Have you ever wondered why one card may be used everywhere while another is only accepted at a few stores? Perhaps you've questioned why certain applications make it so simple to pay in many locations, whilst others restrict you inside a single brand's environment. These distinctions boil down to two types of payment systems: open loop and closed loop.

In this post, we'll go over the mechanics of both open and closed loop payment.

Open loop vs closed loop payment system

These days, electronic payment methods are a necessary component of our everyday existence. These methods, which range from credit cards to mobile wallets, have completely changed how we conduct business.

The issue lies in the fact that small and medium-sized business owners are often overburdened with duties, making it difficult for them to look deeply into payment systems or learn about how they work inside.

If your business is based in the US or the UK, you should do more research to decide which method of payment is most appropriate for you. Because, in the end, the correct payment system is what will drive maximum growth and success.

Let’s simplify the payment systems' open and closed loops, which form the backbone of electronic payment solutions.

While both the systems might seem similar, the way they work - and the impact they can have on your business - are quite different.

Let’s know both of these systems in detail.

What is open loop payment system?

An open-loop payment system is the kind of system most of us use every day without even thinking about it.

If you've ever swiped your Visa or MasterCard at a store, ordered anything online with a credit card or tapped your phone to pay with a mobile wallet like Apple Pay or Google Pay, you've participated in an open-loop system.

How does open loop payment systems work?

When you make a purchase using a credit or debit card, you don’t directly pay the business or merchant. Instead, your card is issued by a bank, and that bank is linked to a large real-time payment network (like Visa or Mastercard).

The merchant you’re buying from also works with a bank, and these banks communicate with each other through this payment network. Consider like a bridge connecting you to the merchant, which allows your money to travel from your account to theirs without either of you requiring a direct relationship.

For instance, picture yourself being at a coffee shop, and you don’t have any cash on hand. You hand over your Visa card. The coffee shop’s payment system checks with its bank (called the acquiring bank) to make sure your card is valid. This bank then communicates with Visa’s payment network, which asks your bank (the issuing bank) if everything is in order - do you have enough funds, is the card legit, and so on. If everything checks out, the payment goes through smoothly, and your coffee is paid for.

One of the primary motivations for using open-loop systems is convenience. You can use the same card practically anywhere, from your local grocery store to booking hotels online. This makes it ideal for anyone seeking extreme flexibility, whether they are a customer wishing to pay quickly or a business owner looking to accept an array of payment methods.

The beauty of the system is that it doesn’t just stop at in-person purchases. It also works while shopping online. When you buy something from Amazon, the same process happens behind the scenes, even though you're not physically handing over your card. Your card number gets sent through the network, your bank verifies everything, and the payment is processed instantly.

There are a lot of steps happening in the background, but the whole thing happens in a snap. This allows you to shop, pay and move on without worrying about whether the merchant will get paid or if your information is safe.

The open loop payment technology also provides additional security for you. If something goes wrong, such as a double charge or a fraudulent transaction, you're shielded on all sides. In a nutshell, the payment network functions as an intermediary, helping to settle disputes promptly so you don't have to deal with disagreements directly with the merchant.

So, the next time you swipe, tap or enter in your card number, remember that the open-loop payment system is silently working in the background to make your life easier, safer and cashless!

What is closed loop payment system?

A closed loop payment system is a way for buyers and merchants to connect directly through a payment network, without any intermediaries like banks. In this system, the payment network itself handles everything - signing up both customers and merchants.

Think of it like a club where both you and the store you want to shop at are members, and the payment network acts as the club organizer.

How does closed loop system work?

Let’s understand this technology from American Express (Amex).

While you can use your Amex card at many places, some stores won’t accept it because they’re not part of the Amex network. That’s the catch with closed-loop systems: they don't have the reach of open-loop systems like Visa or Mastercard, which work with almost any bank and merchant.

In a closed-loop system, the payment network has to individually register every merchant and customer, which can be a lot of work in the backend.

But there are some critical advantages of closed loop systems. Since the payment network controls the whole system, they set all the rules and gather all the data. For example, Amex knows everything about your spending habits and the merchants' sales data, which can help them offer special deals or build loyalty programs. They also have tight control over security, which helps in reducing fraud.

Another good example of a closed-loop system is a gift card or a transit card. Let's say you have a Target gift card. You can only use it at Target - it's part of a "closed loop" between you, the gift card and Target. Or, think of a transit card like the LA Metro's TAP card. It works only within that specific transit system.

On the other hand, closed-loop systems are extremely harder to scale. It's much more challenging for them to grow compared to open loop systems that can piggyback on existing bank networks.

Also, there's a risk for you as a consumer. If a company like a store goes bankrupt and you still have a gift card from them, you’re out of luck - you can't use it anymore. Plus, if you lose a transit card or a gift card, it’s often gone for good.

So, while closed-loop systems offer control and benefits like loyalty rewards, they also come with some limitations - mainly around scale and flexibility.

How to integrate open loop and closed payment systems to your business?

• You can accept popular credit and debit cards through an affordable payment gateway for transactions above $10. This opens you up to a huge customer base while earning enough on larger spends.

• Start accepting online payments through Shopify, WooCommerce or Square integrated with popular open loop digital wallets. This simplifies checkout for mobile-first customers.

• Consider omni-channel payment options like buy-online-pickup-in-store that bridge the convenience of open loop networks with your local operations.

• You can offer a closed loop gift card program specifically for smaller value transactions below $10. Customers can purchase cards online or at your retail outlet for hassle-free repeat spending.

• You can also integrate a loyalty program with your closed loop system. Offer rewards and coupons exclusively for registered users to incentivize repeat visits and spending.

Wrapping things up!

With the correct mix of open and closed loop tactics, you can take payments from anywhere, create long-term relationships and improve revenue through higher customer spending over time.

But before moving ahead, you should take the initial step by researching potential vendors and carefully reviewing terms.