Federal Reserve Bank
Federal Reserve Bank

United States’ central bank, the Federal Reserve System, has proposed a major change to its venerable credit-transfer service Fedwire.

The Fed wants to adopt the ISO 20022 Messaging format for the Fedwire Funds Transfer Service. A press release indicates that the Fed’s Board of Governors is taking comments on the proposed change right now.

The ISO 20022 is an international standard for financial messages designed to standardize and simplify the process. Adopting ISO 20022 would make it easier and cheaper for Fedwire customers to make transactions outside the United States.

One of the world’s oldest funds transfer systems

Fedwire, or the Federal Reserve Wire Network, is one of the world’s electronic-funds transfer systems. The Fedwire began as a telegraphic system back in 1915. Over the years the system was upgraded to Telex, and eventually to a computer network.

Today’s Fedwire Funds Service provides same-day transactions to government agencies, banks, and banks that have Federal Reserve Bank master accounts. Fedwire is used to settle commercial payments, settle positions between financial institutions, complete clearing arrangements, pay US federal taxes, and buy and sell federal funds.

Every Fedwire transaction is processed individually and settled immediately and finally upon receipt. The Fedwire depends upon a highly-secure electronic network that connects thousands of members. The Fedwire operates for 21.5 hours every business day (Monday through Friday). Funds are processed in Eastern Standard (New York) time.

The Fedwire is critical to America’s banking system because it ensures liquidity for banks, businesses, and government agencies. By having access to Fedwire, those institutions have continuous access to the Fed and money.

Fedwire joins the world

The Fedwire currently operates on a proprietary messaging standard that limits connectivity with institutions outside the United States.

Currently, institutions might have to join Fedwire to settle payments to, or receive funds from, the Fed. Adding ISO 20022 would give institutions all over the world the capability to settle Fedwire transactions on a same-day basis.

The ISO 20022 adoption would give foreign banks and financial institutions greater access to the American market. Fedwire is one of the two main large-volume payment systems operating in the United States.

This would increase business opportunities, but it would increase the exposure of American banks to troubles overseas. An unintended side effect of America’s adoption of ISO 20022 might be more exposure to liquidity crises at foreign banks.

If the Board of Governors approves it, the Fedwire would adopt ISO 20022 in three phases between 2020 and 2023. The Federal Reserve has been examining the possibility of utilizing ISO 20022 since 2012.

World’s central banks are increasing connectivity

The Fedwire ISO 20022 proposal is the latest effort to increase connectivity among the world’s financial institutions and central banks. Many of the efforts involve cryptocurrency and blockchain.

Leading the way is the People’s Bank of China (PBOC), which has set up a Digital Currency Research Lab. The Lab applied for 41 cryptocurrency and blockchain technologies in its first year of operation.

The PBOC’s governor Zhou Xiaochuan thinks a national digital currency is inevitable in China, The China Daily reported. Despite that Zhou is not in a rush to adopt a digital coin, he apparently fears the effects cryptocurrency bubbles might have on the wider economy.

Consequently, the PBOC has attempted to ban private cryptocurrencies in China while researching an official one. Zhou confirmed reports that the PBOC has set up an institute to develop a national cryptocurrency.

The Federal Reserve is planning to issue a paper that will reveal its official position on cryptocurrency. Former Fed Governor Kevin Warsh has been promoting FedCoin a cryptocurrency issued by the Federal Reserve, according to The New York Times. It is not clear if Warsh’s proposal has official support.

Central bankers are interested in blockchain because that technology would theoretically allow the extension of same-day payment settlement systems like Fedwire to ordinary citizens. That would enable governments to distribute welfare benefits, pensions, basic income, or emergency funds directly to everybody.

Banks developing blockchain based settlement systems

There are some private efforts to develop a blockchain-settlement solution for central banks. These experiments include BABB (the Bank Account Based Blockchain) an Ethereum-based cryptocurrency and blockchain platform. BABB even bills itself as a blockchain solution for central banks.

A different approach is being tried by the Utility Settlement Coin (USC) and the Hyperledger Project. Both USC and Hyperledger are trying to develop blockchain-based settlement services that will directly connect major banks. The USC is being developed by a consortium that includes the Bank of New York-Mellon and UBS.

Hyperledger is backed by IBM and includes Deutsche Bank, Bank of New York Mellon, and HSBC. The banks are interested in the blockchain because it theoretically offers a far higher level of encryption and security than competing technologies.

Unfortunately, blockchain is much slower, and far less capacity than existing transfer systems. Existing blockchain technologies like Ethereum and Bitcoin can only process less than 20 transactions a second. The limited capacity of today’s blockchains would make it impossible to process the volume of settlements central banks require.

Despite the limitations, solutions like the blockchain and ISO 20022 have the potential to greatly increase connectivity between financial institutions. Insurers should pay attention because increased bank connectivity can increase risks to the financial system – such as the possibility of liquidity crises.

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