The Federal Reserve’s announcement last month that it would compete with private industry to launch a 24-hour-a-day real-time payment service has fintech experts raising an alarm: How will it handle fraud, which they say is inevitable with any financial system.

The Fed’s real-time gross settlement service, to be known as “FedNow,” is not scheduled to be available for at least four more years. Yet some financial services attorneys are already pondering who should bear the loss if it processes unauthorized payments.

Should it be the banks that unknowingly transfer the funds? The consumer in whose name the payment was made? A merchant who has unwittingly provided a service or product to a fraudster? The Fed itself?

The broad adoption of real-time payments marks a “paradigm shift” that lawyers are going to have to grapple with, said Christopher D. Ford, an attorney with Ballard Spahr LLP.

“The Fed is going to be very careful not to be disruptive,” he said. “They need to find a way to play in the middle ground.”

The Fed is proposing a near-instantaneous payment system, which would provide a service that enables consumers and businesses to send and receive payments within seconds.

The questions stem from the fact that the retail payments system in the U.S. is balkanized — a patchwork of different rules over who bears risk and who must correct errors.

The laws and regulations for retail payments differ greatly depending on the type of payment used, whether electronic transaction, paper check, credit or debit cards, or the system known as the automated clearinghouse. Automated clearinghouse transactions are electronic payments transferred from the deposit account of a consumer, business or government to the entity being paid.   

The Federal Reserve Bank of Chicago, in a 2013 study titled “Clarifying liability for twenty-first-century payment fraud,” noted there are also different regulations and case law governing business-to-business transactions and consumer-merchant retail transactions.

The confusion is only likely to grow worse as new financial technologies and near-instantaneous payment systems, including FedNow, become ubiquitous, according to Ford and other lawyers at Ballard Spahr.

“Certainly because of the near instantaneous nature of the transaction, fraudsters have less time to engage in any transaction,” wrote Ford, Judy Mok and David H. Medlar in a client memo late last month. “However, the time barrier that financial institutions and others have used to verify the validity of the transaction will disappear as well, allowing the transaction to ‘settle’ before fraudulent activity can be detected.”

It is difficult to determine, they said, whether cases of fraud will increase or decrease under a real-time payments framework.

Under these circumstances, parties in what the attorneys call the “payments ecosystem” will need to determine who will bear the risk. Ford, Mok and Medlar believe that as consumers increasingly turn to new forms of fintech real-time payments, disputes over fraud risk will be governed more by private contracts between the parties in a payments transaction, such as banks and merchants, that clearly assign responsibility.

When it comes to FedNow, however, the future is particularly cloudy. The Fed itself may decide to dictate where the risk falls, they said.

The Fed’s current credit card rules skew toward shielding consumers from monetary losses associated with fraudulent transactions.

Two long-standing laws, The Truth in Lending Act and the Electronic Fund Transfer Act, and the agency rules that implement them, protect consumers from bearing the brunt of fraud losses in connection with credit cards and debit cards.

Ballard Spahr’s Mok said it’s possible the FedNow real-time payment’s fraud-risk allocation protections will share a similar pro-consumer bent.

“The regulators will always have consumer protection in mind and make sure there is fairness to the consumer at the end of the day,” she told CQ Roll Call in an email. “[But] it’s hard to predict exactly what the FedNow Service will look like in terms of risk allocation until we have more information.”

Kim Ford, executive director of the U.S. Faster Payments Council, a trade association of stakeholders in payment services including banks, consumer groups, tech providers and merchants, said it is difficult to know how FedNow will handle risk allocation issues, but consumer protection will almost certainly be a focus of the Fed and maybe even Congress.

She said consumers are used to certain fraud protections for payment services, such as credit cards and debit cards, and the Fed will likely consider those expectations. Ford said her organization has been studying the issue of fraud in faster payment systems and will provide its input to the Fed.

L. Cary Whaley, who is first vice president for payments and technology policy at the Independent Community Bankers of America, a Washington-based industry group, agreed that it is too soon to say how fraud risk-allocation will be addressed in the FedNow Service, citing both technological issues and matters of regulatory interpretation. But, he predicted, most, if not all, of the questions of who should bear the loss will be settled well before the FedNow Service is up and running.   

The Chicago Fed lamented six years ago that establishing specific, overarching governance objectives for retail payments is becoming increasingly important in light of the growing complexity of the U.S. retail payment system. “Over the years, more and more nonbank firms (such as retailers and technology firms) have entered the payments market, competing with banks, which are regulated and supervised differently,” it said.

The big players in the U.S. financial system are likely to have their say as well. Big banks spent more than $1 billion to set up their own real-time payment system in 2017 known as The Clearing House. The service touts itself as “able to provide a ubiquitous, safe, efficient, and equitable faster payment system by 2020.”

The Clearing House, whose owners include JPMorgan Chase and Capital One, issued a statement that it does not believe there is a need for the Fed’s real-time payment service “and, therefore, does not support it.”

Community banks, on the other hand, were thrilled, saying the Fed’s action would usher in a golden age of universal access to real-time payments for consumers while avoiding the risk of having only one for-profit settlement service run by the nation’s largest and riskiest banks.