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Since the beginning of the COVID-19 pandemic, total fraud has increased 51 percent with almost three-quarters of fraud experts anticipating further increases in 2022. Of the $28.58 billion lost worldwide to credit card fraud for the payments industry in 2020, $10.24 billion was lost by ATM acquirers and merchant acquirers, including merchant fraud. With predictions of increased fraud in 2022, acquirers are assessing their fraud detection strategies. 

Merchant fraud is always a risk. According to PYMNTS.com, 11.6 percent of acquirers report financial losses from fraudulent merchant activity.

Vendors are struggling to pay suppliers or make payroll. Criminals are setting up phantom businesses. Both put acquiring banks and payment processors at increased risk. While merchant fraud can be committed by desperate business owners, there is a more threatening group of criminals that profit from high-stakes fraud. These modern crooks are increasingly tech savvy, understand social and business trends and are adept at evolving fraud schemes into lucrative illicit business enterprises.

Acquirers and processors fall prey to these schemes not because they don’t monitor for anomalous merchant transactions, but because of outdated technology and strategies. Many still depend on legacy, rules-based software in an age when advanced AI solutions offer tools to identify fraud before it happens. A close look at merchant fraud reveals there is a lot of room for improvement.

Fraud isn’t the only cost to acquirers: penalties and fines

Added to the $10.24 billion fraud losses are fines and penalties levied against financial institutions (FIs). Global regulators levied $14 billion in fines and penalties for anti-money laundering non-compliance in 2020, according to the Global anti-money laundering and sanctions survey. Of those surveyed in 2020, 73 percent of North American FIs said they faced more scrutiny over the past 12 months, making detection and prevention of transaction laundering a pressing issue. Respondents also said transaction monitoring is one of their biggest challenges.

Transaction laundering runs parallel to other forms of merchant fraud, with an estimated $155 billion from online sales via transaction laundering in 2016 in the U.S. Infosys also reported U.S. banks process six to ten percent of unauthorized e-Commerce sites of which “about three percent are involved in illegal activities.”

In one case between 2003 and 2013, a group of 18 criminals used both identity swapping and collusion to run what the US Justice Department called one of the most sophisticated synthetic identity crime rings in history. They created 7,000 new identities, applied for and received tens of thousands of separate credit cards and had them sent to 1,800 different addresses. They used the credit cards to make expensive fraudulent purchases, including times where merchants were colluding in the crime. They stole $200 million from acquiring banks and businesses before they were caught.

Watch for these common types of merchant fraud

Acquirers know all too well that merchant fraud comes in many forms, but there are four main categories that law enforcement monitors for:

1. Transaction batch abuse

Rather than submitting transactions as they occur, merchants commit transaction batch fraud by submitting all transactions at once. The hope is to bury fraudulent transactions amongst the authentic sales. A common scheme is to use a stolen identity to process a non-existent sale and let the acquirer deal with the chargeback.

2. Bust-out fraud

In bust-out fraud, someone applies for a merchant account without any intention of operating an actual business. They process transactions with stolen credit cards, may set up an e-commerce site but not fulfill paid orders, or run up debt with banks. By the time the acquirer receives chargeback notifications, the fraudulent merchant has closed shop. The acquirer is then stuck with refunding customers and paying extra fees that may be involved.

3. Identity swap, or merchant-based money laundering

Money laundering is an opportunity to process large amounts of cash that are either the proceeds of crime or intended to finance other crime, such as terrorism. Extremists often use fake or stolen identities to set up online retail sites to bypass money laundering laws. Goods sold through the business are either undervalued or not provided (phantom shipments).

4. Transaction laundering (factoring or collusion)

Transaction laundering happens when a merchant processes transactions for another business, also known as factoring. In some cases, the transactions may be for illegal activities with the merchant colluding as a front for the illegal business, taking a fee for service. More commonly, a merchant sets up a business to sell legitimate goods but is actually selling illegal or stolen products.

Global fraud experts say to prepare for increased fraud risk

ACFE and Grant Thornton, The Next Normal: Preparing for a Post-Pandemic Fraud Landscape, December 2021.

A recent survey of fraud experts from around the globe by the Association of Certified Fraud Examiners (ACFE) and Grant Thornton revealed that 51 percent of respondents uncovered increased fraud since the beginning of the pandemic; 71 percent expect fraud levels to increase over the next year.

While cyber fraud and social engineering are the most anticipated areas for increase in 2022 (82 percent each), survey respondents anticipate that payment fraud and fraud by vendors and sellers will increase by 71 and 69 percent respectively. Their rationale? Shifts in business operations and consumer behaviors, changes in regulatory requirements and supply chain disruptions are affecting the sales environment.

Organizations are responding to this threat: eight out of ten have already implemented at least one change to their fraud protection programs, and 38 percent say they’ve already increased their budgets for anti-fraud technology. They recognize that better insights are needed.

The importance of identifying high-risk merchant accounts

Better insights into customer operations are key to prevention, and this starts by identifying high-risk merchant accounts at onboarding. Using onboarding technology, acquirers who create profiles of new merchants’ past behaviors and credit risk create baselines for future merchant risk monitoring.

This data helps with identifying potential vulnerabilities and with developing risk and decline management strategies. When acquirers are alerted to behavioral changes, these may be indicators of fraud or collusion.

In addition to financial losses from chargebacks and network fines, acquiring banks can also be slapped with criminal charges for aiding and abetting crime. Acquirers subject to credit card investigations may have their accounts frozen, including those of their legitimate merchants.

The challenge of merchant fraud prevention

Acquirers and payment processing companies have long relied on rules-based technology to prevent merchant fraud. The challenge is that rules are written for known fraud schemes, whereas criminals continually evolve their methods to beat detection. When new schemes are discovered, acquirers’ staff write more rules to keep up.

Legacy fraud prevention solutions become bogged down with thousands of rules, have high false positive rates, and lead to lost sales for good customers. Acquirers’ staff become overwhelmed with high alert rates and thousands of rule updates, leaving little time to conduct investigations.

Rules can become so strict that levels of friction and false declines rise. According to a 2019 survey of acquirers, Aite-Novarica Group found:

  •     62 percent reported increased false positives over the previous two years
  •     66 percent performed manual reviews on at least half of their sales
  •     Half of those merchants approved almost three-quarters of those sales in the end
  •     False declines are such a problem that 79 percent of merchants track false decline rates

The ACFE/Grant Thornton study found a quarter of the organizations reported false positives were resulting from “controls or analytics based on pre-pandemic behaviors.”

As consumers and fraudsters become more technologically sophisticated, merchant fraud detection and prevention tools must keep up the pace.

The AI advantage for merchant fraud protection

Acquirers need merchant fraud protection solutions that provide real-time decisioning based on multiple data points of each merchant’s business. This is key to preventing merchant fraud and business insolvency.

An advanced AI model provides one-to-one analysis, and includes multiple data points, such as transaction and user history, geography, current activity and account events to create profiles for each card, account and merchant. These tools provide a 360-degree view of each merchant’s business and transactions.

Machine learning enables the model to continuously learn new schemes while monitoring for fraud. The model refreshes frequently to automatically keep pace with evolving trends, bypassing the need for human input and excessive rule updates.

Unfortunately, most FIs believe implementation for fraud is too expensive when in fact it’s the opposite, according to PYMNTS.com, especially when compared to the costs of merchant fraud.

Outsourcing saves money when adopting AI

Many FIs can benefit from enlisting third-party AI providers. Outsourcing AI operations to firms that specialize in this highly specialized area can help FIs avoid the overhead costs of building and maintaining their own AI department. According to PYMNTS.com, outsourcing AI allows FIs to focus both their operating capital and human resources on their own core competencies.

Working with an experienced AI team with both industry experience and domain expertise will reduce costs and speed implementation time.

2022 will be the year for increased merchant fraud monitoring

Experts anticipate that fraud losses will continue to grow over the next year, and merchant fraud is a large part of that risk to acquirers and payment companies. Monitoring for and preventing evolving fraud schemes requires advanced solutions that analyze and compare data in real time while continuously updating transaction data, profiles and fraud schemes. Only an advanced AI solution customized for your FI’s needs can give you that level of sophistication.

Learn more about the benefits of personalized AI for merchant fraud prevention in our Ebook Reduce transaction-level fraud and merchant risk: a concise guide to mitigation.

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