Third-Party Fraud: Definition, Characteristics, Prevention, and Why It Matters
A comprehensive overview of what drives third-party fraud, how it's executed, and why institutions need to stay vigilant
Overview
Third-party fraud occurs when an unknown or unauthorized entity commits fraud against businesses, financial institutions, or individuals. Fraudsters exploit identity theft, personally identifiable information (PII) obtained through data breaches or social engineering, card skimming, and other means to bypass fraud defenses and open fraudulent accounts, process unauthorized transactions, or secure credit under false pretenses.
Key Characteristics
- Involves compromised account information, compromised identities, or stolen credentials rather than coming from an authorized user of the account.
- Can result in financial loss, regulatory violations, and reputational damage.
- Often detected through unusual transaction behavior (both monetary and nonmonetary), as well as identity inconsistencies.
Common Types of Third-Party Fraud
- Account Takeover Fraud (ATO) - Fraudsters gain control of legitimate accounts using compromised PII from data breaches, phishing, credential stuffing, or malware to steal funds, change account details, or make unauthorized purchases.
- Synthetic Identity Fraud - A combination of real and fake identity details is used to create a completely new identity for fraudulent applications of loans, credit lines, or other financial services.
- Credit and Debit Card Fraud - Stolen credit card information is used for unauthorized purchases, leading to chargebacks and losses for merchants and financial institutions.
Third-Party Fraud vs. Other Types of Fraud
| Fraud Type | Description | Example |
| First-Party Fraud | The fraudster misuses their own credit or financial products. | A borrower takes out a loan or maxes out a credit card with no intent to repay. |
| Second-Party Fraud | Someone willingly gives another person access to their identity or accounts. | A person shares their banking credentials with a fraudster. |
| Application Fraud | A fraudster uses stolen or fake identities to apply for accounts, loans, or other products/services. | A criminal uses stolen data to open a credit card in someone else’s name. |
Third-Party Fraud Detection and Prevention for Financial Institutions and Lenders
- AI-Powered Fraud Detection - Advanced AI models analyze customer behavior and flag suspicious activities in real time to prevent fraud before transactions are completed.
- Transaction Monitoring and Risk-Based Fraud Scoring - Banks and lenders use fraud scoring models to identify and flag high-risk transactions for additional verification.
- Multifactor Authentication (MFA) - Using biometric verification and identity-proofing techniques like fingerprints, facial recognition, or voice authentication can ensure users are who they claim to be before approving transactions or new accounts.
- Regulatory Compliance and Due Diligence - Financial institutions must comply with Anti-Money Laundering (AML), Know Your Customer (KYC), and Payment Services Directives 2 and 3 (PSD2 and PSD3) regulations to help prevent fraud and avoid legal penalties.
Regulatory Compliance Measures
| Regulation | Purpose | Key Requirements |
| AML (Anti-Money Laundering) | Prevent criminals from disguising illegally obtained funds as legitimate income. | Monitor suspicious transactions, report fraud, implement risk controls. |
| KYC (Know Your Customer) | Ensure identity verification to prevent fraud. | Verify customer identities, assess risks before account opening. |
| PSD2 and PSD3 (Payment Services Directives 2 and 3) | Strengthen payment security, increase consumer protections, and promote open banking. | Requires Strong Customer Authentication (SCA), mandates improved fraud prevention in online transactions, and enhances cross-border payment security. |
Internal Fraud Prevention Process
| Process | Purpose | Implementation |
| Identity Verification | Confirm customer legitimacy during onboarding and transactions. | Validate personal and financial details before approving new accounts or suspicious transactions. |
| Continuous Monitoring | Detect fraudulent activity in real time. | Track high-risk transactions and unusual behaviors across financial systems. |
| Enhanced Due Diligence (EDD) | Add extra scrutiny for high-risk customers and transactions. | Conduct deeper background checks and risk assessments for flagged individuals or risky transactions. |
| Fraud Reporting | Ensure compliance with financial regulations. | Financial institutions must report fraudulent activities to regulatory bodies. |
Why It Matters
Third-party fraud has significant consequences for businesses and financial institutions. If not addressed, it can lead to:
- Financial Losses - Fraudulent transactions and unpaid debts impact revenue and profitability.
- Regulatory Penalties - Failing to comply with AML, KYC, and PSD2 can result in fines and legal action.
- Customer Trust Issues - Frequent fraud incidents damage reputation, reducing customer confidence and retention.
- Operational Burdens - Investigating fraud and mitigating its impact requires time, money, and resources.
- Data Breaches - Weak security measures can expose sensitive customer information, leading to large-scale identity theft.
Further Reading and Resources
- Learn how FICO supports your fraud protection and compliance efforts
- Learn more about application fraud
- Learn more about FICO® Falcon® Fraud Manager
- Learn more about PSD3
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