Emerging financial products driven by innovation, such as virtual assets and simplified payment services, introduce both new conveniences and in-transaction risks to customer funds. Despite regulations on segregating customer funds already in place, full compliance by businesses with these rules is unlikely, especially with insolvency on their horizon. This paper proposes a new protection framework that bolsters the safety of new financial products and reduces funding pressures for the compensation scheme.

Ⅰ. Introduction

Accelerating financial innovation continues to drive the emergence of new financial products. Virtual assets like Bitcoin are emblematic of this trend. Other innovative financial products include simplified payment services, such as Naver Pay, and peer-to-peer (P2P) lending, where individuals loan to each other via digital platforms. While not new, prepaid funeral services represent a noteworthy quasi-financial product, with a marked growth in demand anticipated as the number of deaths increases due to demographic shifts.

New financial products can bring benefits distinct from traditional ones. First, the market prices of virtual assets tend to move differently from conventional assets like stocks and bonds, emerging as a new asset investment class that is either alternative or complementary (Nguyen, 2022). Second, simplified services for payments and remittances enable fast and straightforward payments and fund transfers from mobile devices. Third, P2P lending is financially inclusive.

Individual investors can assess credit scores and qualitative data, such as personal stories borrowers share on P2P platforms, enabling distinction between borrowers with sufficient capabilities to pay back despite low credit ratings. Fourth, prepaid funeral contracts relate to end-of-life expenses, usually the third or fourth largest expenditure in a lifetime. In 2015, the average cost of funeral services was 13.8 million won (Korea Consumer Agency, 2015), projected to be even higher today. By entering into these prepaid contracts, individuals can reduce future funeral-related costs by locking in current prices and alleviate the burden on the bereaved families by preselecting necessary goods and services.

However, new financial products may also expose customers to risks during transactions. Virtual assets, digital payment services, and prepaid funeral contracts all involve firms holding customer funds while providing relevant services, with the obligation to return them upon request. Whether these firms can effectively ensure the return of customer funds emerges as an important question. Incidents such as the Mergepoint and TMON cases, alongside numerous failures among funeral service providers and overseas examples, suggest that customer funds may be at risk of loss in times of crisis.

In this study, new financial products broadly refer to products emerging as part of financial innovation, including simplified payment services and virtual assets. Quasi-financial products like prepaid funeral arrangements, which have recently gained significance due to their increasing scale and growth rate, are also included. Rather than focusing on the products themselves, this study emphasizes customer funds collected by firms during transactions for these new products, such as prepaid balances and virtual asset deposits (Table 1).

First, prepaid balances are customer funds collected by digital payment service providers, such as Kakao Pay, in delivering their services. They include foreign currency prepaid balances, such as those charged to providers like TravelWallet that offer prepaid card services. Prepaid balances are functionally similar to demand deposits in banks, as they can be deposited and withdrawn at any time and are used for settling payments, either for goods or services or for fund transfers. Second, virtual asset deposits refer to funds deposited by customers on virtual asset exchanges to purchase virtual assets like Bitcoin, functioning as demand deposits. Third, P2P lending deposits are funds placed by investors on P2P lending platforms to facilitate P2P loans. Once a loan is executed, these funds convert into loan receivables. Both deposits for virtual assets and P2P lending are comparable to investor deposits held at securities firms for stock or bond transactions, as they are set aside to trade investment products like virtual assets and loan receivables. Fourth, funeral service prepayments are funds customers pay in advance after entering into prepaid funeral contracts. These prepaid contracts involve advance payments in installments, with funeral goods and services provided upon the demise of contract holders. Prepaid funeral contracts are similar to life insurance, where a set amount (premium) is paid in advance, and a substantial benefit (insurance payout) is provided upon the policyholder’s death.

The current volume of customer funds related to new financial products is not negligible. As of 2023, the combined total of the four types of such customer funds amounts to approximately 18 trillion won (Table 2). Among these, funeral service prepayments constitute the largest share, totaling about 9 trillion won, with virtual asset deposits at around 5 trillion won. Moreover, these four types are attracting a large number of users. In 2023, 8.64 million people—17% of South Korea’s population—used prepaid funeral services, meaning that one in every six Koreans prepaid for their end-of-life arrangements. Virtual asset users are also considerable, reaching 6.45 million.

Looking ahead, the volume of customer funds is projected to expand further. With the daily average value of simplified payments increasing by 76% annually over the past five years, prepaid balances reached 140.1 billion won in 2023. This upward trend is expected to continue with the advancement of digital finance beyond 2024. Currently, new issuance of virtual assets is prohibited in Korea, and stablecoins remain unregulated. However, global efforts to incorporate virtual assets into legal frameworks are gaining momentum, and Korea is expected to implement relevant regulations soon. Accordingly, deposits for virtual assets are likely to increase over time.

One notable product in terms of growth potential is prepaid funeral contracts. Since the provision of funeral goods and services hinges on the death of the contract holders, mortality trends are a critical factor in shaping demand. In Korea, the number of deaths has been steadily rising, from 260,000 in 2011 to 370,000 in 2022 (Figure 1). Despite a temporary dip in 2023, Statistics Korea’s Future Population Projections suggest that its aging population will drive deaths higher, potentially reaching 750,000 by 2060 (Statistics Korea, 2023). Regression analysis shows that for every 10,000 additional deaths, the number of prepaid funeral service users increases by 450,000, while prepaid amounts rise by 600 billion won (Figure 1). Since this analysis focuses on correlation rather than causality and uses the number of deaths as the sole independent variable, it is insufficient to provide reliable projections. However, given the projected increase of nearly 400,000 deaths, even conservative assumptions about growth in users and prepaid amounts per 10,000 deaths make it difficult to deny that the users could exceed 10 million within a few years, alongside a sharp expansion in prepayments.

However, new financial products carry transaction risks for customers. All four new types involve receiving customer funds during service delivery. Prepaid balances, deposits for virtual assets and P2P lending, and funeral service prepayments are all prepaid and withdrawable as needed. If these funds are not returned in full upon request, customers could face substantial losses, as evidenced by multiple domestic and international cases (Table 3). The 2021 Mergepoint scandal is the primary example of unreturned prepaid balances, resulting in total losses of 75.1 billion won.6) Similarly, the virtual asset exchange CoinZest in 2018, the P2P lending platform Blue Moon Fund in 2019, and the funeral service provider Han River Life in 2021 either failed to return or misappropriated customer funds, causing significant financial losses for customers.

In light of the potential risks, new financial products are subject to fund segregation regulations,7) which require firms to separate customer funds from their proprietary assets by depositing or entrusting them with third-party banks or subscribing to payment guarantee insurance policies from insurers. Despite being a crucial protective measure,8) several conditions must be met to thoroughly shield customer funds: 100% of customer funds must be segregated, obligations must be upheld even in facing bankruptcy, and institutions holding these funds, such as banks, must never fail (Table 4)

The issue lies in the fact that not all conditions are fully met. First, unlike 100% segregation of prepaid balances, virtual asset deposits, and P2P lending deposits, only 50% is required for funeral service prepayments under the current regulations. Consequently, most funeral service providers adhere to the rules but manage the unsegregated 50% with discretion, treating it as part of their own capital. In other words, if they default, customers risk losing half of their funds.

Second, nearing insolvency amid a management crisis, firms may find it highly tempting to misuse customer funds—even by violating segregation rules—to avert collapse. This unethical lure is the greatest limitation of fund segregation. Examining nearly all funeral service providers registered since the 2010 legislation of prepaid funeral contracts (Table 5) reveals that 46% of them whose registrations were canceled had violated the requirements just before their licenses were revoked.10) It is observed that half of these providers in crisis breached this obligation. On average, they only segregated 37% of customer funds, indicating that if a provider fails, up to two-thirds of customer funds might have been lost.

Such violations during times of crisis are not unique to Korea. In the UK, from 2018 to 2021, six payment service providers went bankrupt, and five of them were noncompliant with prepaid balances, resulting in customer losses (K&L Gates LLP, 2021). Segregation rules also apply to securities deposits, functionally analogous to virtual asset deposits, and during the 2008 financial crisis, the collapse of Lehman Brothers’ UK subsidiary uncovered a shortfall of over 100 million dollars in segregated funds (UK Supreme Court, 2012). Additionally, in the US, a large securities firm, MF Global, defaulted in 2011 due to liquidity shortages, later revealing that it had misappropriated customer deposits to secure liquidity (Giddens, 2011). Even heavily regulated financial firms with well-established business models, like securities companies, have violated segregation rules when on the brink of collapse. It would be imprudent to underestimate the risk of segregation violations by businesses delivering new financial products, especially in high-risk sectors.

Segregation violations can occur unintentionally as back-office operations become incapacitated near bankruptcy. On the verge of liquidation, the paralysis of administrative functions becomes highly likely. In April 1999, Dong Bang Peregrine Securities was declared bankrupt, and a bankruptcy administrator was appointed. During its liquidation procedures, both the company and the administrator inadvertently failed to segregate customer deposits, and this oversight led to customer losses.

However, even when operating without the danger of bankruptcy, there are still numerous instances of segregation violations. Annual surveys by Korea’s Fair Trade Commission (FTC) reveal such rulebreaking every year—six noncompliant companies in June 2024 (FTC, 2024). The UK’s Financial Conduct Authority (FCA) discovered multiple noncompliances after investigating 11 prepaid balance service providers in 2019 (FCA, 2021). In June 2023, Korean financial authorities found that approximately 5 trillion won out of 70 trillion won in investor deposits at securities companies were not segregated and had been used for internal operations, with one company temporarily mixing up to 46% of investor deposits with its own funds. Moreover, globally renowned securities firms like JP Morgan and Barclays were fined by UK authorities in 2010 and 2013, respectively, for violating segregation requirements (Morrison, 2014). In practice, it is difficult for regulatory authorities to monitor and oversee fund segregation compliance as events unfold.

Third, institutions responsible for holding and managing segregated funds, such as banks and savings banks, are not invincible. When companies entrust customer funds, the trustee, usually a bank, is supposed to invest these funds in safe assets such as government bonds or money market funds (MMFs). However, normally safe assets are not necessarily safe during financial crises. For instance, during the 2008 financial crisis, a massive fund run occurred in MMFs in the US, and in 2023, Silicon Valley Bank, which had heavily invested in US Treasury Bonds—widely considered the safest assets—collapsed due to significant valuation losses. Whereas P2P lending deposits can be segregated in savings banks,14) they tend to be riskier than regular banks.

In essence, fund segregation is a precautionary measure to safeguard customer funds from potential losses. Yet, even with the best preventive efforts, risks cannot be entirely avoided. This underscores the need for post-incident protective measures for more effective safeguarding—a mechanism in which public institutions like the Korea Deposit Insurance Corporation (KDIC) compensate for losses incurred in customer funds after bankruptcy.

Other major countries employ a two-track approach of preventive fund segregation and post-incident protection. In the UK, the expanded deposit insurance framework FSCS covers prepaid balances and funeral service prepayments. Similarly, in the US, the Federal Deposit Insurance Corporation (FDIC) provides broad protections for prepaid balances, virtual asset deposits, and funeral service prepayments under certain conditions. For instance, PayPal’s prepaid balances and the virtual asset deposits held by Coinbase, the largest virtual asset exchange in the US, are insured under the FDIC scheme.

The rationale behind the adoption of these protective measures is as follows. First, safeguarding customer funds is essential in securing trust in the financial system, a foundation necessary to responsibly foster financial innovation. Second, these customer funds function closely akin to traditional financial products, such as demand deposits, securities accounts, and insurance, all of which are already covered by KDIC (Table 1). Third, some of them like funeral service prepayments hold significant importance in the national economy given their size, growth rate, and instances of customer harm.18) Based on the criteria of (1) stable financial innovation, (2) functional similarity with existing products under protection, and (3) economic importance, this paper recognizes prepaid balances, virtual asset deposits, P2P lending deposits, and funeral service prepayments as targets for protection.

The following provides context for the protection system proposal. Post-incident schemes are categorized as either direct or indirect (Table 6). In the direct system, KDIC safeguards customer funds in much the same way as they cover bank deposits or securities accounts. If a firm declares bankruptcy and customer funds are lost, KDIC compensates up to a specified amount per person—e.g., 50 million won. To fund compensation, firms pay insurance premiums in advance according to applicable rates per the total amount of customer funds they manage.

However, this direct approach has one crucial flaw: applying uniform premium rates for both safer funds segregated in banks and riskier funds internally managed by firms goes against the principle of risk-proportional premium rates. Firms may find it difficult to accept premiums on already safely segregated funds. If the rate exceeds the actual risks of these segregated funds, their burden could grow larger and may be passed on to customers.

In the direct protection scheme, firms pay insurance premiums in advance, and KDIC protects customers in the event of business insolvency.
However, the direct scheme applies uniform insurance rates regardless of fund segregation in contrast to the fundamental insurance
principle of premiums proportional to risk.

The other type of post-incident protection is indirect. Under this scheme, KDIC does not directly safeguard customer funds in new financial products. Consequently, firms are not obligated to pay insurance premiums to KDIC, nor does KDIC compensate customers in the event of business failure. Instead, customer funds separately deposited in a bank are treated as customer-owned deposits, subject to the standard deposit insurance system. Recognizing these segregated funds as pass-through deposits, the customer, as the beneficial owner irrespective of the account holder’s name, holds these deposits indirectly through the firm acting as an intermediary. As a result, if the bank holding the funds defaults, KDIC will recoup customer losses up to the deposit insurance limit per person—50 million won in Korea. In short, rather than directly covering customer funds for new financial products, the indirect scheme merely extends the scope of protected bank deposits to include funds segregated in banks. The firm’s role within this indirect framework is limited to recording and managing customer identification data and submitting them to KDIC as needed.

In the indirect scheme, firms are relieved from the financial burden of paying insurance premiums, so there is no burden to pass on to customers. However, a grave defect arises regarding compensation effectiveness: only customer funds held in segregated bank accounts are protected, leaving the unsegregated portion unprotected. The primary goal of post-incident protection is to shield customers from the risks associated with firms’ noncompliance with segregation rules, and indirect protection falls short of this objective, limiting its efficacy as a protective measure.

In the indirect framework, firms do not pay insurance premiums, and KDIC safeguards only the funds segregated in banks in the event of bank failure.
The indirect approach only protects segregated funds, leaving customers unprotected from violations of segregation rules, resulting in reduced protection effectiveness.

Building on international practices as well as the strengths and weaknesses of direct and indirect protection schemes, this study proposes a new framework—a “hybrid protection system”—designed to enhance protection effectiveness, adhere to the fundamental principle of premiums in proportion to risks, and reduce financial burdens for both sides (Table 6, Figure 2). At its core, this hybrid system offers indirect protection for customer funds segregated into banks while directly safeguarding all other customer funds. This hybrid system operates as follows: Companies are directly integrated into the KDIC protection framework, and as a rule, required to pay insurance premiums on the entirety of customer funds they manage, ensuring customer compensation in case of their default (“primary direct protection”). An exception applies to customer funds separately deposited in banks. Provided that companies submit customer identification details, these funds are recognized as customers’ own bank deposits, exempting companies from paying insurance premiums. Customers are then compensated if the bank fails, rather than in the case of company bankruptcy (“conditional indirect protection for bank segregated funds”).

Suppose a company managing 10 billion won in customer funds deposits 7 billion won in a bank (Figure 2). The company only pays insurance premiums for the remaining 3 billion won, and customers are protected regardless of the company or the bank that defaults. Three scenarios are possible. First, if the company fails but the bank remains solvent, KDIC compensates clients up to the per-customer limit for 3 billion won not set aside, and 7 billion won held in the bank remains intact and accessible to customers as needed. Second, conversely, if the bank fails but the company remains operational, KDIC compensates for 7 billion won held in the bank, and the company returns the remaining 3 billion won to customers. Third, if both fail, KDIC pays back the full 10 billion won within the coverage limit.

This hybrid system offers several key advantages. First, all customer funds—whether segregated or not—are comprehensively protected within the per-customer limit. Second, it aligns with the principle of premiums proportional to risk, exempting segregated funds from premiums and applying them only to unsegregated funds. Third, the premium burden is low for both businesses and customers. Companies are incentivized to deposit most customer funds in banks to benefit from the premium exemption (Table 6, Figure 2). With reduced costs, companies are less likely to pass that burden onto customers. This raises the question of who finances the compensation. Banks assume this responsibility since customer funds placed under their care are treated as bank deposits. Under the current deposit insurance framework, banks pay deposit insurance premiums proportional to their total deposit balances.

However, prepaid funeral service providers that currently manage only half of their customer funds separately may face increased pressure, as the other half—often used as operating capital—needs to be deposited in banks to qualify for the premium exemption. Characteristic of funeral service prepayments, frequent criticism has been directed at large shareholders for embezzlement and misappropriation of customer funds (Dong-A Ilbo, 2024), with financial losses from such cases continuing to be reported. Unlike other customer funds, such as prepaid balances, there are no asset management regulations
requiring the use of safe assets like government bonds, leaving prepaid funeral service customers more vulnerable. With the anticipated surge in the number of deaths, the risk exposure is projected to grow significantly, potentially affecting over 10 million individuals and involving prepaid funds exceeding 10 trillion won. To address these risks, several US states and the UK require 100% of prepayments to be separately managed. The proposed hybrid system—without raising the segregation requirement from 50% to 100%—places a lighter burden on businesses relative to stricter foreign systems.

The proposed hybrid scheme indirectly protects customer funds segregated in banks while directly safeguarding all other customer funds.
This hybrid protection system ensures high effectiveness by safeguarding all customer funds and keeps insurance premium burdens low for firms and customers, as firms are incentivized to deposit most customer funds in banks.

In addition, there are other advantages to this hybrid system. First, it mitigates the issue of risk transfer, where bank failure could trigger a chain reaction of insolvency among firms. Under the direct protection system, when a bank fails but a firm remains operational, KDIC does not compensate for customer funds lost in the collapse. In such cases, firms must repay customers using their own assets. In Korea, where major banks dominate the market, multiple firms are likely to use the same bank to segregate customer funds. Put differently, the failure of one bank could cause cascading failures across a spate of industries and firms. In contrast, under the hybrid scheme, even if a bank fails while a firm remains operational, KDIC compensates customers for losses on behalf of the firm, preventing the spread of risk.

Second, the hybrid proposal facilitates early risk detection. Given the premium exemption, firms would commonsensically segregate their customer funds. Failure to do so, despite the clear gains, suggests potential liquidity issues or engagement in high-risk and high-return investments. Monitoring such behavior allows regulators to identify and supervise risky firms more effectively, reducing the likelihood of accidents.

The hybrid protection system addresses risk transfer, in which a bank’s failure can trigger a firm’s insolvency.
Early detection of firms facing liquidity risks is enabled by the hybrid proposal.

Nevertheless, the proposed hybrid system is not free from limitations. First, the process of compensation may incur losses for KDIC. Even so, the risk to KDIC appears limited: The total customer funds for new financial products amount to only 18 trillion won—categorically lower than traditional financial products exceeding several thousand trillion won, and per-person amounts for customer funds are low—funeral prepayments at 1.08 million won and virtual asset deposits at 760,000 won (Table 2). Moreover, given the high likelihood of fund segregation for most customer funds, KDIC's compensation burden would be even more limited. Besides, regular premium contributions from banks and businesses will provide an additional buffer against losses.

Second, implementing the hybrid system may present more challenges than the indirect system. The indirect protection is highly feasible as it only requires expanding the definition of deposits under the existing insurance framework. Having applied indirect protection to various financial systems like Individual Savings Accounts (ISAs), KDIS has the know-how. On the other hand, the hybrid protection would require material changes to the current framework, necessitating legal amendments to the Depositor Protection Act and coordination among regulatory bodies to bring in new financial products, currently categorized as non-financial, under KDIC’s protection scope.

KDIC’s burden under the hybrid option is not expected to be substantial.
While the indirect protection system is easy to implement, the hybrid option requires substantial changes to the existing framework, making immediate implementation challenging.

Ⅴ. Conclusion

In recent years, major advanced economies with sophisticated financial industries have expanded the scope of public safety nets beyond traditional deposits to encompass various financial and quasi-financial services, despite the considerable hurdle of modifying existing deposit insurance frameworks. The US has extended the coverage not only to prepaid balances, virtual asset deposits, and funeral prepayments but also to Bitcoin ETFs.36) In the UK, FSCS, a comprehensive and centralized protection scheme covering the entire financial sector, compensates for prepaid balances and funeral prepayments, as well as for losses caused by the misselling of various financial products and services. Australia has followed suit, launching the Compensation Scheme of Last Resort (CSLR) in April 2024.

This convergence of international financial policies mirrors a shared awareness that fostering public trust through timely and effective compensation for consumer losses from financial innovation is essential for advancing innovation with stability. Between the two pillars of financial policy—prudential regulation and consumer protection, the former has achieved relative maturity since the global financial crisis, driven by the growing adoption of capital regulations such as Basel III. However, the second pillar remains a critical unresolved agenda, contributing to the common perception of its importance. Moreover, the continuous emergence of new financial products throughout the innovation process places increasing emphasis on consumer protection.

Recently, major developed countries have expanded the coverage of deposit insurance institutions beyond traditional deposits to include a wide range of financial and quasifinancial services, aiming to responsibly foster financial innovation.

Building on these global developments, this study presents a customer protection framework with a focal point on customer funds for new financial products. In conjunction with examining direct and indirect protection systems already in place in major economies, a new hybrid approach is introduced, offering a comparative analysis of their strengths and weaknesses. This study first proposes carrying out the more feasible indirect scheme and addressing shortcomings during implementation. As the significance of new financial products and customer risks grow, selectively pursuing a gradual shift towards the hybrid protection scheme by product category could be considered.

Finally, the inclusive nature of the customer fund protection framework should be stressed. Designed to cover existing products, such as simplified payments, virtual assets, and P2P lending, the proposed framework can also apply to any financial products future innovations may bring as long as businesses collect customer funds through transactions and the need for protection arises. The centralized and integrated schemes in the UK and Australia were introduced with broad applicability, later transitioning to selective regulation based on the significance of individual products. Likewise, the proposed customer protection aims to provide robust and comprehensive regulatory backing, as well as flexibility for selective oversight as new financial products and risks emerge, all the while propelling innovation to proceed confidently.

This study builds on such global trends to propose protection measures for customer funds in new financial products.
The proposed protection system, with its inclusive nature, can serve as a comprehensive framework to protect and foster future innovation by capturing new financial products within its regulatory scope.

CONTENTS

• Ⅰ. Introduction
  
  Ⅱ. The Concept and Current Status of Customer Funds in Emerging Financial Products
  
  Ⅲ. Risks of New Financial Products and Limitations of Fund Segregation Regulations
  
  Ⅳ. Proposals for a Protection System
  
  Ⅴ. Conclusion