How Merchants Exploit Payment Gateways

Chargeback laundering, also known as “transaction laundering” or “factoring,” is an increasingly sophisticated form of fraud within the payment industry. Fraudulent merchants use this scheme to disguise illegal transactions as legitimate ones, exploiting payment gateways and processors to process payments for prohibited goods or services.

This article delves into the mechanisms of chargeback laundering, its impact on payment gateways, and how PSPs, merchants, and customers can identify and combat it effectively.

What is Chargeback Laundering?

Chargeback laundering occurs when a merchant processes payments for illegal or unapproved products/services through a legitimate payment gateway. The fraudulent merchant often operates a front-end business (a “shell” or “dummy” merchant) to obscure their true operations.

For example, a merchant claiming to sell “organic beauty products” might secretly process payments for counterfeit goods, adult content, or gambling services, which are either restricted or outright banned under their merchant agreement.

How Does Chargeback Laundering Work?

Fraudsters exploit the trust between payment gateways and merchants by:

1. Using a Front Business
   • Fraudsters create a seemingly legitimate business that complies with the PSP’s onboarding policies.
   • Once approved, they secretly use this account to process illegal transactions.
2. Routing Transactions Through Third Parties
   • Transactions from prohibited businesses are routed through a “clean” merchant account to disguise their origin.
3. Avoiding Detection Through Transaction Masking
   • Fraudsters manipulate transaction descriptors to make payments appear legitimate on customer bank statements.
4. Relying on Dummy Websites
   • They create websites with minimal functionality to meet compliance requirements but never actually sell the products listed.

Who is at Risk?

1. Payment Gateways
   • Risk financial losses and reputational damage when processing illegal transactions.
   • Face regulatory penalties for non-compliance with anti-money laundering (AML) laws.
2. Legitimate Merchants
   • Fraudulent merchants drive up chargeback rates, leading to stricter scrutiny or higher fees for all merchants.
3. End Customers
   • Often defrauded into purchasing counterfeit goods or services with no recourse for refunds.

Red Flags for Identifying Chargeback Laundering

1. Inconsistent Business Operations
   • The merchant’s website doesn’t match the transaction descriptors or business model.
   • The website lacks essential functionality, such as an actual checkout process.
2. Unusual Transaction Patterns
   • Sudden spikes in transaction volumes, especially from new merchants.
   • High-risk industries disguised as low-risk categories.
3. High Chargeback Ratios
   • A pattern of chargebacks indicating dissatisfaction or unfulfilled orders.
4. Geographical Mismatch
   • Transactions originating from regions where the merchant does not operate.
5. Unverified Beneficiaries
   • Payments sent to bank accounts unrelated to the merchant’s registered business.

Impact of Chargeback Laundering on Payment Gateways

1. Financial Losses
   • PSPs must cover the costs of chargebacks and fines, often without recovering the funds from fraudulent merchants.
2. Regulatory Compliance Issues
   • PSPs may face legal action for enabling illegal transactions, even inadvertently.
3. Reputational Damage
   • Association with illicit activity harms the gateway’s credibility among legitimate clients and industry regulators.
4. Increased Operational Costs
   • Investigating and addressing fraudulent activities diverts resources from business growth.

Preventive Measures for PSPs

1. Enhanced Merchant Onboarding Processes

• Perform in-depth due diligence on all merchants, including business verification and ownership transparency.
• Use site visits and product reviews to ensure the merchant’s operations align with their application.

2. Advanced Fraud Detection Systems

• Implement machine learning tools to monitor transaction patterns and identify anomalies.
• Utilize tools that flag mismatched data, such as IP addresses, billing addresses, and transaction descriptors.

3. Ongoing Monitoring of Transactions

• Monitor high-risk merchants more closely for unusual activity.
• Regularly review and update fraud detection algorithms to keep up with evolving techniques.

4. Educate and Train Staff

• Provide regular training sessions on the latest fraud trends and detection strategies.
• Share real-life case studies to improve awareness and vigilance.

Case Study: Uncovering a Chargeback Laundering Scheme

A PSP onboarded a merchant claiming to sell eco-friendly furniture. After a few months of operations, the merchant began processing an unusually high volume of transactions with vague descriptors like “consulting fees.”

An internal review revealed that the merchant was processing payments for an unregistered gambling site. The PSP terminated the account and reported the incident to regulatory authorities. This case underscores the importance of ongoing monitoring and robust fraud detection mechanisms.

How Merchants and Customers Can Protect Themselves

Merchants

1. Stay Transparent
   • Accurately represent your business model and products during the onboarding process.
   • Avoid partnerships with entities offering “backdoor” payment processing services.
2. Maintain Records
   • Keep detailed records of all transactions, including customer details and invoices.

Customers

1. Verify the Merchant
   • Research merchants before making payments, especially for high-ticket items.
   • Check reviews and ratings to ensure the merchant’s legitimacy.
2. Monitor Bank Statements
   • Regularly review transactions for unfamiliar charges or misleading descriptors.

Collaborative Solutions to Combat Chargeback Laundering

1. Industry-Wide Data Sharing
   • PSPs can collaborate to maintain shared databases of blacklisted merchants and suspicious activities.
2. Regulatory Oversight
   • Governments and regulators should enforce stricter guidelines and penalties for fraudulent merchants.
3. Technological Innovations
   • Blockchain and AI-powered systems can enhance transparency and traceability in payment processing.

Conclusion

Chargeback laundering is a sophisticated form of fraud that exploits the trust between payment gateways and merchants. By implementing robust onboarding processes, leveraging advanced fraud detection tools, and fostering industry collaboration, PSPs can mitigate the risks associated with this fraud. Education and vigilance at every level of the payment ecosystem—from PSPs to merchants to customers—are critical to building a secure and trustworthy payment landscape.