Getting looped in: Understanding open-loop versus closed-loop card systems
Issue 3 | 16 October 2023
Today, we are going to explore one of the first and most popular mobile payment apps in the market - the Starbucks payment app. In 2021, the Starbucks app had 30M users, and was the second most used mobile payment app for point-of-sale (POS) transactions behind Apple Pay. So, how did Starbucks, a coffee retailer that got its start in Seattle’s Pike Place Market, become one of the leading payment apps?
Starbucks’ Payment App
To drive customer engagement, Starbucks introduced the Starbucks card in 2008 - a loyalty program where customers received rewards, such as free refills, based on their purchases.
Starbucks required customers to load their Starbucks card, so that they could use them to earn rewards. This strategy served two purposes - it allowed Starbucks to gather data about their customers’ purchases and it discouraged the use of credit cards, allowing Starbucks to save on interchange fees 1. The Starbucks card became a huge success, with the card becoming the payment option for 1 in 7 Starbucks transactions and customers loaded and redeemed more than $1B on these cards in 2008.
Although the first Starbucks card was physical card, it wasn’t long before Starbucks introduced a stand-alone Starbucks Card mobile app in 2009. The Starbucks payment app used a 2D barcode that could be scanned at the POS terminals to complete the payment transaction. Starbucks continued to develop the payment app and eventually combined it with the primary Starbucks app.
Essentially what Starbucks created was closed-loop payment card, which is a card that stores value and can only be used at Starbucks locations. Customer can preload funds into the Starbucks app or physical gift cards to pay for Starbucks purchases, but the cards can’t be used for non-Starbucks purchases.
What are closed-loop cards?
Closed-loop cards are payment cards that can only be used at specified locations, either locations from a single organization or approved locations. Closed-loop cards can be used in one of two ways:
As a debit card: These types of closed-loop cards are generally pre-loaded with funds like a gift card, however, they may also be linked to a separate account.
🎴 Examples: In addition to the Starbucks card/app, other common examples of closed-loop cards are the Target REDCard, Walmart Rewards Card, Amazon Secured Store Card, Exxon Mobil Smart Card and certain transit cards like Bay Area’s Clipper card.
As a credit card: Closed-loop cards which function as credit cards are applied for through the business or organization, and credit limits, spending power, and perks will all be maintained through that single entity.
💳 Examples: Card networks such as American Express (Amex) and Discover essentially operate closed-loop card networks, acting as the issuer, card network and acquirer 2.
Advantages of closed-loop cards
Data: Since the merchant or card network has a direct relationship with the customer, they are able to capture valuable information
Security: Since there are limited/ no intermediaries, the payment system is much simpler and easier to control, making it more secure than open-loop cards
Additional customer benefits: Typically closed loop cards offer additional benefits. For example, customers are able to pre-order, check balance availability, earn and redeem loyalty rewards with closed-loop cards like the Starbucks card/app
Additional merchant benefits: For merchant closed-loop cards, the financial benefits are obvious for the merchant, since there are savings on card processing or interchange fees. In addition, card networks like Amex also offer value-added merchant services to help merchants with marketing and operations.
Disadvantages of closed-loop cards
Although it is simpler for a customer to pay for goods through one merchant or business, they also require customers to acquire and manage new payments cards and/or payment apps for each merchant. This makes it less convenient for customers who prefer having a central platform or app from which they manage purchases at any store.
What are open-loop cards?
On the other hand, an open-loop card is a general-purpose card that can be used at any location that the card network brand is accepted. These cards will bear the card network logo (e.g., Visa or Mastercard) and typically include that name of the issuer. Open-loop cards can be either credit cards, debit cards, or prepaid cards.
Co-branded cards are a special type of open-loop card - they are cards from an issuer working with a merchant on an open-loop card network. These co-branded cards can be used at any store and if the customer uses this card in one of the merchant stores, they can still earn loyalty points and rewards. For example, the Chase Southwest credit card is a co-branded card that can be used for any purchases with special Southwest perks (e.g., upgrades, annual travel credits).
Advantages of open-loop cards
The biggest advantage of open-loop cards is the flexibility and ease of use for the customers - customers can use these cards at a variety of locations where the card network is accepted. For example, Visa and Mastercard are both accepted at almost 11 million U.S. merchant locations (approximately 99% of US merchant locations)3.
Disadvantages of open-loop cards
The main disadvantage of open-loop cards is the number of third-party players and intermediaries, which results in fragmentation and open-loop cards being less secure than closed-loop cards.
Note: We looked at the roles of payments processors, Payment Service Providers and Payment Facilitators play for open-loop cards.
Learn more:
Interchange fees are fees that the merchants pay their acquirer (merchant bank) to process payments. Since the Starbucks card is preloaded with a debit card, Starbucks avoids the interchange fees.
Amex and Discover will sometimes partner with an issuer (such as Wells Fargo) to offer cards
SEC filings from Visa and Mastercard