Let’s start with a pure digital wallet. We’ll begin with how the tech works, then discuss the business model and finally, identify potential rooms for improvement. For this video, we’re going to use the example of PayPal. It’s one of the earliest modern fintech companies in the payment space that pretty much popularized the idea of a digital wallet, which has been further refined by many other fintech companies afterward. The technological aspects are surprisingly simple. A digital wallet acts, well just like a wallet, it digitally connects to our bank accounts as the source of money. Just like we can put cash into our physical wallets, we can transfer actual money in the connected bank accounts into a virtual balance in the wallet app.
Then we can send this balance instantly to other people who also use the wallet with more user friendly identifiers like their email addresses instead of routing and account numbers. Actual money will follow later on the conventional rails like the ACH. So let’s put that in a familiar five-party graph with the sender and the receiver, their banks and a conventional payment rail like the ACH. Now, let’s give PayPal accounts to both the sender and the receiver, which will be linked to their respective phone numbers. In addition, we’re going to need another bank account for PayPal itself. This third bank account serves as the central conduit of money flow in the system.
Note that very importantly, PayPal and most other digital wallets, they’re not banks. They don’t want the increased regulation with the banking charter. Therefore, to legally hold your money, the wallet has to first partner with the bank and setup as main bank account there. Now, to put money into the wallet, say a $100, the app first authenticates the user and the request. This could be done again bio metrically. Then initiates an ACH transaction that pulls a $100 from the sender’s bank account into PayPal’s bank account. Although this is a PayPal’s account, they can not touch this money and use it for other purposes. It simply hosts that a $100 as a custodian on behalf of the sender.
That amount will be linked to the sender’s PayPal account, showing up as a $100 virtual balance in the wallet. Let’s pause and briefly review the steps here. So far, money moves along the existing payment rail, the ACH. But now that is in the wallets bank account and designated to the sender, the information flow, which is now in the form of virtual money balances within PayPal, is decoupled from the traditional payment rail. If for instance, the sender wants to send the $100 to another PayPal user, they simply put in the receiver’s identifiers, the email or their phone numbers, and the virtual balance can be transferred instantly. On the back-end, PayPal does not have to actually move the money.
You can simply change a line of code that moves the designation of this $100 from the sender to the receiver in the software. Now, the receiver can keep that Virtual balance and use it to pay someone else, and the e-wallet re-designation process
will repeat itself, or they can decide to withdraw, converting the virtual money back into real money in their bank account. The withdrawal process occurs again via standard rails like the ACH, from PayPal’s bank account to the receivers. The actual settlement depend on the ACH speed, maybe in the same day or the next day. From this picture, we can see the key distinguishing feature of digital wallets. Money flows on the original payment rails as usual. Banks in the setting are doing what they’re best at, moving money from one account to another efficiently and securely. Information flow, on the other hand, is decoupled from the traditional rails and it’s predominately initiated within the digital wallet applications.
As long as it’s within the wallets ecosystem, virtual balances can be moved around instantly and freely and used just as money. This innovation enables the digital wallets to facilitate economic transactions without becoming a bank. The tech innovators are doing precisely what they do best by taking on the tasks like information processing and basic authentication from the banks. Because as opposed to revamping the entire payment rail, is much easier to improve the efficiency of these tasks with incremental technology. Now that we know the tech behind digital wallets, let’s take a look at their business model, again, using the example of PayPal. Let’s first take a look at the revenue side.
PayPal’s early revenue model is fairly simple using this system as free. But when you try to withdraw, that is moving your wallet balance back into your bank account, there’ll be a small service fee, say between 0.1 percent and one percent. This was designed to encourage users to keep their balance within the wallet, but users likely didn’t take it too well. For many people, it’s better to use a slower payment method like a check, than to pay a fee every time they try to take the money out. So to attract more consumers who are on average quite price sensitive, the service really has to be free or at least appears to be free.
That’s when PayPal transition to the current tiered pricing model. Is free for most people, unless you either, number 1, want your withdraws to settle fairly quickly by not using ACH, number 2, you are a merchant who’s getting paid, or number 3, you want to use a credit card to fund the wallet’s balance. We’ll talk about credit card processing and PayPal’s role in it in the next module. But from the first couple of points, you can see that the current pricing model does have the advantage of drawing in and keeping the most price sensitive customers while at the same time maintaining similar margins by charging the merchants a slightly higher rate, say between two and three percent per transaction.
As long as you maintain a fair share of merchant users in your system, you can sustain this revenue model. Now, let’s take a look at the cost side. This is where not being a bank and not having to develop a new payment rail, really paid off. By utilizing the existing rails, the main development is on the software side rather than the hardware side. So the fixed costs are relatively low. Once developed, because the maintenance of the wallet bank accounts and bank related compliances are the responsibility of the bank partner, the ongoing costs are mostly related to R and D in software maintenance.
So the marginal cost of processing one more transaction or having one more user, is minimal and the system is easily scalable. So if you combine the relatively stable revenue and the load fixed and marginal cost, it’s not a surprise that digital wallet providers can have much higher profit margins compared to traditional financial institutions.