How Digital Wallets Work

We can lump the types of digital wallets into two broad categories:client-sideand server-side. Within both categories are wallets that function only with specific vendors (either online or offline) and others that will work with just about any merchant.

Client-side wallets generally refer to those maintained by you, the end user. You download and install a program and then enter all of your pertinent payment and shipping information, all of which is stored on your own personal computer. Then, when you decide to check out at a compatible Web site, your wallet's software completes most of the basic information so you don't have to. Suddenly, your impulsive online shopping sprees get much faster and much, much more expensive.

Contrast that with server-side wallets; for example, Visa's V.me digital wallet. Instead of storing data to your own hard drive, all of your wallet data is stored and maintained by Visa on the company's secure computers.

Visit a V.me-supported retail site, and your checkout process is extremely quick. Just type your personal V.me e-mail address and password, and the order is complete. The store receives payment from whichever credit card account you choose, and you're spared the frustration of typing that information. You're also shielded from any security risks associated with revealing your card number online.

A V.me account, like most other digital wallets, works with more than just your Visa card. It actually lets you store data for your other cards and bank accounts, too, such as MasterCard, Discovery and more. Additionally, V.me retains shipping information.

In a server-side wallet, the company supporting the digital wallet (Visa) maintains your e-wallet account on their servers. You don't have any physical plastic cards to lose, nor can anyone steal them, which is a benefit to both you and the retailer, which would otherwise expect to deal with a significant amount of credit card fraud.

Merchants generally prefer server-side wallets because they have a greater degree of standardization. Client-side software, on the other hand, varies depending on the developer, and differences can result in frustrations for both buyers and sellers, which is why server-side wallets are gaining more steam.

Paying at home is one thing; paying on the go is quite another. On the next page, you'll see how digital wallets have gone mobile and how they put substantial financial firepower in your hands.

It's easy to see how quick and easy checkout benefits you while you're at your home or office computer. Doing your Christmas shopping from your desktop? A digital wallet spares your fingers the constant repetition of typing your 16-digit credit card number. But a mobile digital wallet -- that is, one on your smartphone -- could transform the way you pay no matter where you are.

More than half of Americans now own smartphones, and experts say that number will only continue to rise [source: Daily Mail]. More and more of those phones are equipped with an NFC (near-field communication) chip, which is a vital component to the mobile digital wallet infrastructure. It was estimated that around half of smartphones could have NFC by 2015 [source: USA Today]. If you've never heard of NFC technology, you may see it everywhere very soon, so be sure to read How Near Field Communication Works.

Basically, NFC is a type of wireless communication with a short range of only a few centimeters. With regard to digital wallets, NFC means you can pay for everything from bagels to parking meters simply by tapping your phone to a compatible POS (point-of-sale) terminal and then entering your secret PIN. That's the way Google Wallet works.

Google Wallet is one of the most prominent smartphone apps leveraging the power of NFC. All of your credit card data (as well as loyalty and gift cards and all sorts of other data) is stored on Google's servers and not your phone. Wallet works online, too, much like PayPal or other wallet services. Just sign into your password-protected account and you'll complete a purchase in seconds instead of minutes.

Right now, Google Wallet is the one NFC-based wallet system that's really making any inroads into the United States market. That's because around 150,000 merchants have Wallet-ready payment kiosks. Without compatible systems, of course, merchants simply aren't equipped to process digital wallet payments.

But other companies are trying to catch up. Isis Mobile Wallet is a direct competitor to Google and is supported by wireless carriers Verizon, AT&T and T-Mobile, as well as Deutsche Telecom. As with Wallet, Isis uses NFC tech, and thus, is subject to the same challenges of weak NFC infrastructure.

That's why some wallets are anti-NFC. PayPal, for example, now works at major stores such as Home Depot, Office Depot and about a dozen others [source: CNET]. After you set up your account online, to check out, you simply provide your mobile phone number and punch your PIN, and that new kitchen countertop or office chair is all yours.

Regardless of the payment method involved, wallets still have major hurdles to clear. On the next page, we'll jump into the concerns that plague just about everyone considering trading their old cowhide wallet for one made of bits and bytes.

When it comes to unveiling digital wallets to consumers, two hot-button words always appear: security and privacy. It's easy for people to imagine all of the ways criminals could abuse digital wallets. Those digitally masked bad guys could hack into your account, spend away your life savings and run up your credit card balances. Or maybe they'd steal your identity.

Concerns are heightened when you consider the complexity of a digital-wallet transaction, especially compared to the simplicity of cash or straight credit. In the case of a smartphone, your data passes through not only the smartphone's hardware and operating system but then also through a specific payment app, and finally, the source of the payment, such as your bank or PayPal account.

The more parties involved, the greater the chances that one of them could experience a security lapse on any given day.

In spite of those potential problems, some experts say that the digital wallet concept is still superior to older payment methods. Lost a wad of cash? You're not getting it back. Stolen credit card? That thief ran up your tab at stores all over the place before you even realized it was missing.

Digital wallets, however, have redundant integrated protections. For both online and offline purchases, your digital wallet relies on digital certificates. Digital certificates are simply attachments to electronic correspondence that verify your identity (as well as that of the recipient) and provide a way for a receiver to encode a reply.

What's more, smartphones with NFC have encrypted chips specifically designed for managing financial security. This so-called secure element does nothing but house the data needed to initiate and complete a transaction. Even with your phone and your PIN, a hacker can't get at the data on that rigorously guarded chip.

It's worth noting that NFC doesn't require battery power to function. NFC chips need so little energy that they operate by borrowing power from the magnetic field of NFC terminals. So if your phone's battery is completely dead, you may still be able to buy groceries and pay for a cab to get home.

Maybe now you're convinced that digital wallets are worth a look? Be forewarned, though: The digital wallet wars are just heating up, and it's getting messy for companies and consumers alike.

Major companies are falling all over themselves to get your digital wallet business. Household names such as Google, Visa, MasterCard, Verizon, Apple, AT&T, PayPal and Square are vying for your attention.

All of these organizations are jockeying for the upper hand, in part by creating alliances with other corporate giants. PayPal started with Home Depot. Square teamed up with Starbucks. Google Wallet first found love with MasterCard. It's all part of the plan to slowly worm their way into your life. They know that if they can convince you to use their form of wallet first, you'll be unlikely to switch anytime soon.

Yet in spite of their efforts, the United States and most of the rest of the world lag far behind Japan and South Korea in terms of digital wallet adoption. Understanding why is a simple matter of seeing just how convoluted the digital wallet landscape has become, especially in America.

From smartphone manufacturers and banks to credit card companies and wireless carriers, there are a lot of stakeholders in the digital wallet puzzle. All of them want a cut of the profits. And hardly anyone can agree to a business model that satisfies everyone. Some pundits call this standoff the "digital wallet wars."

Here's just one example of how tricky this business model juggling has become. A few Verizon phones are equipped to run Google Wallet, but Verizon has disabled the app from running on their network. Why? Because as we mentioned earlier, Verizon is one of the wireless companies working to develop Isis, which is a direct competitor to Google Wallet.

The intense competition creates an overcrowded and confusing digital wallet marketplace for consumers. No one knows how they're supposed to choose between Google Wallet, PayPal or any of the many other wallet options.

That's especially true for NFC-based wallets, because so few vendors are equipped to accept that form of payment. The obstacles to NFC, in addition to business model wrangling and no-holds-barred competition, mean it will be a while before you can ditch your old wallet in favor of a digital one. It will probably be, at minimum, a decade before the digital wallet dream comes true [source: Wired].

Until then, digital wallets could remain something of a novelty, and you'll lug around your leather-bound wallet the way you always have. Keep an eye on the corporate wars surrounding digital wallets, though, because the outcome could determine the form of money you use for a long time to come.

Eventually, digital will complete its takeover and we'll all be left using virtual money. Whether that's a good thing remains to be seen. In the meantime, we all fumble with cash and checks, both of which are remnants of a pre-digital economy and are primitive (and sometimes aggravating) simply by the nature of their design. Digital, of course, will have its own set of frustrations, and until we all confront them, we won't know whether they're worth the trouble of giving up cash. But after dealing with paper money for most of my life, I, for one, would be just fine if I never again had to visit an ATM.

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