The why, how and future of digital wallets

A version of this article appeared in The Business Times.

What is a digital wallet?

In the most simplistic sense, a digital wallet is a facility to store and transfer money in an electronic format in a convenient manner. The key aspect to be highlighted here is the convenience, as the owner of the digital wallet could even otherwise have accessed this money through other conventional channels available to them - a bank account, a debit card, a credit card or a prepaid instrument.

The convenience element is particularly accentuated in situations where either the ‘Sender’ OR the ‘Receiver’ OR both do not have access to conventional mechanisms of funds transfer listed below:

Let me illustrate this through some simple everyday situations –

  1. When 3 friends share a taxi, one pays for the ride and needs to recover the proportional fractional amount from the other 2. If the ride happens to have been paid by one of the three friends then each of the 3 needs to possess specific denominations that they are required to contribute. If all 3 have to contribute then they need to possess specific denominations of currency or have to present 3 different cards (debit or credit). More so, if they go out together quite often - what about restaurants, shared take outs and many other similar situations!

  2. A plumber comes home and repairs a leaking tap while the house owner is in office. The plumber seeks payment from the domestic helper who does not have the cash.

  3. One frequently makes purchases on an ecommerce portal & wishes to minimize the time spent on the payment process and hence wants to keep some money readily available to enable a single click purchase rather than going through the entire rigmarole of a credit card or internet banking.

Why digital wallets?

The advent of digital wallets can be attributed to the conventional payment channels being unable to address such situations efficiently.

However, some smart innovators recognized that even though entities (whether individuals or enterprises) did not have access to conventional channels, almost everybody possessed the ubiquitous smart phone. Hence, communication between counterparties could be effected in a manner which could be monitored by the mobile service provider. Hence, the first digital wallet and payment providers were the mobile phone companies as they had all the constituents necessary for a peer to peer (P2P) money transfer namely –

  1. Access to the payer and the receiver and their payments related communication

  2. Ability to transfer monies to and from them through their billing process. Any change in value i.e. increase due to a credit received or decrease in value due to payment made could be transferred to receiver / payer by crediting or debiting the amount in the bill generated. (while any other utility which has the billing capability could also be a digital wallet, but they do not have easy access to the communication channel which mobile companies had)

How does a wallet function?

Simplistically, the digital wallet is just an application which resides on the smart phone and has been allotted dedicated funds through any of the conventional payment products mentioned in the table above. When we ‘add funds’ to the wallet through a particular mean, we are actually effecting a withdrawl of money exactly akin to any other transaction using that mean. E.g. when the digital wallet owner debits their credit card to add funds, the Wallet Service Provider (WSP) acts like any other merchant establishment to the credit card issuer where the card holder would have swiped the card. The WSP incurs the charge which the card issuer charges any merchant establishing which could range from approx. 1-3%. Hence, if the added value is 100 units of a currency, the wallet shall receive, say 98 units. Since these are nascent businesses, many wallets continue to show you full value of 100 by actually funding the discount themselves.

The physical funds seen as the digital wallet balance continue to lie in a bank account that the wallet maintains – albeit in a fiduciary capacity. The WSP has only a restricted asses to those funds which can only be used for the purpose that the wallet holder directs the services provider to. The WSP is actually required to be licensed by the regulators in most jurisdictions.

The WSP maintains a ledger account, in its own books, of all the entities who have opened accounts with them. When a transfer is made, it just transfers the funds, in its ledger, from the Payee’s account to the Recipient’s account and reflects this in the wallet that each sees on their respective smartphones.

As the wallet service provider holds a very large number of wallet accounts, it maintains what in banking parlance is termed as a ‘float’ – cheap funds that are available to the bank with which the WSP maintains its account. For maintaining this float, the bank might reward the WSP with some complementary services which offsets some of the costs that the WSP incurs including the discount it has to pay upon receiving funds from a credit / debit card. In addition, the WSP’s revenues arise from the fee that they charge for transfer of funds out of the wallet.

When the wallet holder wishes to transfer funds from the wallet out into their own bank account or any other instrument, then there is an actual flow of funds from the WSPs bank account into that instrument.

Emergence of digital payments & wallets is the outcome of the failure of the card issuance companies to innovate and read the market?

The card issuance companies have a very long presence in the payments space. However, in the views of this author, the emergence of digital payments and wallets is the direct outcome of the smugness and lack of innovation in these enterprises.

While the need to make payments and transfers pervades across all segments of social strata and across geographies, these organisations continued to focus on the segment of population which was relatively economically advanced, urbanized and savvy enough to afford the plastic and to understand it’s working. Till the wallets started eating into their space, they seldom made efforts to extend themselves lower down the pyramid and actually try and reach the bottom of the pyramid. They remained content with maximizing upon the various types of charges which their customers - namely the card holders AND merchants incurred.

As with most businesses which were intermediating between 2 counterparties and charging a brokerage or seeking ‘rent’ (on POS real estate), the card providers have also had their moment of reckoning with the new breed entrepreneurs and innovators seeking to eliminate all such opportunities.

It has now reached a stage where each of the card services providers has had no choice but to create their own digital payments and wallet product. In the mind of this writer, it is too late and unless these companies undergo a complete overhaul in their mindset, they have very tough challenges ahead.

Future of digital wallets

I believe that the future of wallets themselves is under threat with the advent of services like the Unified Payments Interface (UPI) in India on account of 2 broad reasons:

  • The wallets themselves are intermediaries (albeit more friendly and less usurious than the card issuers) as also the fact that they are currently not a viable business in themselves. Their losses continue to be absorbed by the large amount of venture capital that fund them. Services like the UPI in India eliminate the need for a payment intermediary and facilitate direct ease of payments. While it is a laudable initiative and probably the only one of its kind innovation across the world, it has suffered from a typical government related phenomenon – lack of ease of use and commercialization capability. However, as an innovation, it ranks second to none other in the world.

  • As the wallets do not connect to each other (at the time of writing this piece however there are now efforts in India to connect them through the UPI) and have a limit on use, both the receiver and payer need to have multiple wallet account if they were to route a majority of transactions through the wallets. UPI like products solve this problem as well.

Overall, while wallets themselves shall continue to evolve till they can offer a seamless transfer to anybody across geographies. Till then, this is a space to watch out for!

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