What Is a Digital Wallet and How Does It Work? (A Comprehensive Guide)

Oct 07, 2023 / Reading Time: Approx. 7 mins

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What Is a Digital Wallet and How Does It Work

Digital wallets, also known as mobile wallets or e-wallets, have significantly improved our daily lives by offering exceptional convenience. In India, a large portion of the population now relies on digital wallets for conducting online transactions and making payments.

The widespread adoption of digital payment methods by both merchants and consumers is the result of convenience and the security assurance they provide for transactions. These wallets enable us to effortlessly purchase goods and services, completing payments in a matter of seconds.

Moreover, they offer businesses the added benefit of streamlining the complexities associated with handling physical cash. Nevertheless, security concerns while using digital wallets still persist among many users.

In this article, we will delve into the definition of a digital wallet, how it works, the benefits of using digital wallets over physical cash and other means of payment, and the precautions to take when using a digital wallet.

What Is a Digital Wallet?

A digital wallet is a software-driven solution designed to facilitate electronic transactions, including activities such as bill payments, topping up mobile balances, and booking travel or movie tickets. Moreover, digital wallets deliver the convenience and security of money transfers between bank accounts, serving as an alternative to conventional physical wallets. Through the utilisation of a digital wallet, individuals can easily access their financial data and execute transactions, eliminating the need for carrying physical cash or cards.

Digital wallets offer users a convenient and effective means of making digital payments. They provide flexibility for a variety of transactions, spanning from reserving train or plane tickets to recharging mobile phones and settling utility bills.

To initiate transactions via a mobile wallet, users must initially transfer funds from a linked bank account. Digital wallets prioritise security and can be applied to a diverse array of financial transactions.

To engage in transactions using a digital wallet, all you need is a smartphone, a dedicated digital wallet application, and an active internet connection.

Mobile devices and digital wallets use the following technologies:

1. QR Codes: Quick response codes, known as QR codes, are matrix barcodes designed to store information. To initiate a payment, you use your device's camera with the scanning system of the digital wallet.

2. Near Field Communication (NFC): NFC is a technology enabling the connection and information transfer between two smart devices through electromagnetic signals. It requires the proximity of two devices for them to establish a connection.

3. Magnetic Secure Transmission (MST): MST is the same technology used by magnetic card readers that read your card when it's swiped through a slot on a point-of-sale terminal. Your phone generates an encrypted field that the point of sale can read.

What Are the Types of Digital Wallets?

There are three types of digital wallets: closed, semi-closed, and open.

1. Closed Wallets:

A closed wallet is exclusive to specific individuals or entities. For instance, a company may create a closed wallet exclusively for its customers. Funds from returns and cancellations are held in this wallet, and users can only conduct transactions with the issuer of that wallet. Ola Money and Myntra Credit are examples of a closed wallets.

2. Semi-closed Wallets:

A semi-closed wallet allows users to make transactions at designated merchants and locations. Payment information is securely stored in a centralised location, but users might need to share a key or password with another party before initiating a transaction. Semi-closed wallets enhance convenience by storing multiple public addresses while maintaining private keys offline. Some of the popular semi-closed wallets are Paytm and MobiKwik.

3. Open Wallets:

An open wallet is designed for managing and monitoring payment information online. These user-friendly online applications can be downloaded on any device or web browser with internet access. Open wallets are compatible across all platforms, enabling users to carry out transactions at any time and from anywhere. Pockets by ICICI Bank and PayZapp by HDFC Bank are examples of open wallets.

How Does a Digital Wallet Work?

When it comes to picking a digital wallet, numerous choices are at your disposal, including options like Google Pay, Apple Pay, PhonePe, Paytm, MobiKwik, and many more. For international transactions, digital wallets such as PayPal can also be used, and these digital wallets typically function in a similar manner.

After downloading the respective app from either the App Store or Play Store, you will be required to complete a registration process by providing personal information such as your name, contact number, email address, and banking details, followed by the creation of a password.

Whether you are making an online or offline purchase at a restaurant, supermarket, grocery store, or any other retail establishment, you can utilise your mobile wallet to execute the payment using your preferred payment methods, which may encompass mobile wallet balance, debit card, credit card, internet banking, or UPI.

Most digital wallets can be installed as an application on your computer, smartphone, or another smart device. Subsequently, the user links the wallet to their bank account and inputs details for alternative payment methods like credit or debit cards.

After successfully inputting your payment information, the digital wallet effectively supplants the need for a physical wallet. For online shoppers, this means the potential to make payments using a digital wallet without the necessity of entering payment details during the checkout process. When shopping in brick-and-mortar stores, you might be able to settle your purchases simply by opening your digital wallet on your mobile device and having it scanned by a compatible reader equipped for virtual wallet payments.

Certain digital wallets even offer the capability to store transit cards, gift cards, as well as digital versions of items like concert tickets and flight boarding passes.

Are Digital Wallets Safe?

Digital wallets come with built-in security measures, and the transactions benefit from multiple layers of security. Each transaction is safeguarded by the digital wallet application, the retail outlet, and the bank or credit card issuer.

One of the highly secure payment methods used by digital wallets is tokenisation. This process involves encoding your information in a highly secure manner. Consequently, even in the event of a retailer experiencing a breach, your credit or debit card number remains protected and won't be compromised.

Digital Wallets rely on established security measures, such as Personal Identification Number (PIN) and Two-factor Authentication, to safeguard your information. They use encryption technology to protect your financial data and passwords, making it challenging for hackers to gain unauthorised access or decipher your data. Therefore, you can trust digital wallets with your personal and financial information, as the implemented security measures make this payment method more secure than using cash or debit/credit cards.

Here Are the Key Security Benefits of Digital Wallets:

1. Tokenisation:

Digital wallets use tokenisation, a technique that conceals your bank or credit card account details. Instead of transmitting your credit card information, the digital wallet assigns a random identification number, known as a token, to your purchase.

2. Encryption Technology:

Digital wallets also use encryption technology in all for every transaction. This technology scrambles your financial information, making it significantly more difficult for hackers to access your personal information.

3. Passwords:

You have the option to set up a password and enable two-factor authentication within your digital wallet. Alternatively, you can use biometric features like Face ID or Touch ID on smartphones to provide an additional layer of protection for your financial information. In the unfortunate event of your phone being lost or stolen, your password and biometrics act as the initial defence against unauthorised access. This security advantage is unique to digital wallets and not present with physical cards.

[Also Read: 7 Security Measures You Need to Know While Using E-wallets]

What Are the Benefits of Digital Wallets?

Numerous attributes contribute to the popularity of digital wallets among consumers. These features may vary depending on the specific payment application, but they typically encompass the capability to easily execute transactions, transfer funds, and access transaction history. Here are some of the common benefits of digital wallets:

1. Security:

While your physical wallet can be subject to theft, your digital wallet is immune to such risks. As mentioned earlier, even if you lose your phone, your digital wallet incorporates security features that guarantee exclusive access to you. Consequently, unauthorised individuals cannot simply reach in and seize your debit card.

2. Easy Registration And Payment Process:

Digital wallets typically have an easy registration process and simplify bill payments for electricity, gas, and mobile phone services.

3. Wide Usage:

A digital wallet has a wide range of uses, such as making payments for services like electricity, water, DTH, and broadband, as well as buying tickets for flights, buses, or trains, movie tickets, groceries, and facilitating money transfers. In recent times, the utility of digital wallets has expanded significantly.

4. No More Missed Payments:

Amid your busy routines, it is easy to overlook your bill due dates. In such situations, a digital wallet can come to your rescue. By configuring automatic payments, the application will handle your bill payments on the due date.

5. User-friendly Interface:

Digital wallets prioritise user-friendliness and safety in their design. They feature an effortless and intuitive user interface that enables users to oversee and monitor their transactions easily. With digital wallets, users can effortlessly perform a range of actions, including fund transfers, wallet top-ups, balance checks, and more.

6. Real-time Assistance via Chatbots:

The integration of chatbots in digital wallet apps enables businesses to engage with their customers in real-time, regardless of their location. This allows customers to conveniently connect with 24/7 customer support services for inquiries or to report concerns about a product or service.

7. Discounts And Offers:

Digital wallets frequently offer promotions, Reward Points, CashBacks, bonuses, gifts, and various incentives that have the potential to reduce your expenses and save you money.

To sum up:

Digital wallets have significantly enhanced the convenience and speed of transactions. Users can link their bank accounts or cards and add funds to their digital wallets, subsequently using these digital wallets to access various products and services.

While most digital wallets are typically free of charge, especially for lower transaction amounts, there may be some fees associated with certain wallets.

Given the substantial innovations occurring in the financial technology realm, it will be interesting to see what comes next in this space.

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KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.


Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.

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