Investigating possible DNA of cryptocurrencies
bitcoin

By HYLMUN IZHAR  / Pic By BLOOMBERG

Thee unprecedented hype of cryptocurrency over the past few years coupled with an increasing prominence of digital economy should not go unnoticed.

For sure, the rapid emergence of such phenomenon has considerably altered the landscape of financial transactions and the methods by which the global economy would grow.

More importantly, it will potentially change the way economic agents interact in a great deal. Islamic finance, as a growing and niche industry, must respond timely to this.

Various attempts have been made by different enthusiasts and advocates of Islamic finance to address this topical issue.

One central question being constantly discussed is whether investing in cryptocurrency through blockchain technology is Shariah-compliant. To be able to answer this question, the fundamental aspect to dig out is to ensure “the nature of cryptocurrency”.

Why it matters? Because this will determine whether an investment in cryptocurrency is justified from the Shariah point of view.

As many advocates of Islamic finance would unanimously agree, the structure by which a contractual agreement is assembled and the type of items being transacted can determine the validity and permissibility of any financial transactions.

On this, Shariah through its abundant fiqh interpretations provides guiding principles and a variety of avenues for Shariah-compliant financial activities.

With respect to investing in cryptocurrency, there hasn’t been any undivided answer until now, but there are characteristically four opinions:

• Cryptocurrency cannot be considered as mal (wealth); it is purely speculative, hence it is not Shariah-compliant.

• Cryptocurrency is money/ currency.

• Cryptocurrency is an asset.

• Cryptocurrency is a security. This article, therefore, is an attempt

to investigate the possible DNA of cryptocurrency. The word “possible” is used deliberately since the analysis or opinion articulated in this article, could in no way be considered as a final statement, let alone a verdict. Rather, it is an endeavour to further stimulate the discussion on this emerging topic.

The authoritative bodies to come up with a verdict, in my opinion, would be the Accounting and Auditing Organisation for Islamic Financial Institutions’ Shariah Board and the Islamic Fiqh Academy.

The analysis of this article is structured as follows: The second section following the introduction discusses briefly cryptocurrencies, the third up to sixth sections attempt to analyse whether cryptocurrencies could qualify as being mal, currency, asset or security.

The last section deliberates upon the finding of the possible new DNA of cryptocurrency and its potential interconnection with Islamic finance, followed by a conclusion.

Cryptocurrencies, an Introduction

Cryptocurrencies are digital or virtual currencies that are encrypted (secured) using cryptography.

Cryptography refers to the use of encryption techniques to secure and verify the transfer of transactions. Bitcoin represents the first decentralised cryptocurrency, which is powered by a public ledger that records and validates all transactions chronologically, called the blockchain.

Physical tokens have been, and are, still being used as a means of payment (eg shells, gold coins, bank notes). In such a setting, a direct exchange of sellers’ goods and buyers’ tokens allows them to achieve an immediate and final settlement. This option is unavailable, however, when the two parties are not present in the same location, necessitating the usage of digital tokens.

In a digital currency system, the means of payment is simply a string of bits. This poses a problem, as these strings of bits as any other digital record can easily be copied and reused for payment. Essentially, the digital token can be counterfeited by using it twice, which is the so-called double-spending problem.

Cryptocurrencies such as bitcoin go a step further and remove the need for a trusted third party. Instead, they rely on a decentralised network of (possibly anonymous) validators to maintain and update copies of the ledger.

This necessitates that consensus between the validators is maintained about the correct record of transactions so that the users can be sure to receive and keep ownership of balances. But such a consensus ultimately requires that (i) users do not double-spend the currency and (ii) that users can trust the validators to accurately update the ledger.

How do cryptocurrencies such as bitcoin tackle these challenges? Trust in the currency is based on a blockchain which ensures the distributed verification, updating and storage of the record of transaction histories.

This is done by forming a blockchain. A block is a set of transactions that have been conducted between the users of the cryptocurrency. A chain is created from these blocks containing the history of past transactions that allows one to create a ledger where one can publicly verify the amount of balances or currency a user owns. Hence, a blockchain is like a book containing the ledger of all past transactions with a block being a new page recording all the current transactions.

To ensure consensus, validators compete for the right to update the chain with a new block. This competition can take various forms. In bitcoin, it happens through a process called mining. Miners (ie, transaction validators) compete to solve a computationally costly problem which is called proof-of-work. The winner of this mining process has the right to update the chain with a new block. The consensus protocol prescribes then that the longest his- tory will be accepted as the trusted public record.

Why Cryptocurrency is Deemed Speculative?

The proponents of this view opine that cryptocurrencies such as bitcoin are just numbers with digital entries on a cryptic blockchain.

They have no intrinsic function. Yet, they are just numbers which are fluctuating in value due to pure speculation. There is no real substance or underlying asset; it is just speculation on the fluctuation of numbers.

This can result in cryptocurrencies being non-compliant and a form of maysir and prohibited speculation.

This group of proponents liken bit- coin or any other type of cryptocurrencies to solely settling price differences, where the objective is purely the fluctuation of price.

It is important to note that for something to be the subject of a contract, it must be mutaqawwam, meaning that its use is lawful under Shariah. Mal is an essential building block of Islamic contract law. Mal is defined as tangible things to which human nature inclines.

Nazih Hammad, a contemporary jurist, in his article in 2007 argues that the entire community of Islamic jurists — Shafi’ites, Malikites, Hanafites and Hanbalites — are of the opinion that there are three elements of wealth. That is, three elements which, when present, will lead to the conclusion that the obligation has value and, from the Shariah perspective, can be exchanged for a counter value.

Those three elements are: (1) That the obligation be an intended usufruct, or contain the same; (2) that the usufruct has a monetary value in commercial practice or custom; and (3) that the usufruct be lawful from a Shariah perspective.

Based on this proposition, although there is no issue in cryptocurrencies being mutaqawwam, it cannot be classified as mal; as inherently, it does not have usufruct to be benefitted by contracting parties. Its value can only materialise when it is cashed-in using fiat money that backs it up.

  • Dr Hylmun Izhar is a senior economist at the Islamic Research and Training Institute, Islamic Development Bank Group. This is the first of a two-part article on cryptocurrencies.