Why security tokens are Shariah-compliant crypto instruments.

In 2019, the assets under the management of Islamic Funds were estimated at hundred and forty billion dollars. Entrepreneurs who correspond to the principles of Shariah have an additional source of capital. Another strong capital source is crypto investors, who prefer blockchain-based instruments and have driven the cryptocurrency market to a collective valuation of more than $1 trillion.

Since most crypto instruments are not Shariah-compliant, some business owners think these two groups of investors are incompatible. However, some ways of working with crypto can be recognized as fully righteous from the Islamic point of view, so let's dive deeper into the financial side of Shariah.

What are the principles of Shariah compliance and Islamic finance?

Firstly, let's discuss the principles of Islamic financial instruments. This is not an exhaustive list, and there are debates among scholars about the nuances of principles and their applications so perceive it rather as a practical guide for beginners.

One of the most basic principles is that payment of interest is prohibited. It is considered as an unjust transfer of risk from the lender to the borrower. Instead, all counterparties should share the potential risk and profit in a fair way.

The next principle is that the investment in businesses that are engaged in forbidden activities is prohibited. Forbidden activities include gambling, selling alcohol and pork, and engaging in the creation of obscene content and comparable products. Businesses must also not be overleveraged, i.e. have excessive debt.

A seemingly inherent aspect of mainstream finance ― speculation and ambiguity in the transaction execution ― is outside the realm of Shariah compliance as well. Basically, it means that transactions unrelated to the actual creation of economic value are not permitted. This includes the prohibition of most derivatives.

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Permitted transactions should have the so-called "material finality", which should result in the delivery of something of value. For example, trading of options does not pass this criterion because they may never be executed.

What are Shariah-compliant investments?

Despite these strict rules, there are financial instruments that are permitted and in which Islamic funds actively invest. The most simple of such agents are equity securities issued by businesses not engaged in prohibited activities. They comply with the principle of risk-sharing and no speculation in a very straightforward way.

Another example is Islamic bonds, the so-called Sukuk. The payments to Sukuk holders depend on the company's financial performance, and at a fixed point in time, the securities are redeemed. Sukuk may be thought of as redeemable non-voting shares with a 1x non-participating liquidation preference. The last condition considers the fact that upon liquidation, bondholders are paid before shareholders, and the amount of the payment corresponds to the body of the debt. If the term "liquidation preference" is confusing to you, please see our video “How venture capital harms startups? | Choose security token offering or equity crowdfunding instead”

The majority of conventional cryptocurrencies are not Shariah-compliant. In other words, Shariah-compliant cryptocurrency is almost an oxymoron.

The primary reason is that many cryptocurrencies are purely speculative and derive their value only from supply and demand. This is especially true about Bitcoin, the main currency that constitutes more than 50% of the total crypto market cap. Given this lack of underlying value, many consider investing in or trading cryptocurrency as a form of gambling.

It's true, however, that certain kinds of tokens have underlying value and the use case, in particular utility tokens. Nevertheless, the problem is that utility tokens by default cannot be a Shariah investment or trading instrument. The economic nature of utility tokens is that they should provide access to the product or service or another kind of utility. Consequently, compliant transactions with utility tokens are prepayments for obtaining the corresponding utility. If the purchase has been conducted without the intention to use utility tokens, then it's mere speculation without a material finality, a delivery of a good or service. The given circumstances make an investment in Shariah-compliant utility tokens rather an oxymoron.

The same refers to payment tokens. In Islamic Finance, money does not have intrinsic utility outside being used as a payment method. Therefore, investment in payment tokens, as well as speculation with them, is not Shariah-compliant.

This also makes getting profit via different DeFi schemes non-compliant as they function the same way as receiving interest: the transaction is basically about making money out of money instead of conducting productive economic activity.

What makes security tokens Shariah-compliant?

As mentioned above, certain types of financial instruments, in particular equity securities, can be Shariah-compliant. Security tokens are not a new type of financial instrument ― instead, they are conventional securities, such as shares and bonds, stored and transacted using blockchain as a technology infrastructure instead of existing as physical share certificates or records in a spreadsheet.

Therefore, if the Shariah-compliant financial instruments exist in the form of a security token, then the token itself is compliant. An important note here is that the security token is not a derivative providing a claim to the security ― it is the underlying security itself. This is the reason why another name for security tokens is tokenized securities. Therefore, prohibitions on derivatives do not apply in this case.

Conclusion

Though conducting financial business may have many limitations when it comes to cooperating with Islamic investors, it's still possible to work with them on the basis of conducting a security token offering. The given instrument matches the requirements of not being a prohibited activity, having a material finality, and not being speculative. Stobox's in-house team will gladly help develop such a solution.