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KYC AML Guide: the Clock shows the average reeding time of the blog11 min Read

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KYC AML Guide: the Clock shows the average reeding time of the blogSeptember 14, 2023

What is Chargeback Fraud?

A hidden danger lurks beneath the surface of the financial world: Chargeback Fraud. Consider the following scenario: You buy something, but instead of a smooth transaction, a web of fraud emerges. According to research, a significant portion of chargeback claims, approximately 60%, will be fraudulent in 2023. Let's begin to understand what exactly is a chargeback fraud, and how does it affect your money?

Misbah Tayib

Compliance Journalist

Chargeback Fraud

Chargeback fraud occurs when a customer requests a refund for an entire transaction. According to a Juniper Research report, chargeback fraud will cost businesses an estimated $20 billion by 2021. Chargeback fraud has been steadily increasing, with an annual growth rate of 20%.

Chargeback fraud is a significant problem for merchants, especially those who do business online or in the service sector. When a customer disputes a valid transaction with their bank or card issuer, they are claiming a lack of authorization, receipt, or satisfaction. Chargebacks can occur for a variety of reasons, including business errors or customer dissatisfaction with a product or service. Merchants may suffer revenue losses, product or service forfeiture, and fees. Merchants are projected to incur a substantial financial loss due to chargebacks, with an estimated cost of $117.47 billion in 2023.

What is Chargeback Fraud in Banking?

Fraudsters frequently use a variety of methods, which are becoming more prevalent in e-commerce. In 2021, 75% of eCommerce businesses expect an increase in fraud attempts. They contact the bank and file a complaint, for example:

A customer, let’s call him Alex, makes an online purchase from a reputable eCommerce store. Alex receives the ordered product, which is in perfect condition and matches the product description. However, Alex contacted their bank a few days later and initiated a chargeback, claiming that the purchase was unauthorized and that they never received the product. Chargeback fraud occurs in this case when Alex intentionally misrepresents the transaction to their bank. The bank issues a chargeback to Alex, refunding the purchase amount and potentially penalizing the eCommerce store, by standard procedures. In reality, this was not a case of unauthorized use, non-receipt of goods, or any other genuine issue; it was a case of chargeback fraud, which put the eCommerce store in jeopardy.

Chargeback Fraud Punishment

False chargebacks can result in fines and imprisonment, with sentences ranging from one to three years and fines ranging from $1,000 to $10,000 depending on state laws. A recent case involved a Florida man sentenced to ten years in prison for chargeback fraud, in which he defrauded multiple merchants of over $9 million by disputing charges on behalf of unsuspecting third parties and intercepting the returned funds.

Types of Chargeback Fraud

According to a May Justt survey, 78% of Americans filed a chargeback in the previous 12 months.

Friendly Fraud:

Friendly Fraud involves customers falsely disputing a purchase, frequently due to buyer’s remorse or misunderstanding the transaction. Because there are no third parties involved, this type of fraud is difficult to detect. Chargebacks from friendly fraud account for 60-70% of all chargebacks. For example, a buyer may refuse to purchase something that they later regret, resulting in a refund.

Return Fraud:

Return fraud occurs when a customer returns a product to a retailer claiming it is defective or damaged, even if the item is in good condition or has been used. This frequently leads to refund requests, particularly when the seller’s return policy is unknown. For example, a customer may return a used phone for a refund, claiming it is defective.

Identity Theft:

Identity theft occurs when a fraudster uses another person’s personal or financial information to make fraudulent purchases. This type of fraud can be extremely damaging to both the victim and the merchant. Criminal fraud accounts for 1-10% of all chargebacks. For example, a thief could obtain stolen credit card information and use it to make unauthorized online purchases, leaving the legitimate cardholder to deal with the consequences.

Subscription Fraud:

Subscription fraud occurs when a customer disputes repeated fees for a subscription service, such as a streaming platform, despite having heard the information for months. A customer may claim that they did not authorize recurring billing or that they canceled their subscription but were still charged. As an example, consider a subscriber who is disputing a fee for an advertising service that they claim has been canceled but is still receiving.

Digital-Goods Chargebacks:

Digital product chargeback fraud occurs when a customer disputes payment for a digital product, such as software or an online system, after accessing and using the product. Companies face difficulties in preventing this type of fraud because customers may have already downloaded or used the product. A user, for example, can request a refund for an e-mail he has already read and benefited from.

Merchant Error:

Although not considered fraud, merchant errors can result in chargebacks when companies break their commitments or commit errors. These mistakes can include sending the incorrect product, delivering late, overcharging, or providing poor customer service. For each claim, merchants are charged a fee ranging from $25 to $30. Merchant error accounts for 20-40% of all chargebacks. As an example, suppose a retailer sends an incorrect item, prompting the customer to dispute the charge due to the merchant’s error.

How do Chargebacks Work?

Chargeback fraud is a fraudulent practice in the banking industry in which shady people use the reimbursement system to obtain unjust refunds for legitimate transactions. It takes four weeks to 90 days to complete. The Chargeback fraud works as follows

  1. This process begins with a legitimate customer making a credit or debit card purchase.
  2. Following the transaction, the customer contacts the card issuing bank and falsely claims that they did not authorize the charge or that they are dissatisfied with the product or service received.
  3. When a refund request is received, the customer bank contacts the merchant bank, thereby initiating the dispute process. They request proof from the customer to confirm the legitimacy.
  4. The customer must provide supporting documents such as invoices, receipts, proof of delivery, or any other information required to demonstrate that the purchase is legitimate and authorized.
  5. The customer’s bank verifies the proof presented by both the customer and the cardholder. They will decide whether or not the accusation is justified.
  6. The issuing bank decides whether or not the refund request is valid based on its assessment. If the cardholder approves the transaction, the customer receives a refund.
  7. Arbitration may be used if the issuing bank and the merchant’s bank are unable to reach an agreement. The credit card company (e.g., Visa or Mastercard) typically governs this process. The credit card company examines all evidence presented and makes a final, binding decision on who is liable for the charges.

Chargeback fraud occurs when customers knowingly use this process to obtain refunds for goods or services received. It can result in financial losses for merchants and banks, as well as legal disputes in some cases.

How to Prevent Chargeback Fraud?

Companies can implement strong policies to protect their jobs, reduce friendly fraud, and protect themselves from unethical practices in the fight against chargeback fraud. Businesses must follow the Payment Card Industry Data Security Standard (PCI DSS), which ensures secure card transaction processing and lowers card fraud.

Here are some useful steps, along with Know Your Customer (KYC), you should consider:

Know Your Customer (KYC) Measures

To establish a clear understanding of business counterparts, conduct thorough customer documentation and KYC onboarding.  KYC measures allow businesses to verify the identities of those with whom they do business, lowering the risk of fraudulent transactions.

Digital ID Verification

Businesses can use digital ID verification methods such as face and document checks, proof of address, 2-factor authentication, and consent verification to strengthen transaction integrity and security and prevent chargeback fraud.

Transaction Verification Systems

On the bank statement, make sure the transaction has a descriptive and easy-to-understand name. Clear payment codes serve to remind customers of their purchases, which lowers the possibility of friendly fraud. Also, Address verification systems (AVS), credit card security codes (CVV), and security questions should all be used, especially in e-commerce transactions. These systems increase security by verifying customer identities and preventing fraudulent activity.

Know Your Transaction

Set purchase order-based transaction limits and require reconfirmation for high-value transactions  Alerts immediately alert you to potentially monitor transactions, protecting your company’s security and detecting fraud.

Monitoring Chargeback Codes

Pay close attention to chargeback codes and examine potentially fraudulent transactions for clues. Monitoring chargeback codes allows you to identify recurring issues and address them before they become chargebacks.

Artificial Intelligence and Machine Learning

Businesses can use AI and machine learning to automate order approval decisions by analyzing fraud and trust-related signals. This automation reduces the need for manual reviews while increasing order approval rates. Customized business policies that are aligned with specific risk thresholds improve precision risk assessment (234) and mitigation.

Bottom Line

An ethical approach to chargebacks not only benefits businesses by reducing profit loss but also educates consumers on their proper use. With increased awareness and responsible chargeback usage, both businesses and customers can expect a reduction in fraudulent chargeback claims, which will mitigate harsh consequences for businesses.

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Misbah Tayib

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Misbah Tayib is a compliance journalist and freelance writer with almost 6-year long experience of covering developments in blockchain sector, crypto industry, AML compliance, privacy regulations, and relevant political advancements.