TURN LEFT OFF the main reception to PayPal's offices in San Jose, open a nondescript door and you step into a garish living room dominated by a flat-screen television. This is a laboratory for what PayPal calls “couch commerce”: people sit in front of the television buying things with their mobile phones or tablet computers. Next door is a make-believe shopping mall complete with a mock hardware store, grocery and coffee shop. In each, consumers can order, buy and pay for things using their phones, or even just their phone numbers.

The virtual mall and living room are exercise grounds for the next big battle in banking: over who will control the new digital wallets that will change the way in which people shop and spend—and, by implication, the way they save and borrow.

On the face of it, the business of facilitating payments seems a particularly unpromising one for start-ups to enter. Most transfers of money run down a few main highways that link banks to one another. They carry huge volumes of traffic and are generally strictly regulated. “They move quadrillions a day and take just a few crumbs,” says Simon Bailey, a payments expert at Logica, a consulting firm. To consumers, most payments appear to be free because they are given away by banks as part of a bundle of banking services that some customers subsidise through low interest rates on deposits.

Yet payments turn out to be a battleground between banks and a slew of innovators trying to disrupt the market. Many of these firms have relatively humble ambitions. Some are trying to grab thimblefuls of the huge flows of money that wash around the world by concentrating on particular areas, such as cross-border payments (see article). Yet they find themselves getting ever closer to offering bank-like services without having to be banks themselves.

There has been massive growth in supplying payments services to tradesmen such as plumbers or flea-market stallholders, which until recently could accept payment only in cash or by cheque. Yet cheques are bouncy, and although cash has its attractions—foremost of which is that it is easily hidden from the taxman—carrying large amounts of it is risky, and customers can spend only as much of it as they have in their wallets.

In America two firms, Square and Intuit, lead this market with small devices that attach to smartphones and allow even the smallest business or tradesman to accept credit-card payments. Both firms offer free card-readers to users and then charge them a fee of about 2.7% of the amount that changes hands. Both are growing at a rapid clip. Square has signed up more than 1m customers since its launch in 2010. Among them is the Salvation Army, which last Christmas started testing the device to accept digital donations alongside its traditional red kettles. Intuit's GoPayments, which also launched three years ago, says the number of its clients increased by 1,200% last year, though it will not give an actual number. “Before this, small businesses would have had to take cheques or lose sales,” says Chris Hylen, the head of Intuit's payments division.

In little over a year, Square alone has increased the number of credit-card readers in America by about a sixth. The growth of both firms highlights the huge pent-up demand for mobile payments. Both reckon that some 26m small businesses and self-employed people in America had wanted to accept card payments but were put off by the cost and the paperwork. A traditional card-reader sells for hundreds of dollars, with fixed monthly fees on top, and applicants have to submit to credit checks and provide accounts for the previous year—impossible for a start-up.

Some big banks sneer at these newcomers, arguing that the technology involved in adding a card reader to a phone can be easily replicated. In fact, the innovation has less to do with the device reader than with a business model that has made a huge difference to costs involved in accepting credit-card payments. It is rapidly overturning a lucrative industry of “merchant acquisition” that allowed banks to earn wide margins for agreeing to provide credit-card readers to shops. The first Square device was built by Jack Dorsey, one of the founders of Twitter, who found it so simple that he wondered why no one had done it before, says Keith Rabois, Square's chief operating officer. “They literally made this thing work in a month,” he explains. “It took another year-plus to navigate the financial-services industry.”

The success of mobile payments would not have been possible without the massive growth in the number of smartphones and the falling cost of computing power, both of which are lowering the barriers to new entrants in parts of finance. Smartphones are vital to this, because by providing consumers with powerful computing devices and internet connections that are always on, they open the way to all sorts of other innovations. Square and Intuit can give away their card readers free in part because all the processing power to run them is already on the phones they are plugged into. “It is a device that can link the online and offline worlds,” says Zilvinas Bareisis, an analyst at Celent, a consultancy. “The smartphone gives such a rich experience that we are playing games on it, we are tracking stars, so it is a natural extension to check your bank account or even make a payment.” Its use is also spreading fast. Nielsen, a research firm, reckons that by the end of last year almost half of American mobile-phone subscribers had smartphones, compared with under a fifth two years earlier.

The two companies whose online-payments experiments are being watched most closely are Google and PayPal. PayPal initially set itself up as a mobile wallet that would allow people to beam money from one Palm Pilot (an early handheld device) to another. That idea died pretty quickly when PayPal realised that people were not particularly interested in being able to beam money to someone standing in front of them, but that they did want a safe way to send money over the internet to people who might be complete strangers. It is now arguably the world's biggest bank, with more than 100m account holders. It provides a virtual wallet that can be used to pay for online purchases on a computer at home as well as for things bought in bricks-and-mortar stores on a smartphone. The wallet can even be completely dematerialised. In shop trials in America, customers were happy to pay at the till by typing in their phone numbers and secret code. PayPal is also padding out its virtual wallet with other bank-like features such as loans. Even after a customer has bought and already paid for something in a shop, PayPal offers him various options for funding the purchase. The amount owed can be debited to his current account, credit card or debit card. PayPal also offers its own line of credit to customers who want to borrow money to pay for things they have just bought. A wizard in your pocket Since customers can link a vast number of different accounts to their PayPal wallets, the system can help them ensure that they always pay for things in the most cost-effective way. It might suggest they use a store card when shopping at a particular retailer to maximise the number of loyalty points they accumulate, but propose that they use a different card somewhere else. Such advice poses a serious threat to the banks.

Google is, for the moment, somewhat coy about its wallet and insists it is working in partnership with the banks rather than trying to supplant them. Its wallet allows customers to store bank-issued cards on their phones, which they then swipe across a reader when paying for something. Google is interested in payments because in rich countries more than 90% of all shopping still takes place in real stores rather than online. It too threatens to stand between banks and cardholders.

In Europe, where the market is more fragmented, the idea of an electronic wallet has been slower to take off. iZettle, a Swedish firm, also offers free card readers and charges a fee similar to Square's and Intuit's. It reckons it has already expanded the number of merchants able to accept card payments by about 15% in Sweden, and has recently expanded into Denmark, Finland and Norway. Some emerging markets are leapfrogging rich ones, going straight to mobile banking from having hardly any banks in rural areas. In Brazil and India banks are also reaching far beyond their traditional branch networks by using agents. These are often shopkeepers in small villages, equipped with mobile phones and card readers. Customers can make small deposits, withdrawals and money transfers through these agents instead of visiting faraway branches. The poster-child of mobile banking is Kenya, where some 14m people now save and send money using M-Pesa, a telephone-based banking system. It allows them to deposit with or withdraw cash from a network of small agents. Similar systems have also been deployed in places such as Bangladesh, Uganda, Nigeria and the Philippines, but with less success. In this rapidly evolving market even relatively young firms run the risk of being outpaced themselves by fresh and even more disruptive innovations. One such very new firm is Stripe, which has attracted investment from some of the original founders of PayPal and is trying to muscle in on PayPal's online market. It wants to make online payments easier to accept for website owners than by using PayPal or Google.

The agony of choice

There are two big and interrelated questions about how people will behave when they start using electronic wallets on a large scale. The first is whether they will consolidate all their spending into a single account or spread it even more widely than they do now. The arguments seem finely balanced. Those who expect spending to be consolidated reckon that when people are no longer faced with a physical choice, they will simply use whichever card or account has been set as the default. Those who think that spending will be spread more widely point out that phones eliminate the inconvenience of carrying around a lot of different cards, which may prompt some consumers to have more banking relationships.

The second question is whether consumers will use just one electronic wallet on their phones, choosing between, say, Google, PayPal and their own bank, or whether they will have several. Most analysts think that consumers will gravitate towards a single electronic wallet which will hold many cards. This is because there may be significant benefits to be gained from aggregating transactions and the data associated with them. For example, PayPal's wallet will allow consumers to use various stores of value besides money when paying for goods or services. These could include coupons, loyalty points from stores and banks and air miles from airlines. PayPal stands to profit from steering customers into shops, perhaps by reminding them that they have unused coupons. It could also tell shopkeepers about the tastes of their customers, allowing retailers to make targeted shopping offers (“this would look great with the black skirt you bought last week”) or extend credit on the fly.

Google, too, is hoping to do far more with its wallet than process payments, which it sees as akin to queries typed into its search engine. In the same way that it sells advertisements that are precisely targeted to a user's search, it hopes to be able to deliver offers matched to people's spending patterns.

Innovations of this sort are forcing big banks and the credit-card networks to respond in kind, either by teaming up with the innovators or building their own competing systems. Some are doing both. Citigroup is working with Google; at the time of writing it is the only bank to have its card in the Google wallet. “I'm not sure any of us will carry [physical] wallets ten years from now,” says Michelle Peluso, the head of marketing and internet banking for Citigroup's consumer business.

JPMorgan has built its own network to allow people to make payments by e-mail, using their phones or computers. In Britain Barclays recently introduced a similar system. “Technology is to some extent disintermediating legacy banks,” says Antony Jenkins, the head of retail and business banking at Barclays. “But we also see it as a huge opportunity because with our access to the banking system and our technology we can build these [systems] ourselves.”