Cryptocurrency in Islamic Banking and Finance

Abstract

This paper analyzes the compliance of distributed, autonomous block chain management systems (BMS) like Bitcoin with the requirements of Islamic Banking and Finance. The following analysis shows that a BMS can conform with the prohibition of riba (usury) and incorporate the principles of maslaha (social benefits of positive externalities) and mutual risk-sharing (as opposed to risk-shifting). It concludes that Bitcoin or a similar system might be a more appropriate medium of exchange in Islamic Banking and Finance than riba-backed central bank fiat currency, especially among the unbanked and in small-scale cross-border trade.

Introduction

Islamic banking Modern Islamic banking and its financial system dates back to more than half a century, the industry can be still seen at its infancy. Islamic banking and finance follows the principles of sharia. As per shariat law, money hold no intrinsic value-therefore it cannot be traded as a commodity which means that it cannot be lend for a fee(interest) for a specific period of time, this particular practice is called “riba”. Another characteristic of Islamic Banking and finance would be the fact that it cannot be used to invest in instruments or entities considered as ‘haram’ as per Sharia laws, these include businesses that are involved in the trade or sale of alcoholic beverages, businesses involved in financing activities, businesses involved in the sale of pork to name a prominent few, these types of businesses are considered as ‘haram’ or forbidden as per the sharia law. Islamic banking and finance Islamic banking basically works on the principle of interest free banking, which means that there is no concept of interest on any loans granted. The main logic behind this concept is the fact that the investor should not be making an undue profit from the hard work of another. The banks survive on “profits” earned from it investments. As a result, Islamic banks make available accounts which provide profit or loss instead of interest rates.

The banks use this money collected by them and invest in something that is shariat compliant, that is not haram and does not involve high risks. Businesses involving alcohol, drugs, war weapons etc. as well as all other high risk and speculative activities would have zero exposure as they are prohibited as per sharia law. Islamic Banking, therefore, acts as an agent by collecting the money on behalf of its customers, investing them in shariat compliant projects and sharing the profits or losses with them.

The main principles of Islamic Banking

The following points are the main principles followed in Islamic banking and finance as per Sharia laws. Prohibition of Interest or Usury is strictly forbidden. Interest most commonly known as riba or usury is strictly forbidden. Money, on its own, may not generate profits. When riba infects an entire economy, it jeopardises the wellbeing of everyone living in that society. When investors are more concerned with rates of interest and guaranteed returns than they are with the uses to which money is put, the results can only be negative.

Ethical Standards Islamic investing must seriously consider the business to be invested in, its policies, the products it produces, the services it provides, and the impact that these have on society and the environment. Islam has rules and regulations on involvement in financial activities. For example, in share trading or the securities market, there must be scrutiny of the activities of the companies to establish whether they are in line with Sharia.

Moral and Social Values

The Qur'an calls on all its adherents to care for and support the poor and destitute. Islamic financial institutions are expected to provide special services to those in need. Going beyond mere charitable donations, Islamic banks are involved in social projects. They also offer profit-free loans or Al Qard Al Hasan. For example, if an individual needs to go to hospital or wants to go to university, we would usually give them Qard Al Hasan for a short period of about a year and do not charge them anything for that.

Liability and Business Risk

This is the overarching concept of fairness - the idea that all parties should share in the risk and profit of any business endeavour. To be entitled to a return, a financial provider must either accept business risk or provide a service (such as supplying an asset). Otherwise, the financier is, from a Shariah point of view, not only an economic parasite but also a sinner. This principle is derived from a saying of the Prophet Muhammad (May Peace be upon Him): Profit comes with liability. One is only entitled to profit when one bears the liability, or risk of loss. By linking profit with the possibility of loss, Islamic law distinguishes lawful profit from all other forms of gain.

Difference between Islamic banking and conventional banking Islamic banking Conventional banking Focus is on the investment Focus is on the lending There is emphasis on the soundness of a project There is emphasis on the ability to repay Coordination with partners in resource mobilization Dependence on borrowing for resource mobilization Apply moral criteria in investment Apply only financial criteria

Islamic banking and finance: Criticisms faced

The concept of Islamic banking has often been criticised by both purists as well as modern conventional bankers. It is stated that the instruments in Islamic banking are essentially the same as the ones in traditional banking and have the same purpose with merely different terminology. Such a criticism has been faced due to the definitions and the differentiation between interest(riba) earned and profit both have very similar definitions; profit can be defined as money earned when there is a commodity on any one side of the transaction and interest can be defined as the money earned when there is money on both sides of the transaction, both these concepts are separated by a thin line resulting in such critics. However, going in detail about this particular aspect in Islamic banking is beyond the scope of this paper as this paper focuses on the compatibility of the cryptocurrency, bitcoin in the Islamic banking system.

Virtual (Cryptocurrency)

There exist various types of cryptocurrencies, but only a very few are well known globally, namely Bitcoin and ethereum. They have gained such global prominence due to their exponential increase in value in a short time span, but many are still unaware as to what they really are and what their potential applications and benefits would be in the future. Cryptocurrency is built on the concept of the “blockchain”. Blockchain is nothing but a decentralised digital ledger which records transactions chronologically and publicly, allowing anyone to verify and access the data. This is basically the underlying technology that powers or supports any cryptocurrencies in existence today. What this enables is the ability to send money in the form of cryptocurrency from anywhere in the world from peer to peer without the involvement of any third party like banks, gateways etc. that generally tends to take a fee. This particular facility of the blockchain is not only restricted to the transfer of money, but can be applied to various others forms of asset classes such as property rights and various other goods. At the present moment the most widely used application of blockchain is for cryptocurrency, predominantly bitcoin.

How it’s made

Unlike fiat money, cryptocurrencies cannot be made out of thin air or printed from the press for that matter. A huge amount of effort and resource is required to produce the supply of cryptocurrencies like bitcoin. This process of generating bitcoin is called “bitcoin mining”. The highly complex process of mining is what helps keep the intrinsic value of bitcoin at such high levels and is growing at a staggering pace.

The process of bitcoin mining

The exertion of computing power, electricity and time by the miners represents the value that validates the creation of cryptocurrencies. This is contrary to the fiat system, where governments and banks can create money out of impulse with no corresponding injection of value. It is important to point out that fiat money is debt-based. It follows that whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The generation of bitcoin blocks takes place in the following process:

Step 1: collecting the transactions

As bitcoins are being traded all the time, its trade records have to be kept in the form of a general public ledger. This is where the miners come in, they deal with this by collecting all of the transactions made during a set period into a list, called a block. It’s the miners’ job to confirm those transactions, and write them into a general ledger.

Step 2: creating the hash

The name blockchain is derived from the nature of the long list of the general ledger where there are several blocks arranged in the form of a chain, thus the term “Blockchain”. Whenever a new block of transactions is created, it is added to the blockchain, creating an increasingly lengthy list of all the transactions that ever took place on the bitcoin network. A constantly updated copy of the block is given to everyone who participates, so that they know what is going on. So, the blockchain has been made, the ledger is made public for everyone on the network to see, but then comes in a very important factor, and that is the factor of trust. The bitcoin miners make sure that this factor is well taken care of. When a block of transactions is created, miners put it through a process. They take the information in the block, and apply a mathematical formula to it, turning it into something else.

That something else is a far shorter, seemingly random sequence of letters and numbers known as a hash. This hash is stored along with the block, at the end of the blockchain at that point in time. Hashes have some interesting properties. It’s easy to produce a hash from a collection of data like a bitcoin block, but it’s practically impossible to work out what the data was just by looking at the hash. And while it is very easy to produce a hash from a large amount of data, each hash is unique. If you change just one character in a bitcoin block, its hash will change completely. If you tried to fake a transaction by changing a block that had already been stored in the blockchain, that block’s hash would change. If someone checked the block’s authenticity by running the hashing function on it, they'd find that the hash was different from the one already stored along with that block in the blockchain. The block would be instantly spotted as a fake. Because each block’s hash is used to help produce the hash of the next block in the chain, tampering with a block would also make the subsequent block’s hash wrong too. That would continue all the way down the chain, throwing everything out of whack.

Step 3: coin generation

Every time someone successfully creates a hash, they get a reward of 25 bitcoins, the blockchain is updated, and everyone on the network hears about it. That’s the incentive to keep mining, and keep the transactions working. Furthermore, to keep things interesting, every time someone successfully creates a hash, the system makes creating the next hash even more difficult to control the supply of bitcoin so that its value could be kept at the high levels it is currently at. The performance of bitcoin over the years bitcoin became operational in the year 2008 with an underlying value of $0.8. at that point of time people and investors alike had not adapted well to the platform due to its newness and lack of ‘proof of concept’. But as the concept of blockchain became more widely well-known and its benefits more well understood, people started to look at bitcoin as an alternative investment asset class skyrocketing its value jumping more than 1000 times with a further uptrend predicted by analysts.

The security of bitcoin In recent times there have been incidents of bitcoin exchanges getting hacked resulting in losses to the tune of millions to investors bringing the security of the virtual currency into question. Certain incidents of attacks on bitcoin MT. Gox Mt. Gox, which used to be one of the leading Bitcoin exchange services, has filed for bankruptcy protection, having lost a staggering amount of bitcoins: $468 million worth. Mt. Gox’s demise began in early February when it, alongside other Bitcoin exchange sites such as BTC-e, froze Bitcoin withdrawals citing heavy Distributed Denial of Service (DoS) attacks aimed at taking advantage of bitcoin transaction malleability. Silk road 2.0 In February this year, $2.7 million worth of bitcoins were stolen from Silk Road 2.0‘s escrow account. This heist occurred at roughly the same time as the aforementioned DoS attacks on bitcoin exchanges such as Mt. Gox, and exploited the same transaction malleability in the bitcoin protocol. There are still loopholes in the system that can be taken advantage of, but these loopholes generally occur in the exchanges or points of sale where bitcoin is involved.

The security protocol of the blockchain is highly robust as it relies on:

1. Use of cryptography: Blockchain uses cryptographic techniques backed by complex mathematical algorithms to verify and secure the data.
2. The nature of decentralization: It is much harder to hack a decentralised network rather than a centralised, single-point-of-failure system. Imagine the amount of work needed to hack into thousands of computers distributed in a decentralised network. What’s impressive about Blockchain is that the level of security rises the longer the chain gets. This is because a tremendous amount of computing power is required to “hack” or alter the information in the blocks. As the chain grows longer, the amount of computing power needed to “hack” them increases exponentially. In addition, the features of immutability and transparency of the Blockchain process removes the possibility of fraud and theft.

Concluding discussion

The analysis of the compatibility between a distributed, autonomous blockchain system, the bitcoin and Islamic banking and finance(IBF) is done in this paper. Hence, we can clearly see that the concept of bitcoin conforms with the prohibition of interest(Riba) in IBF as bitcoin incorporates the principles of social benefits of externalities(maslaha) and mutual risk sharing (as opposed to risk shifting). Furthermore, in Islamic finance there needs to be an underlying asset. The majority of today’s fiat money is created in the form of loans from within the banking system, whereby Bitcoin is created in limited volume through a mining process with actual computer power and does not involve debt creation, seen by some as digital gold Thus, it can be described as an asset class with an intrinsic value and this fits well with the principles of Islamic finance.