How Digital Wallets dominate E-commerce (#15)

A primer on how digital wallets are becoming mainstream for online payments

Oct 04, 2020

Chinese fashion designers are leaving the back pockets off jeans because no one uses them anymore (wallets)

This was a small quote in a Reuters article last month. Now, wallets have existed for over four hundred years, and back-pockets in jeans for over a hundred. But the last decade, it seems, has signalled a real threat to both. And remarkably, the concept of wallets will likely continue to exist, just not in a physical form.

China, especially, offers a peek into this future. While the Alibaba’s, Taobao’s, and Tmall’s made e-commerce purchases mainstream in the country, Alipay and WeChat have acted as enforcers to raise the share of digital wallets to >70% of online payments. (I had covered a part of this digital payments shift in China with the story on Ant Group)

Saying that, China will not remain an outlier for long. A Worldpay report early in the year forecasts digital/mobile wallets to make ~52% of all online payments by 2023, from ~20-35% across countries today. On the first look, the concept of digital wallets seems straightforward, but because of its simplicity – it is also quite misunderstood. In this article, I reflect on how and why digital wallets work.

What are digital wallets?

To a consumer, the concept of a wallet has been as exact as it has been abstract – yes, you store money but you also store licenses, photos, cards, and whatever else that fits. A digital wallet is not too different. While the basic premise of a digital wallet is to store money in a cloud-based software with a bank or with a payments platform, digital wallets have also been adopted for other purposes.

For example, a cryptocurrency wallet stores public and/or private keys. In this case, for you to spend coins, the private key in the wallet must match the public address assigned to the currency. And if does, you get to spend the coins in the wallet – though no actual exchange of real coins ever takes place. Similarly, a DigiLocker helps store documents, while a Digi.me acts as a parent data library to store health, finance, and even social data.

But unlike our ‘pocket’ wallets, digital wallets are not restricted by physical space and are neither required to store physical money or objects. The only information required is the users’ payment credentials and passwords, which allows transactions without the use of personal account information. Moreover, digital wallets are being adapted to even greater use cases every day – storing credentials, messages, private documents, etc. So, the parallels to physical wallets end quite early.

Saying that, the core purpose of digital wallets remains cashless payments, be it to your friends, family, or merchants. So, what explains the high growth expectations of digital wallets in the future?

Before I get to that, it will help us to understand how digital wallets operate in more depth.

How do digital wallets work?

Cash has long been used at the point of sale – either on the delivery of goods or in-store. Cards expanded this flexibility by allowing remote payments on a website or an application. You only ever needed the card details for an online transaction, and the physical card in-store. Digital wallets go a step further.

There are roughly six ways in which digital wallet models work, differentiated on the basis of technology and processes. The US Payments Forum does a great job of deliberating on them. I’ll briefly cover these here.

A device-centric mobile proximity wallet acts to convert a mobile phone into a payment device, and allows payments with a single tap of the smartphone instilled with, say, the Apple Pay or Samsung Pay capabilities on the merchant payment terminal to make payments. This obviates the need to carry a physical card, and uses Near-Field Communication (NFC, which most phones today come installed with) or Magnetic Secure Transmission (MST) to perform the transaction. The wallet application within the device can later be used to access these secure transactions stored on the cloud – allowing better transaction management.
A digital checkout wallet is next, which works similarly to a card payment on any e-commerce website or merchant application. The option to pay through, say, Paytm wallet is provided at checkout. Post which, a simple authentication through a passcode or biometric is sufficient to complete the transaction. The process is similar to card payments, but the added safety of not distributing bank or card details acts as an enabler of wallet transactions.
A card-on-file (CoF) wallet, or if we avoid the lingo – a wallet that uses previously stored payment information to make repeated automated payments. For this purpose, merchants and payment service providers (PSPs) wallets even allow almost all types of payment methods, incl. credit cards, debit cards, prepaid cards, private-label store cards, and so on, while the consumer only has to authenticate the CoF transactions initially. An example of this is Netflix accepting recurring transactions through PayPal.
The next method, and possibly the most popular today, is QR code wallets. These are cloud-based payments at the point-of-sale (POS), which require the merchant or the customer to simply scan the other’s QR code and make the payment. QR code wallets have been used quite successfully by Alipay, WeChat, PhonePe, Paytm, and many others, and have gained acceptance across millions of small and large merchants.
Another wallet model, probably the most popular that you have not heard of, that has gained acceptance among the less-banked population is text-based wallets. These platforms use messages through SIM cards to send or transfer money to vendors and family members. M-Pesa is one of the brightest examples of this model, with millions of those unbanked in African countries relying on M-Pesa kiosks and merchants to make payments.
Finally, P2P wallet models such as Venmo and Cash, which sometimes use NFC, use QR or operate on hybrid models, allow the exchange of money between friends and family, and have gained popularity in the last decade. These have particularly seen an incredible lift from COVID.

There are a few other wallet payment methods that use hybrid models or run on alternative payment rails (UPI, for instance) to allow for digital wallets. Across all of these models, the technologies and processes differ but most benefits and challenges remain quite consistent for the consumers and service providers.

Improving online payments with simplicity, loyalty, and security

With payments, we hardly ever unlock new spending from consumers with new payment methods – all that we see is a shift in the method of payments. For consumers then, factors related to convenience, monetary savings, or security often force this shift. And with online shopping demanding both convenience and security, digital wallets score well on both counts.

One view: Organise all your credit, debit, loyalty cards, card information, and more in one digital wallet
Simpler payments: The number of steps at checkout is fewer with wallets as consumers simply confirm their passcodes, card pins, or biometrics on purchase.
Less clutter: The interplay with wallets by card issuers in the form of virtual cards or simple transfers from account to wallets has allowed consumers to obviate the need to carry physical cards or cash
More secure: The account information in digital wallets is encrypted and never really sent to third-parties – instead a unique token is shared, which does not have any traces of account information. Moreover, while a stolen physical wallet or a card can mean trouble for you, your phone and digital wallet can be protected with biometrics and PINs.
Expense Management: wallets, by collecting all your information in one app and storing them on servers, allow real-time tracking of expenses – which has always been a pressing consumer need
Loyalty rewards: lastly, value-added loyalty and promotion programmes have become central to acquisition for digital wallets with tens of wallets competing against each other. Moreover, loyalty programs act as incentives to consumers to switch payment methods, which is a tough habit to force a shift from.

In particular, the last benefit of loyalty has become the most prominent for wallet makers – with a focus on offering better deals and savings than the competition. In combination, all these benefits explain why consumers would shift towards digital wallets, but it does not explain the wave of retailers building their digital wallets.

For retailers online, ease of checkout is perhaps the most significant driver of closing a deal. And this often means reducing the number of clicks and inputs that the user has to go through. This is where digital wallets allow retailers to build one-click payment options with options to use PayPal, Apple Pay, Samsung Pay, or any other debit or credit cards within. The convenience aside, digital wallets also help merchants with the following:

More informed and targeted communication with the customer based on consumer preferences, as established from data, and as a result,
Greater engagement and customer loyalty by tying-in the customer for the long term by reflecting the brand proposition better with the wallet

Security protocols such as tokenisation that improve customer experience by making their transactions more secure, and

Lower transaction fees and costs through store-branded, closed-loop payment cards that eliminate interchange fees from payment networks

The utility of digital wallets is becoming more obvious now. The consumers and merchants equally benefit. But, hold on.

If everything is so bright and shiny, why do so many digital wallets fail?

It is true that while success stories like Google Pay, Starbucks, and Amazon Pay make headlines, most of the digital wallets are born and extinguished on the way. In fact, Microsoft released Microsoft Passport as an attempt to get all information in one place, including features such as single sign-on and storing credit cards, twenty years ago! But it failed, like hundreds of other wallets following it. Multiple factors explain this.

Lack of merchant and banks’ acceptance towards wallets has been, for more than a decade, a consistent deterrent for businesses not as proficient as Google or Apple. Five years ago, even consumers’ acceptance was quite low due to the lower presence of NFC-based mobile phones, although this capability is all-pervasive today. Moreover, as for the features, wallets offering standalone store-based promotions and loyalty programs have always stood second to aggregators such as Apple Pay, and the costs of such promotion programs have been tough to justify for many without sufficient consumer engagement. Lastly, and at the same time, lagging behind the accepted security and technology standards of the payments industry has caught many off-guard, incl. wallets such as Lemon and Square.

For a digital wallet to be successful then, the wallet must act to support the core shopping experience with the merchant, provide the right loyalty programs and promotions, and adopt the technology that fits the consumer habits and sentiments. Recognising that consumers often bargain hunt, taking your digital wallet at the top-of-the-wallet for consumers becomes even more challenging against the bigger competitors.

Final thoughts: the road ahead…

There is little doubt that with businesses moving online at speed, with internet connectivity only getting faster and more widely available, and with consumer preferences moving towards all things mobile – the acceptance of digital wallets only stands to gain.

To add, the ability to encourage subscription services and improve customer experience also makes this payment method preferable for online retailers. But knowing that the growth is inevitable, what other innovations can be expected of digital wallets?

New payments markets: while solving for payment convenience, digital wallets have the potential to go one-step further than B2C, C2B, and P2P services towards more complex and sophisticated B2B payments, with provision for complete control of operations such as invoicing and payrolls within company wallets. This notion is already gaining some speed, but the opportunity ahead is immense as well. Similarly, targeting the less developed payment areas such as international remittances and unbanked populations would offer opportunities for innovations.
Investments and lending: Ant Group did a great job in leveraging the money lying idle in the wallets to offer investment opportunities to consumers, and in using the customer spend behaviour to model lending risks and to offer credit to customers. These initiatives have been widely successful and, if regulation permits, can make a substantial difference in making investments and credit more viable to the consumers for digital wallets across geographies.
Checkout experiences: as outrageous as palm-based Amazon One is, the checkout experiences for the next few years will largely see smaller jumps. Saying that, using digital wallet technologies with a phone in-hand should definitely progress the world slowly towards cashier-less checkout experiences at the point of sale – although cash and debit will continue as top payment methods in-store for a while.

To be honest, there is little risk in making these predictions with the speed at which digital payments, in particular, are progressing. Even if, in five years, we have cashiers filled stores or make little progress on other innovations, there is little doubt in my mind that mobile payments would become as popular as our pocket wallets!

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