The Blockchain & Islamic Finance – A Perfect Match?

Islamic Finance

Islamic finance is a growing niche area of banking and investment. Understandably, this has originally been focused within the Middle East and other significant Muslim countries. Further afield, however, it is beginning to take hold as Muslim communities in the western world demand more sophisticated financial services. Islamic finance is based around the types of financial instruments that are permissible under Sharia law (Islamic law), with Islamic finance restricting the types of investments that are allowed. As a general rule, purely interest-bearing assets not being permissible, with this focused around the concept of usury.

Usury is not a new concept – even for the Western World. Usury was banned even in Elizabethan times in the UK – and a little known fact is that William Shakespeare’s father was in court twice for violating the usury laws and that Shakespeare himself sued people for the non-repayment of debt – check out my 2011 article Was Shaespeare a fraud? A banker’s perspective for more details. Essentially, usury involves the charging of excessive rates of interest for money that is borrowed. Under Islam, usury is banned as the ‘investor’ can be seen to force the ‘borrower’ to do things that are against the common good or the good of the borrower themselves, causing potential significant conflicts, both personal and societal.

Islamic Banking and Finance is a relatively new field of study for the financial industry, and, in itself, is still evolving. So when it comes to the newer asset types and classes, such as cryptocurrencies, there will undoubtedly be disagreement among Islamic scholars. With that in mind, let’s explore the role of Blockchain and Islamic finance.

BITCOIN AND CRYPTOCURRENCIES AS ASSET CLASSES

Bitcoin was the first use case for the blockchain. Invented by Satoshi Nakamoto and released to the world in 2009, its principles form the basis of almost every new cryptocurrency in existence today. Most of these are public blockchains, i.e. they are free for participation for everyone around the world without restrictions. As we will see below this is an important feature of the cryptocurrency and Islamic Finance. Equally, most of the public blockchains or cryptocurrencies are traded on exchanges, thus giving them value.

Bitcoin and cryptocurrencies are considered asset-based money as opposed to the traditional monetary system in use today which is debt-based. Owning Bitcoin as an asset class is increasingly considered to be digital gold – this was seen very recently where its value rose significantly as a result of detrimental global issues – e.g. when Brexit occured, bitcoin’s value rose by 15%. The similar structure applies to other cryptocurrencies. Since there is no debt involved and no interest payments, owning Bitcoin and cryptocurrencies fit well with the Islamic finance principles.

In fact, several Islamic scholars hold the view that Bitcoin is more Halal (allowed) than fiat money (e.g. US dollars) in use today. For example, in Islamic literature, money needs to have intrinsic value. This is not true for paper-money in use today, but is true for Bitcoin because its value comes from the proof of work protocol (for bitcoin at least) and is backed by the use of electricity required to reach the appropriate mining difficulty level required to actually produce a bitcoin (through the solving of a cryptographic puzzle). In addition, the majority of today’s fiat money is actually in the form of loans from the banking system, whereas Bitcoin is created through a mining process that doesn’t involve lending/debt (called “Riba” in Islam).

Therefore, as an asset class and as a currency, Bitcoin and cryptocurrencies seem to be compatible with the principles of Islamic finance.

CROWDFUNDING

There is another core tenet of Islamic finance of making sure the ‘lender’ and ‘borrower’ have a system to share profits and losses. This is why most of the Islamic banking contracts involve profit-and-loss sharing contracts, or some form of partnership. This ensures that the incentives of both parties are aligned, and helps reduce the principal-agent problem that plagues traditional institutions.

In this sense, cryptocurrencies, especially the ones that go through a crowdsale (see my Linked In article on Initial Coin Offerings), are compatible with this “sharing” principle. The crowdfunding donors who give money to the project developers get a cryptographic token whose value is based on the success or failure of the underlying project. The project developers don’t “owe” the token holders anything, and both parties succeed or fail in rhythm. This makes their incentives mutually aligned. The idea of Islamic finance is around ‘mutual risk sharing’, and crowdsales conform to that principle in the blockchain world.

One caveat to the alignment of incentives is that the original development team must still hold the tokens that are given to early investors. Without that, the development team might not have a strong incentive to complete the project. However, given the Islamic finance principles of the ‘investor’ forcing the ‘borrower’ to do things that are against the common good or the good of the borrower, this situation could be argued not to arise in cryptocurrency crowdsales even when the development team doesn’t hold original tokens.

So in conclusion, bitcoin and other cryptocurrencies underpinning blockchain developments do appear to have very favourable conditions geared towards Islamic finance given their lack of reliance upon debt, the lack of investor/borrower control and the mutually aligned profit and loss sharing of the funding process of crowdsales. With careful consideration, this could potentially open up a raft of opportunities. With so many Islamic communities being based in developing and poorer countries that lack basic infrastructure, the use of the blockchain and mobile technologies – such as that seen with m-pesa out of Kenya – could be the future of low cost technology that by virtue of its support from Islamic scholars could gain ready adoption from its local communities through its positive Sharia components.

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