Prospect of Cryptocurrencies in Islamic Finance (as published in the Jakarta Post on February 24, 2020)
Prospect of Cryptocurrencies in Islamic Finance
By Emir Hrnjic and Nikodem Tomczak
In May of this year a mosque in London announced it would begin to accept donations in cryptocurrency form.
Although many were skeptical, the mosque received four times more donations in cryptocurrency during the month of Ramadan than in traditional cash.
Even before the mosque’s experiment, debate has been raging about the permissibility of cryptocurrencies under Islamic law as religious scholars deliberate the issue of sharia compliance.
Some religious scholars in Egypt, Turkey, and India for example have directly opposed the use of cryptocurrencies citing various issues such as their use in illegal activities, widespread speculation and price volatility. Others, however, have declared bitcoin sharia compliant, paving the way for Islamic institutions to start accepting cryptocurrencies.
Considering that the worldwide Islamic finance market recently surpassed U$2 trillion, the issue of sharia compliance has huge economic significance. Muslims make up almost a quarter of the world’s population and Muslim countries account for approximately 10 percent of global GDP.
To comply with sharia, financial products should avoid interest, speculation, and excessive uncertainty. They should also be ethical and underlying contracts should be transparent, whilst Islamic financial instruments should be backed by real economic activity or a physical asset.
Against these benchmarks, concerns have been raised about widespread speculation and the extreme price volatility of cryptocurrencies. Furthermore the majority of cryptocurrencies have no underlying economic activity or physical asset.
However, taken to an extreme, strict interpretations of Islamic finance disapprove even of traditional fiat currencies – especially so after the gold standard was abandoned in 1971 and money lost its “real” value.
As a solution, some have argued for the creation of Islamic gold dinar and Islamic silver dirham currencies, backed by gold and silver, saying that such a system would alleviate several problems of modern economies such as inflation and recurring financial crises.
Whilst the ambiguity about sharia compliance has kept many devout Muslims on the sidelines, companies across the Islamic world have started incorporating blockchain and cryptocurrencies into their business models.
Among ASEAN countries, Malaysian government formed partnership with Hong Kong’s iSunOne which specializes in digital banking services to develop the blockchain–based Islamic financial network and to establish a blockchain–based Islamic bank.
In Indonesia, Blossom Finance offers Smart Sukuk Tokens which represent an ownership in the sukuk used in funding microfinance projects. The platform is able to reduce the cost of sukuk issuance by automating much of the legal, accounting, and payment cost.
Meanwhile in the Middle East, a crypto token for money transfers received sharia certification from an advisory agency licensed by the Bahrain’s central bank, while Saudi Arabia’s monetary authority signed a partnership with blockchain firm Ripple to use the company’s platform for cross-border payment settlements. In April, Saudi British Bank (SABB) launched an instant cross-border transfer service based on Ripple’s blockchain technology.
One crypto solution that seems tailor-made for sharia compliance is stablecoin – a cryptocurrency backed by a stable commodity such as gold or silver.
Since the concepts of the Islamic gold dinar and Islamic silver dirham represent ideals of Islamic finance, a stablecoin backed by gold or silver provides an opportunity for an emergence of a “digital Islamic gold dinar” or “digital Islamic silver dirham.”
The market value of a stablecoin theoretically equals the value of its underlying collateral deposited in a crypto company’s bank account. Hence, a stablecoin should have a stable value regardless of the ups and downs of the rest of the crypto market. This should avoid excessive volatility fueled by speculation and market manipulation, although of course gold and silver are not completely immune from these.
Recently, a stablecoin issued by a Swiss firm and backed by a basket of eight fiat currencies and gold received sharia certification from a leading consultancy and audit firm in Bahrain.
However, a concern for collateralized coins is that they require intermediaries including the token issuer guaranteeing redeemability of the stablecoin and the banks safekeeping of the collateral. In this case credibility of an authenticator of the commodity held in reserves would be an issue. Furthermore, the presence of intermediaries renders such schemes effectively centralized, and as a result subject to a single point of failure.
Along with their impact on Islamic finance, truly resilient stablecoins would profoundly impact the cryptocurrency world in various ways. For example, enabling crypto-based loans with significantly reduced volatility risk would make a large impact on lending and borrowing markets. Moreover, stablecoins could be used for payments, remittances, salaries and many other purposes.
If stablecoins prove resilient, they will unlock the blockchain potential to its fullest with the potential to even rival bitcoin as they become a truly global medium of exchange.
Islamic investors and entrepreneurs are increasingly aware of the seemingly endless opportunities.
While the debate over the permissibility of cryptocurrencies is still ongoing among Muslim scholars, governments must decide whether to back cryptocurrencies or risk being ostracized from the new economies.
Furthermore, central banks in Muslim countries should embrace opportunities offered by the growing importance of cryptocurrencies.
In that spirit, development of stablecoins backed by gold or silver will revitalize a “digital Islamic gold dinar” or “digital Islamic silver dirham” providing a tailor-made solution for sharia compliant cryptocurrencies.
Marrying the cryptocurrencies with key principles of Islamic finance may finally bring the needed stability and scale to Islamic finance.
Beware of Risks in Blockchain–Based Smart Contracts (as published in South China Morning Post on November 16, 2019)
Beware of Risks in Blockchain–Based Smart Contracts
By Emir Hrnjic and Nikodem Tomczak
Among the many technological advances enabled by blockchain technology, such as the emergence of cryptocurrencies, smart contracts have attracted significant attention due to their potential transformative power in business and finance.
Digital contracts, much like traditional contracts, outline the terms of an agreement between two or more parties but the terms are in the form of computer code residing and executed on a blockchain. The “smart” aspect of these contracts comes supposedly from their ability to automatically enforce and execute the contract provisions on the blockchain when preset conditions are met.
The self-verifying, self-executing and self-enforcing nature of smart contracts removes the need for any central authority or intermediaries for the contract execution, drastically reducing the cost of doing business.
Transacting parties can easily audit the smart contract code, while the blockchain technology theoretically provides a tamper–proof record of the contract code and of every transaction executed by that code, minimizing risk and greatly improving transparency and accountability.
However, these contracts are arguably neither “smart” nor “contracts.”
The code describing the contract provisions is not necessarily legally binding.
For its obligations to be legally enforceable the transacting parties may also need real-world legal agreements to facilitate the resolution of potential disputes that would arise from human-made errors in the smart contract code.
Appropriate legislation needs to be passed to recognize the legal effect of smart contracts when conducting electronic business transactions. To this end, many jurisdictions have recently passed relevant bills recognizing the legal effects of smart contracts, helping to pave the way for their wider acceptance.
Smart contracts have widely proliferated on different blockchain platforms and currently underpin the emerging decentralized finance sector that facilitates funding and servicing of loans, digital securities trading, as well as initial coin offerings.
Furthermore, they are poised to transform businesses by drastically cutting overhead costs, increasing efficiency by automating many business tasks, and accelerating financial transactions by reducing the likelihood of disputes.
However, smart contracts are relatively new, and to achieve wider adoption, some key hurdles need to be overcome.
Since a smart contract is as good as the underlying computer code, vulnerabilities and hacking that would result in loss of funds are major concerns that may force potential adopters to stay on the sidelines.
In one infamous example of smart contract vulnerability, a weakness in the smart contracts code underpinning a blockchain-enabled venture capital fund, caused a loss of 3.6 million Ether (the equivalent of roughly US$50 million at the time) in 2016.
The recovery of the funds came at a major reputational cost to the blockchain security and governance.
Despite regulatory efforts around the world, unscrupulous developers remain a danger to the industry, while the legal uncertainties of conducting business on blockchain platforms across different jurisdiction significantly increase the risk.
Before smart contracts achieve wider adoption, the code vulnerabilities and the legal frameworks need to be properly addressed. In the meantime, entrepreneurs should figure out what role smart contracts can play in defining the future of their business and factor in the risks involved.
Blockchain path to more inclusive world