Understanding How Digital Wallets Function

Main Takeaways

The classic leather wallet has long been your trusted ally, keeping safe all the essentials: cash, credit cards, family photos, IDs, insurance cards, and loyalty cards. However, as it fills up, it becomes heavier and bulkier, making your spine groan every time you sit on it incorrectly.

Oh, and it's completely vulnerable. Any thief who gets their hands on your wallet can quickly drain your cash and potentially empty your credit accounts as well. Despite this, 85% of global transactions are still based on cash and checks [source: Yahoo News]. In 2009, Americans alone wrote about 14 billion checks [source: Huffington Post].

To reduce the risk of theft, streamline your finances, avoid being the 'check-writer' at the checkout line, and possibly save your back from constant chiropractor visits, it may be time to upgrade your wallet. Consider switching to a digital wallet.

Before diving deeper, it's important to know that the term 'digital wallet' refers to a variety of technologies that enable you to carry out multiple tasks. Generally, a digital wallet (sometimes known as an e-wallet) represents a shift in how you make payments.

Many digital wallet services operate through apps on your smartphone. For instance, at the grocery store, you can tap your phone on a compatible register to pay instantly. Some wallets only require a familiar identifier, like your mobile number and a PIN (personal identification number).

Regardless of its form, a digital wallet uses encryption software to replace your traditional, physical wallet during financial transactions. It offers protection and convenience for users, while merchants benefit from increased security against fraud and faster sales.

A smartphone digital wallet not only facilitates payments but also stores your concert tickets, bus and subway passes, and gift cards. Retailers may offer instant rewards such as freebies, discounts, and coupons for your loyalty. Your digital wallet could even open the doors to your home.

A digital wallet could change the way you manage your finances and overall lifestyle. Keep reading to discover how.

Digital Wallet Magic

Digital wallets can be categorized into two main types: client-side and server-side. Within these categories, there are wallets that work exclusively with certain vendors (either online or offline), and others that are compatible with nearly any merchant.

Client-side wallets are typically those managed by the user. After downloading and installing the necessary software, you enter all your relevant payment and shipping details, which are stored directly on your personal computer. When you proceed to checkout at a compatible website, the wallet software automatically fills in most of the required information, making your online shopping quicker—and perhaps a bit more expensive.

In contrast, server-side wallets, like Visa's V.me, store your wallet data on secure company servers rather than on your hard drive. Visa takes care of maintaining and securing your data.

When shopping on a V.me-supported retail website, the checkout process becomes nearly instantaneous. You simply enter your V.me email and password, and the transaction is complete. The store receives payment from your chosen credit card, sparing you the hassle of manually entering card details and protecting you from the risks of sharing your card number online.

A V.me account, like many digital wallets, supports more than just your Visa card. It allows you to store information for other cards and bank accounts, such as MasterCard, Discover, and more. Additionally, V.me stores your shipping details as well.

With a server-side wallet, the company managing the digital wallet (like Visa) maintains your e-wallet account on their secure servers. This eliminates the need for physical plastic cards, reducing the risk of losing or having them stolen. This benefits both you and the retailer by lowering the likelihood of credit card fraud.

Merchants tend to favor server-side wallets because they offer a higher level of standardization. In contrast, client-side software can vary depending on the developer, which often leads to issues for both buyers and sellers. This is one reason why server-side wallets are gaining traction.

Paying from the comfort of your home is one thing, but paying on the move is a whole different experience. On the next page, we’ll explore how mobile digital wallets are making it easier to manage your finances wherever you go.

The Mobile Digital Wallet

It’s easy to see how convenient quick checkout is when you’re at home or the office. If you’re doing your holiday shopping from your desktop, a digital wallet saves you from repeatedly typing your 16-digit credit card number. But a mobile digital wallet—one on your smartphone—could completely change how you pay, no matter where you are.

Over half of Americans now own smartphones, and experts predict this number will keep growing [source: Daily Mail]. A significant number of these phones now come with an NFC (near-field communication) chip, which plays a crucial role in mobile digital wallet technology. It was projected that by 2015, approximately half of smartphones would be equipped with NFC [source: USA Today]. If you're unfamiliar with NFC technology, you’ll likely encounter it more often soon, so be sure to read How Near Field Communication Works.

Essentially, NFC is a short-range wireless communication technology, operating within just a few centimeters. When it comes to digital wallets, NFC allows you to pay for everything from coffee to parking meters simply by tapping your phone on a compatible POS (point-of-sale) terminal and entering your PIN. This is how Google Wallet operates.

Google Wallet is one of the leading smartphone apps utilizing NFC technology. It securely stores all your credit card details, loyalty cards, gift cards, and more on Google's servers, not on your phone. Google Wallet also works online, similar to PayPal or other wallet services. By signing into your password-protected account, you can complete purchases in seconds instead of minutes.

Currently, Google Wallet is the NFC-based wallet system making the most headway in the United States. Around 150,000 merchants are equipped with Wallet-compatible payment kiosks. Without compatible systems, merchants are unable to process digital wallet transactions.

Other companies are striving to catch up. Isis Mobile Wallet, a direct competitor to Google Wallet, is backed by wireless carriers Verizon, AT&T, and T-Mobile, along with Deutsche Telecom. Like Wallet, Isis uses NFC technology, meaning it faces the same challenges due to the limited NFC infrastructure.

That's why some wallets are resistant to NFC. Take PayPal, for instance, which now works at big stores like Home Depot, Office Depot, and around a dozen other retailers [source: CNET]. After setting up your account online, checking out is as simple as entering your mobile phone number and PIN, and just like that, that new kitchen countertop or office chair is yours.

No matter which payment method you're using, digital wallets still face significant challenges. On the next page, we'll dive into the issues that concern nearly everyone who's thinking of swapping their traditional leather wallet for one made of data and technology.

Why Be Wallet Wary?

When introducing digital wallets to consumers, two major concerns always emerge: security and privacy. It's easy to envision all the ways hackers could exploit digital wallets. These digital criminals might hack into your account, drain your savings, and rack up charges on your credit cards. Or perhaps they'd steal your identity entirely.

Concerns rise when you consider the complexity of a digital wallet transaction, especially when compared to the simplicity of cash or direct credit card payments. With a smartphone, your data travels through the device’s hardware and operating system, then through a specific payment app, and finally reaches the payment provider, such as your bank or PayPal account.

The more entities involved, the higher the chances that one of them could have a security lapse on any given day.

Despite these potential risks, some experts argue that digital wallets still outperform older payment methods. If you lose a wad of cash, it's gone for good. If your credit card gets stolen, the thief could rack up charges at various stores before you even notice it's missing.

Digital wallets, however, come with multiple layers of integrated security. For both online and offline purchases, your wallet uses digital certificates. Digital certificates are attachments to electronic communications that authenticate your identity (as well as the recipient's) and provide a secure way for the receiver to respond.

Furthermore, smartphones equipped with NFC have encrypted chips specifically built to handle financial security. This 'secure element' is dedicated solely to storing the data needed to complete a transaction. Even with access to your phone and PIN, a hacker would not be able to access the information on this highly protected chip.

An interesting fact about NFC is that it doesn’t require battery power to work. NFC chips use so little energy that they can operate by drawing power from the magnetic field of NFC terminals. So even if your phone’s battery is completely drained, you could still manage to buy groceries and take a cab home.

Now that you’re seeing the benefits of digital wallets, you might be eager to try one out. But beware: the battle for dominance in the digital wallet space is just beginning, and it’s creating challenges for both companies and consumers.

Digital Wallet Wars

Big companies are scrambling to earn your business in the digital wallet arena. Leading brands like Google, Visa, MasterCard, Verizon, Apple, AT&T, PayPal, and Square are all competing for your attention.

These companies are competing fiercely to take the lead, in part by forming partnerships with other industry giants. PayPal started its journey with Home Depot, Square teamed up with Starbucks, and Google Wallet began its relationship with MasterCard. It’s all part of the strategy to subtly integrate themselves into your life. Their goal is clear: convince you to adopt their digital wallet, making it less likely you'll switch to another service once you’re hooked.

Despite their efforts, the United States and many other countries are far behind Japan and South Korea when it comes to digital wallet adoption. The reason for this is simple: the digital wallet landscape, especially in the U.S., has become incredibly complex and difficult to navigate.

A range of entities, from smartphone makers and banks to credit card companies and telecom providers, are all involved in the digital wallet ecosystem. Each of them is vying for a share of the profits, and finding a universally accepted business model is proving to be a challenge. This has led some experts to label the situation as the "digital wallet wars."

Here's an example of the complexities that arise in this business model tug-of-war. A few Verizon phones are capable of running Google Wallet, but Verizon has blocked the app on its network. Why? Because, as mentioned earlier, Verizon is one of the telecom providers behind Isis, which is directly competing with Google Wallet.

This fierce competition has resulted in a cluttered and confusing digital wallet market for consumers. With so many options like Google Wallet, PayPal, and others, it’s difficult to know which one to choose.

This is particularly true for NFC-based wallets, as very few merchants are currently set up to accept this method of payment. Along with the business model conflicts and intense competition, these hurdles indicate that it will take a while before you can leave your traditional wallet behind and fully embrace a digital one. Realistically, it could take a decade or more for the digital wallet revolution to fully materialize [source: Wired].

Until then, digital wallets may remain a bit of a novelty, and you’ll still find yourself carrying your traditional leather wallet just as you always have. However, keep an eye on the corporate battles over digital wallets, as the outcome could shape the future of how we handle money for years to come.