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What Is Fraud Detection and Why Is It Important?

Fraud Knowledge & Training

During seasons of economic volatility, businesses have historically faced numerous enhanced risks to their operations, such as supply chain disruption, staff retention, and cyber threats. In 2023, this has led to an increase in fraudulent activities as fraudsters use advanced tools to exploit the situation.

According to Juniper Research’s 2022 study Combatting Online Payment Fraud, global payment fraud losses are expected to exceed $343 billion between 2023 and 2027. As a result, financial institutions (FIs) are taking steps to enhance their fraud detection measures to protect themselves and their customers from financial damage.

What is Fraud Detection?

Fraud detection refers to the process of monitoring transactions and customer behavior to pinpoint and fight fraudulent activity. It is usually a central part of a firm’s loss prevention strategy and sometimes forms a part of its wider anti-money laundering (AML) compliance processes. When fraud detection and its related functions are integrated into a wider AML framework, the combination is sometimes referred to as fraud and anti-money laundering (FRAML). Regardless of the structure it belongs to, fraud detection relies on technological tools, subject-matter experts (especially analysts), policies, and procedures to function well.

Why Is Fraud Detection Important?

Traditionally, firms have used fraud detection and prevention to curb company financial losses and maintain positive customer relationships. However, in some jurisdictions, legislation requires fraud programs for firms providing certain services, such as insurance providers in multiple US states. In the UK, a “Failure to Prevent Fraud” offense was introduced in April 2023 that holds firms liable if they benefit from employee fraud and don’t have an adequate fraud prevention program in place. Additionally, on June 7, 2023, the UK’s Payment Systems Regulator (PSR) announced a new reimbursement requirement for firms whose customers become victims of authorized push payment (APP) fraud. 

Fraud detection is essential for companies to safeguard their customers’ transactions and accounts by detecting fraud before or as it happens. The FBI reports that in 2022, elder fraud victims in the US lost an average of $35,101 each, resulting in a total loss of over $3 billion. In 2021, global fraud losses exceeded $55 billion, aided by technology that allows illegal funds to cross international borders.

As global awareness of fraud’s growing varieties and complexity of typologies, firms should expect the introduction of more regulation and enforcement that will impact their compliance requirements. Even if a firm is not subject to direct requirements now, fraud is a predicate offense for money laundering and may be connected to a larger pattern of criminal activity. Firms that include fraud in their overall risk management framework can better protect consumers, ensure compliance, manage loss, and fight financial crime.

Fraud Typologies and Classification

Due to the large number and range of fraudulent activities, identifying the type of scam being attempted can be challenging. When businesses can accurately identify fraudulent activity and stay up-to-date on the latest fraud trends, they are more prepared to protect themselves against them.

To help firms accurately identify fraud typologies, the US Federal Reserve has developed an interactive tool called the FraudClassifier Model. This model offers a user-friendly diagnostic process that categorizes fraud based on the perpetrator of the payment, the methods used to carry out the fraud, and the tactics employed. FraudClassifier’s consistent terminology and classification system acts as a lingua franca for different institutions, businesses, and fraud detection providers, enabling them to communicate current threats clearly and develop effective fraud prevention strategies.

Common Types of Fraud

Fraud comes in many different forms, with new types constantly emerging. Some fraud typologies persist because they exploit weaknesses in a company’s processes and systems. Some common tactics include:

Payment Fraud

Payment fraud occurs when a criminal acquires another individual’s payment information and makes unauthorized transactions. This type of fraud not only causes harm on its own, but can also lead to other fraudulent activities as payment information can be used for money laundering or cybercrime by those who obtain it.

Return Fraud

Return fraud takes advantage of a retailer’s return policy to receive refunds that aren’t legitimate. It’s often carried out by individuals but can also be adopted in organized crime. Fraudulent returns may consist of stolen goods, counterfeit products, old and worn-out goods, or items bought from a different retailer. 

ACH Fraud

Automated Clearing House (ACH) is a means of transferring money between bank accounts, usually those of businesses and institutions. The payment goes through the Clearing House for authorization before being sent to its intended recipient. ACH fraud is carried out using a bank account number and bank routing number. It takes advantage of weaknesses in the ACH process to intercept legitimate payments, for example by impersonating an employee and then changing beneficiary account details.  

Chargeback Fraud

Chargeback fraud involves an individual requesting chargebacks for transactions that were fulfilled by the company they purchased from. Although the company does have the right to contest fraudulent chargebacks, they represent a drain on its resources – whether or not the requests are upheld.

Account Takeover Fraud

Account takeover fraud (ATO) occurs when a criminal acquires the login details of an online account, such as a bank account, online payment service, mobile account, or e-commerce site. The login details may be stolen or bought via the dark web. The account is then used to make false transactions without the knowledge of the customer or the account issuer. 

What are the Best Tactics to Enhance Fraud Detection?

To safeguard businesses and consumers from evolving fraud risks, employing the most effective fraud detection techniques is essential. When auditing an exisiting fraud detection solution or evaluating the market for a new one, compliance professionals should consider whether the software offers most, if not all, of the following functionalities:

  • Machine learning and AI: Leveraging machine learning algorithms and artificial intelligence will significantly enhance fraud detection capabilities. These technologies can analyze vast amounts of data in real-time, identifying patterns and anomalies that might indicate fraudulent activities.
  • Behavioral analytics: By monitoring and understanding users’ behaviors, businesses can detect deviations from normal patterns. Behavioral analytics can flag suspicious activities, such as unusual login locations, sudden changes in spending patterns, or atypical transaction amounts.
  • Anomaly detection: This technique involves creating a baseline of normal behavior and flagging any data points that deviate significantly from it. Anomaly detection can uncover fraudulent transactions, unusual login attempts, or other malicious activities that do not fit typical patterns.
  • Identity clustering: Grouping user identities based on common attributes and behaviors can help identify patterns of fraudulent behavior. Identity clustering can be particularly useful in detecting organized crime groups and cybercrime activities. 
  • Data analytics: Advanced data analytics tools can sift through large datasets and identify potential fraud indicators. By correlating information from various sources, businesses can gain valuable insights and stay one step ahead of fraudsters.
  • Real-time monitoring: Detecting fraud as it happens is crucial for minimizing damages. Real-time monitoring tools can promptly identify suspicious activities, trigger alerts, and enable quick responses to mitigate the impact of fraud.
  • Collaborative fraud intelligence: Sharing fraud intelligence and insights with other organizations and industry partners can lead to a more comprehensive understanding of evolving fraud tactics. Collaborative efforts enable proactive prevention and collective defense against fraudsters.
  • Ongoing monitoring and updates: Fraud detection techniques should be regularly reviewed, updated, and improved to keep pace with emerging threats and vulnerabilities.

The Main Challenges of Fraud Detection

  1. Cost Management
    To keep up with the ever-expanding litany of fraud techniques and typologies, businesses may feel the need to invest in more fraud-detection tools and operations. Relying soley on rule-based transaction monitoring and fraud detection can be a challenge as scam techniques change.
  2. Remote Transactions
    Business is increasingly carried out without physical interaction taking place. While this is convenient and cost-effective, it also opens the door for fraudsters to impersonate genuine customers or intercept their details.
  3. Speed of Transactions
    Today’s transaction ecosystem is built for speed and convenience. Even a relatively complex process like a loan application can be carried out via smartphone, while more routine purchases are completed in a few keystrokes. This high-speed, low-friction environment can make it easy for fraudsters to complete their crimes and disappear before they can be detected.
  4. False Positives
    A fraud detection system that is over-zealous can lead to higher false positives. This is inconvenient for customers, who may become less loyal as a result, and expensive for businesses, who must expend time and resources following up the alert.
  5. Range of Transaction Types
    A huge number of tools and services are now used to move money around, from payment apps and cryptocurrency trading platforms to traditional loans, credit cards, and savings accounts. The proliferation of digital financial services in particular creates multiple potential access points for fraudulent actors.

Implement Fraud Detection with ComplyAdvantage

Because fraud detection is an ongoing battle, companies need to be able to partner with expert providers who can support their needs as they scale. . Not all companies have the necessary expertise, or the human resource bandwidth, to maintain transaction monitoring in-house or to commit to the continuous learning required to track fraud trends and typologies. 

By implementing fraud prevention services, businesses can access the expertise of specialists in fraud detection in a customized and adaptable manner that can be sustained over time. This ensures that their fraud detection methods remain innovative and their business is safeguarded against evolving threats as it expands.

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Originally published 09 August 2023, updated 09 August 2023

Disclaimer: This is for general information only. The information presented does not constitute legal advice. ComplyAdvantage accepts no responsibility for any information contained herein and disclaims and excludes any liability in respect of the contents or for action taken based on this information.

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