Image Credit: Apple
There has been some confusion here and there about which iPhones will work with the Apple Watch when the Watch is doing Apple Pay. There is also some confusion about how Apple Pay itself works on the Apple Watch. I'll try to sort out the issues based on some discussion and deductions amongst the TMO staff. We don't claim here to be perfect— this is just a summary of what we think we know so far.
Apple's Apple Pay page has an interesting matrix at the very bottom (shown below).
What's notable is that you'll be able to use Apple Pay on the Apple Watch when paired with these iPhones: iPhone 5, iPhone 5c, iPhone 5s, iPhone 6, or iPhone 6 Plus. The limiting factor is not whether the iPhone has Touch ID. Rather, that it has Bluetooth LE for communication with the Apple Watch.
The other thing to note is that while Apple Pay got off to a strong start with just the iPhone 6/6 Plus, the Apple Watch's appeal for Apple Pay is greatly broadened by the compatibility with these older iPhones. (Of course, in terms of the sheer numbers of transactions, the number of iPhone 6/6 Plus units sold is expected to be much higher than Apple Watches sold. But we shall see.)
Image credit: Apple
The other thing to note is that an iPad mini 3, with Touch ID, still can't be thrown into a purse (or murse) and paired with an Apple Watch for Apple Pay. That's too bad because a lot of women/men find the iPad mini small enough to fit into a large purse/murse.
Apple Pay Process on Apple Watch
The same Apple Pay page, near the top, shows the button under the Digital crown being used. Apple says,
... just double‑click the button next to the Digital Crown and hold the face of your Apple Watch near the contactless reader. A gentle pulse and beep confirm that your payment information was sent.
Note that there's no mention of needing to authenticate first with a fingerprint on the paired iPhone's home button with Touch ID. To explore that means to explore the pairing of the Apple Watch to the person.
We learned more about this recently. When putting the Apple Watch on the wrist, one will have to enter a 4-digit passcode. That appears to serve two purposes. 1) Apple Pay is then (we believe) authenticated with the Apple Watch and 2) If the Apple Watch is removed from the wrist, the absence of a human pulse is detected, and Apple Pay is disabled. In addition, PYMNTS.com writes:
For general use, owners can also set their Apple Watch to automatically unlock when they unlock a paired iPhone. The wearable will unlock this way so long as the owner is wearing it.
Our guess is that in this pairing process with a qualifying iPhone, the information the Apple Watch needs for a payment transaction is accepted, then securely stored, ready for the next Apple Pay event. But that's just a surmise of the TMO staff based on what we know so far.
The Apple Pay Differentiation
As I've written before, Apple Pay is going to be a key differentiator compared to other smartwatches. There will indeed be many new smartwatches coming to market in 2015—as well as refinements of current models. But when it comes time for the customer to choose an item to reside on that precious few centimeters of wrist real estate, the decision may well come down to a choice between having or not having Apple Pay.
If you thought pulling out your iPhone 6 to pay with Apple Pay was cool, just wait until all you have to do is wave your hand.