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How Fraud Detection Works: Common Software and Tools

Detecting and mitigating fraud is vital for both businesses and customers. Learn how to protect your data from fraud.

Fraud is a pervasive issue in many industries worldwide, including finance, healthcare, e-commerce, and government. Effective fraud detection solutions are essential to address the ever-changing landscape of fraudulent activities and help prevent the financial, personal, or legal harm that fraud can cause.  

What Is Fraud Detection?

Fraud detection is the process of identifying and preventing fraudulent activities within applications, APIs, systems, transactions, and data. It involves the use of various techniques and technologies to monitor transactions and customer behavior to recognize patterns, anomalies, or suspicious activities that may indicate fraudulent actions or transactions. The primary goal of fraud detection is to proactively identify and mitigate fraudulent activities to minimize financial losses, protect assets, maintain the integrity of operations, and ensure regulatory compliance and customer loyalty.

Importance of Fraud Detection Systems

Fraud detection is critically important on multiple fronts. Fraudulent activities can result in substantial financial losses for individuals and organizations, and can disrupt normal business operations, causing delays and reputational damage. Many industries are subject to regulatory requirements for fraud prevention, and failing to detect and report fraud can lead to legal penalties and fines. In addition, fraud detection often goes hand-in-hand with data security and protecting sensitive information from fraudulent access or theft is a major component of overall cybersecurity.

How Long Does Fraud Detection Take?

The time requirements for fraud detection varies significantly depending on whether the approach is real-time or retrospective, each with its own advantages and limitations:

  • Real-time detection methods identify fraudulent activities as they occur or shortly after, allowing for immediate response, such as preventing fraudulent transactions from being completed. This is critical for industries like finance and e-commerce, where rapid action can prevent financial losses. However, real-time detection mechanisms require substantial computational resources and can be complex to implement; they also risk producing false positives, which can be frustrating for legitimate customers who may find their transactions blocked or be required to provide additional authentication, such as MFA.
  • Retrospective detection involves examining historical data from fraud files and case management tools to identify patterns or anomalies from the past that may indicate fraud. This method is often used for in-depth investigations after a fraud incident is suspected. Because there is no pressure for immediate action, retrospective methods allow for a more thorough examination of data, allowing analysts to delve deeper into suspicious patterns and behaviors with support for post-incident analysis and remediation. However, while retrospective detection can uncover past fraud and its root causes, it doesn't identify or prevent fraudulent activities in real time.

Organizations can also gain faster and more effective fraud protection by aligning their internal security and fraud teams.

In many organizations, it is common to have a cybersecurity department protecting computing networks and externally facing applications and a fraud department focused on online/digital transactions, event correlation, and incident responses. This creates a segregation of responsibilities and two departments with different tools, data sets, performance indicators, staff, and budgets.

However, many of today’s most dangerous attacks, including credential stuffing which leads to account takeover, span both security and fraud team responsibilities. If the security and fraud teams are not communicating, threat intelligence and context are lost, and it is difficult (maybe impossible) to see the entirety of the attack. As a result, fraudsters slip through the cracks, and companies and their customers experience losses.

By breaking down organizational silos, it is possible to create a multi-dimensional view of activities across both fraud and security jurisdictions. Pooling data between teams can lead to more predictive and precise machine learning models resulting in more proactive and actionable intelligence and faster, more effective remediation.

Common Types of Fraud Detection Software

There are different technical approaches to fraud detection software and systems.

Rule-Based Systems

These systems operate by using predefined rules and conditions to identify fraudulent patterns or behaviors within data flows. The system continuously monitors incoming data, such as transactions, account activity, or user interactions, and each data point is checked against the predefined rules, which can include various aspects of data, such as transaction values, time of day, geographic locations, and user behavior. If a condition within a rule is met, the system triggers an alert or takes a specified action, notifying the relevant parties, such as fraud analysts or security personnel.

The rules are based on knowledge of common fraud patterns; for example, if a customer repeatedly attempts to transact with invalid credit card numbers, this can trigger a rule alert. If a transaction amount exceeds a predefined threshold, such as $5,000, or if a customer typically makes transactions during business hours and suddenly conducts a transaction in the middle of the night, these activities can trigger an alert.

While static rule-based systems are straightforward and can quickly detect known fraud patterns, they have limitations. They tend to have varying requirements across business applications within an organization (such as loyalty point programs vs. reservations apps), making them cumbersome to maintain. They may also generate false positives or fail to identify novel fraud tactics without rewriting rules and system optimization.

Anomaly Detection and Transaction Monitoring

Anomaly detection and transaction monitoring are approaches to fraud detection that focus on identifying unusual patterns or outliers within data flows, based on the assumption that fraudulent activities often deviate from typical behaviors or patterns. Anomaly detection systems create a baseline for data gathered from various sources, such as transaction records or user behavior logs, which represents typical, legitimate behavior. The system continuously compares incoming data against the established baseline and when data points or behaviors significantly deviate from this baseline, they are flagged as anomalies and an alert is generated.

Anomaly detection and transaction monitoring are commonly used in credit card fraud detection. They monitor transaction data and flag unusual patterns, such as unusually large purchases or multiple transactions from different geographic locations in a short time.

Machine Learning and AI-Based Systems

Fraud detection systems based on machine learning models can identify complex patterns and relationships in vast amounts of data at speed, well beyond the capacity of human observers or traditional rule-based systems. ML models can be trained on historical data, but they also adapt and learn from new data in real time, which is critical for identifying emerging fraud trends and ensuring that these systems remain effective over time. AI-based tools can make real-time decisions, such as approving or declining transactions as they occur. AI and ML can also be fine-tuned to reduce false positives by learning from previous decisions. As they gather more data, they become more accurate in distinguishing between legitimate and fraudulent activities.

Banks and financial institutions use AI and ML to detect various forms of fraud, including account takeover, money laundering, and insider trading. These systems monitor transaction data, user behavior, and market conditions to identify suspicious activities. For instance, if a large sum of money is moved between accounts that have no prior connection, AI can flag it for further investigation.

Key Components of Fraud Detection

Advanced fraud detection systems share a number of key components.

Data Collection and Aggregation

Fraud detection systems rely on data collection and aggregation from multiple sources as the initial stage in identifying fraudulent activities. In financial institutions, data sources might include account activity and transaction data across all channels a user engages with, including web, mobile, call centers, and others. In e-commerce, it could involve order and payment data. After preprocessing, which involves data cleaning and normalization, the data is aggregated into a single dataset and transformed into a suitable format for analysis by either rule engines or other analytical models.

Feature Engineering

Feature engineering is the process of selecting, creating, or transforming variables in raw data to improve the performance of data analysis or machine learning models. Features are the characteristics within a dataset that models use to make predictions or identify patterns. Well-engineered features can lead to more accurate predictions and better understanding of the relationships between variables.

Fraud detection heavily relies on identifying patterns, anomalies, and deviations from normal behavior. Feature engineering helps capture these patterns by creating attributes that can highlight suspicious activities. For example, the average transaction amount over a specific time period or the number of failed login attempts can be indicative features.

Model Training and Validation

Model training and validation are essential steps for creating effective and reliable models for fraud detection. A subset of the available data, often called the training set, is used to teach the model. This dataset typically includes labeled examples, with input data and corresponding target labels (for instance, fraud or non-fraud in the case of fraud detection). The model learns patterns and relationships within the training data and adapts its internal parameters through an optimization process, aiming to minimize the difference between its predictions and the actual outcomes. After the training period, a separate dataset, known as the validation set, is introduced to assess the model's performance. This dataset is distinct from the training data and contains examples not seen during training to ensure the model can generalize to new situations. Various performance metrics are used to evaluate the model's accuracy and predictive power and the system is fine-tuned to optimize performance.

Common Fraud Detection Tools

To defend against the proliferation of evolving attacks, and protect ever-expanding attack surfaces, organizations must leverage multiple fraud detection tools and data sources to gain the critical functionality that effective fraud prevention platforms require to proactively detect and mitigate fraud in real time.

The following tools support fraud detection efforts and are elemental parts of robust fraud detection systems.

Transaction Monitoring Systems

Transaction monitoring systems (TMS) track and analyze financial transactions as they occur and are a critical component of fraud detection and risk management processes. TMS continuously monitor transactions, looking for suspicious or anomalous patterns that may indicate fraud, such as unusual transaction amounts, frequencies, or locations. If a potentially fraudulent transaction is detected, the TMS can send alerts, block the transaction in real time, or initiate further investigation. Most TMS can handle large volumes of transactions, making them suitable for industries like e-commerce, where transaction rates can be very high, and are important for ensuring regulatory compliance, especially in the financial sector.

Identity Verification Solutions

Identity verification solutions are used to confirm the identity of individuals or devices during transactions or activities, reducing the risk of identity theft, account takeovers, and other fraudulent activities. A range of methods and tools can be used to verify identity, and are often used in concert to support multi-factor authentication (MFA), which requires users to provide at least two or more authentication factors. These can include government-issued identity documents, such as driver's licenses, passports, or national IDs, and biometric authentication which uses unique physical attributes of individuals for identity verification, such as fingerprint and facial recognition or iris scans. Identity verification isn’t just for human users anymore: Device fingerprinting is important for MFA-and CAPTCHA-free authentication processes, which verify the legitimacy of the device used for a transaction by examining its unique characteristics, such as its IP address, geolocation, and hardware configuration.

Behavior Analytics Platforms

These technologies analyze and monitor user and device behavior within an organization's network, applications, and systems and are valuable tools for fraud detection. User and entity behavior analysis (UEBA) is typically the core functionality of these platforms, which create user profiles and alert security teams when unusual activity or deviations from typical behavior occurs. These platforms often assign risk scores to users and devices based on their activities, allowing organizations to prioritize monitoring and response to higher-risk incidents.

Network and Security Monitoring Tools

These tools help organizations monitor, analyze, and protect their IT infrastructure and data from potential threats, vulnerabilities, and suspicious activities that could lead to fraud. These tools and systems include:

  • Intrusion prevention systems (IPS), which actively block suspicious network traffic or activities in real time, helping to prevent potential fraud or security incidents.
  • Security information and event management (SIEM) systems, which collect, aggregate, and analyze log data from various sources, helping organizations correlate security events and detect anomalies that may indicate fraud.
  • Web application firewalls (WAFs), which are specialized firewalls designed to protect web applications from security threats and cyberattacks, making them valuable for safeguarding online transactions from fraud.
  • Web application and API protection (WAAP) solutions, which help prevent fraud from account takeover attacks by implementing authentication and authorization mechanisms, multi-factor authentication, and bot mitigation to protect login and session management processes.

Necessary Capabilities for Fraud Detection Solutions

In addition to the tools noted above, any fraud detection solutions that you consider should address the following key functionality areas.

  •  Credential intelligence, which are capabilities that provide information about prior usage of digital credentials such as usernames, passwords, and other authentication data, in the context of fraud detection and prevention. Credential intelligence answers questions such as “has this credential known to have been recently compromised?” or “has this credential been used for fraud at other sites?”. By focusing on the security and integrity of user credentials, these solutions can identify and prevent fraudulent activities related to compromised credentials, unauthorized access, and account takeovers.
  •  Device intelligence, which involves the collection and analysis of data related to the devices used to access online platforms, systems, or networks. This information includes device characteristics, attributes, and behavior, and is used to create unique device fingerprints for each device, and also includes location history to detect unusual login locations.
  •  Behavioral/passive biometrics, which include the ability to analyze the metrics of users’ physical interaction with devices for comparison against registered samples. These biometrics may include behavioral information on keystroke dynamics or mouse movements, or passive monitoring of biometric sensors such as fingerprint scanners or facial recognition cameras.
  • Bot detection and management, which focuses on identifying and mitigating the activities of malicious bots to determine on a per-session basis whether a real user or a bot is requesting access. Bot defense solutions help ensure that legitimate users can access and interact with services securely while mitigating the impact of automated fraud attempts.

Challenges in Fraud Detection

As data protection processes have improved and fraud detection systems become better at identifying specific fraud patterns, fraudsters have continued to evolve their tactics. They employ tactics like social engineering to trick individuals into revealing sensitive information, and use technologies such as machine learning and AI to craft attacks that mimic legitimate activities, making it difficult for traditional rule-based systems to spot anomalies. New fraud techniques and vectors require ongoing updates to detection models, creating an arms race between fraudsters and fraud detection system developers.

Legacy fraud detection systems also struggle in an era of big data. The sheer volume of data generated by today’s organizations makes fraud detection an even larger challenge, as traditional fraud detection systems may not have the scalability or processing power to analyze and effectively make sense of these massive data flows in real time.

In addition, rule-based fraud detection is also prone to generate false positives, leading to operational inefficiencies and alert fatigue, which fraudsters can exploit by launching low-impact, high-frequency attacks to divert attention from high-impact, low-frequency ones. In fact, there is a trade-off between minimizing false positives and catching all fraudulent activities. While prioritizing the detection of all fraudulent activities ensures a higher capture rate and prevents more fraud, it can also lead to additional operational costs, as fraud analysts must manually investigate alerts, which can be resource-intensive and expensive. This trade-off can be ameliorated by employing adaptive fraud detection systems that adjusts the stringency of detection based on factors like transaction risk and user behavior.

Businesses and organizations also face the challenge of putting in place effective fraud prevention measures without interfering with the customer experience. Some anti-fraud mechanisms impose annoying security controls like CAPTCHA—with confusing traffic-light-identification challenges—and time-consuming MFA procedures, or enforced short user sessions that can automatically log customers off while in the process of completing an order. These fraud prevention mechanisms can be challenging to complete correctly and can lead to account lockout for legitimate customers. Organizations need to find a way to balance fraud prevention without adding friction for users.

 

Future Trends in Fraud Detection

To keep up with the pace of evolving fraud tactics, fraud detection systems will need to maintain their own technology evolution and incorporate new tools to keep up with the fraudsters.

Advanced AI and Machine Learning

Advanced AI and machine learning systems are now in use to analyze vast datasets to recognize intricate patterns and relationships within data, which are crucial for identifying anomalies and potentially fraudulent activities. ML models continuously learn from new data, allowing them to evolve along with emerging fraud patterns and adapt to changing tactics. As fraudsters modify their methods, ML models can keep pace and quickly adapt to emerging threats.

However, like many other technologies, AI can be used for both legitimate and malicious purposes. Generative AI presents an especially complex picture, with the potential to be both a valuable cybersecurity tool and a threat. On the one hand, generative AI can be used for positive cybersecurity functions, such as supporting security hygiene, generating inline documentation for security detections, and data enrichment of alerts and incidents. Generative AI may also be capable of helping alleviate existing skills gaps and talent shortages in current security teams by undertaking labor-intensive and time-consuming security functions that are chronically understaffed.

On the other hand, powerful and ubiquitous generative AI is increasingly harnessed by bad actors to create more sophisticated and effective cyberattacks. Criminals can employ AI to understand how fraud detection systems work and develop strategies to evade them. This may involve using adversarial machine learning techniques to create attacks that bypass traditional fraud detection methods. AI can also speed up the process of password cracking by using machine learning algorithms to guess passwords more efficiently.

AI-generated deepfake videos and audio can be used to impersonate high-level executives or other trusted figures within an organization to manipulate employees into taking actions that compromise security. Deepfake spear-phishing attempts, ransomware attacks, and social engineering scams can easily bypass traditional security measures.

In addition, easy access to powerful AI is democratizing cybercrime by lowering the barriers to entry for conducting sophisticated and damaging data breaches, making it easier for a wider range of individuals or groups to engage in fraud.

Blockchain Technology

Blockchain is another emerging technology that has the promise to enhance transparency and security in fraud detection. Blockchain maintains a tamper-resistant, immutable ledger of all transactions, and once data is added to the blockchain, it cannot be altered or deleted. All participants in a blockchain network can view and verify transactions in real-time, making it difficult for fraudsters to operate covertly. Blockchain can also be used to securely store and verify user identities, helping to reduce identity theft and account takeovers, which are common in fraud activities.

Collaboration and Data Sharing

Collaboration and sharing of fraud data among organizations can also improve fraud detection. By circulating data and insights among trusted partners, fraudulent activity detected by one entity can serve as a warning for others, allowing them to proactively protect themselves. Shared data and collaboration also allow organizations to access a larger volume of data for analysis. With more data points, machine learning models and algorithms can be trained more effectively to detect patterns and anomalies associated with fraud.

Selecting the Right Fraud Detection Solution

Selecting the right fraud detection solution for your organization is a critical business decision. Following are some primary considerations to keep in mind when deciding which fraud detection solution to deploy.

Business Needs Assessment

Be sure that the fraud detection solution you consider aligns with your specific business requirements and your organization's strategic goals and organizational risk tolerance.  Identify the specific types of fraud your organization is most vulnerable to, which may include payment fraud, identity theft, account takeovers, or insider fraud, and make sure the solutions you consider address the types of fraud relevant to your business.

For instance, an e-commerce company with a high volume of online transactions may be most concerned with payment fraud, and wish to minimize false positives to ensure a smooth customer experience while still effectively identifying fraudulent transactions. This company may wish to consider a fraud detection solution that incorporates machine learning algorithms for real-time analysis of online payment transactions with a focus on adaptive models that continuously learn and adapt to emerging fraud patterns.

A healthcare provider that needs to protect sensitive patient data and comply with healthcare regulations such as HIPAA may want to focus on preventing unauthorized access to patient records and ensuring data security. The organization should consider implementing a fraud detection solution that specializes in identity and access management with robust user authentication, encryption, and auditing features to safeguard patient data.

Integration and Compatibility with Existing Systems

Ease of integration and compatibility with legacy systems is another important factor when considering fraud detection solutions.

Existing systems within an organization contain valuable data that can be used for fraud detection. A compatible or easily integrated solution can tap into this data faster to provide a more immediate and comprehensive view of transactions and user behavior to enhance the accuracy of fraud detection. Easy integration of legacy systems also reduces error-prone manual data transfer and reconciliation efforts, and streamlines workflows to improve operational efficiency. Incompatible systems may also require custom development to facilitate data exchange, leading to higher implementation and maintenance costs.

Scalability and Performance

Selecting a scalable and high-performance fraud detection solution is important for maintaining efficient and effective fraud prevention as your business grows.

Ensure that the fraud detection solution you are considering can handle not only your current transaction volume but can easily scale to accommodate increased volumes as your business increases. Evaluate the solution's ability to handle peak transaction loads, such as during holiday seasons or special events. It should not experience performance degradation under high traffic conditions. Also, if your business is expanding geographically, be sure the solution supports scaling across multiple regions and time zones.

How F5 Can Help

Effective fraud detection solutions are essential for maintaining the financial health, operational integrity, and trust of organizations across many industries. Fraud management not only protects against immediate financial losses for businesses but also safeguards the data, finances, and privacy of individuals and customers. Deploying effective fraud detection tools and strategies offers a range of benefits that help your organization and your customers stay ahead of fraudsters and evolving fraud schemes.

F5 fraud detection and mitigation services defend against an escalating threat environment where online accounts are more vulnerable than ever. F5 application security and fraud mitigation solutions are powered by a closed-loop AI engine and adaptive ML models that provide fast retraining and continuous enhanced detection. The system’s large-scale unified telemetry is built on data from over a billion transactions per day, with the capacity to monitor transactions in real time from across the user journey. Using advanced signal collection, as well as behavioral and environmental insights, the system uniquely determines user intent, accurately detects malicious activity, and delivers high fraud detection rates.

To learn more about the impact of F5 fraud detection and prevention solutions, download and read this independent Aite report.