What Is Merchant Fraud & Its Types?

As online transactions grow, understanding what merchant fraud is becomes essential to safeguard your business and customers. With digital commerce surging, cases of merchant fraud rose by nearly 20% between FY23 and FY24.

Whether you manage an e-commerce store, retail outlet, or fintech firm, such fraud can severely impact your finances and reputation. This guide unpacks the growing menace of merchant fraud, helping you recognise warning signs, strengthen your defences, and stay a step ahead of scammers in today’s fast-changing digital world.

What Is Merchant Fraud?

Merchant fraud refers to deceptive activities that occur during online or card-based transactions. It can involve fake merchants who trick customers into paying for products or services that are never delivered, or fraudulent buyers who manipulate genuine merchants through tactics like chargeback fraud.

For example, a scammer may create a fake website to collect payments illegally, or a buyer might falsely dispute a legitimate transaction to obtain an undeserved refund.

Merchant fraud harms both consumers and businesses, leading to financial losses, damaged trust, and increased operational risks.

Types of Merchant Fraud

1. Chargeback Fraud (Friendly Fraud)

Chargeback fraud, often referred to as friendly fraud, occurs when customers dispute genuine transactions to obtain refunds while retaining both the product and the payment. This leads to financial losses, additional processing fees, reputational damage, and operational strain.

For example, if a customer buys a smartphone, receives it, and then falsely claims non-delivery, you lose both the item and the money. To prevent this, use delivery tracking, signature confirmation for expensive items, detailed transaction logs, and clear billing descriptors.

Read More: What is Chargeback Fraud? A Guide for Businesses

2. Transaction Laundering

Transaction laundering occurs when criminals hide illegal transactions within legitimate merchant operations. They may use your merchant details to process payments for banned goods, making detection difficult.

Warning signs include:

• Sudden transaction spikes

• Mismatched product details

• Payments from unknown regions

Regularly review your transaction patterns and report irregularities promptly to your payment provider.

3. Identity Theft & Account Takeover

In this fraud, criminals steal merchant credentials to control accounts and redirect funds. They use phishing emails, malware, or social engineering to gain access. Once inside, they can make fake transactions or steal customer data.

Protect yourself by enabling two-factor authentication, monitoring login activity, restricting access, and performing regular security audits.

4. Phishing & Social Engineering

Phishing fraudsters impersonate trusted brands or banks to steal login credentials, bank details, and API keys. They may send fake emails, texts, or calls urging you to act quickly.

Always verify the sender, avoid sharing sensitive data, and use official communication channels to confirm any suspicious requests.

5. Application Fraud

Application fraud happens when criminals use fake or stolen identities to create merchant accounts. These accounts are then used for laundering or processing stolen payments.

Ensure robust Know Your Customer (KYC) verification, document validation, and cross-platform monitoring to identify inconsistencies during the onboarding process.

6. Refund Fraud

Refund fraud manipulates return policies to claim money without returning genuine goods. Fraudsters may return counterfeit items or claim non-receipt of digital goods.

Combat this by verifying returns with photos, shipment tracking, and cross-checking refund patterns for repeated offenders.

7. Collusion or Insider Fraud

Insider fraud occurs when employees misuse their access to alter records, leak customer data, or create fake transactions. Because they understand system loopholes, such frauds are hard to detect.

Regular audits, access segregation, and strict monitoring of internal activities help reduce insider risks.

Common Signs of Merchant Fraud

Recognising the warning signs of merchant fraud enables you to respond swiftly and minimise damage. Watch for these critical indicators:

• Transaction Anomalies:

• Sudden spikes in transaction volumes or values

• Multiple transactions from single IP addresses

• Purchases mismatch with typical customer behaviour

• Geographic inconsistencies in billing and shipping

• Account Irregularities:

• Unauthorised changes to bank account details

• Login attempts from unfamiliar locations

• Modified user permissions without authorisation

• Unusual patterns in settlement requests

• Customer Behaviour Patterns:

• Repeated disputes from the same individuals

• Claims of non-receipt despite delivery confirmation

• Urgent requests for expedited processing

• Resistance to verification procedures

• System Indicators:

• Unexpected system performance issues

• Altered transaction logs

• Missing or corrupted data files

• Unauthorised API access attempts

• Financial Red Flags:

• Discrepancies between recorded and actual settlements

• Unexplained chargeback clusters

• Mismatched inventory and sales records

• Unusual refund patterns

These signs often appear in combination, creating patterns that sophisticated fraud detection systems can identify.

Related Read: What is Payment Fraud?

How to Prevent Credit Card Fraud as a Merchant

To prevent credit card fraud, merchants must implement multiple layers of security measures, as detailed below:

Use PCI-DSS Compliant Payment Gateways

Merchants should ensure that their payment systems follow PCI-DSS standards to protect cardholder data. Choose gateways that encrypt information during transfer and storage, maintain updated firewalls, use strict access controls, and regularly test their systems. A strong information security policy forms the backbone of this protection.

Enable 3D Secure Authentication

Adding 3D Secure (3DS) authentication helps verify each transaction through an OTP or password, redirecting customers to their bank’s secure page. This step not only reduces unauthorised transactions but also shifts liability from the merchant to the card issuer, significantly lowering fraud risk.

Implement Fraud Detection Tools

AI and machine learning-based fraud detection tools quickly identify suspicious activity by analysing behaviour patterns in real time. Platforms like Razorpay Thirdwatch analyse device details, transaction frequency, purchase habits, and geographic data to identify irregularities, such as multiple cards used on a single device, rapid purchases, or transactions from unusual locations.

Monitor Transaction Patterns

Ongoing monitoring is essential. Be cautious of multiple failed payment attempts, high-value orders from new customers, mismatched billing details, or transactions originating from high-risk regions. These could signal potential fraud.

Keep Strong Internal Controls

Establish role-based permissions, maintain access logs, and require dual approvals for sensitive actions, such as refunds. Regular reconciliation and segregation of duties prevent both insider and external fraud.

Educate Staff and Customers

Training employees to recognise phishing and handle payment data securely is vital. Customers should also be educated on safe shopping habits, creating strong passwords, and identifying suspicious activity.

Use Tokenisation for Card Storage

Tokenisation replaces card details with encrypted tokens, eliminating the need to store sensitive data. It enhances security, simplifies compliance, and prevents data breaches while maintaining a smooth checkout experience.

Legal and Compliance Measures

Complying with India’s regulatory framework requires meeting the Reserve Bank of India’s (RBI) strict payment security standards

• Data Protection and Localisation: All payment data must be stored within India as per RBI guidelines. Failure to comply can lead to account suspension and regulatory penalties under the IT Act 2000.
  

• Payment Security Standards: Businesses must adhere to PCI-DSS standards for secure card handling, implement card tokenisation for recurring payments, and ensure two-factor authentication for every digital transaction.
  

• Transaction and Incident Controls: RBI defines specific transaction limits for different payment modes, and any security breach must be promptly reported to CERT-In to avoid regulatory action or criminal consequences.

Steps to Take if You’re a Victim of Merchant Fraud

Despite strong preventive measures, fraud incidents may still occur. Your response speed and thoroughness determine the extent of damage limitation:

Immediate Actions (Within 24 Hours):

• Contact your payment gateway provider to freeze suspicious activities

• Change all system passwords and access credentials

• Initiate internal investigation protocols

• Document all suspicious transactions

Evidence Collection Phase:

• Compile comprehensive transaction records, including:

• IP logs and device information

• Customer communication history

• System access logs

• Financial reconciliation reports

Formal Reporting Procedures:

• File detailed reports with:

• Your acquiring bank

• Local cybercrime cell

• Payment gateway security team

• Industry fraud databases

Customer Communication:

• Notify affected customers transparently

• Provide clear remediation steps

• Process legitimate refunds promptly

• Maintain open communication channels

System Hardening:

• Conduct a forensic analysis to identify vulnerabilities

• Implement additional security measures

• Review and update fraud prevention protocols

• Schedule comprehensive security audits

The post-incident phase offers valuable learning opportunities. Analyse what went wrong, identify system weaknesses, and implement stronger controls to prevent recurrence.

Best Practices for Ongoing Fraud Prevention

Maintaining strong fraud defences requires continuous effort and adaptation. Implement these ongoing practices:

 Regular Security Assessments:

• Quarterly vulnerability scans

• Annual penetration testing

• Continuous monitoring systems

• Third-party security audits

Technology Maintenance:

• Prompt security patch installation

• API versioning and updates

• Integration security reviews

• Performance optimisation

 Partner Verification:

• Due diligence on payment providers

• Regular compliance verification

• Service level monitoring

• Incident response coordination

 Advanced Monitoring Techniques:

• Real-time transaction analysis

• Behavioural pattern recognition

• Geolocation verification

• Device fingerprinting

 Communication Protocols:

• Transparent customer policies

• Clear dispute procedures

• Regular security updates

• Industry collaboration

Stay Ahead of Merchant Fraud

Fraud prevention is not a one-time task but a continuous process that demands constant attention. Merchants must stay proactive by combining secure technology, strict compliance, and consistent vigilance. By doing so, they can protect every transaction, minimise potential risks, and strengthen customer confidence. Staying alert and adapting to evolving fraud patterns is key to ensuring safe and secure digital commerce.

FAQs

1. What is merchant fraud in payment processing?

Merchant fraud encompasses fraudulent activities involving payment transactions, either perpetrated by fake merchants against customers or by criminals targeting legitimate merchant accounts. It includes schemes like transaction laundering, identity theft, and account takeover.

2. How does merchant fraud affect small businesses?

Small businesses face disproportionate impacts from merchant fraud, including immediate financial losses, a damaged reputation, increased payment processing fees, potential account suspension, and a diversion of resources from growth activities to fraud management.

3. What are common types of merchant fraud?

Common types include chargeback fraud, transaction laundering, identity theft, phishing scams, application fraud, refund manipulation, and insider collusion. Each type exploits different vulnerabilities in payment systems.

4. How can merchants prevent credit card fraud?

Merchants can prevent credit card fraud by implementing PCI-compliant payment gateways, enabling 3D Secure authentication, deploying AI-powered fraud detection tools, monitoring transaction patterns, maintaining strong internal controls, and educating staff about security protocols.

5. What is chargeback fraud?

Chargeback fraud occurs when customers dispute legitimate transactions to obtain refunds while keeping the products. Also known as “friendly fraud,” it results in merchants losing both merchandise and payment, as well as facing additional processing fees.

6. Are payment gateways responsible for preventing merchant fraud?

Payment gateways share responsibility for fraud prevention by implementing security features, adhering to compliance measures, and maintaining robust monitoring systems. However, merchants must also implement their own security protocols and maintain vigilance against fraudulent activities.

7. What is transaction laundering?

Transaction laundering involves criminals processing illegal transactions through legitimate merchant accounts, disguising prohibited activities as regular business operations. It’s particularly challenging to detect due to mixing with genuine transactions.

8. How can merchants detect refund scams?

Merchants can detect refund scams by tracking return patterns, photographing returned items, validating shipping documentation, monitoring serial returners, and implementing strict verification procedures for high-value refunds.

9. What tools help detect fraudulent transactions?

Modern tools include AI-powered fraud detection systems, device fingerprinting technology, behavioural analytics platforms, real-time monitoring solutions, and comprehensive risk scoring algorithms that analyse multiple transaction factors.

10. What legal action can be taken against merchant fraud?

Legal remedies include: Filing criminal complaints with cybercrime cells, pursuing civil litigation for damages, reporting to regulatory authorities, initiating bank chargebacks where applicable, and collaborating with law enforcement agencies for investigation and prosecution.