TX Zhuo
The payments industry is on the cusp of a revolution.
Thanks to the Federal Reserve’s new instant payments initiative FedNow, transactions will soon be faster, more secure and more cost-effective than ever before. This initiative promises to benefit consumers, small businesses and banks of all sizes. As such, given its potential to completely overhaul the way we make payments in the years to come, many opportunities, as well as challenges, are likely to arise.
Say hello to the tax man
The IRS estimates that nearly two-thirds of income goes unreported due to a lack of third-party reporting. A significant portion of small and mid-size businesses (SMBs), which are highly dependent on hourly workers, typically handle payments via cash and, similarly, consumers do the same with many of their everyday service providers (i.e., gardeners, dog walkers, etc.). The key factor contributing to this is independent contractors’ reliance on instantaneous payments.
With the advent of FedNow, contractors can now get paid immediately, specifically via ACH, which will result in many transactions moving away from cash as the primary medium of payment. Yet, while this is cause for celebration among independent contractors, increased transaction traceability brings with it increased tax reporting requirements and liabilities.
Moving forward, we foresee a heightened focus on assisting independent contractors with tax management navigation, as well as financial planning.
Main Street can now compete with Wall Street
Smaller financial institutions like community banks can now offer the same level of service as larger banks or modern fintech companies and support further migration to online banking. In effect, this could reduce the need for physical locations, due to the reduction of check flow and improve the margin profile for these smaller financial institutions that have historically shouldered the cost of a large retail footprint.
Given the absence of risk in overdrawing one’s bank account or paying overdraft fees (as banks verify fund levels before initiating instant payments), this will greatly diminish the costs that banks currently incur for settlement fees and fund verification.
As this novel technology takes shape, it will be critical to observe the impact on existing payment platforms such as Zelle, PayPal and Venmo. These services can no longer rely on speed as an advantage and will be forced to expand their product offerings (i.e., financing, rewards programs or other value-added services) in order to differentiate themselves.
We could finally see a breakthrough in consolidation, where online payment platforms move beyond Wall Street and look to smaller financial institutions as key distribution partners.
Payday sharks making a retreat
The global payday loans market size has been on a healthy growth trajectory, projected to reach $48.68 billion by 2030. One could argue that the average length of a payday loan is two weeks, and thus shortening the payment cycle by two to three days will not adversely affect the market size. That said, we cannot ignore the power of compounding interest if consumers can make a partial repayment faster.
We may not see an immediate impact on payday loans in the short term, but we are likely to see a reduction in payday loan amounts or balances moving forward.
Several fintech companies provide an earned wage access service for hourly wage workers, and we believe this much needed service offers a massive benefit to independent contractors. Yet, similar to traditional payday loan providers, it is increasingly likely that instant payments could cannibalize payday loan volume. Rather than seeing this as a problem, we believe this to be a catalyst for many fintech platforms to expand their product offerings and incorporate tax reporting and longer-term financial planning. Ultimately, this better aligns with hourly workers’ financial well-being as opposed to quick one-off loans, which could lead them to long-term debt.
The faster you go, the riskier it gets
Overall, FedNow presents both compelling opportunities and potentially complex challenges. The immediate opportunity we see is risk management, given the increased risk of fraud and potential scams that might occur as transfers become harder to recall once activated. We believe that startups building across the following categories will provide critical risk-prevention services to participants in the FedNow program.
- Digital footprint analysis: A feature that leverages digital data to answer the question: “Am I dealing with a real person, and are they who they say they are?”
- KYC checks: Customer ID verification is a huge part of know your customer (KYC) checks. Better banking fraud detection software should help with that.
- Real-time monitoring and alerts: Understanding how fraud happens at a bank is one thing. Setting up real-time monitoring and notifications is the next step.
- Machine learning suggestions: Fraudsters are adaptive. One must ensure their fraud-detection software can also adapt to new attack vectors. This is where AI can help suggest new risk rules tailored to one’s risk challenges.
While some might argue that the FedNow program will temper the proliferation of web3 and crypto technologies across banking, we see things a bit differently. In fact, we portend that the program will allow for the transfer of technology, and that risk management and fraud mitigation, which were built for crypto (real-time risk assessment), are in fact going to be highly relevant to all financial institutions.
More convenience but more risk — less debt but more taxes
Current regulatory changes are also driving toward instant payments as regulators are increasingly requiring financial institutions to have heightened visibility into large cash flows across multiple accounts in order to prevent money laundering and other illicit behavior.
This points to a future of increased convenience and transparency for processing payments. The Fed’s initiative has opened up a window for innovation, the effects of which could be realized as early as next year. It will be illuminating to see how banks, fintechs and even consumers respond and the type of products that emerge from this evolution in payment technology.
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