Unveiling Fraud: The Future of Fraud Prevention
Fraud is not something new throughout history. The earliest known fraud in human history can be traced back to 300 B.C., when two Greek sea merchants, Hegestratos and Zenosthemis, devised a scheme involving a loan to purchase a cargo and an insurance plan to protect the merchandise. According to the plan, if they failed to repay the loan, the lender would gain possession of the cargo. However, the two merchants intentionally sank the ship after its departure in order to keep all the money for themselves. Since then, fraud prevention has remained one of the top priorities for individuals to avoid financial loss.
Is fraud prevention important?
Nowadays, the complexity of global businesses has elevated the intricacy of fraud to a level beyond our imagination. It is estimated that businesses are losing more than $4.7 trillion annually to fraud, a 56% increase from 2009. PwC’s 2022 Global Economic Crime and Fraud Survey showed that 51% of the surveyed organizations have experienced fraud in the past 2 years, the highest level over the past 20 years. The numbers speak for themselves: it is crucial that fraud prevention remains a top priority to minimize and even avoid financial loss. As fraud continues to evolve and become more complex, it’s important for individuals and organizations alike to stay vigilant and take proactive steps to prevent it.
Internal Fraud is the main cause of failure in corporate governance, and no one should ignore the consequences.
It goes without saying that effective corporate governance leads to sustainable business performance and a positive culture of integrity. However, the significance lies in the downside of corporate misconduct, which affects nearly all stakeholders within the organization. According to the Association of Certified Fraud Examiners (ACFE), companies on average lose approximately 5% of sales to fraud annually, making fraud prevention one of the top priorities for governments around the world. Corporate misconduct also leads to value destruction for investors, who have lost approximately $245 billion globally through investments in securities issued by enterprises suffering from internal scandals. Employees are not exempt from these losses — more than 45% of employees have left their jobs when facing corporate misconduct, giving up their ESOPs, remuneration, and worst of all, promotion opportunities.
Numerous case studies remind us of the importance of avoiding poor corporate governance. Ride-hailing giant’s lawsuits from women harassed by drivers caused a $1.4 billion decline in its market cap in 6 months; a series of scandals of the Swiss banking conglomerate led to its acquisition at only ~10% of its peak market cap; Japanese electronics group’s accounting scandal has forced it to streamline its business by letting go of more than 14,000 employees and selling off multiple business units to mitigate its $1.2 billion decline in market cap; German payment company’s involvement in the biggest fraud in German history resulted in a more than 40% drop in share price and the company’s declaration of insolvency; and these are just the tip of the iceberg. While we will never know what would have happened if the above-mentioned incidents had not occurred, the consequences make it worthwhile to take precautions against fraud and avoid corporate misconduct.
…and External Fraud is on the rise too
More and more brick-and-mortar merchants are going digital and selling online, with over 20 million merchants operating online globally. It is also estimated that global B2B payment volume reaches ~$120 trillion p.a. and is expected to reach ~$200 trillion p.a. by 2028, while only ~7% of the payments were conducted digitally. With the payment volume growing exponentially, the world saw losses of $41 billion to payment fraud p.a. with a ~30% CAGR.
The following chart illustrates the digital payment workflow of a typical online merchant.
Although digital payment is extremely convenient for both merchants and customers to conduct transactions, the complexity of the digital payment workflow has made merchants, customers, as well as various solution providers in between prone to fraud. Merchants are not able to receive payment in a timely manner if any of the workflows have fallen victim to fraud, resulting in the following outcomes.
- Higher Chargeback Rate: Most Payment Solution Providers (PSPs) will issue an early warning to merchants with a chargeback rate >0.7% and will put those with a chargeback rate >0.9% into detention programs. A chargeback rate of >1.8% will result in merchants being fined by PSPs and even having their services terminated, losing the payment collection channel for online businesses.
- Lower Conversion Rate: Fraud will directly cause customers to halt transactions with Payment Issuers, such as banks and card networks, leading to a lower conversion rate and reduced sales. Over-aggressive precautions against fraud by merchants will also result in unnecessary losses in sales if they block the “wrong” transactions.
Given the severity of external fraud and the complexity of the digital payment workflow, merchants often struggle to effectively prevent fraud. Every $1 of fraud will, on average, cost the merchant $3.75 to fight against.
The Future of Fraud Prevention
With fraud becoming an increasingly significant problem, more and more companies are innovating on fraud prevention solutions in various aspects. Our views on the opportunities in this space are as follows.
Internal Fraud Prevention
- Regulations coming into force are making the disclosure of fraud prevention activities a “must-have” rather than a “good-to-have”
Stock exchanges, legislations, and governments around the world are making regular disclosure of corporate misconduct necessary for corporations. The enforcement of the Sarbanes-Oxley Act, DOJ Guidance, SEC Whistleblower Program, and so on has covered the majority of publicly listed companies in the US and regulated them to frequently and actively disclose fraud prevention activities and initiatives. This makes it easier for employees to file complaints anonymously and efficiently within the organization.
- GRC Incumbents and HR Platforms are active acquirers in this space
Several M&A activities from GRC Incumbents and HR Platforms have proven the significance of this space. OneTrust completed the acquisition of Convercent to drive ethics into the center of business and strengthen ethics management offerings. Workday acquired Peakon to obtain sentiment data from employees and reduce talent losses while retaining top performers in a data-driven approach. EQS Group acquired Got Ethics to add whistleblowing functions to its GRC platform, and NAVEX’s acquisition of WhistleB indicated a similar strategy. Frequent activities in this space are expected to attract more VCs to invest in early innovators.
Featured Company: Vault Platform
Vault’s digital platform, underpinned by a sophisticated unstructured data capture engine, provides employees with a safe space to raise concerns, have their queries intelligently routed to the correct avenue, and promptly addressed. Not only do their customers benefit from the savings in administrative improvements, but they can also improve the work culture and strengthen corporate governance.
External Fraud Prevention
- SMEs are “hidden gems” given their vulnerability to fraud prevention.
Given the sophistication of external fraud, solutions often require significant customization depending on PSPs, the industry of customers, and other existing systems customers have adopted to facilitate online transactions. This complexity brings up the complexity of sales cycles and costs of solutions, making it unaffordable and hard to maintain for SMEs to implement. In other words, most of the external fraud solutions target “premium tier” online merchants with an annual GMV > $1B, while the merchants with GMV between $5M — $1B, accounting for more than 85% of online merchants, are struggling against external fraud.
- “On-boarding” as an emerging space with verticalized use cases.
Several countries, such as India, Brazil, and Singapore, are issuing authorized e-IDs that function as physical proof of identity. While the digital identity and KYC/KYB sectors have matured and proved valid and lucrative business use cases, “on-boarding” solutions are attracting more attention by managing the end-to-end journey of customers when subscribing to online merchants. This includes preventing suspicious identities from signing up, managing activities of customer accounts, and ensuring the validity of transactions and payments. Specialized use cases in a specific industry or sector have been provided to ensure the accuracy and efficiency of fraud prevention.
Featured Company: Corgi AI
Corgi builds an end-to-end SaaS suite of fraud detection and prevention solutions, including an analytics product to monitor and understand dispute and fraud metrics, an AI product that highlights transactions for merchants to follow up on, and an AI solution to recommend rules that can be implemented in payment provider platforms (Stripe, Shopify, Adyen) to proactively reduce dispute and fraud rates.
Featured Company: Instnt
Instnt is a fully-managed fraud and KYC (Know Your Customer) on-boarding platform designed for financial institutions. Founded by the former CEO of Socure, a major player in real-time fraud detection, it offers a low-code/no-code solution for onboarding customers, encompassing fraud defense, KYC compliance checks, and identity verification. Instnt’s unique approach shifts fraud losses away from customers’ balance sheets.
If you are a like-minded investor, early-stage company entrepreneur, or thinking about opportunities in the fraud prevention and analytics space, we at Illuminate would love to chat with you. Feel free to reach out to me at ty@illuminatefinancial.com
