Merchant Fraud

April 5, 2021 | 8 min read

Merchant Fraud: How Fake Businesses Hurt Real Merchants

Merchant fraud is one of the most overlooked types of fraud associated with retail. Issues like data breaches, identity theft, and account takeover may get the most press. However, fraud committed using fake merchant accounts, thereby allowing fraudsters to masquerade as legitimate businesses, can do their share of damage, too.

Consumer fraud is a serious problem, but the bulk of it is concerned with illegitimate purchases or chargebacks. This means the risk largely falls on merchants and issuers. Merchant fraud, however, represents an initial threat for acquiring banks, but later trickles down to hurt legitimate merchants, too.

In this post, we’ll talk about what merchant fraud is, the common ways it’s committed, and why it matters to legitimate businesses.

What is a Merchant Account?

Before we get into merchant fraud, let’s take a moment to examine how merchant accounts are supposed to work.

A merchant account is a bank account, but not a typical one. You can’t write checks or withdraw cash from this account; in fact, you won’t have direct access to it at all. Instead, it serves as a “holding” account in which funds from customers’ payment card transactions are temporarily held.

Prior to each customer purchase, a processor confirms the availability of the cardholder’s funds and will authorize the transaction if all necessary conditions are met. Funds are then moved from the cardholder’s issuing bank to the merchant account. Once the transactions are processed and finalized—usually within a couple of days—the money automatically transfers to your regular business banking account.

You can’t accept credit or debit cards without a merchant account. However, getting one can be a complicated process. You must submit an application and a variety of other information and documentation before an acquirer will decide whether to grant the account.

This may sound a lot of hassle. It’s necessary, though; the bank needs to ensure that you’re a legitimate merchant, and ascertain how much risk you represent. It’s a way for the acquirer to protect their own interests by ensuring that they’re not doing business with a scammer. Of course, these checks don’t always work.

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What is Merchant Fraud?

Merchant Fraud

[noun]mɝ ● tʃənt ● frɔd

Merchant fraud is a tactic that allows criminals to open a fake merchant account and impersonate a legitimate merchant to accept credit card payments. The criminal can then use the stolen cardholder data to complete fraudulent purchases.

Merchant fraud is sometimes referred to as “fake merchant fraud.” In reality, that is a more accurate description. Merchant fraud, as we’re talking about it here, does not generally involve genuine merchants. Rather, the term refers to criminals who open bogus merchant accounts that allow them to accept credit card payments.

In a world where commerce increasingly happens in a digital environment, criminals have found new and sophisticated methods of committing fraud. Easy access to a global market translates to a larger pool of potential victims, while the ease of creating a fake company or ID means there is less investment involved for any particular scam.

Obviously, acquirers try to give merchant accounts only to verified businesses. They use a mixed set of criteria to check the authenticity of a merchant before the account is opened. Unfortunately, once criminals have the account, they know multiple ways of leveraging it to commit fraud. For example:

Transaction Laundering

With transaction laundering—sometimes called “factoring”—a fraudulent company processes payment card transactions through the merchant account of a real business. While the acquirer isn’t aware of what is going on, the “legitimate” merchant is a partner in crime.

This scheme can allow businesses in high-risk verticals (gambling, for example) to secure standard merchant processing. They can then process transactions at a lower cost, and with less regulation, than would usually be the case for high-risk businesses.

“Bust Out” Fraud

Bust out schemes involve merchant accounts opened by fraudsters who have no intention of running a legitimate business. The goal is simple: open the account, process a bunch of fraudulent transactions in a short period of time, then walk away from the account before the fraud is discovered.

Since the crooks must first be approved for a merchant account, fraudsters must go to great lengths to make their phony storefronts appear real. Fortunately for them, the internet has made it easier than ever create fake identities and phony businesses.

In more elaborate schemes, fraudsters may create dummy businesses to open fake merchant accounts, then open consumer accounts for non-existent cardholders, complete with fictional credit histories and other false data. They can then use these fake identities to complete purchases with their fake business.

Identity Swap

This trick allows criminals to bypass Anti-Money Laundering (AML) rules. The idea is to launch a legitimate online store with a merchant account, then use the store as a front for a shady enterprise. This allows an illicit group to solicit funds, or even a legitimate business to operate from a prohibited locale.

An identity swap scam can work for illicit parties (such as drug cartels or terrorist groups), or for residents of countries under economic sanctions. While everything may appear to be above-board, acquirers can get into serious trouble by allowing these parties to operate in opposition as merchants.

Business Model Swap

One of the least complicated ways to commit merchant fraud is to simply switch the business type and/or format after the merchant account has been opened. The fraudster sets up an eCommerce store in a category that qualifies as “low-risk.” Once the merchant account is established, the content on the website is switched to whatever merchandise the proprietor wants to sell—low-risk or not.

Why You Should Care About Merchant Fraud

Merchant fraud clearly hurts acquiring banks. This has latent effects for you as a merchant, though, as acquirers’ losses make it harder and more expensive for you to open and maintain a merchant account. As acquirers’ costs increase, they will have to pass those losses along to their merchant clients. That’s not the only liability here, though.

The consequences of merchant fraud can vary depending on who’s benefitting from a merchant fraud scheme. It could expose an acquirer to chargebacks, network fines, and regulatory injunctions. It could also expose them to charges of facilitating criminal activity, which may carry serious legal consequences. If an acquirer gets caught up in a credit card fraud investigation, it may result in legitimate merchant accounts—and the assets in those accounts—being frozen, which could mean your cash is inaccessible.

The same is true of authorized merchants who aid these criminals or do business with them. If you get implicated in transaction laundering, for instance, you may be on the hook for any activity carried out by the criminal.

To avoid the risk of accidentally abetting fraudsters, both acquirers and merchants must perform due diligence. This extends beyond the beginning of a partner relationship; you must conduct ongoing monitoring as well. To uncover suspicious activities, relationships must be regularly reviewed in the context of the entire surrounding eCommerce ecosystem.

A Final Word

As a merchant, it’s critical that you know who you’re dealing with. That means knowing your customers as one way of preventing fraud, but it can also go hand in hand with knowing your partners to keep from getting caught up in fraudulent activity unintentionally.

It’s important to know about merchant fraud, but in reality, criminal fraud and friendly fraud are the more serious and growing threats to your revenue and sustainability. If your chargeback rate is increasing and you don’t know why, contact the experts at Chargebacks911 today. We can help mitigate fraud risk and let you get on with growing your business.


What is merchant fraud?

Merchant fraud is the term for acts perpetrated against acquiring banks through a merchant account that was either gained through deception or is used in a fraudulent manner.

Do I need to worry about merchant fraud?

Yes, to some extent. Merchant fraud is seldom a direct threat to legitimate businesses, but the overreaching impact affects all merchants. Learning to recognize the warning signs can help keep you from doing business with these faux merchants, or inadvertently abetting their actions.

What are some of the common types of merchant fraud?

Bust-out fraud, transaction laundering, and identity or business model swaps are all common schemes fake merchants use to defraud acquirers.

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