What Is Tokenization in Payments & How Does It Work?

I use tokenization every day and strongly recommend it — for business owners and shoppers. It’s secure, reliable, and easy to implement.

In this guide, I’ll explain what tokenization is, how it works, and why it matters.

Let’s begin with a definition.

Key Takeaways

• It replaces sensitive payment data with secure tokens.
• Visa reports it reduces fraud rates by 26%.
• Apple Pay and Google Pay use tokenization.
• It simplifies PCI DSS compliance and lowers the risk of data breaches.
• Payment gateways handle payment tokenization.
• Experts expect tokenization to grow from $2.81B in 2023 to $13.2B by 2032.

Tokenization is a powerful way to reduce fraud and chargebacks. But it doesn’t stop all disputes. That’s where tools like chargeback alerts can help. These services notify you when a customer files a chargeback. Giving you a chance to act before it causes harm.

Learn how they work.

What Is Tokenization (In Finance)?

Tokenization is a process that replaces sensitive credit card data with a unique, random token. This token only works in its specific system or transaction, making it useless to hackers.

Want to learn more about PANs? Check out our guide on bank identification numbers.

With tokenization, real payment data never enters the merchant’s system. As a merchant, you store and transmit tokens, not actual card details. A token provider locks the original data in a database called a "token vault."

Tokens can work for single transactions or replace card numbers for saved payments, like subscriptions. For example, when you add your credit card to Apple Pay, the app stores a token instead of the actual card information.

Tokenization enables secure payment methods, including:

• Mobile wallets
• Contactless NFC payments
• Online shopping
• Recurring billing.

Even if someone intercepts tokenized data, they can’t use it without access to the token vault.

Here’s how this works in practice.

Glossary

• Token: A random string of numbers.
• PAN (Primary Account Number): The 16-digit number on a credit or debit card used to identify the account.
• NFC (Near Field Communication): A wireless technology that enables contactless payments.
• Token Provider: The entity responsible for generating and managing tokens and storing data.
• Token Vault: A database where the original payment data is stored.

Summary: Tokenization replaces sensitive data with secure tokens.

Example of Tokenization

Imagine a customer shops on your e-commerce site and saves their credit card details for future use. 

Here’s how tokenization works in that scenario:

1. The customer enters their card details, like the 16-digit PAN, expiration date, and CVV.
2. Your payment processor creates a random token to replace the actual card details.
3. Your system stores the token instead of the real card data.
   
   1. The sensitive information stays locked in the token provider’s secure vault.
4. For future purchases, the saved token processes transactions without revealing card details.

Even if someone breaches your system and accesses the stored tokens, they wouldn’t be able to reverse-engineer them into the original card details. The real data remains safe and accessible only to the token provider.

This same process happens when customers add their credit cards to digital wallets like Apple Pay. The wallet stores a tokenized version of the card, which is used during transactions instead of the actual card number.

You probably want to know how the whole process works.

How Does It Work?

Here’s a quick overview of how it works:

1. Data collection: Customer provides payment details during a transaction.
2. Tokenization request: Merchant sends sensitive data to a tokenization service.
3. Token generation: Service generates a unique token instantly.
4. Secure storage: Token replaces sensitive data stored by the merchant.
5. Token usage: Merchant uses the token to process transactions

Let’s break down each step in more detail:

1. Data Collection

The customer enters payment details like the card number, expiration date, and CVV.

2. Tokenization Request

The merchant’s payment system sends the customer’s data to a tokenization service. This service connects with a payment processor (like Adyen), an acquirer, or a specialized provider.

Quick note: An acquirer processes payments for merchants. Acting as a bridge between the merchant and the customer’s bank.

3. Token Generation

The tokenization service instantly replaces the payment data with a random token. This ensures a frictionless experience for customers.

4. Secure Storage

The merchant stores the token instead of the real card details. Meanwhile, the token provider securely stores and manages the original data.

If a customer’s card expires, the provider updates the token with the new expiration date. The merchant doesn’t need to collect updated card details.

This setup reduces the risk of sensitive data exposure, protecting sellers and shoppers from breaches.

5. Token Usage

Merchants use tokens to process payments without accessing the original card data.

For recurring payments, the token eliminates the need for customers to re-enter their details. If a refund or settlement needs the original data, the tokenization service retrieves it by detokenizing the token.

Now, is tokenization the same for digital wallets? Let’s find out.

Variations Across Systems

Token generation and management vary based on the acquirer, bank, or digital wallet. Each uses its own standards for issuing, storing, and managing tokens.

For instance, adding a card to a digital wallet works differently than tokenization for e-commerce merchants.

Here’s how adding a card to a service like Apple Pay would work:

• The digital wallet checks with the payment network to confirm the card issuer supports tokenization.
• Once verified, the wallet requests a token from the token service provider.
• The token service provider collaborates with the card issuer to finalize the process.

The issuer might approve the request instantly, ask for authentication (like an OTP, app verification, or a phone call), or deny it.

Once approved, the token service provider sends the token, a cryptographic key, and a digital image of the card to the wallet. This "digital card" is then ready for transactions.

The entire process takes seconds. When I did it, I thought it was actual magic and nearly threw my phone at the wall.

Still not convinced? Let’s dive deeper.

Benefits of Tokenization

Its key benefits include:

• Enhanced security: Reduces the risk of data breaches. 
• Fraud reduction: Limits the potential for payment fraud. 
• Support for emerging payment technologies: Helps the adoption of new payment methods.

If you’re a business owner, you’ll want to read this next part.

1. For Businesses

Here’s why tokenization works so well for businesses:

• Simplified PCI compliance: Reduces the need to store or process sensitive payment data.
• Efficiency: Makes payments easier to manage by removing sensitive data. 
• Builds trust: Secure purchases may lead to more loyal shoppers.
• Support for recurring payments: Safely handles ongoing transactions.
• Scalability: Easily integrates with new payment technologies.

Now, customers will want to pay attention to this next part.

2. For Shoppers

Customers gain big benefits from tokenization too:

• Data protection: Keeps payment details safe by ensuring actual card data stays hidden.
• Streamlined checkout: Enables fast, one-click payments for a smoother shopping experience.
• Seamless recurring payments: Customers don’t need to re-enter payment details.
• Cross-platform consistency: Delivers the same secure, smooth payment experience across devices and platforms.
• Privacy assurance: Offers more privacy during transactions.

Should your business use tokenization? Absolutely.

Should My Business Use Tokenization?

Yes, your business should use tokenization. It doesn't matter whether you run an e-commerce store, SaaS platform, or physical shop.

Adoption is growing fast.

Here are some stats to back it up:

• The global tokenization market was valued at $2.81 billion in 2023. It’s expected to hit $13.20 billion by 2032, growing at a CAGR of 18.8%.
• In the first half of 2024, 22 billion tokenized transactions were recorded — a 49% leap from the previous year.
• Mastercard aims to tokenize 100% of e-commerce transactions by 2030, marking a major shift in online payment security.

These numbers show tokenization is the future of secure payments. By adopting tokenization now, your business aligns with best practices. It also stays ahead in payment technology.

Too good to be true? Let’s explore further.

Here Are the Risks of Tokenization

Risks of tokenization include:

• Token vault vulnerabilities: A compromised vault could expose all sensitive data.
• Lack of standardization: Inconsistent tokenization practices can create compatibility problems across providers.
• Data synchronization issues: Maintaining consistent tokenized data across platforms can be difficult.
• Compliance gaps: Tokenization aids compliance but doesn’t guarantee full regulatory adherence.

Tokenization is a strong security measure, but its success relies on proper management.

For instance, token vaults, while secure, represent a single point of failure. Businesses must ensure their token provider uses strict access controls to protect the vault.

Lack of standardization can complicate tokenization, especially when integrating multiple payment providers. Businesses may need customized solutions to ensure compatibility. Increasing implementation complexity and costs.

Lastly:

Tokenization doesn’t replace broader compliance strategies. While it reduces PCI DSS requirements, businesses must still address other risks. Think employee training and endpoint security.

Now, since we’re experts on chargebacks, let’s cover that next.

How Does Tokenization Tie In With Chargebacks?

By replacing payment data with tokens, stolen card information is useless to fraudsters. This reduces true fraud and lowers chargebacks from unauthorized transactions.

Visa reports that network tokenization can cut fraud rates by 26%, leading to fewer chargebacks [4]. That only applies to true fraud disputes, though.

About 1% of chargebacks come from true fraud. Meanwhile, over 70% result from friendly fraud. This happens when customers dispute charges they actually authorized. 

That said, merchants only win about 37% of friendly fraud disputes involving Google Pay or Apple Pay, according to Ravelin. That's less than the 40% that merchants typically win with regular debit cards.

Thus, dealing with friendly fraud when using tokenization still poses problems.

If friendly fraud is an issue for your business, here are other strategies we recommend to prevent it.

Now, are there different types of tokenization? Let’s find out.

Summary: It reduces chargebacks related to true fraud, but not friendly fraud.

Network vs. Payment Tokenization

Tokenization comes in two main forms: payment tokenization and network tokenization. Both replace sensitive data with tokens. However. They differ in creation, storage, and management.

1. Payment Tokenization

In payment tokenization, a payment service provider (like Adyen) stores the card details and makes tokens for merchants. These tokens are unique to the merchant or payment environment and managed independently of card networks.

This method provides strong security but has limitations. For example, if card details change (due to expiration), sellers must work with the provider to update tokens.

2. Network Tokenization

Network tokenization, managed by card networks like Visa, store the PAN and generate tokens directly.

These tokens automatically update if a shopper updates their card, offering better convenience. 

Merchants may also benefit from higher transaction approval rates. That's because banks and issuers trust network tokens as more reliable. This leads to fewer declined transactions and smoother recurring payments.

Which should you choose?

For most businesses, network tokenization provides superior convenience and security. Especially for recurring or high-volume transactions. The automatic updates reduce friction for customers, while better approval rates help merchants.

That said, payment tokenization can still work well for businesses with unique needs.

Encryption vs. Tokenization

Tokenization replaces sensitive data with a random token. This token has no connection to the original data and attackers can only reverse it if they can access the token vault.

Encryption scrambles data into an unreadable format using algorithms. Hackers can reverse it with the correct encryption key. If the key is exposed, the data is at risk.

Both methods are useful, but each works best in specific situations.

Curious to learn more?

Check out our guide on tokenization versus encryption for a full comparison.

Now, let’s dive into some Q&A.

FAQs

Does Apple Pay Use Tokenization?

Yes, Apple Pay uses tokenization to secure payments.

How Can I Tokenize My Debit or Credit Card?

You can tokenize your card by adding it to a digital wallet like Apple Pay, Google Pay, or Samsung Pay. These wallets work with your card issuer to generate a secure token for use in transactions.

Wrapping Up

Tokenization is a reliable way to protect data and reduce the risk of true fraud.

However:

It’s less effective against friendly fraud.

That’s why you’ll need more tools. This is where chargeback alerts can help.

Our chargeback alerts cover transactions from all major card providers. Some merchants have reduced their chargeback rates by up to 91% using them.

Try them out.

Sources

• [1] Tokenization Market Size. Fortune Business Insights. 12/23/2024.
• [2] Mastercard is Making Huge Changes. The Scottish Sun. 6/18/2024.
• [3] Tokenization Offers New Ways to Monetize Data. PYMNTS. 8/01/2024.
• [4] Embedding Tokenization. Visa. 2021.