Islamic DeFi: Back to Basics – IV

Simplicity is not just a virtue. It is an imperative in Islamic finance. Let us keep the game simple and comprehensible. Let us play the game differently.

Part I | Part II | Part III

Now-a-days I receive at least one headline pertaining to the crypto world among many others, as I click on Google, thanks to its AI derived from my past usage data. I got up this morning to find that one story dominated, reported by Bloomberg, Coindesk, Investopedia and what-have-you. It is about XRP, a token by Ripple. The Crypto Exchange called Coinbase that sold XRPs is facing a lawsuit. It is alleged that Coinbase knew XRP was a security rather than a commodity and illegally sold the tokens anyway and collected the commissions. This is in the aftermath of Ripple being sued by the U.S. Securities and Exchange Commission alleging that the former had misled investors by selling more than $1 billion of the virtual tokens for the world’s third-largest cryptocurrency without registering with the agency. Coinbase as well as other Exchanges are suspending XRP sales forthwith. Apparently, the SEC cannot be blamed for being too tough. The memories of 2017-18 boom in the unregulated Initial Coin Offerings (ICOs) and the subsequent finding (1) that over 80 percent of all ICOs were frauds are still fresh. Security Token Offerings (STOs) and Initial Exchange Offerings (IEOs) have since appeared as new games in the town but are naturally under close watch of the regulators.

I felt pity for the investors. I use the term investor, since the SEC has categorized it as a security token. I tried to put myself in the shoes of the XRP investor and feel the impact of this catastrophic event. What should be a rational course of action, now that the XRPs can no longer be liquidated easily? Someone had to display considerable naivety to buy it a reasonable price? That naturally led to another question: what is a reasonable price? How have the prices of XRPs behaved in the past? One can get the complete history of prices since listing, thanks to the transparency ensured by all Exchanges including Coinbase. 

The price-chart is exciting enough to charge up the gambling instincts of any ordinary mortal.

The price-chart is exciting enough to charge up the gambling instincts of any ordinary mortal. From an initial price of IDR 44 in January 2014, it had reached a level of IDR 440 in April 2017 going up by ten times over a period of three years. Then the impossible (in a fundamental/ economic sense) happened. The price climbed sharply to IDR 4330 over the next single month. The next Himalayan vertical climb started in December 2017 and the price reached a peak of IDR 51626 in the first week of January 2018. Lo and behold, it then nosedived like a fighter jet that had lost all its engines reaching the level of 6700 by April 2018. Since then it has hovered in a rather narrow range (by its own standards). The latest volatile cycle materialized during the last couple of months. Starting from IDR 3500 in the first week of November 2020, it reached a peak of IDR 13025 in just about two weeks on November 26 before plunging to IDR 7500 three days later. It hovered around this level for about two weeks reaching a peak in mid-December at around 8100 before falling again to around 3000 level by end of the month. Can we expect our buyer to have any clue about the realistic price reflecting the fundamental value of this asset being traded on a transparent Exchange? 

The Exchange had more to offer. For any buyer, relevant information required for valuation of the asset is what an Exchange should offer. This is critical for informational efficiency of an Exchange that also leads to its pricing efficiency. Isn’t it what we are taught in Investments 101 classes on Market Efficiency? Islamic economists explain this by drawing a parallel with the notion of excessive “gharar” in a contract that invalidates the same. Gharar has several dimensions. One of these is jahl or inadequacy of value-relevant information. Another is deceit or fraud or inaccuracy of information. Yet another dimension is undue or unnecessary complexity in contracts that makes it difficult for either or both parties to the contract to make a fair and reasonable assessment of countervalues being exchanged. The relevant information for XRP was just a click away. It is called a white paper. (I am told an aspiring ethical DeFi player plans to call its document a green paper amply demonstrating its respect for the Islamic color. But that is another story.) The abstract of the XRP white paper reads as follows:  

“While several consensus algorithms exist for the Byzantine Generals Problem, specifically as it pertains to distributed payment systems, many suffer from high latency induced by the requirement that all nodes within the network communicate synchronously. In this work, we present a novel consensus algorithm that circumvents this requirement by utilizing collectively-trusted subnetworks within the larger network. We show that the trust required of these subnetworks is in fact minimal and can be further reduced with principled choice of the member nodes. In addition, we show that minimal connectivity is required to maintain agreement throughout the whole network. The result is a low-latency consensus algorithm which still maintains robustness in the face of Byzantine failures. We present this algorithm in its embodiment in the Ripple Protocol.”

Is it written in Greek? Or in the language of the Byzantine Generals, I wondered. Does it not sound too complex? What would be its readability and comprehension score, if there were one for an average investor? What kind of minimum competence one must have before one begins to see the value in the XRPs? Arguably, it is not so demanding, since one finds so many investors buying and selling XRP on the Exchange, unless these are die-hard speculators and gamblers. Even if they are, their intentions are largely unobserved. On this ground, a few Islamic scholars display some reluctance to label such speculative games as unIslamic. The more conservative and concerned ones do not. In today’s data-driven world, it is not hard to figure out if and when the overall game at the Exchange is dominated by gamblers playing by their animal instincts. There may be rare instances when the saner value-investment takes place. As far as the Crypto Exchanges are concerned, the price distributions don’t need much analysis beyond a visual one to label the games as gambles. Even if one refrains from labelling the entire game as unIslamic, the faithful visitor to an Exchange can always introspect and find what his/her intention is and to what extent s/he is equipped to undertake a rational valuation of the asset before engaging in trade.

Value beyond algorithms

Can value flow from mathematically complex algorithms alone? It does flow from a robust token design. For instance, the additional value from XRP apparently comes from the reduced requirement of trust in the subnetworks and member nodes. However, is it the only dimension of value that the investor looks forward to when s/he invests? And has this value been fluctuating so wildly, as reflected in the super-volatile prices?  The investment function is about maximizing returns and minimizing risk. Genuine investors like returns and dislike risk or volatility. What ensures this is a project with strong fundamental values and of course, robust token design (or, good tokenomics). Such projects should experience steady appreciation in value and prices over time. First, let us consider the token design.

A robust token design begins with mathematically complex consensus algorithms. A consensus algorithm motivates users on the network to reach a consensus in validating transactions. Bitcoin and Ethereum both use a proof-of-work model. In the PoW model, miners work to secure the network, verifying transactions by solving cryptographic puzzles organized in blocks. Solving the equations gets more and more challenging as the network grows, and the number of coins awarded to miners drops over time. A second type of algorithm is called proof-of-stake, used by crypto projects like DASH and Tezos (Ethereum is also moving to PoS from PoW). The proof-of-stake model allows holders of the currency to stake their value in a wallet and thus allowing those wallets to act as security deposits in a validator, which then validates blocks. The more tokens a particular user holds, the more likely they are to get the reward for solving the next block. Overall, both of these consensus models use incentives for engaging network members to participate and secure the network, confirm transactions and maintain the integrity of the network. 

For an average market participant, however, value has two components – intrinsic value and speculative value. 

So, how does a token get its intrinsic value? The intrinsic value is created by the underlying project and how much percentage of this value is captured by the token. This is one of the primary functions of tokenomics or token economics. William Mougayar came up with the term and he also came up with the three tenets behind a token’s value. According to Mougayar, there are three tenets to token value and they are: Role, Features, and Purpose. Each token role has its own set of features and purpose. Let’s examine each of the roles that a token can take up:

• Rights (bootstrapping engagement): By taking possession of a token, the holder gets a certain amount of rights within the ecosystem, e.g. partial access to e-library resources, right to undertake a survey, voting rights on membership privileges etc.
• Value Exchange (economy creation): The tokens aim to create an internal economic system within the confines of the project itself. This helps the buyers and sellers to trade value within the ecosystem. This creation and maintenance of individual, internal economies are one of the most critical tasks of tokens.
• Toll (skin in the game): It can also act as a toll gateway for one to use certain functionalities of a particular system, e.g. you need to use tokens to gain access full e-library access and a few other premium services, e.g. preservation of documents on blockchain, free transfer of money within network.
• Function (enriching user experience): The token can also enable the holders to enrich the user experience inside the confines of the particular environment, e.g. holders of tokens will get the rights to enrich the customer experience by adding advertisements or other attention-based services on the mother platform.
• Currency (friction-less exchange): A token can be used as a store of value which can be used to conduct transactions both inside and outside the given ecosystem.
• Earnings (distribution of profit shares): A token can help in the equitable distribution of profits or other related financial benefits among members of the network.

A token by having multiple properties will have more intrinsic value.

The speculative value is what the token gains from speculative traders who expect its price to fluctuate in the near future. In conventional DeFi space the speculative value is usually under focus as the following narrative clearly suggests.

For better or worse, speculation and fear of missing out (FOMO) are major culprits behind why people have been buying and trading utility tokens. Although you can redeem a utility token for goods or services, a holder can go onto crypto exchanges (think of a thinly regulated NYSE or Nasdaq type of entity) to buy and sell utility tokens. A person purchases a utility token hoping that there will be positive sentiment towards the underlying project, which will entice someone else to want to pay a higher price for the same token. Another person sees how the utility token has been increasing in price, and fears that if he or she does not buy now, he or she will miss out on buying the utility token cheap enough (i.e. FOMO), and thus buys the utility token at the higher price. The price or value given to the utility token is derived mostly from speculation, and the merry-go-round of price appreciation continues as long as there is a third party willing to buy the utility token at a higher price. That being said, utility tokens have the potential to create and retain real value as well.(2)

While the presence of some speculative investors may improve the liquidity of the token, it is hazardous for it to be priced purely on its speculative value. Overall, it is grossly un-Islamic, though it may not be possible to label a specific transaction as prohibited, since intentions behind transactions are largely unobserved. In the Islamic framework the intrinsic value or the value that the token gains from the credibility and utility of the project, is what governs the economics of tokenization.

I will end this blog with an example of a token that can perhaps be cited as an ideal token, especially from the standpoint of the Islamic economy with its focus on linking the financial sector firmly with the real economy. The HARA token designed as a farmers’ token currently covers 31.3K farmers in 741 villages and 9.9K Ha of farm land in Indonesia. How will farmers benefit from HARA Token? The HARA app and web portal are gamified in such that data providers, such as farmers, who supply data are rewarded with loyalty points. These points may be redeemed for various products and services, such as phone credits, discounts on agriculture supplies, and education supplies. Its whitepaper provides further details about the incentive structures. HARA Tokens are based on ERC-20, distributed on the Ethereum and are meant to be used for transactions at the exchange. The same token is used by the ecosystem as well as the investors. It is listed on Exchange for trading. It is extensively featured in global media, such as, AWS, Forbes and CNN Indonesia.

HART is used by the ecosystem as well as the investors, listed on Exchange for trading. It is extensively featured in global media.Yet, its price-chart looks like a dead man’s heartbeat.

Yet, its price-chart looks like a dead man’s heartbeat. Apparently, it is not a favorite of the speculators.

Simplicity is not just a virtue. It is an imperative in Islamic finance. Let us keep the game simple and comprehensible. Let us play the game differently.

Notes:

1. Available from: https://cointelegraph.com/news/new-studysays-80-percent-of-icos-conducted-in-2017-were-scams
2.  https://www.linkedin.com/pulse/utility-tokens-general-understanding-joel-camacho/

(To be continued)