Risk Merchant Practices: Reasons and Types of Merchant Fraud

July 7, 2021

Merchant fraud has traditionally gone hand-in-hand with advancements in digital payment technology. The greater the world’s reliance on digital transactions, the bigger the merchant fraud risk to mitigate. 

To put the matter into some kind of perspective, PayPal recently revealed that when the platform was first introduced, it was losing around $1.6 million each month to fraudulent transactions. Having subsequently stepped up its fraud detection and general fraud monitoring protocols, it has been able to put this issue to rest almost entirely. 

But this does not mean that issues with various different types of fraud are not still widespread and extremely problematic. According to a recent report from the Reserve Bank of India, financial fraud grew over the past year alone by 28% in volume and 159% in value. 

An effective fraud monitoring system designed to learn and evolve with every transaction can hold the key to heightened security in an age of digital payments. Nevertheless, many experts warn that businesses in general are still not prioritising fraud transaction monitoring or prevention nearly as aggressively as they should be.

Merchant Fraud vs. Transaction Fraud

Merchant fraud and transaction fraud pose equally severe threats to the victims they target, though are fundamentally different in nature.

Transaction fraud typically refers to the more conventional type of payment fraud, covering things like unauthorised transactions, false refunds/chargebacks and so on. Measures implemented to reduce the risk of transaction fraud include payer authentication via 3-D Secure, tokenisation, SMS alerts and a variety of merchant measures (like monitoring suspicious customer activity).

By contrast, merchant fraud is different in that the source of the fraudulent activity differs to that of typical transaction fraud. It usually revolves around the identity of the merchant, often performed with the intent of duping individuals (fraudulent transactions) or authorities (money laundering, tax evasion, terrorist financing).

The Different Types of Merchant Fraud

Merchant fraud comes in a variety of different ways - some of which are more commonplace than others. Though by far, the most common categories of merchant fraud that require robust protection to detect and circumvent are as follows:

Bust Out Fraud

This is a common type of merchant fraud that involves the establishment of fake business entities, in order to subsequently open multiple merchant accounts and seek as many lines of credit as possible. These are then exhausted by the perpetrators, who then disappear without ever repaying their debts. Fraudsters often create quite sophisticated and convincing fake ‘storefronts’ to dupe banks and lenders into funding them. 

Identity Swap

Another surprisingly common merchant fraud scheme is referred to as identity swap, which applies when businesses or individuals in sanctioned countries or on watch lists set up merchant accounts using fake identities to bypass Anti-Money Laundering (AML) rules. 

Fake Business Operations

Organised crime networks are often fronted as legitimate businesses, which do not technically exist. This is where a fake business is established and sits dormant or inoperable, used simply as a fraudulent front for the illegal activities its proprietors are conducting - drug dealing, hacking, producing counterfeit products etc. The web has made it surprisingly easy for anyone wishing to do so to set up a fake business and pass it off as legitimate.

Identity Theft

Fraudsters have mounted a wide variety of different types of identity theft attacks and schemes for decades, though today’s threat level is more elevated than ever before. All the information fraudsters need to create fake identities or hijack the identities of others is held online, quite often protected by safeguards that are not sufficiently robust. 

Transaction Laundering (Factoring)

This occurs when a merchant knowingly and illegitimately processes unknown transactions for a different business entity.  Recent estimates suggest that this one form of fraud alone costs the US economy as much as $352 billion each year. 

Business Format Change

Merchants who are involved in higher risk or illegitimate activities often change or falsify information about the nature of the products and services they provide. This subsequently enables them to continue these illegal more high-risk activities without detection.

These are just a few of the most common types of merchant fraud, with new types of attacks and categories of fraud emerging all the time. 

Detection and Protection for Merchant Acquirers

Proactive prioritisation of merchant fraud detection and improved merchant risk monitoring practices are considered essential in today’s risk-heavy landscape. It is also a formal compliance requirement in most Western nations to make all reasonable efforts to detect, prevent and/or deal with fraud appropriately where it occurs.

Cutting-edge technology is paving the way for a future where artificial intelligence and machine-learning will play a major role in all aspects of fraud detection and prevention. Systems linked with complex neural networks - like that of Fraudio - create something of a centralised ‘brain’ that is able to think, evolve, adapt and even bring an advanced level of automated intuition into the mix. 

Nevertheless, experts insist that it is not simply a matter of relying on technology alone. The experience, expertise and input of a skilled fraud prevention team will always be priceless for many types of organisations.

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