Investing via utility tokens to provide capital will not only expose an investor to risk of a project, but also the excessive uncertainty in the value of the tokens
By MARIZAH MINHAT & NAZAM DZOLKARNAINI / Pic By BLOOMBERG
Humanity is progressing from the financialisation of values to the digitisation of financial values. Values are increasingly succumbed to digitisation with the rise of “digital assets”, “crypto-assets” and “cryptocurrencies”. These are the exciting buzzwords of the day. The world of Islamic finance is equally excited to be up to speed in exploring opportunities associated with financial technology.
However, scholarly views about the permissibility of the above mentioned assets are rather mixed, while regulators are still catching up with the speed of innovations in what was previously a “black” segment of financial markets.
Consumers are very much in the dark due to information asymmetry, which stems from knowledge gaps, and not to dismiss the possibility of misleading marketing and fraudulent activities aimed to garner financial capital for numerous ends. A recent research cited by regulators in Europe found that 78% of initial coin offerings (ICOs) are scams.
In the UK, crypto-assets are defined by the Financial Conduct Authority (FCA) as “a cryptographically secured digital representation of value or contractual rights that is powered by forms of distributed ledger technology and can be stored, transferred or traded electronically”.
Crypto-assets are categorised into three types of tokens based on different uses. First, “exchange tokens” are typically used as a means of exchange to facilitate the buying and selling of goods and services. Second, “security tokens” are held and traded for investment. Third, “utility tokens” are to support capital raising and/or the creation of decentralised networks through ICOs or other distribution mechanisms.
In Malaysia, digital assets refer to digital tokens and digital currencies. The enforcement of the Capital Markets and Services (Prescription of Securities) (Digital Currency and Digital Token) Order 2019 means that the Securities Commission Malaysia will put in place guidelines to regulate the offering and trading of digital assets. This regulatory framework seems to regulate digital assets as utility tokens and security tokens.
Bank Negara Malaysia has reiterated that digital assets are not a legal tender in Malaysia. This means that there is no obligation on consumers and traders to use digital assets as exchange tokens. The tokens are rendered useless if counter-parties (eg, sellers and creditors) are unwilling to accept payment in digital assets.
Hence, counting on such tokens will expose consumers to excessive uncertainty and highly speculative purchasing power that is not recognised by law. If the value of the exchange tokens is “linked to” or backed by fiat currency, crypto-ssets or other forms of assets and commodities to stabilise their volatility, then the basic question is what marginal value do the tokens offer that is not achievable through existing legal tender?
In terms of potential harm, digital assets as security tokens are understandably speculative instruments. The value of these tokens has been more vulnerable than the value of traditional securities such as equities or shares that should fluctuate according to the perceived performance of issuers.
We gathered from CoinMarketCap that the total market capitalisation of cryptocurrencies had climbed beyond US$700 billion (RM2.86 trillion) in January last year, up from just US$18 billion a year earlier. However, the market has since lost more than 80% of its value to stand at slightly above US$100 billion recently.
The value of the original and most valuable cryptocurrency (bitcoin) has plummeted from about US$19,000 in December 2017 to bump along at below US$4,000 since the end of last year. Our analysis shows that the standard deviation (as measuring volatility) of bitcoin during the 2011-2017 period was 0.71, compared to only 0.03 for the FTSE350 Index.
Security of Tokens
In addition, security of the tokens is a real issue. It was cited by the FCA that US$731 million worth of crypto-assets were stolen from exchanges in the first half of 2018 alone. Hacking of exchanges had increased to US$927 million by October 2018.
To what extent consumers are guaranteed protection is questionable. Buying insurance (if any) or custody services that includes vaulted cold storage — such as that offered by Fidelity Digital Asset Services — will simply increase transaction costs for consumers.
That said, losing access to digital wallets that store the keys or passwords is not impossible. For example, Bloomberg reported recently that digital asset exchange QuadrigaCX was not able to retrieve about US$145 million in bitcoin, litecoin, ether and other digital tokens held for its consumers because the passwords appear to have been lost with the passing of the start-up’s CEO.
Given the above issues, here are some basic questions: What “value” do digital assets bring to humanity? Are the markets for traditional securities with established regulatory infrastructures in place no longer attractive?
Perhaps arbitrage opportunities for abnormal returns within traditional markets are disappearing as the markets are becoming more efficiently regulated. There is, of course, promising arbitrage opportunities in any new lightly regulated markets such as that of digital assets where little is known about them.
Unfortunately, the likely victims of information asymmetry are always those less sophisticated consumers who are often lost in naivety, fancy jargons or simply marketing gimmicks. Not to mention the greedy instinct to get rich quickly with the minimal effort possible.
Investing through utility tokens to provide capital for an investment project will not only expose an investor to the risk of the underlying project, but also the excessive uncertainty (gharar) in the value of the tokens — which are neither recognised, nor regulated as legal tender.
Is gaining exposure to highly speculative tokens necessary to finance socially responsible projects (eg, building a mosque)? The rationale for gaining exposure to the tokens is unknown and questionable. What we do know is that Islamic finance should not be supporting the growth of gharar instruments of speculative values in capital markets. Islamic finance should be about nurturing genuine investors, rather than speculators.
Humanity is already suffering from the fluctuating values of traditional securities and currencies. Adding more speculative instruments (ie, digital assets, crypto-assets and cryptocurrencies) to the markets will simply increase the risk of financial instability. History has shown that financial instability has a real impact on humanity. It is common sense, not rocket science.
- Dr Marizah Minhat is assistant director of International Centre for Management and Governance Research, and Dr Nazam Dzolkarnaini is associate professor in accounting and finance at The Business School, Edinburgh Napier University, UK. The views expressed are of the writers and do not necessarily reflect the stand of the newspaper’s owners and its editorial board.