FORTUNE -- Café Grumpy is the kind of hipster hangout that wouldn’t deign to trumpet itself. Tucked away on a quiet street in New York’s Chelsea neighborhood, it’s easy to miss. There’s no sign out front, just a frowning face stenciled on a large shop window. And yet when I walked in for the first time, I immediately felt like one of the regulars. “Charge it to Miguel,” I told the barista after ordering a cappuccino, and charge it he did -- to my phone. Not that I ever pulled my iPhone from my pocket. Seconds after the barista tapped my order on Grumpy’s minimalist register -- an iPad mounted on a stylish countertop stand -- my phone vibrated in my coat pocket, signaling that our transaction was complete. I couldn’t wait to check that everything had worked as promised. (It had.) For the first time ever I was tickled by the act of paying for something.
Perhaps you, too, have experienced a gee-whiz moment at the checkout counter when you used your phone to pay for a Starbucks (sbux) latte, a blouse at Macy’s (m), or a box of screws at Home Depot (hd). Perhaps you’ve read how smartphone payments, already popular in parts of Asia and Europe, are coming to the U.S. in a big way. Or you may have read about Jack Dorsey, the Twitter co-founder, who is now disrupting the byzantine world of payments with his new company, Square. The white-hot San Francisco startup is already responsible for many breakthrough products, including the so-called digital wallet app I used for my touchless, cashless cappuccino purchase at Grumpy. (The café is a Dorsey favorite, and he steered me there. The coffee’s good too.)
These are telltale signs that the mobile-payments revolution has arrived. But what the glowing profiles of Dorsey -- he’s often compared to Steve Jobs -- and the breathless predictions about your phone replacing your wallet don’t tell you is this: Changing the way Americans pay for stuff is going to be really hard work. For starters, retailers and their partners will have to offer mainstream shoppers some pretty sweet perks to get them to replace a swipe of a plastic card with a tap of a phone. Then there’s the chicken-and-egg problem: Merchants don’t want to upgrade pricey point-of-sale terminals so that they can work wirelessly with smartphones unless e-wallets become mainstream, and e-wallets won’t become mainstream until consumers can use them just about everywhere.
And it’s not just innovative startups like Square that hope to reinvent payments for the mobile era, but also everyone from mega-technology companies to financial institutions, giant telecoms, and national retailers. Until those companies agree on common technology standards and platforms, mobile payments won’t work across devices, wireless networks, credit card types, and retailers. (Imagine if Target (tgt) took only an American Express (axp) card that had to be triangular, Wal-Mart (wmt) took only a round US Bank (usb) Visa and a square Citibank (c) MasterCard, and Starbucks would let you pay only with a prepaid Starbucks card. It’s that absurd.)
Yet once these issues are sorted out -- and with so many billions at stake, they will be -- cash will find itself on the endangered-species list. Paying by phone will be as transformative as the advent of the credit card in the 1950s. It will change the way we shop and bank. With powerful smartphones and tablets taking center stage on both sides of the checkout counter, it will reshape the relationship between buyer and seller. Not only will the phone or the tablet become a wallet for consumers, but it will also turn into a credit card reader and a register for merchants. Shoppers will use their mobile device as a coupon book, a comparison-shopping tool, and a repository of those unwieldy loyalty cards they carry from everyone from giant retail chains to the corner bakery. And your smartphones will serve as beacons that will alert a retailer when you walk into its store so that it can recommend products, show you reviews, or direct you to aisle five, where that beanbag chair you didn’t buy last week still beckons -- and you can now have it for 10% off. You won’t even need a few singles to tip the valet or pay the dog walker, because they’ll take mobile payments too.
What’s in play: millions of merchants, billions of transactions, and trillions of dollars in commerce. Which is why the burgeoning revolution has already turned into a free-for-all. Everyone wants in, from big phone companies like AT&T (t) and Verizon (vz) to the credit card networks like Visa (v) and MasterCard (ma) to tech giants like Google (goog), Microsoft (msft), and eBay’s (ebay) PayPal unit. Scores of startups have joined the fray; so have traditional banks, retailers, and makers of point-of-sale hardware like VeriFone (pay). All those contenders are eager to know whether Apple (aapl), which has 400 million credit cards on file, or perhaps Facebook (fb) or Amazon (AMZN), will enter the game soon. Indeed, Apple seemed to tiptoe into the space in June when it announced that the iPhone will soon hold boarding passes, movie tickets, and prepaid store cards.
While this revolution will be powered by complex technology, its ultimate effect will be to greatly simplify things for consumers. Think about my experience at Grumpy. While I had to fiddle with my phone ahead of time -- to upload my credit card to the Square app and to authorize it to talk to the Grumpy register -- once there, the phone never left my pocket. All I had to do was order my cappuccino. That’s just the kind of experience that Dorsey was after when he built Pay With Square, the app that powered the transaction. He tells me it is his company’s proudest creation to date. “To me that is the pinnacle of technology -- when the technology disappears completely,” he says. And with technology out of the way, he adds, there’s room for a more personal interaction between buyer and seller, one that harks back to a quainter time, when our great-grandparents walked into the general store, picked up a shovel, and walked out after telling the owner to write the purchase on his ledger. “You just have to focus on what you want and how much it is,” Dorsey says. “All the mechanics of payments fade away.”
It’s 9:15 a.m., and the bugle call “Reveille” begins to play at Square’s San Francisco headquarters. Never mind the dissonance between the martial tune and the eclectic group of young urbanites who toil in Square’s post- industrial office space. As they do every morning, engineers and product managers across the floor heed the call to get up from their desks for their daily “standups.” They huddle in small groups, where, one by one, they explain what they did the day before and what they plan to do today.
Square, founded in 2009, offers a window into the promise and complexities of the mobile-payments future -- and not necessarily because it will lead us there. In fact, as a pioneer, Square has a big bull’s-eye on its back. But because Dorsey is hugely ambitious, building out products for nearly every part of the transaction chain, Square’s journey helps show why the business is so ripe for disruption -- and why it will be so hard for any company to single-handedly upend the system.
Most people still know Square for its first product, its hugely successful white plastic credit card reader that plugs into a smartphone. The invention has allowed some 2 million small, cash-based merchants -- hairdressers, piano teachers, cabbies, and even babysitters -- to accept credit cards, and it’s growing at warp speed. Merchants are now processing transactions with Square’s Card Reader at a rate of $6 billion a year, up from just $2 billion a year in October, making Square one of the fastest-growing young companies ever by revenue and one of the buzziest in Silicon Valley’s hot startup scene. It has raised plenty of money from A-list investors, including Visa, which sees Square as a way to boost the use of credit cards. Today the company is attracting talented engineers and executives from Apple and Google. It helps that Square may eventually go public or be acquired for a nice premium, making its stakeholders fabulously wealthy. Valued at $1.6 billion after a $100 million cash infusion last year, it was seeking additional financing at twice that valuation in June.
Dorsey hatched the company in his 400-square-foot San Francisco apartment, after the Twitter board asked him to step down as CEO. (Dorsey returned to Twitter triumphantly in 2011 and is now its chairman and chief product guru.) Every morning Dorsey would flip up his Murphy bed to make room for Jim McKelvey, a glassblower, entrepreneur, and Square’s co‑founder, and Tristan O’Tierney, an engineer specializing in mobile apps. Within a month the trio had built a system that could swipe a card and complete a transaction.
It’s not hard to see why Card Reader became a hit almost overnight. Retailers no longer had to fill out a lengthy application form, submit to a credit check, and wait -- sometimes several days -- for an answer, which could often be a denial. After asking for a few pieces of information to verify a person’s identity, Square approves more than 90% of new applicants in a matter of seconds. Square’s Card Reader is free, so there’s no need to buy pricey, and often unsightly, hardware. And Square set transaction fees at 2.75%, bringing simplicity and transparency to what can be a thicket of pricing options, including teaser fees that rise over time. With no sales force and minimal marketing, the Square reader spread largely by word of mouth. The credit card industry, which had been struggling to expand its base of merchants for years, welcomed the new additions. And many merchants say the ability to accept cards boosted sales by as much as 20%. Early this year Chris Timbrell, who co-owns Grumpy with his wife, used Square to replace a $2,000 point-of-sale system that was slow and buggy. “We love it,” Timbrell says.
But on its own, Square’s sugar-cube-shaped reader, which has spawned a string of copycats, was never going to help Dorsey fulfill his ultimate ambition. “We want to carry every transaction in the world,” Dorsey says without a hint of self-doubt. And so the company has expanded beyond the reader with Pay With Square and Square Register, an app that allows merchants to run stores from an Apple iOS device.
A walk through the daily “standups,” when employees discuss the intricacies of Square’s products, is an eye-opening lesson about Square’s aspirations. With Register, Square is going after point-of-sale terminals used in retailers small and large, a business now dominated by hardware makers such as VeriFone and NCR (ncr). Register also allows retailers to keep track of their customers and inventory (think lightweight enterprise software) and to offer loyalty deals and discounts (think Groupon (grpn) but better targeted). Register also delivers analytics that tell merchants what their customers buy and when they buy it -- the kind of data that, until now, only large offline retailers could afford to track.
Pay With Square not only stores your payment credentials but also includes a directory of merchants. It gives merchants a way to have a simple app on mobile devices that displays their menus or merchandise, hours, and other features. And it recently became a repository for loyalty cards from select merchants.
Now Square is planning to expand aggressively into yet another area: hardware. Earlier this year it hired Jesse Dorogusker, an Apple refugee who led the team that built headphones, docking stations, and other peripherals for iOS devices, as its vice president of hardware. “We are going to be doing a lot of hardware,” says Keith Rabois, chief operating officer of Square and a former executive at PayPal and LinkedIn (lnkd). Rabois cagily declines to elaborate, but consider this: In a pilot program the company recently began installing a software and hardware bundle that includes Square-powered iPads and iPhones in New York City taxicabs. It serves as a payment mechanism and replacement for those annoying TV screens that are common in the backseats of cabs. People with knowledge of Square’s plans say that in the future the company hopes to develop similar bundles for other vertical markets. It also plans to build different versions of its reader as it expands overseas. (Did we mention that Dorsey is ambitious?)
Taken together, Square’s products begin to offer a glimpse of what a utopia for buyers and sellers could look like: You’re in a new city and feel like sushi, so you fire up your phone and Square’s software offers you a series of suggestions that reflect your tastes; a nearby eatery offering you 20% off your bill catches your eye. Once you’re at the sushi bar, your phone talks wirelessly to the restaurant’s register and settles your bill, including the discount. And the restaurant collects a slew of information about you, which it can use to market to you in the future. “We are reinventing payments from the ground up, based on the principle that everyone is carrying a general-purpose computer in their pocket,” Rabois says.
The problem with Square’s utopia -- and those of its rivals -- is that it is a bit of a walled garden, for now at least. Pay With Square works only at some 75,000 small merchants (and it works seamlessly only at the much smaller number that also have Square Register). Say you are in search of a caffeine boost. You’ll be able to use Square at a smattering of mostly independent, mostly urban coffee shops. You can pay with your phone for coffee at Peet’s, as long as you have Google’s competing Wallet app, which connects to registers via a gentle bump of your phone. Oh, but it only works with MasterCard, on a handful of phones running on Sprint (s). You prefer Starbucks? No problem: You can use your smartphone there too, as long as you have the Starbucks app. It has great features, but don’t expect to use it anywhere other than Starbucks.
And that’s just coffee. “You have a potential situation where consumers are confused into doing nothing,” says Drew Sievers, CEO of mFoundry, the company that helped Starbucks develop its mobile app. For all the investment in mobile wallets and readers, the marketplace is at a bit of a standstill: Until mobile wallets are more mainstream, retailers won’t rush to accept them, and until wallets work in more places, consumers won’t embrace them. “There is no ubiquity, so a mobile wallet is a complement to your wallet, not a replacement,” says James Slavet, a venture capitalist at Greylock Partners, who has invested in payment startups.
And the landscape is only becoming more crowded and potentially more confusing for consumers and retailers alike. Every month seems to come with an announcement of another giant -- say, Microsoft or MasterCard -- going after e-wallets. Many are powered by a wireless technology called NFC (for “near field communications”) that is endorsed by several phonemakers but not by Apple. Square and some of its competitors have pooh-poohed NFC, and many retailers are taking a wait-and-see attitude. Meanwhile mobile card readers are proliferating. In March eBay’s PayPal unit introduced a card reader for mobile phones and added capabilities to its mobile app that mirror those of Pay With Square. “We can help small businesses wherever they do business,” says David Marcus, president of PayPal. (Soon after, PayPal expanded a program that gives customers access to their PayPal account with their mobile-phone number and a pin for purchases at 16 major national retailers.) Less than two months after PayPal, VeriFone also introduced a card reader and a point-ofsale system that can work with products from other companies, like digital wallets from Google or ISIS, a joint venture of AT&T, Verizon, and T‑Mobile. And both PayPal and VeriFone set their processing fees at 2.7%, undercutting Square by five hundredths of a percentage point. NCR’s own reader is launching in July.
None of that is good news for Square unless it’s going after a prize for most imitated company. Just about every Square rival has something the hot startup lacks: scale. Most also have far more financial resources, deep ties to the mobile phone or the financial services industries, and a global footprint, whereas Square has yet to expand outside the U.S. “I’m not quite sure what all the hype is about,” says Doug Bergeron, the chief executive of VeriFone, whose terminals process trillions of dollars in transactions every year. “It is common knowledge that Square is now being surrounded by many competitors with real business models, and that they continue to bleed mountains of cash.” Dorsey and his team brush off such remarks. “It’s the same tech story all the time,” says Rabois. “There are always large, entrenched players that have lots of assets that are trying to compete with a focused startup with a compelling vision and a lot of talent.” His point: Focus, vision, and talent will leave incumbents in the dust.
Indeed, there are no indications that Square’s core business is slowing at this point. “We had pretty heroic growth expectations for the business, and they have consistently met or exceeded those expectations,” says Mary Meeker, a partner at Kleiner Perkins Caufield & Byers and a Square board member.
Still, Square is starting to show some signs of strain. Some employees have griped, both privately and on Quora, a question-and-answer website, that Square is being mismanaged and has become a challenging place to work. Some people who work with Square say that Dorsey has been too focused on the design of Square’s products and not enough on engineering. And they complain that his divided attention -- every day he spends eight hours at Twitter and eight hours at Square -- robs Square of the focus it needs from its CEO. (Dorsey dismisses such critics. “I am going to do whatever it takes in my life to make sure that both succeed massively,” he says.) For all its success, the company remains relatively small. Square won’t disclose its finances; however, its 2.75% commission on a reported $6 billion in annualized transactions translates to about $165 million in revenue. Square pockets only a small fraction of that, as the majority goes to the payment processors and credit card networks.
While Square remains a work in progress, the Starbucks experience suggests that consumers will warm to digital wallets. By all accounts the coffee retailer may have built the No. 1 mobile payments system in the U.S., through a relatively simple mobile app that allows users to upload their Starbucks loyalty cards to their phone and then use their phone to pay. The company won’t give precise dollar figures for mobile transactions, though it says in the last nine weeks of 2011 alone, it processed more than 6 million mobile transactions. While the pay-by-phone feature is convenient for customers and has sped up checkouts, payments were not the primary focus of the app. “We look at the app as a way to tell the Starbucks story,” says Adam Brotman, chief digital officer for Starbucks. Brotman says the biggest benefit of the mobile app is that it has increased customer participation in its loyalty program, which drives multiple billions in revenue for Starbucks each year.
Indeed, a cashless future is more real than many suspect. In The End of Money, author David Wolman set out to live an entire year without using cash, and he largely succeeded. For the rest of us, the departure from cash is more likely to proceed in fits and starts. Credit card networks like MasterCard and merchants have certainly helped with the first wave by allowing small transactions to go through without a signature, and by installing credit card readers in taxicabs. We may embrace one app first, like Starbucks’ or PayPal’s or Square’s, and slowly grow more comfortable using our phones to pay for more and more things. And the credit card companies and retailers may lead the way to uniform standards and registers that can accept all forms of payment, just as they have with plastic. “Financial institutions are going to have a big role to play,” says Bill Gajda, the global head of mobile at Visa. No proprietor wants to turn away a customer because he has the wrong kind of phone.
Dorsey, for his part, seems confident that the change is proceeding apace. On a recent trip to St. Louis, where he grew up, Dorsey managed to use Square to pay for lunch, dinner, and coffee. Adoption of the technology, he says, is happening faster than he expected because people are yearning for a more high-touch experience in all aspects of their lives, including at the checkout counter. “I think there is a general desire in American culture right now to find something that is more crafted, that is more personal,” he says. And as anyone who has ever received money as a gift will tell you, there’s nothing more impersonal than cash.
This story is from the July 23, 2012 issue of Fortune.