In the first and second blogs dedicated to the subject of Islamic Decentralized Finance (DeFi) we attempted to trace the trajectory of what we know as mainstream Islamic finance. We discussed the entire range of adoptions and adaptations of classical contracts adding up to constitute the Islamic financial system. With the benefit of hindsight, we attempted to analyze why some of these served the purpose, while some did not and indeed, created new problems. We hoped that Islamic DeFi would provide better and purer solutions with the use of emerging technologies. One such solution is the digital currency that should serve the four functions of money more efficiently. In the third and fourth blogs we discussed digital currencies from the perspective of Shariah; why or why not the fiqhi rulings relating to currency exchange should apply to their digital versions. This catapulted to the centerstage the issues of illegitimate and unearned earnings from various forms of riba and from zero-sum games under conditions of uncertainty or forms of maysir and qimar, lack of adequate information (jahl) and of accurate information, or fraud and deceit (gharar). The two causal factors or determinants were identified as “deferment” and “complexity” in the transactions.
A token may serve as a digital currency and must follow the Shariah rules of bai-sarf and regulatory prescriptions of the central bank of a country. A token may be a security token and must follow the relevant Shariah rules and the regulatory requirements of the capital markets authority of a country.
The last blog also put the spotlight on the issue of token types, tokenomics and valuation of tokens. The key factor underlying the XRP story was the difference in the way it was classified by its issuer (Ripple) and the regulator (SEC). There still exists a lot of ambiguity about digital assets, currencies and tokens. So we begin with a quick classification scheme. A token is the most generic description. It may represent value, stake, part-ownership, in voting right, or anything (such as, right to use a parking space). Technically speaking, a token has come to be known as something designed to support a specific use case of distributed ledger technology. A token is not limited to one particular role; it can fulfil a lot of roles in its native ecosystem. Tokens typically exist on top of an existing smart contract platform.
A token may serve as a digital currency – as a medium of exchange – such as, bitcoin. As a currency it must follow the Shariah rules of bai-sarf and regulatory prescriptions of the central bank of a country. A token may be the digital version of a financial security or asset or a security token. In this form, it must follow the Shariah rules relating to various types of sukuk (debt-based or lease-based or asset-based etc.), and the regulatory requirements of the capital markets authority of a country. A token may be a utility token that is simply something of value. It derives its value from providing holders with access to a product or service. Utility tokens give holders no ownership in a company’s platform or assets (unlike a security token). Although they might be traded between holders, they are not primarily used as a medium of exchange (unlike a digital currency).
Since utility tokens apparently fall outside the regulatory domains of the central bank and the capital market authority, these have emerged as the popular choices of issuers. The tug-of-war between the issuer and the regulator has led to application of what is now called the Howey Test according to which, a transaction is considered a security if it meets the following criteria:
- It is an investment of money.
- The investment is in a common enterprise.
- There is an expectation of profit from the work of the promoters or the third party.
A token that passes the Howey Test is treated as a security token. A security token is also different from a tokenized security. Security tokens are newly issued securities that function on distributed ledger while tokenized securities (and more generally, tokenized assets) are just token or digital representations of already existing financial products (and real products, such as livestock). It is the security token or the new financial product with security features that is subjected to stringent capital market regulations.
A few points relating to the valuation of tokens should be noted, in continuation of the last blog before we proceed further. How should a security token be valued? Going back to basics again, our lessons learnt during Investments 101 classes should help. Security tokens should be valued like the securities. If they represent equity or part-ownership of an asset or a company, then the value of such tokens should depend on the expected cash flows from the company capitalized at a rate that includes a compensation for the risk associated with the flows. If a company is expected to generate huge volumes/revenues, earnings and cash flows, its value is high and vice versa. The converse is true in case of risk or volatility associated with the revenues, earnings and cash flows. However, did this happen in case of XRP? I reproduce some portions of a very interesting piece on Tokenomics that interestingly used the same example to make its points that we used earlier to discuss the gharar and jahl related dimensions of tokens.
Case of XRP, Again?
“Ripple Labs (i.e. the company behind the XRP token) has invented a blockchain-based protocol called Ripple Network which aims to replace the SWIFT protocol in bank to bank transfers. Ripple’s total addressable market is huge. Ripple Labs has already signed partnerships with over 100 financial institutions worldwide who pay it to use its Ripple Network service. In contrast, consider XRP. All the evidence seems to indicate that demand for the XRP token is extremely uncorrelated to demand for the Ripple protocol. XRP serves three main purposes: (1) it can be used as a bridge currency for banks to settle international transactions; (2) it is burned to pay for transaction fees; and (3) it is required as a small reserve for any address using the network. Of these, only (1) would provide any significant demand for XRP while the latter two serve primarily as anti-spam measures and long-term supply constraints. However, Ripple Labs doesn’t force banks to use XRP as a bridge currency and as a result almost none of them do as they use digital IOUs instead. In fact, some sources indicate that Ripple’s xRAPID system (the only one that uses the XRP token) currently only has one small user and one pilot. As a result, only (2) and (3) are left which provide minimal value to XRP. For (3), while each account is required to hold a small reserve, thus constraining supply and increasing the price of XRP, this reserve is too small a percentage of total supply. For (2), while some XRP is burned to pay for transaction fees, thus constraining supply and increasing the price of XRP, the current transaction fee is only 0.00001 XRP which means that only 10XRP tokens need to be destroyed if a bank wants to settle 1M transactions in a year. Once again, a tiny force to have any impact on supply and value. As a result, this is a clear case in which demand for the protocol (i.e. Ripple Network) is only very weakly correlated to demand for the XRP token. Whereas Ripple Labs may create immense value for its customers, almost none of this value seems to be captured by the XRP token”.
What are the lessons or take-aways from this story? It presents XRP as a utility token and not a security token (firmly contradicting the view of the regulator without being explicit about it). In the process, it threw up more interesting aspects of token valuation. Since a token represents utility or currency in the protocol, the value of a token must be linked to the value (supply and demand) of that protocol. While a security token similar to equity, should entitle its owner to ownership stake in the underlying protocol, a utility token simply entitles its owner to a certain utility in the protocol. The value of a utility token also depends on the degree of correlation between demand for the protocol and demand for the token itself and on how much of the value of the token is already captured by equity or the security token. Indeed, equities or security tokens and utility tokens effectively compete for the fixed amount of value created by a company, entity or protocol. Since they are both value capture mechanisms, a company that has valuable equity will necessarily have a less valuable token and vice versa.
Let us take the example of our very own IBFx token that is still in the drawing board stage. What would be the key drivers of value of IBFx, assuming it is designed as a security token and then as a utility token. First, let us focus on value created by the Network effect. There is a strong relationship between the size of the IBF network, the number of transactions on the network and the value of that network itself. This is captured in the Metcalfe’s Law that provides the theory underlying the said effect. Metcalfe’s law states the effect of a telecommunications network is proportional to the square of the number of connected users of the system (n^2). For example, if there are two telephones in a network, then one can only make one connection. If there are x phones, then one can make xC2 connections (if there are 10 phones in the network then one can make 45 connections). As the number of connections increase, there is an exponential growth in value. The value of IBF Network will increase exponentially with increase in its size, directly impacting the volume of transactions. IBFx may be designed as a security token that captures the full value of these transactions similar to an equity stake in the company itself. Alternatively, IBFx may be designed as a utility token that captures part of the value. For example, members holding the token may be entitled to a fifty percent discount in the courses offered by IBF Net, prices of articles, books and reports, costs of placing adverts and promotional material at its portal, entitled to conducting surveys and votes, and to access premium content and to other membership privileges.
Conflict of Interest?
An interesting possibility that may emerge is the inverse relationship between the values of these two token types. One can seek to increase the value of the utility token compared to equity or the security token. For instance, it can charge for many of its transactions (products and services) in fiat currency and use the cash to purchase tokens and burn them (thus reducing the supply of the token and putting upward pressure on the price), effectively transferring value from the equity to the token. Alternatively, it could charge for its services in the token, then sell that token on the market and distribute that money to shareholders in the form of dividends. This would lower the value of the token by increasing supply and putting downward pressure on price, effectively transferring value from the token to the equity. The key here is that given a limited amount of value created by a service, tokens and equity are competing to capture as much of that value as possible. As such, we can think of the token used on a protocol and the equity of the company developing the protocol as being inversely correlated, the more value is being captured by cash flows, the more the equity will be worth and the less the token will be worth, and vice versa.
Whether this is all ethical and acceptable from the Islamic point of view, is another question. Clearly, the actions involve a conflict of interest between types of stakeholders and should be transparently dealt with in a governance framework. Any action that involves unjust enrichment of one group of holders at the expense of other should be rightly frowned upon by the regulator. In the first blog in this series, we have discussed a possibility of raising capital (ICOs or IEOs) beyond what is required to create the assets and using a component only to play up the token prices in the aftermath is a clear case of unethical transfer of value from equity holders to token holders.
Build, Build and Build
Build, build and build. There is a growing realization that network building is ultimately the critical success factor for entrepreneurship in the digital business and finance space. This is where the interests of all stakeholders seem to converge. When the size of the pie grows, the share of all stakeholders in it should increase. A sustained growth in the size and effectiveness of the network often fueled by a conscious engagement with “influencers” is now a sine qua non for sustained value creation and sharing among all stakeholders.
Other than the issue of (mis)classification of tokens as security/utility tokens, the XRP case also throws up the issue of regulation. It appears from the discussion above that the last word is not out yet on whether XRP is to be treated as a utility or a security token. It does point out the possibility of an error of judgment by the regulator. It also does point at the possibility of emergence of private clubs – the private digital exchanges – that help unscrupulous agents to cheat the investor community, either to earn hefty fees, or have an alignment of interest (funding by same VCs) or other hidden purposes.
Decentralized but Regulated
Shariah favors open and free markets. In free markets, the forces of demand and supply should have a free play in the determination of prices. That Shariah proscribes any attempt by economic units to artificially reduce supply (ihtikar) or increase demand (najash sale) is well documented in Islamic economics literature. Prices and transactions would be deemed fair in a market free from the prohibited elements, when economic units self-regulate to remain within the bounds of the Shariah. Regulation by an external party or state agency would be deemed unnecessary, if all economic units act in a manner required by Shariah. This is an unrealistic scenario, however. An intervention by the regulator, a state agency is considered imperative where there is any deviation from the Shariah norms. Indeed, compared to the norms of conventional regulations, Shariah norms e.g. prohibition of riba, gharar, maysir, qimar, ghubn, rishwah, ihtikar etc. and their implications for the financial system are far more demanding. Shariah aims for a much higher level of ethical conduct in human affairs including in the financial markets.
I refuse to accept any equivalence between Islamic DeFi with open and unregulated finance. Conventional DeFi bats for complete anonymity with no role for any centralized body. This also rules out any role for a government agency as regulator. However, the idea of zero-regulation is alien to Shariah. It mandates a corrective role for the state and its agencies to bring the markets to order.
Therefore, I refuse to accept any equivalence between Islamic DeFi and open/ unregulated finance. Conventional DeFi bats for complete anonymity with no role for any centralized body. This also rules out any role for the regulator (government agency). However, the idea of zero-regulation is alien to Shariah. It mandates an overwhelmingly corrective role to the state and its agencies to bring the markets to order. This is not to deny the noble aspects of and the endless possibilities with DeFi, which is to minimize the collusive and exploitative role of the financial intermediaries in the system.
Indeed, there is little to cheer about the creative financial engineering displayed by most of the Islamic financial intermediaries so far, in addressing the needs of the Muslim saver and investor. At the same time, there is reason for optimism. DeFi backed by Shariah can design better and create the “pure” financial products from the Shariah point of view with a better understanding of what the faithful and the believers need; and can better price the products making them affordable to the lowest strata in the society (blending philanthropy and not-for-profit with for-profit finance). Financial inclusion in the Islamic world demands Islamic DeFi, which is decentralized and disintermediated finance, but monitored and regulated by agencies of the sovereign state.
 For an excellent taxonomy of Tokens and review from the standpoint of Shariah, see this piece by Mufti Faraz Adam