Does a closed-loop payment system lead to higher revenue?

Buying products and services today could hardly be easier. But each time one of those transactions goes through, an array of service providers takes a small bite out of the total, eating into the funds that eventually end up with the merchant. 

And when consumers are buying small-ticket items like cups of coffee, or incremental upgrades in an online game, the per-transaction fees can start to add up. This is why organizations find themselves drawn to the idea of a closed-loop payments system, one in which they make more of the rules, and keep more of the revenue.

What is a closed-loop payment system? 

There are two kinds of payment systems:

• Open Loop Payment System: A general-use payment system that facilitates transactions between multiple parties. The classic example is the credit card: although the consumer only has a direct business relationship with a single entity (the issuing bank), they can use the card network to enter into deals with millions of vendors. The card network facilitates communications between the various back-end entities (issuing bank, merchant bank, payment service providers and gateways, etc.) to make the experience seamless. Of course, each of those involved systems charges a fee to ride their rails.
• Closed-Loop Payment System: A payment system that is managed, controlled, and used by a single entity. The classic example here is the Starbucks card (or mobile app): as of 2024, the Starbucks system held $1.6B in value, which customers use to buy their morning brew or afternoon cup of chai. Once money is deposited into the Starbucks system, it is available for use by the mobile app - but only at Starbucks. Each transaction is fully managed by Starbucks, which is not beholden to intermediaries and is not subject to transaction fees.

You might reasonably ask the point of all this because someone has to put money into the closed-loop system at some point, which will almost inevitably happen using an open-loop system. 

While this is true, the savings are, as often as not, driven by a reduction in individual transactions. Imagine, if you will, a coffee shop that sells a coffee and a bagel for $10, which Bob stops by to buy every morning on his way to work. 

Assuming a rough average transaction fee of 2.3% + 30 cents per transaction, over the course of the week, Bob pays $50, but the shop receives $47.35. On the other hand, if Bob buys a $50 credit all at once, Bob receives the same service, but the shop receives $48.55, that’s $1.20 more. 

Extrapolate that out to, say, a $200 credit, and the shop can avoid 19 transaction fees or $5.70. If there are 200 Bobs out there buying their breakfast daily, moving to a closed-loop payment system could put over a thousand ‘free’ dollars into the till.

Meanwhile, many of the risks and pesky fees that plague merchants are reduced: if Bob only runs his debit card once every month or so, the odds of a decline plummet, as do the risks of his processing a chargeback. 

Meanwhile, as the Starbucks example illustrates, his favorite coffee shop has access to cash that it can use to buy supplies, ensuring Bob has a steady supply of breakfasts. Working capital is the lifeblood of any organization, and, accepting what is to all intents and purposes, prepayments is an exceptionally low-cost way of generating that capital.

Return to Top

Closed-Loop Payment Systems and Online Merchants 

Online merchants learned the value and appeal of closed-loop payment systems early in the development of e-commerce, as they attempted to sell low-cost items using payment systems that penalized them with fees.

This was particularly true for online games providers, who wanted to encourage players to buy in-game upgrades. The challenge was that, with a payment processing fee of, say, 2.5% plus $0.30, a one-dollar charge ended up netting only $0.67. They quickly realized that, in order to protect their revenue model, they needed to consolidate small purchases into larger ones.

But, holding off charging a player until their account reached a large enough sum created the risk that their selected payment instrument would fail. As a result, they created in-game economies: closed-loop payment systems in which gamers could purchase ‘coins’ that themselves would be used for in-game purchases.

Imagine the impact of this closed-loop payment system on a game that sold an average of twenty-one-dollar items to players:

• Twenty-one dollar charges, at a rate of 2.5% + $0.30 per transaction = $13.50 in post-processing fee revenue.
• One twenty-dollar charge at the same rate = $19.20.

This same principle applies to numerous online merchants beyond the gaming world, particularly when it comes to offering gift certificates and store credit.

Return to Top

Steps to Building a Closed-Loop Payment System 

Clearly, a merchant must establish credibility to run a closed-loop payments system: it is offering to hold value on behalf of its customers, so they must trust that it will treat them fairly. This can be achieved either by operating for a period of time and building a reputation or by demonstrating a commitment to customer advocacy, such as by offering a stablecoin and publishing the audits of the reserve value that underpins it.

Next, the merchant must establish a payment system that can not only collect money, but also safely track and tap into stored value for customers, whether through accessing an account-based tally or using a unique and verifiable coupon number. 

For both the payment collection and the value storage, a programmable payments vault is an attractive foundational element: not only does it empower the merchant to build a fee-optimizing multi-processor payments system, it enables the merchant to securely store and retrieve customers’ stored values without taking on a risk that their own systems could be compromised.

With the vault in place, merchants can decide whether to focus their attentions on:

• Stored Value: Asking customers to prepay by buying in-app credits. 
• Shared values: offering customers the opportunity to buy credits for others (e.g. gift cards.)
• Both

The former will work best when offered with promotions: customers are more likely, for instance, to prepay for ten coffees if they get the last one free. The latter will work best when enveloped by a comprehensive delivery system. 

Implementing a closed-loop payments system provides significant financial benefits to merchants, effectively reducing processing fees for small transactions and providing working capital that can be utilized to support ongoing business growth.

For merchants whose business lends itself to this approach, closed-loop payments can be a powerful and even transformational tool.

Return to Top