What is a digital wallet and how do they work?

Digital wallets are increasingly becoming the de-facto choice for financial transactions. A recent McKinsey study reveals that nearly 9 in 10 Americans use digital wallets, and consumers using 3 or more digital wallets has grown from 18% in 2021 to 30% in 2022.

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As a business owner, offering digital wallets as a payment choice online or in person makes your business more accessible to a broader pool of customers. If you're still uncertain, this guide will walk you through the finer details of a digital wallet—and how accepting them could impact your business.

What is a digital wallet?

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A digital wallet is an excellent way to store your card information and make purchases online, in-store, or over the phone. You can also use it to store digital versions of your identification documents, such as your passport or driver's license. Popular digital wallet apps include Apple Pay, Google Wallet, Amazon Pay, and Samsung Pay.

How digital wallets work

Digital wallets use the wireless functionalities of a mobile device, such as Bluetooth, WiFi, and magnetic signals, to securely transfer payment information from your device to a point of sale terminal that is able to read and establish a connection using these signals. This allows for a contactless payment method.

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The technologies used by digital wallets include:

• Near field communication (NFC): NFC technology allows two devices placed within a few centimeters of each other to exchange data. This means you can simply tap your smartphone near a payment terminal, and the payment information stored on the device is transmitted securely to complete the transaction.

• Magnetic secure transmission (MST): MST replicates a card swipe by emitting a magnetic signal that simulates the magnetic strip found on the back of a credit or debit card. The smartphone sends a magnetic signal to the payment terminal's card reader, mimicking the action of swiping a physical card without needing the actual card.
• QR codes: QR codes work by storing information in a machine-readable optical label. The merchant scans this code with a QR code scanner to process the transaction. This method doesn't require physical cards or NFC technology, making it versatile and accessible for various types of payments.

Digital wallet vs. mobile wallet

Both digital and mobile wallets are a convenient and secure alternative to carrying dozens of physical cards or paying with cash. The primary difference between these two is how you access them.

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Digital wallets can be accessed via any digital device like a browser on a computer, tablet or smartphone, while a mobile wallet (as the name implies) is accessible only via a mobile device.

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The term “digital wallet” refers to payment software that allows you to store your bank account details, credit and debit card numbers, loyalty cards, vouchers, and event tickets securely in the cloud. You can use digital wallets to pay when shopping online (e.g. PayPal), send money to your friends and family (e.g. Venmo), or pay for fuel at a gas station using your phone (e.g. Apple Pay).

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In contrast, a mobile wallet is a specific type of digital wallet that you can access only via an app on a mobile device like a smartphone or a smartwatch. You can use a mobile wallet to “tap to pay” at a physical store or complete online payments using the mobile wallet’s app.

What are the different types of digital wallets?

Below are some of the well-known forms of digital wallets:

Closed wallet

Closed wallets are digital wallets that can only be used to pay for items or services at the issuing merchant. The Starbucks Rewards program is an example of a closed wallet. The money you load onto the Starbucks Rewards account can only be used at Starbucks locations or the website, and cannot be transferred to other merchants or payment systems.

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Businesses often give closed wallets as an incentive to encourage customer loyalty. When a customer loads money into their Starbucks account, they’re paying for future purchases at Starbucks. Starbucks incentivizes customers to use their closed wallets by offering various perks and benefits to members such as free drinks and birthday rewards.

Semi-closed wallet

A semi-closed wallet has more functionalities than a closed one. However, it's operational only within a particular geographical area and limited to only partner merchants. To accept payments from a semi-closed wallet, small business owners and merchants must enter into an agreement or contract with the wallet issuer.

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Zelle is a popular example of a semi-closed wallet. It partners directly with several leading banks so that users can send and receive money in their bank account via the wallet.

Open wallet

The biggest benefit of an open wallet is its flexibility and range of use. With an open wallet, you can link your bank account, credit/debit cards, and other payment sources and use your funds to pay for goods and services online and offline at a wide range of merchants. You can also send or receive funds between financial institutions and even withdraw cash from an ATM.

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Open wallets are versatile. They can be used at any merchant or website, not just one. They're different from closed wallets, which are only used at a specific merchant. You don't have to carry physical cards or cash with open wallets.

Crypto wallet

You can use a crypto wallet to store, send, or receive digital currencies like Ethereum, Bitcoin, and others. Crypto wallets use public and private keys to store and secure users' cryptocurrencies stored on the blockchain. Crypto.com and Coinbase are common examples of crypto wallets.

IoT wallet

An IoT wallet allows users to make payments via smart devices such as wearables like the Apple Watch or appliances like Alexa. Since IoT devices are already connected to the internet, you don't need a separate device to access these wallets. For example, a smart fridge with an IoT wallet can pay for groceries online.

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What are the benefits of using a digital wallet?

Digital wallets have numerous features that make them convenient and business-friendly. Here are some of the top advantages of using a digital wallet for your business:

Faster transactions

Digital wallets are super-fast and reduce transaction processing times, making it easier for small businesses to streamline cash flow. It lets customers make payments instantly, meaning you receive the funds faster. Similarly, you can use it to pay vendors, suppliers, and utility service providers via a single app or online interface.

Enhanced security

Digital wallets use sophisticated cryptography algorithms, offering increased security and protecting you from credit card fraud and scams. Accepting payments via a digital wallet also reduces the volume of physical cash your business handles, reducing the chances of burglaries and thefts.

Superior customer experience

Digital wallets offer a more streamlined, convenient, and hassle-free payment experience. Customers can make payments directly from their smartphones or tablets. Several digital wallets also accept contactless payments, which enables customers to pay by tapping their phone or a smartwatch on the payment terminal.

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Some digital wallets also offer loyalty programs that help customers get discounts, accumulate reward points, and cashback offers, all of which can help improve customer satisfaction and loyalty.

Lower fees

To accept credit card payments, merchants pay an array of fees including assessment, interchange, and processing fees. The average card processing fee ranges from 1.3% to 3.5% for each transaction depending on the network, the type of credit card, and the merchant category code. With card swipe fees increasing regularly, digital wallets provide an appealing alternative for businesses to lower payment processing costs.

Reduce cart abandonment and increase sales

With the rise in online scams and identity thefts, card-based payments are subject to additional scrutiny. For example, multi-factor authentication requires customers to provide additional information, like a fingerprint or PIN code to authenticate the transaction. This additional security requirement becomes a point of friction, causing customers to abandon their purchases. A study by PaymentsDive revealed that 12% of European retailers have seen their customer approval rates decline due to strong authentication requirements.

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Offering digital wallets allows your business to deliver a first-class customer experience. This means customers don’t have to go through additional authentication procedures, which leads to frictionless payments, which increases sales.

Are digital wallets safe?

This is a common concern. However, you can breathe easy knowing that digital wallets are equipped with the best-in-class security features, such as:

• Encryption: Financial data stored in digital wallets are encrypted using sophisticated cryptographic algorithms. This helps to secure users' payment information, such as bank accounts and credit and debit card details, from hackers and other unauthorized users.
• Fraud monitoring: To prevent fraudulent activity, digital wallets periodically implement new fraud monitoring and prevention algorithms.
• Pins and passwords: To access your digital wallet, you must provide a pin or passcode. This prevents unauthorized users from accessing the app if you lose your mobile phone.
• Two-factor authentication: Several digital wallets have an extra layer of security via two-factor authentication. This requires users to enter a code sent to their email or phone to validate their identity and access the app.
• Biometric authentication: Some digital wallets also use advanced authentication techniques such as fingerprint or facial recognition.

How can I ensure the security of my digital wallet and financial information?

Here are a few tips to protect your digital assets:

• Use strong passwords: Choose passwords that are difficult to guess and include a mix of letters, numbers, and symbols. Avoid using the same password for multiple accounts, and change your passwords regularly.
• Update it regularly: Ensure that your apps and software are up-to-date with the latest security patches and updates. This helps to protect your digital wallet and financial information from known vulnerabilities.
• Enable two-factor authentication: Two-factor authentication requires a code or token in addition to your password. This helps to prevent unauthorized access to your digital wallet and financial information.
• Be wary of phishing scams: Phishing scams trick you into revealing your personal information or login credentials. Be wary of suspicious emails, text messages, or phone calls, and never provide personal information unless you know the request is legitimate.
• Choose a trusted payment partner: Look for trusted and reputed financial partners with robust security protocols to protect your financial information.

Embrace the future of payments processing

As a small business owner, you want to make payments as easy as possible for customers. Digital wallets offer numerous benefits for both you and your customers.

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The best part is that you can instantly start accepting and sending payments via digital wallets by integrating it with your accounting automation software like Ramp in just a few clicks. Our accounting software provides business owners with the best features such as seamless accounting, expense tracking, effortless bill payments, and more.

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‍Schedule a free demo and learn how powerful Ramp can be for your business.