Cryptos: Distinguishing Hype and Realities in Islamic Finance

Dr Fares Djafri

Introduction

According to the Financial Stability Board’s recent study, crypto-asset market capitalisation grew 3.5 times in 2021 to USD2.6 trillion. Still, the market remains a small portion of the overall global financial system, and direct connections between crypto assets and systemically important financial institutions and core financial markets are limited at the present time. The market, according to the European Central Bank, represents less than 1% of the global financial system in terms of size, but it is still similar in size to, for example, the securitised sub-prime mortgage markets that triggered the global financial crisis of 2007-2008. However, most central banks perceive the use of cryptocurrencies for payments to be trivial or limited to niche groups and not widely used in critical financial services (including payments) on which the real economy depends. Besides, the different incidences of price volatility in cryptocurrency markets have, so far, been contained within crypto-asset markets and have not spilled over to other financial markets and infrastructures.

This report—which is based on the notes and commentaries shared by the participants of the workshop “Cryptos: Distinguishing Hype and Realities in Islamic Finance”, held at SOAS, University of London on 16th June 2022—discusses the above-mentioned topic in some detail. Although the full commentaries are extremely valuable and beneficial, this ‘summary of commentaries’ aims to discuss the most crucial concerns regarding cryptos that the world faces today. The report gives some insights regarding the crypto-asset industry and sheds light on some legal and sharīʿah issues that can arise in cryptocurrencies. To serve this purpose, this report is a brief compilation, with selective editing, of the notes and commentaries shared by individuals prior to the workshop. A list of contributors is placed at the end of this report.

The report is divided into four sections: the first section provides an overview of cryptocurrencies and the relationship between Islamic finance and crypto assets. The second section discusses the legal and technical issues in cryptocurrency, while the third section deliberates stable coins and central bank digital currencies (CBDCs). The fourth section reports the sharīʿah ruling on cryptocurrencies and the way forward.

Cryptocurrencies: An Overview

Crypto assets and cryptocurrencies are becoming an increasingly pervasive aspect of financial activity. They are considered an innovative virtual form of money that is different from a traditional form of money. Crypto assets can be classified into three types: cryptocurrencies, or payment/exchange tokens, that are used as a means of value exchange; utility tokens that grants access to a digital product, service or platform; and security tokens representing an investment instrument.

One of the most significant characteristics of cryptocurrencies such as Bitcoin is decentralisation, which means that no government or private entity supervises their issuance. Likewise, cryptocurrencies are characterized by being encrypted and having no tangible physical existence or presence. Transactions involving them might entail trading between parties without intermediaries, which is known as a peer-to-peer system. Most cryptocurrencies exist and function on blockchain technology. Blockchain is a decentralized digital ledger technology which operates without the need for a central authority or third party. More specifically, blockchain is a computer protocol that tracks and records data using a distributed digital ledger system. The importance of this technology is evident in the fact that it allows many participants of the same network (the so-called nodes) to store and verify information/data on a single shared ledger so that everyone can see the same data.

Unlike fiat currencies, no central public authority issues cryptocurrencies, and their quantity and value are beyond the purview and control of the state. Instead, they are based on the interactions of decentralised actors and on technologies such as cryptography, which ensures their security, and blockchain, which prevents counterfeit and fraud.

Cryptocurrencies need to be distinguished from digital or electronic currencies, known also as electronic money (e-money). While the latter is an electronic representation of existing fiat currency, the former is an alternative currency that is supported by cryptography and blockchain. In other words, e-money is issued through authorized financial institutions and represents the nominal value of banknotes in a different form, whereas cryptocurrencies can be issued by anonymous individuals or groups that are independent of the state’s authority. The Sharīʿa Advisory Council (SAC) of Bank Negara Malaysia at its 201st meeting and 26th special meeting on 29 January and 30 January 2020 has made a ruling that: “electronic money (e-money) is a permissible payment instrument under sharīʿa, provided that the e-money is structured based on appropriate sharīʿa contract(s) to preserve the rights and obligations of the contracting parties".

It is worth noting that transactions in crypto assets would not have taken off unless there were perceived advantages over other tradable assets. Their success was due to clever exploitation of new technologies which had clear advantages over the traditional bundled assets in financial portfolios. The aim of the instigators was not to replace managed funds but, rather, to propose digital alternatives that had much lower transaction costs. In other words, crypto assets are not quoted in national currencies but in their own unit of account everywhere; thus, the need for exchange rate transfers is eliminated. The second advantage is that data from crypto transactions, including orders and transaction notifications, are encrypted. This converts the original information into ciphertext which only authorised users can read. As a result, the scope for fraudulent activities is drastically reduced. In addition, a third safeguard, blockchain, prevents unwanted entry or access. This refers to a global network of computers which possess all the data or transactions pertaining to a particular block. In other words, because full records have been retained, any abuse of the system by unauthorised parties can be quickly traced and appropriate action taken. This ensures transaction security with electronic records always available.

Islamic Finance and Crypto Assets

Islamic finance and crypto assets have little in common. To elaborate, Islamic finance involves risk sharing, the aim being to encourage and facilitate social assistance with a stress on mutual endeavour. Islamic finance is socially centred, whereas the placement of crypto funds is self-centred, with each investor on their own. Ironically, despite the goal being to reduce risk, crypto is much more risky than Islamic finance. Risk avoidance and mitigating risk are standard features of Islamic finance, often through teamwork. In contrast with crypto assets there is no collective endeavour; rather, there is concern that rivals could damage one’s own financial returns and business prospects.

Islamic finance offers a wide range of products, catering for both families and investment in small and medium-sized enterprises (SMEs). Most Islamic finance is provided by Islamic banks, which although sharīʿah compliant, is organised on the basic model of conventional banks. In contrast, crypto assets are usually acquired through exchanges, which have more in common with stock or commodity exchanges.

Islamic financial institutions make considerable efforts to build client relationships which can last over decades. In contrast, the buying and selling of crypto assets is largely transactional, with clients searching for the best bargains. There is no loyalty to a particular exchange; these only cater for transaction orders and do not provide client advice

In Islamic finance, investors take an interest in how and where their funds are invested. The how refers to the investment vehicle such as an Islamic equity fund or a sukuk, which is similar to a bond in its fixed-income nature but links to a specified asset. Such disclosure is helpful to investors seeking to share risk. In contrast, purchasers of crypto assets have little interest in what the assets represent and what is actually being financed. The assets may be designated currencies, whose price reflects macroeconomic conditions but not company-level microeconomic data. Such investments are not viewed as productive, the main gain being the liquidity provided to the market for the assets. It should be stressed that there is no inherent immorality in cryptocurrencies; rather, the concern is with high-risk practices in very speculative markets. Speculation is the driver, and it becomes the dominant market force.

Legal and Technical Issues in Cryptocurrency

The basic premise that cryptocurrencies are money can be questioned. While cryptocurrencies such as Bitcoin can be used for transactions, their general use in the wider economy is very limited. A key feature of cryptocurrencies is the high volatility of their prices, which makes it difficult to use them to store value and to measure the value of other things. Given the price volatility and relatively higher transactions costs relative to fiat currencies, cryptocurrencies fail to perform the functions of money, which are: unit of account, medium of exchange, and store of value. There are several legal and technical issues involved in dealing with cryptocurrencies. The most important of them are:

      Hacks and Cybersecurity Issues: The virtual system is still prone to attack and the possibility of tampering. Hacking and cybersecurity threats are not new to the digital world; however, their occurrence may be more frequent in the crypto space because this space is still in its infancy. Consequently, the use of cryptocurrencies (e.g., Bitcoin) as an alternative to the existing monetary system may not be secure as they are not asset backed.

      Legal Risk: Most cryptocurrencies are not considered as legal tender that an authority like a government supervises the issuance of. Without legal recognition of cryptocurrencies and the patronage of official authorities, they will be exposed to the harsh volatility of market price fluctuations.

      Tax Evasion Risk: The exchange of goods and services through virtual platforms using Bitcoin make it susceptible to the risk of tax evasion as there is no room for oversight by the relevant authority.

      Consumer Risk: The decentralized nature of cryptocurrencies and the instability of the market price may harm the consumer. Cryptocurrencies’ high volatility makes trading in them highly risky, rendering investments in them a gambling-like business, which raises a sharīʿah issue. The high fluctuation of market value can result in cryptocurrencies losing purchasing power and, thus, exposes consumers to the inability to retain the value of money and store wealth.

      Black Market and Illegal Transactions: The crypto-asset industry is one of the largest unregulated markets in the world. Some research finds that, as of 2018, approximately one-quarter of users were involved in illegal activities in this space.

      Market Competition for Islamic Finance: As a P2P decentralized system, crypto assets have posed a challenge to financial intermediaries. Should Islamic financial institutions consider this seriously? Many large banks have already started offering crypto products and related services to their clients, realising that they cannot win the war against it. How should Islamic banks seize this opportunity and remain competitive? What would be the ultimate economic impact of this phenomenon on the OIC countries?

      Regulatory Risk: The absence of effective supervision and regulatory frameworks can create regulatory arbitrage and curtail enforcement. Changing the Bitcoin protocols requires consensus among miners rather than a monetary authority that makes policy.

      Electricity Consumption and Environmental Impact: The cryptocurrency mining industry has serious environmental ramifications due to the energy- intensive process through which coins are created. Cryptocurrencies require large amounts of energy—more than is used by entire countries in order to perform the computations associated with crypto mining.2

      Sharīʿah Screening Criteria: Since there are various types of crypto assets, screening crypto assets for sharīʿah compliance before investing is essential. In fact, cryptocurrencies still do not possess the necessary sharīʿah characteristics of a valid currency, and the high risks associated with their trading give them a gambling nature. It is only if those issues are resolved that the sharīʿah may recognize them as valid currencies, similar to what fiqh scholars did for paper (fiat) money.

Stablecoins and Central Bank Digital Currencies (CBDCs)

As discussed above, cryptocurrencies are characterized by high price volatility, which makes them incapable of performing the three functions of money. Although the aggregate market value of cryptocurrencies now exceeds USD 2 trillion, extreme price volatility, strong price correlation to Bitcoin, and often slow transaction confirmation times have impeded their utility as a practical means of value exchange. Consequently, stablecoins have been introduced as an attempt to overcome the volatility problem and to address these shortcomings by pegging their value to a unit of an underlying asset, often issued on blockchains, and backing the coins wholly or partially with state-issued tender (such as the dollar, pound, or euro), highly liquid reserves (like government treasuries), or commodities such as precious metals.

It worth mentioning that the Bank for International Settlements (BIS) conducted a survey in which central banks were asked about their perception of the future potential of different types of stablecoin. The finding of the survey shows that stablecoins pegged to and backed by a single currency are perceived as having the highest potential to become a widely accepted and used method of payment. Some stablecoins are fully backed by legal-tender money to which they are pegged, whereas others are only partially or fractionally backed by legal-tender money or equivalent liquid assets. To demonstrate, there are two competing forms of private stablecoins: stable coins backed by a reserve pool of assets, and algorithmic stablecoins. In a reserve dollar stablecoin, the dollar proceeds from a newly-issued stablecoin are used to purchase an equivalent value of high-quality, short-term, liquid dollar-denominated assets held by the stablecoin sponsor as a “reserve.” There are also private dollar- linked stablecoins that hold cryptocurrencies as their reserve assets. These stablecoins need to maintain a reserve pool of cryptocurrencies that have a greater market value than the dollar value of stablecoins sold. Over-collateralisation of the reserve pool is necessary because cryptocurrencies like Bitcoin have a dollar value that fluctuates daily, sometimes by large amounts. It is presumed that a stablecoin fully backed by cash and short-term treasury securities should be immune from run risk as long as treasury securities retain their safe-asset status. Stablecoins will address problems related to plain vanilla cryptocurrencies such as volatility, lack of government supervision, and authorisation as legal tender.

It should be noted that some of the efforts to create CBDCs3 have been born out of reservations about the impact of privately issued stablecoins on financial stability and traditional monetary policy, and with the goal of improving access to central bank money for private citizens, creating greater financial inclusion and reducing payments inefficiency. Thus, many see the current development of CBDCs as a response to the challenge private sector stablecoins could pose to central bank prerogatives, and as evidence of the desire of institutions to address long-term goals such as payment system efficiency and financial inclusion.

Overall, private stablecoins cannot serve as the basis for a sound monetary system. There may yet be meaningful specific-use cases for stablecoins. But to remain credible, they need to be heavily regulated and supervised. They need to build on the foundations and trust provided by existing central banks, and thus to be part of the existing financial system. Moreover, if digital currencies are needed, central banks should be the ones to issue them. It is a new form of money and how it could improve retail payments in the digital area should be in line with central bank mandates.

Major central banks across the world are exploring the possibility of delivering a credible version of a central bank digital currency. However, there is a wide acknowledgement that the full realisation of such a digital currency will take time. Thus, according to the US Secretary of the Treasury Janet L. Yellen, “CBDC would likely present a major design and engineering challenge that would require years of development, not months”.4 On a similar note, one member of the Executive Board of the European Central Bank (ECB) noted that “the bank launched in October 2021 a two-year investigation phase to define the design features of the digital currency, and it is projected that by the end of 2023 the bank could decide to start a realisation phase to develop and test the appropriate technical solutions and business arrangements necessary to provide a digital euro, which could take three years. Only thereafter the bank will decide whether to actually issue a digital euro.”5

Cryptocurrency from a Sharīʿah Perspective

A number of fatwas have been issued by Islamic scholars around the world on the legality of cryptocurrencies from a sharīʿa point of view. Many sharīʿa scholars claimed that cryptocurrencies such as Bitcoin (BTC) are not acceptable as a medium of exchange and are banned under Islamic law, as declared by a number of countries.

For example, the Indonesian National Council of Sharīʿa Scholars (MUI) issued a fatwa banning all cryptos based on the fact that there is the element of uncertainty, speculation, and potential harm to the society. The Religious and Charity Institution in the United Arab Emirates issued a fatwa about cryptocurrencies and stated that, cryptocurrencies are not permissible (ḥarām) because they are not accepted and recognised by states and international authorities as money.

Shawky Ibrahim Allam, the Grand Mufti of Egypt´s Dār al-Iftāʾ, stated that all uses of cryptocurrencies, including trading, buying, selling, and leasing are religiously prohibited (ḥarām) because of their negative effects on the economy, disruption of the market equilibrium and the concept of work, and the lack of required legal protections and financial oversight for traders. The Grand Mufti also concluded that cryptocurrencies infringe on the rights of those in authority, dispossessing them of their special prerogatives in this domain, and may give rise to damages from uncertainty, ignorance, and fraud in novel banking processes, standards, and values. Likewise, the General Authority of Islamic Affairs and Endowments in Egypt issued a Fatwa on Bitcoin and Other Digital Cryptocurrencies. The fatwa declared that ‘A currency is not legitimate and legal unless it meets the following criteria: that it is issued by the state and enjoys guarantee and protection of the law to reassure people, when dealing with them, to guarantee their rights, and fulfil their obligations’.

The Syrian Islamic Council has also issued a fatwa asserting that the use of cryptocurrencies is inherently high-risk, as their digital-only format renders them susceptible to loss in the event of technical malfunction or hacking. The ambiguity of cryptocurrency production, as well as the lack of reference points for the evaluation of cryptocurrency in trading and pricing prevents any authority or regulatory body from controlling market liquidity. Furthermore, their decentralisation and the lack of regulation regarding their circulation means they can be used for money laundering and other illegal activities.6

Likewise, prominent scholars in Islamic economics and finance such as Ali Muhyudin Al-Quradaghi mentioned that supervisory authorities in most countries either prohibit dealing with electronic currency or have not adopted it. He has issued a fatwa that cryptocurrencies such as Bitcoin are prohibited because they are not issued as a legal tender and do not fulfil the function of money.

On the other hand, other fatwas do not declare cryptocurrencies as impermissible, but mainly cautioned against their volatile nature. For instance, Turkey’s highest council of religious authority – the Directorate of Religious Affairs, also known as the Diyanet – declared that buying and selling of digital currencies is at odds with religion due to their lack of regulation and close connection to criminal activities.

In its 24th symposium, the Council of the International Islamic Fiqh Academy of the Organization of Islamic Cooperation stated that the legal ruling on cryptocurrency needs more examination and research to understand its nature and whether these currencies are commodities or usufruct (manfaʿah).

In Malaysia, the Sharīʿa Advisory Council of Malaysia’s Securities Commission (SC) has advised that it is permissible, in principle, to invest and trade cryptocurrencies and tokens on registered and approved digital asset exchanges or cryptocurrency exchanges.7 So far, four cryptocurrency exchanges have been approved: Luno Malaysia, Sinegy Technologies, MX Global Sdn Bhd., and Tokenize Technology.8 The Securities Commission Malaysia (SC) has issued the Guidelines on Digital Assets pursuant to section 377 of the Capital Markets and Services Act 2007. The guidelines set out the requirements that all offerings of digital tokens be carried out through an initial exchange offering (IEO) platform operator registered with the SC.

The Way Forward: Conditions to Accept Crypto Currencies

Cryptocurrencies should be evaluated by considering their advantages and harms. In other words, evaluating all cryptocurrencies using just Bitcoin will lead to incorrect judgments as the characteristics of each crypto are different. Cryptocurrencies should not be denied as a whole, and the technological developments should not be neglected. The sharīʿa principle with regards to business transactions (muaʿāmalat) is that every transaction is permissible except when there is a clear text which prohibits it. The permissibility principle provides flexibility regarding new practices in business and financial transactions. Thus, all innovations in muʿāmalat are considered permissible and welcomed unless there is clear evidence from the primary or secondary sources of sharīʿa to the contrary. Having said that, a number of conditions must be met to accept cryptocurrencies. This includes:

 The presence of supervisory bodies that supervise the issuance of a cryptocurrencies and guarantee their value, stability and purchasing power. An example of this is the existence of a coinage house in the history of Islam to convert gold and silver into dinars and dirhams, which indicates that the issuance of currency is one of the state’s responsibilities. In this regard, the initiative taken by the SC of Malaysia which allows investment and trade in digital currencies and tokens on registered digital asset exchanges is worth assessing. This is also similar to the notion of issuing digital currencies by the central banks which is known as central bank digital currencies (CBDC). The key innovation with CBDC is the potential for non-banks (individuals and firms) to hold direct accounts with the central banks or to transact directly with one another using the CBDC as a legal tender. This has been made possible by the technology used in private digital currencies, namely the distributed ledger technology (DLT).

 Crypto should have the function of money or currency that is generally accepted as a medium of exchange, a unit of account, and a store of value in an economy. In other words, crypto must have an intrinsic value as in dirhams or in dinars, or a nominal value granted by central banks or other monetary authorities. To achieve that, cryptocurrencies should be backed by real financial assets such as currency backed by any type of assets or services. The unpredictable price swings of most cryptos discourages many investors from taking part in the market. Asset-backed cryptos will avoid high price volatility and bring the stability that is distinctly lacking in the current crypto market. Therefore, investors will have the chance to invest in digital currency without having to deal with the uncertainty (gharar) of market changes.

 From a sharīʿa perspective, a currency whose value is technical and not intrinsic has to be properly backed by real valuable assets or be supervised by a trustworthy financial authority, in order to protect people dealing in it from possible fraud and excessive fluctuations in its value. Cryptocurrencies which are not backed by any type of assets or services should not be used as an instrument of investment or speculation. This is to preserve people’s rights and assets, which would be safeguarded with the existence of a solid legal and regulatory framework.

 Nonetheless, asset-backed tokens have suffered from fraud and lack of regulatory enforcement. Authorities should clearly take more stringent action to enforce their rules on asset and security tokens. A challenge in doing so is that those tokens are issued cross-border while authorities still have a strong local focus, making them rather ineffective to act.

 Robust and comprehensive regulatory frameworks should be developed to ensure the operation of crypto is in total compliance with sharīʿa, minimize sharīʿa non-compliance risk to firms and individuals who utilize it, and minimize dispute and conflict. In addition, regulatory frameworks must also be developed that address consumer protection and market conduct issues as well as the iconological impact on the orderly functioning of financial markets. Such frameworks should promote benefits (maṣlaḥah) to the general public. According to an IMF report ‘a sound regulatory framework for crypto assets, and decentralized finance markets more generally, must be a priority on the global policy agenda. This is particularly pressing for stablecoins, for which some business models have been subject to the risk of sudden and severe liquidity pressures. A regulatory level playing field is a key priority.’

 Most projects regarding CBDC are in their early stages and the sharīʿa position regarding CBDC is yet to be determined. However, Islamic financial institutions and finance support institutions such AAOIFI, the IFSB, the Islamic Fiqh Academy and the IsDB Institute are urged to work closely with central banks and be part of the change.