?

None of this is to say that there is no space in the cross-border payments landscape for a Twitter-based payments option, stablecoins, or blockchains. There is! It simply means that the incoming competitors need to update their oppo research. Traditional finance isn't the oaf that it is so often made out to be. It already has the technological capability for doing instant cross-border payments, which means the rebels will have to find other factors to differentiate themselves by.

Nor is this spreading bedrock of real-time infrastructure that I’ve just described at all incompatible with the new entrants. If Elon wants to build an instant Twitter payments network, he'll find the web of central bank real-time systems that have blossomed during his 20-year interlude outside the payments space to be a very useful set of rails on which to build.

As for stablecoins and blockchain-based offerings, they too may find it useful to be integrated into 24/7 central bank instant payments systems. For instance, if a DeFi speculator wants to move $10,000 from their bank into a stablecoin at 11PM on Saturday evening in order to take advantage of a fleeting DeFi arbitrage opportunity, and then move the funds back into their bank account by 11:01 PM, central bank instant payments systems can make this possible.

Let a thousand instant payments options bloom, built on top of central bank instant rails.

A back-of-the-envelope estimate of the size of the US crypto ETF market

I'm hearing all sorts of silly projections about how big the U.S. market for a physical crypto ETFs will be, and how their eventual approval will drive new bitcoin demand and pump its price into the stratosphere.

To date, the Securities and Exchange Commission (SEC) has refused to give its permission to a physically-backed crypto ETF. As such, the main way for U.S. investors to get exposure to exchange-listed crypto products has been to buy the Grayscale Bitcoin Trust or Grayscale Ethereum Trust, which are closed-end funds, and lack the many of the nice features of an ETF.

Luckily, we already have a good idea about what market demand for physical crypto ETFs looks like. Canada has allowed these products since 2021. According to the Canadian Securities Administrators (CSA), our version of the SEC, the combined value of all listed crypto financial products was C$2.865 billion as of April. Almost all of that (C$2.289 billion) is comprised of physical bitcoin and ether ETFs, with a small contribution from close-end funds and futures-backed products.

Source: CSA

Applying the rule of 10 to this number, the implied total value of all U.S. exchange-listed crypto products, both physically-backed ETFs, futures-backed ETFs, and closed-end funds, comes out to C$28.65 billion, or US$22 billion. The rule of 10 is based on the idea that Canada's population is a tenth the size of the US's, and since Canadians and Americans are quite similar, just multiply Canadian data by ten to get U.S.-equivalents.

The Grayscale Bitcoin and Ethereum Trusts, worth US$13.7 billion and US$3.5 billion respectively, are likely to convert into ETFs if the SEC allows it, so US$17.2 billion of this US$22 billion in theoretical headroom for total U.S. exchange-listed crypto products is already taken. That leaves another US$4.8 billion in theoretical as-yet unused capacity. 

This is hardly a game changer, folks.

If the eventual approval of physical crypto ETFs unleashes US$4.8 billion in potentially new crypto demand from U.S. investors, that is tiny relative to the US$900 billion combined value of bitcoin and ether. And keep in mind that this US$4.8 billion may not necessarily represent new investor buying power, since the introduction of physical ETFs could simply cannibalize existing demand by pulling crypto holders away from storing crypto on exchanges like Coinbase, or from owning it physically.

Will the digital euro be like cash?

The European Union published its proposal for a digital euro late last month, which will be issued by the European Central Bank (ECB) if it goes ahead. There's plenty to digest in the 62-page document, but the one area I want to focus on in this post is privacy.

Digital euros will be permitted to have cash-levels of privacy, says the EU, although only for a certain type of transaction: offline transactions.

An offline transaction is one that doesn't require the internet or any sort of connection to an ECB database. The buyer and seller each carry a local storage device where digital euros are recorded, say a "euro card" with a chip on it, and these devices can talk to each other when in close proximity, the transaction getting settled directly between the two devices. If the electricity is down, no problem. The payment will still go through.

By contrast, for online transactions there will be an ECB database in some Belgian or French data centre where individual balances are recorded. When a buyer and seller transact, the payment request is communicated over the wires to this database and respective balances are updated, much like a debit or credit card payment.

An online transaction can be made anywhere, assuming that the internet isn't down. A person in Holland can use it to buy shoes from a German website, for instance. But these transactions won't be private.

The privacy levels of offline transactions, however, will be comparable to "the use of cash," says the ECB. If you pay me 200 euros using the offline format, the ECB and third party payments services providers will "not gain access to personal transaction data." The catch is that because our local storage devices must sync up, offline transaction can only be made face-to-face, sort of like cash. So no Holland-to-Germany payments.

Who are these payments services providers, and how do they figure into the equation? If you want to get physical cash, one way to do so is to withdraw it from a bank ATM. In that same vein, to get digital euros you can't get them from the ECB, but will have to withdraw them from a payments services provider with whom you have a relationship. That provider may be a commercial bank, but it could even be the post office.

These payments services providers will also be in charge of registering the storage devices that allow for offline payments. The idea behind registration is to prevent people from having multiple storage devices, and thus evading what will surely be personal holding limits on private offline euros.

The proposal doesn't mention what the limits would be. Will there be, for instance, a maximum of 1000 in offline euros allowed on one's Euro Card at any point in time, and perhaps a monthly spending limit of 5000 euros? Lower? Higher?

My thoughts:

It's great to see the EU champion the cause of financial privacy. In consultations with citizens, privacy was considered the most important feature of a digital euro, so the EU is responding to their needs by ensuring that the ECB's role as a financial privacy provider, historically confined to paper money, continues in the digital era.

Privacy is important, but limiting the size of this anonymous financial space is also prudent, in my opinion, in order to reduce the scope for harmful activities, particularly fraud. Maximum offline balances and transaction sizes will be a key part of this delimiting effort. 

But ceilings should not be set too low, since that will make for unusable privacy. The proposal doesn't mention specific numbers for ceilings, but going forward they will be the a key line of contention, with law enforcement no doubt lobbying for the lowest possible allowance for offline euros, and thus a mostly unusable product, and citizens groups pushing for higher limits and usability.

In additional to limits on balances, the EU's proposal uses personal proximity as the way to set out the boundaries to transactional privacy. That is, in an attempt to limit the availability of privacy, and thus its potential danger, it will confine the option to in-person scenarios.

Unfortunately, if only face-to-face transactions can ever be private, then the EU is saying that it is comfortable with a large percentage of Europeans' financial lives being permanently non-private. Having already opened the door to private offline transactions, the EU has tacitly accepted the ECB's responsibility as privacy-provider to the people. Shouldn't its responsibilities extend further than that? In addition of allowing for in-person private payments, why not allow Europeans to make small amounts of private online transactions, too? This category of transactions will only get proportionately larger over time as people increasingly hunker down into their internet lifestyles.

Lastly, is the EU's commitment to offline privacy one that can be trusted? Will there be back doors? Even if there are in fact no back doors, and offline digital euro transaction are truly 100% private, in our post-Snowdon era how can users even be sure of this? The proposal gives no hints at how and why Europeans can build trust in the EU's privacy claims.

The strange new world of multifunctional assets

I would never own it, but the cryptocurrency BNB is probably one of the strangest most interesting assets I've ever analyzed. No other asset (perhaps ever?) provides its owner with so much functionality. 

Is the sort of multi-functionality offered by assets like BNB a feature that all assets will have in the future? Is this the dawn of a multi-functional asset world? I'll explore this question at the end of this post.

BNB was issued by Binance, the beleaguered global crypto exchange, through an initial coin offering in 2017. It has around four, maybe five (?) different functions.

1. a medium of exchange

 BNB can be digitally transferred in a P2P fashion to other people. You can use it to buy stuff, send funds to friends or family, or move funds between crypto exchanges. It's like cash, except electronic (and volatile).

2. an investment security

BNB provides yield to its owner, sort of like a stock or bond. Most securities issuers pay securities owners an explicit return in the form of a stream of dividend payments or interest payments, generated out of the issuer's revenues. Rather than paying a return directly, Binance repurchases and cancels BNB using a portion of revenues.* It dubs this process burning, but it's functionally the same thing as paying a dividend.

3. loyalty points

Like the points issued by Starbucks, BNB can be used at the Binance.com exchange to get deals on trading fees and access to other Binance perks and services.

4. a ticket, or commodity

In addition to running a big crypto exchange, Binance controls a "decentralized" blockchain. The only way to use that blockchain is to have some BNB on hand to pay fees. No BNB, no play. So we can think of BNB as a ticket to get network access or, alternatively, a very select sort of commodity. That is, in the same way that the demand for pork bellies is driven by people's desire to consume bacon, the demand for BNB is driven by people's desire to consume the services available on Binance's blockchain.

So BNB is Swiss army-knife asset, with four functions packed into one instrument. There's probably more that I've missed.

The dawn of a multi-functional asset world?

Might this sort of multi-functionality, heretofore confined to the crypto ecosystem, become popular in the regular world? 

Let's imagine what Apple multi-functionality might look like. Apple shares wouldn't just be securities providing a yield. They could also be sent to friends and family as payment, or used to buy apples at the grocery store. They could also be used as loyalty points, say to get perks at the Apple store (i.e. priority in line to see a technician), and as a necessary commodity for accessing certain types of Apple product functionality.

Or, imagine if your Air Canada ticket also provided a flow of dividend payments, like Air Canada shares do. And say that ticket could also be used as a digital medium-of-exchange for buying stuff and/or remitting funds back home to family.

One thing that has historically prevented this sort of multi-functionality is that securities, media of exchange, coupons, loyalty points, and tickets have always existed on separate databases, each with its own set of rules,  none capable of communicating with the other. When you start out from scratch, however, with a single database, as was the case with blockchains, and thus a unified set of rules, then that opens the door to multi-functional assets.

But even if the technological problem is solved (as well as a legion of legal and regulatory issues), there's another key reason that multi-functionality may never become widely adopted. It may not offer end-users an ideal customer experience. The problem is that functions start to interfere with each other, the final result being that the total usefulness of the multi-functional asset is less than the total usefulness of the set of separate assets, each offering its functionality independently.

For instance, if loyalty points are imbued with features that turn them into securities, then they will become much more volatile. For folks who simply want to be able to reliably and consistently consume a given product, these fluctuations will be a turn-off.

Alternatively, if a bundle of features (like p2p transferability and loyalty benefits) are added to an existing security, this will probably increase its price, upsetting many asset managers who don't want those perks, but want to enjoy a stream of dividends at the cheapest price possible.

So even though new technologies may allow for multi-functional assets, a multi-functional world may never actually emerge because people naturally prefer that functions be split apart.

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* More specifically, the revenue stream that funds repurchases, or "burns," of BNB comes from user fees levied on users of BSC Chain, Binance's "decentralized" blockchain. There's a formula that calculates how much fees get burned. Prior to this, revenues from Binance.com were used to fund repurchases and cancelleations of BNB.