Merchant FraudHow Scammers Give Online Merchants a Bad Name

January 18, 2023 | 12 min read

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Merchant Fraud

In a Nutshell

Picture this: you're running a legitimate business. You're just trying to make a living while offering the best service possible to your customers. Out of nowhere, a scammer comes along, victimizes a bunch of cardholders, and damages your reputation by association. Well, that's the basic reality of merchant fraud. In this article, we'll give you the rundown on some of the most common scams out there, and also some advice to help merchants and cardholders stop these fraudsters.

Merchant Fraud: What Happens When Bad Actors Impersonate Legitimate Businesses? 

When it comes to fraud, threats like identity theft tend to get most of the attention.

With all the hype surrounding consumer-side digital crimes, it’s easy to overlook other significant threats. Merchant fraud, for example, is one of the most common and costly causes of financial loss for acquirers. Of course, there could be damaging side effects for consumers and legitimate merchants, as well.

In this post, we’ll talk about what merchant fraud is, and explore some of the common ways it’s committed. We’ll also see why it matters to legitimate businesses, and what can be done to turn the tide.

What is Merchant Fraud?

Merchant Fraud

[noun]/Mər • CHənt • frôd/

Merchant fraud can refer to any situation in which a bad actor pretends to be a merchant, with the intent of committing fraud against either consumers or a financial institution.

Merchant fraud is sometimes referred to as “fake merchant fraud.” In reality, that’s a more accurate description.

As we’re talking about it here, merchant fraud does not generally involve legitimate merchants. Rather, the term refers to criminals who open bogus merchant accounts that allow them to accept credit card payments from victims.

When operating online, scammers enjoy anonymity and easy access to a global pool of potential victims. There’s also the ease with which one can create a fake storefront. All together, this means there is less investment — and less risk — involved in this type of card-not-present fraud scam.

How Do Merchant Fraud Scams Work?

Like most other scams, merchant fraud can be committed in a variety of ways. The basic steps, however, are usually the same.

First, the fraudster sets up a fake online store, advertising and selling goods that may or may not exist. Cardholders make purchases from the store, assuming that it’s legitimate. The crook then either pockets the funds, or uses the card numbers stolen from “customers” to make unauthorized purchases.

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Of course, accepting payment cards requires a merchant account and some type of payment processor, though. This is why acquiring banks ultimately tend to be the hardest hit by merchant fraud scams, as we’ll see shortly.

These institutions perform due diligence to make sure they’re accepting merchant accounts only for authorized, verified businesses. Try as they may, however, scammers still manage to break through their fraud detection mechanisms from time to time, and establish accounts for fake businesses.

Cardholders have recourse to recover from scams, in the form of the chargeback process. Banks do not have this protection.

How Does Merchant Fraud Affect Different Parties?

Merchant fraud can be highly profitable for a fraudster. However, it can be devastating for the bank (and other businesses) on the opposite end of the scheme, as we see below:

Chargebacks List Item

First, there’s the prospect of covering the financial impact of chargebacks filed by cardholders that were victimized by a merchant fraud scammer. The bank will be on the hook for any funds that cannot be clawed back from the merchant.

Second, the burden of proof is on the bank to demonstrate that they had no reason to suspect merchant fraud. Otherwise, they could be hit with network fines, regulatory injunctions, and even serious legal consequences from charges of facilitating criminal activity. 

If there is a fraud investigation, even innocent acquirers could potentially have their accounts or assets frozen. The assets in question could be temporarily inaccessible to the bank, as well as their merchant customers.

Other Merchants or Vendors

Service providers or other merchants that unknowingly worked with the fraudster may be on the hook for resulting criminal activity. The consequences could range from chargebacks, fines, and higher processing fees, all the way to regulatory injunctions or even legal action. 

This holds true even if the business is totally unaware of what’s going on. In fact, a legitimate business could find their accounts and assets frozen pending an investigation, just by being accused of criminal activity.

Consumers

The burden of merchant fraud falls most heavily on acquiring banks and other businesses. That said, it has an underlying effect on consumers, too.

First, there’s the initial stress involved in discovering the scam. The cardholder may be able to recover their funds by filing a chargebacks. However, the funds from the fraudulent sale will, at least temporarily, be unavailable to the cardholder.

In a broader sense, fraud-related damage drives up banking costs, and those increases will eventually be passed along to account holders. Opening and maintaining any kind of account will be more expensive for both merchants and individuals.

In the end, merchant fraud hurts everyone except the transitory fraudsters. They will disappear at the first sign of trouble, but leave everyone else to end up paying the price for their activity.

Common Merchant Fraud Scams to Watch For

So, now that we’ve run down the basics of merchant fraud, let's look at some of the specific tactics these scammers employ.

Perhaps the simplest merchant fraud scam is what’s called a “swipe and snatch” scam. This involves a legitimate merchant, but an employee who handles customer credit cards processes the transaction but also copies the card information. This usually involves some type of card reader or skimmer. However, it’s technically possible to just write the cardholder information on a piece of paper.

Once they have the information, they can use it to make online purchases, or resell the information (which helps prevent the crime from being tracked back to them). A favorite trick is to use the stolen info to purchase gift cards, which are nearly untraceable.

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Stealing card numbers may work for small-time fraudsters. However, larger operations use techniques that have a wider reach. That usually means setting up a fake store online and obtaining a merchant account that allows them to accept credit cards. 

The business must look legitimate to be approved for a merchant account, so criminals go to great lengths to make their phony websites look real. Fraudsters have even been known to create dummy consumer accounts for non-existent cardholders and use those to complete purchases with their fake store – all to make the business look legit.

Some commonly-used merchant fraud tactics include:

Bust Out Fraud

Bust-out schemes are a common method of merchant fraud. Criminals use their fake store to acquire a merchant account, which is then used to process a bunch of fraudulent transactions in a short period of time. The fraudster then transfers the funds to a new account and vanishes.

The name refers to the fact that, by the time the fraud is discovered, the crook has already “busted out” of the bogus profile and disappeared.

Learn more about bust out fraud

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.

Scammers engaged in transaction laundering sometimes operate in high-risk verticals such as gaming. They launder transactions through a low-risk merchant category code, allowing them to secure standard merchant processing and enjoy lower costs and fewer regulations.

Learn more about transaction laundering

Triangulation Fraud

This scheme involves three distinct parties: a scammer, a customer, and a legitimate merchant.

It starts when the shopper orders from what appears to be a legitimate merchant, but is actually a fake storefront. The fraudster uses credit card data stolen from previous victims to purchase goods from a legitimate merchant, having the order shipped to the original customer.

The fraudster will probably lose money on the initial purchase. However, they can potentially charge thousands of dollars to the cardholder using the information acquired.

Learn more about transaction laundering

Identity Swap

Many types of merchant fraud are little more than money laundering schemes designed to bypass anti-money laundering (AML) laws. This is distinct from transaction laundering, in that the fake merchant is trying to launder funds acquired from illegal activities.

With identity swap, the criminal launches a legitimate online store with a merchant account. The real store may have little to no actual sales, but it allows the fraudster to process payments from illicit parties, such as drug cartels or other organized crime factions. Identity swap schemes may also be used simply to hide the sources of funds in an attempt to evade taxes.

Business Model Swap

Business model swap is one of the more straightforward merchant fraud tactics. This happens when a fraudster opens a legitimate business, then swaps it out for a different business type or payment model once the account has been established.

A seller may want to operate using a recurring payments model, for example. This is typically considered a “high-risk” practice, though, meaning the merchant will incur more fees and restrictions. So, the seller sets up an eCommerce store without revealing their plan. They then proceed to switch the payment choices to include subscriptions later, concealing this practice from the merchant.

Two Key Facets of Merchant Fraud Prevention

When it comes to fighting merchant fraud, the only real defense is vigilance. Acquiring banks, vendors, and legitimate merchants must perform due diligence in two key areas to avoid the risk of accidentally abetting fraudsters:

Relationship Monitoring

The partner must conduct ongoing merchant monitoring. This requirement extends well-beyond the beginning of a partner relationship.

Activity and relationships must be regularly reviewed in the context of industry standards and past performance. Especially for cases of money laundering, a less-than-constant approach runs the risk of letting fraudsters slip through the cracks.

Conducting ongoing reviews of merchant activity can help identify potential fraud. It may also help pinpoint other potential problems as well. For instance, if a merchant is seeing a surge in chargeback issuances, the bank can take action and work with the merchant to get the situation under control.

Data Analytics & Automation

Activity monitoring can eat up a lot of time and resources in itself. That’s just the first part of the process, though; this data must be tracked and analyzed in a broader context.

The problem is that, without the right tools and technology, a do-it-yourself approach will likely fail.

The right automation and machine learning tools can sift through, aggregate, and analyze all the data, establishing activity patterns, and reporting results in a user-friendly format. Advanced analytics can process hundreds or thousands of data points in a fraction of the time a human could, raising red flags for manual review.

A Final Word

Both acquirers and merchants have an obligation to do whatever they can to ensure that sensitive customer data is protected. For banks, vendors, and merchants especially, this means knowing your partners to keep from getting caught up in fraudulent activity. 

The number of merchant fraud instances increases with each passing year. It’s important for all stakeholders to mitigate their risk using stringent security systems. But, like we said, this demands careful monitoring and analytics.

Having trouble establishing good fraud data benchmarks? Or, does fraud and chargeback risk detection analysis seem like too daunting a task? Not a problem — the experts are on the job.

Contact Chargebacks911 today. We can help mitigate fraud risk and let you get on with growing your business.

FAQs

What is merchant fraud?

Merchant fraud can refer to any situation in which a bad actor pretends to be a merchant, with the intent of committing fraud against either consumers or a financial institution. Most often, these are acts perpetrated using a merchant account that was either gained through deception or is used in a fraudulent manner. 

How do you identify merchant fraud?

Detecting merchant fraud requires careful relationship monitoring, data analytics, and automation on the part of banks.

A fraudulent business must look legitimate to be approved for a merchant account, so criminals go to great lengths to make their phony websites look real. Fraudsters have even been known to create dummy consumer accounts for non-existent cardholders and use those to complete purchases with their fake store – all to make the business look legit. Piercing these veils is not easy.

What are the types of fraud facing merchant banks?

Bust-out fraud, transaction laundering, and identity swaps are all common schemes fake merchants use to defraud acquirers. However, these represent only a share of merchant fraud scams, as new tactics emerge constantly.

How do I report a merchant for credit card fraud?

The best way to report suspected cases of merchant fraud is to contact the Federal Trade Commission.

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