As far as I can tell, they can't actually see anything. But I'm not spewing out anything, because I derived my theory from the fact that during the pokemon sumo ban wave, only those who went online and connected to pokemon servers were actually stung. Some folk left wireless on, so it was connected to N servers, such as friends list, but didn't actually connect to things ln game, and got off Scott free.
Therefore, that leads me to believe they can't directly see what your doing, and that gamefreak was actually responsible for flagging consoles.
And no, free shop games won't get you banned.