Understanding the inherent limitations of crypto finance in the Islamic finance context

Abstract

The Islamic finance industry has demonstrated its ability to grow steadily and secure a strong foothold on the international financial scene. Financial technologies (fintechs) are becoming an integrated part of the financial industry at large, and therefore, Islamic finance needs to adapt and benefit from these advanced digital technologies. The adoption of fintechs by the Islamic finance industry should be guided by the established principles of Islamic law in order for the industry to preserve its identity. The use of fintechs associated with the ‘fourth industrial revolution’ can be broadly classified into three main categories: automation, disintermediation and decentralization. The use of automation and disintermediation by the Islamic finance industry does not pose any challenge to the established principles of Islamic law; it even has the potential of promoting the compliance with these principles. The technologies associated with decentralization are the most challenging to use in the context of Islamic finance. Some of the identifying characteristics of cryptocurrencies and cryptoassets are inherently incompatible with some of the established principles of Islamic law. Therefore, the Islamic finance industry should err on the side of caution when it comes to utilizing these advanced digital technologies. The Islamic finance industry dates back to the early 1970s, which makes it relatively young compared to its conventional counterpart. However, the rate of growth in terms of its assets and markets’ reach demonstrates a noticeable success story. On the one hand, it is estimated that the industry is currently worth $2.2 trillion1 with an expected continuous growth rate in 2022–2023 of about 10 per cent.2 Although in 2020 the global financial market suffered from the double shock of the Covid pandemic and the drop in oil prices, the industry grew rapidly that year albeit at a slower rate compared to 2019.3 This expansion continued throughout the year of 2021 with the rate of growth in total assets reaching 10.5 per cent.4 On the other hand, Islamic finance products are now available in all major international financial centres outside the Islamic world. The industry offers a wide range of financial products that utilizes equity- and debt-based techniques to offer financial alternatives that comply with the teachings of Islam. A prime example of its international appeal is the UK Government sovereign Sukuk al-ijara, worth £200 million, issued in 2014 and matured on 22nd July 2019. Given the success of the first issue, the UK government issued a second sovereignty Sukuk al-ijara on 25 March 2021 worth £500 million with 5 years maturity.5 Since the inception of the industry there has been a dominant trend in its business model, namely the emulation of conventional finance instruments with certain twists. It can be suggested that at the beginning the industry needed to relate to the existing market practices, which are primarily driven by debt instruments. Therefore, the Islamic finance industry relied heavily on more debt-based products rather than equity while attempting to ensure a margin of risk sharing—concerning the potential profits and possible losses as well—to maintain its compliance with the principles of Islamic law. As time moved on and Islamic finance is no longer an alien concept, the industry has not moved on from this format towards more equity-based instruments.6 This would mean more genuine profit–loss sharing among participants, especially those who are providing the capital, in business ventures. Accordingly, the industry has come under heavy criticism for lacking compliance with the spirit of the Islamic doctrines on finance. This was expressed in some of the academic writing7 and by some members of the industry. In 2007, the chairman of the board of Islamic (Sharia) scholars at the Accounting and Auditing Organization for Islamic Financial Institutions, Sheikh Muhammad Taqi Usmani, criticized some of the sukuk structures in the market, sukuk murahaba and mudaraba, for non-sharia compliance. Another example of the problematic use of debt-based instruments in Islamic finance is the saga of Dana gas sukuk, issued in 2007 using murabaha structure (ie debt based) and were declared by the issuer in 2017 as non-Sharia compliant.8 The digital technological advancements, connected to the so-called ‘fourth industrial revolution’,9 brought some new changes to how the financial industry operates its business and interacts with its client base. The term financial technology ‘fintech’ is used to summarize a range of computer-based digital innovations that have been used to utilize financial transactions and services through untraditional means and formats. Fintech has, to an extent, influenced the operations of the global financial industry most apparently in the wake of the 2008 global financial crisis. The Islamic finance industry has already explored aspects of fintech that would broaden its offering and improve its accessibility. However, it is fair to suggest that although the Islamic finance industry has come a long way on the path of standardization,10 the industry has not yet fully addressed some of the major uncertainties concerning the Sharia compliance of a range of its products. With this in mind, there seems to be a worrying trend in the industry that advocates venturing into new fintech territories that are riddled with controversies and uncertainties, namely crypto finance. This article demonstrates that the characteristics of some of the crypto finance products, namely cryptocurrency and cryptoassets, are inherently incompatible with the fundamentals of Islamic law and its finance theory. Therefore, a more cautious approach to engaging with these technologies is needed; otherwise, the industry may further risk undermining its Islamic characteristic that is central to its existence. This article is structured as follows: Section 2 examines the main categories of the advanced digital technologies (automation, disintermediation and decentralization) associated with the so-called ‘fourth industrial revolution’ and maps out their application in the context of Islamic finance; Section 3 provides an overview of Islamic law and demonstrates its inherent incompatibility with two of the decentralization products namely cryptocurrencies and cryptoassets; Section 4 reflects on the future of fintechs in the context of Islamic finance and argues that solutions could be found to address some of the issues identified as Islamically problematic regarding the use of cryptoassets as token to raise equity finance (Initial Coin Offering). For many decades, technology and the traditional financial sector have had a fruitful partnership, which allowed the latter to broaden its reach, improve its services and obtain significant financial rewards along the line. From ATMs and card payment systems to online banking, these technological advances have served well the financial sector and its customers. However, since 2008 there has been a new breed of fintechs that are not all designed to work in partnership with the traditional financial sector, rather some are more designed to challenge and disrupt the sector’s existing business models.11 The use of this new breed of digital technologies can be broadly classified into three main categories: automation, disintermediation and decentralization.12 The technological advancement in automation, namely artificial intelligence (AI) and big data analytics, is owed to the advanced computer processing powers that can analyse large sets of data using complicated algorithms to generate insights and predictions, which inform and drive business decisions.13 The application in the financial context means that established financial institutions, alongside their new start-ups competitors, are using these technologies for making investment and lending decisions at the wholesale and retail levels.14 Further, these technologies are being further developed and used to ensure institutional compliance with regulatory requirements for money laundering, fraud and illicit transactions detection.15 As for disintermediation, the premise is the use of new digital technologies to reduce the reliance on intermediaries for financing and other services. Peer to peer (P2P) finance is a prime example; the creation of a web-based platform that connects businesses with investors directly has challenged the conventional business model that required a financial institution to make the link. The use of this finance model is not exclusive to businesses but it is also utilized for credit consumers. Another example is open banking, which means the sharing of consumers’ financial data, after they consent, with trusted third-party providers (TPPs) in order to tailor services and applications to serve their best financial interests and accommodate for their financial circumstance.16 This, for example, includes applications and websites that provide automatic saving options and budgeting tips.17 Open banking also facilitates online payments in a quicker, easier and more secured way,18 as once the payment is initiated the online retailer website will connect the customer to their banking app to authenticate the payment without the use of a debit card.19 Similar to other segments of the global financial sector, the Islamic finance industry has been influenced by these digital technological advances, and Islamic fintech is a growing part of this industry with great potential. 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