Resolving the Shariah-Ethical Issues with Token Offerings – I

Market observers have time and again pointed at serious ethical issues and shortcomings with the initial offerings of crypto tokens. Bad practices in the form of poor market conduct by large sections of token issuers have led to wide-spread scepticism among market participants.  Cases of misinformation, fraud and deception and finally disappearance of the projects leading to loss of investors’ funds have been widely reported. Lack of effective regulations to curb such practices in most countries has justifiably led to a trust-deficit and the consequent inability of the participants to discern the good offerings from the bad ones. Much of the observed unethical market conduct may also be unacceptable to the Shariah that demands a high level of moral and ethical conduct. In this 2-part blog we seek to capture the thoughts of two well-known observers of the crypto markets – Dr. Mohammad Abo Jazar and Dr. Ahmad Younes, founders of Crypto Halal and TokenBench respectively, on addressing the Shariah-ethical issues in the markets. We revisit some of the conventional models for initial token offerings, such as, ICO, IDO and IEO, identify some serious problems from a Shariah and ethical point of view and seek to offer a possible solution. 

Initial Coin Offering (ICO)

ICOs are the earliest type of offerings known to the cryptocurrency markets. ICOs seek to mobilise funds for projects that are yet to see the light of the day. Touted to be based on futuristic technologies about which not much is “known” yet to market participants, the native currencies mostly represent a means of payment for future services. ICOs, unlike sale of equity stocks, do not imply transfering a part-ownership of the project to the investors. The process in this case involves a direct sale of tokens to investors by the owner of a non-existent project, followed by listing and trading of the currencies on central and decentralised platforms.Observers underline several issues with ICOs:

1. There are no guarantees regarding successful project completion provided by the issuer for the currency buyers.
2. During the pre-construction phase of the project, a token essentially represents nothing of commercial or non-commercial value.
3. There are no real projects  or services associated with the currency during the initial offering phase.
4. There is no systematic evaluation of risk and expected returns from the project by a neutral third party prior to the ICO.
5. Historical evidence points to a large number of projects left incomplete by the issuers as well as cases of delays in allocation of tokens resulting in unfulfilled promises for the investor community. 
6. Historical evidence also points to a large number of cases of outright frauds by and disappearance of project owners, once funds have been mobilised through token sales.
7. There are also cases of non-listing of the tokens on trading platforms leading to liquidity issues and loss of investors’ money.

Initial Exchange Offering (IEO)

The initial exchange offerings (IEOs) are believed to be an improvement over ICOs. Introduced as a response to the frequent scams reported with ICOs and the consequent loss of investors’ confidence in the cryptocurrency markets, the IEOs are sponsored by central trading platforms. In case of IEOs, the trading platforms are entrusted with the task of verifying the quality of the projects and its team prior to the offering on the launch platforms. The platform also ensures the inclusion of currency for trading immediately upon the completion of the subscription process. While this is a definite improvement over the ICO model, a few problems persist.

1. Similar to ICOs, the IEOs too don’t require existing real projects; it is enough for the idea to be promising and exciting.
2. In most cases the token doesn’t represent any real value or service as the project is yet to be operational.
3. The token is not subjected to any independent valuation with respect to the pricing. The third party in this instance doing some kind of valuation is the central exchange, which is not necessarily a neutral party.
4. The trading platform requires the issuer to make a deposit in the platform currency for a period of time in return for interest payments. Such riba-based incentivisation of investors’s participation in the trading, clearly has no place in Shariah.
5. The funds remain in the possession and disposal of the trading platform and this raises additional concerns and risk factors.

 Initial DEX offerings (IDOs)

This is about initial offering of tokens to investors with involvement of decentralised Exchange platforms. The process involves smart contracts for automatic mobilisation of funds and allocation of tokens among investors. IDOs are also seen as a veiled return to the ICOs that enabled any project owner to contract with a decentralised platform and sell its currency by means of smart contracts deducting a part of the proceeds to finance the liquidity pool. IDOs essentially made the process easier and therefore enabled fund-raising through token sales on a larger scale, without finding a way to distinguish between genuine and fraudulent projects. The umbrella of “decentralised” platforms provided a false sense of confidence to the investor community.

1. The scrutiny undertaken by decentralised platforms on the quality and reliability of projects and their teams is not real; and anyone with a few tools can list their worthless tokens and sell the same through these platforms.
2. The token doesn’t represent any real value or service at present, as the project is yet to be operational and the expected future value from the project is grossly uncertain.
3. Projects can withdraw the liquidity and empty the pools and leave the investors with useless and value-less tokens.
4. Some platforms require deposits to be made in exchange for (riba) interest in order to allow those wishing to participate in the initial offering process.
5. The token’s price is not subject to any evaluation by a neutral party but by the project’s owner.
6. Historically, there have been many cases of frauds associated with this model.

 In the next part, we undertake a comparative evaluation of the offerings of various types from the perspective of Islamic law.

(Source: Crypto Halal)