Resolving the Shariah-Ethical Issues with Token Offerings – II

In part 1 of this blog we presented an overview of mechanisms for initial offerings as these have evolved in the crypto markets. In this concluding part, we undertake a comparative evaluation of the offerings of various types from the perspective of Islamic law and present an alternative ethical solution.

Deception (Gharar)

Shariah demands that a valid sale must be free from any element of deception. Broadly termed as al-gharar, such deception may be caused due to inaccurate information being shared by the counterparties. The possibility includes any factor that may prevent a proper understanding of the counter values being exchanged and cause an avoidable dispute/ conflict between the parties concerned, such as undue complexity in the contract. In most cases with the initial offerings, neither the benefits or risks that go with the tokens, nor with the project can be comprehended fully as they are non-existent at the time of the sale and relate to a time in future. Prohibition of sale of a non-existent item (value) is fundamental to Shariah. Both in cases of sale of (1) non-existent tokens or of (2) existing tokens where the underlying benefits/ projects are non-existent, we encounter Shariah-ethical problems. The first case involves violation of the principle – do not sell what you do not have. The second case involves deception of another kind – sale of zero-value tokens at a price leading to ghubn or unjust enrichment. 

It may be noted that a specific form of sale – bai salam – is permitted as an exception to prohibition of short-sale with some additional conditions (such as, fungibility of object of sale). A permissible use case relates to provision of pre-cultivation financing where farmers may receive “advance” sale price of specified quantity of their produce from merchants against post-harvest delivery of the produce. This has been cited as a justification by a few, in favour of salam-sale of (non-existent or zero-value) tokens. In an earlier blog, we subject this contention to detailed scrutiny and underline the fallacy in the same. 

Inadequate Information (Jahl)

Another ethical issue relates to adequacy of value-relevant information for the parties to the contract. While most transactions are undertaken under conditions of “incomplete information”, the conditions of excessive or gross inadequacy of information raise a question over the validity of a sale. Now in case of the token offerings, the tokens at the time of sale do not represent any asset or benefit. Any benefits expected to accrue in future to the token-holders need therefore, to be assessed or evaluated at the time of the sale. It is logical and rational that any such evaluation must not be left to the project owners but to a neutral third party. This is the prevailing custom in stock markets. However, a large number of projects going for initial token offering have been observed to offer their tokens at inflated prices. The true price and the extent of over-pricing was discovered only in the after-market post-listing on the platforms. While such grave anomalies would draw instant regulatory response in case of equity markets, (for example), the crypto market hardly has any corrective mechanism in place. Such gross information asymmetry among parties about the true value of the object of sale has often led to tens of thousands of investors losing their money across the globe in favour of a handful of fraudsters. 

Unlawful Projects

This is a problem with many projects going for initial offerings. A very large percentage of crypto projects, especially those that deal with the financial services after the DeFi Revolution are not permitted. When token holders provide funds to such forbidden projects through purchase of tokens, it is similar to cooperating in a sinful act. 

Usury (Riba)

As mentioned earlier,  as a condition to participate in the token sale, IEOs and IDOs require token holders to deposit funds on centralised/ decentralised platforms for a period of time in exchange for interest payments, which is prohibited riba. 

Given the above Shariah-ethical issues with available mechanisms, how does one proceed with a token offering that is free from the unethical elements? It is interesting to note that the Crypto Halal project has come up with a new offering model, known as, initial launchpad offering (ILO) as a solution.

Initial Launchpad Offering (ILO)

What is new in the ILO model?

1. This model permits real projects to go for token-offering. Only existing projects that are ready to provide the declared services may raise resources through this mechanism. Tokens are linked to real services and have real use. ILO does not support projects based on promises about the future.
2. ILO doesn’t accept projects that violate International legal standards.
3. ILO supports only those projects that have licensed companies in countries where they can be referred to and be sued in the event of any dispute.
4. The token price is evaluated by a neutral third party, usually a reputed accounting firm to ensure a true and fair price.
5. The initial offering is done by an independent launch platform only or launchpad and not through a trading platform to ensure that there is no conflict of interests.
6. The process involves a deposit by the two parties – issuers and investors – of tokens and currencies into a smart contract. As and when the funding goal is realised, the transfer to the wallets automatically takes place. This ensures that the funds are locked in the smart contract and would flow to the issuer only after proper verification. In case of any hiccup or compliance failure, the smart contract would ensure automatic refunds to investors’ wallets. This ensures that no one is able to access the funds until the entire process is completed.
7. Any unsold tokens would be burnt and not revert back to the issuer. This ensures that the prices do not depart wildly from the benchmark used in valuation and the balance between demand  and supply in the free-market is maintained.
8. The issuer undertakes to list the tokens on the centralised or decentralised platforms immediately after completion of the initial offering process and provides guarantees for this through contracts with the platforms. In case the offering is listed on a decentralised platform it is required to be free or flash loan options and riba-based returns.
9.  ILO doesn’t allow any prior deposits that may exceed the initial offering amount and that may generate interest-based returns.

It is clear from the above that ILO demands much more than cosmetic changes to the earlier mechanisms. It offers a radical departure from ICO/ IEO/ IDO ensuring the integrity and legitimacy of the process at all stages and insulates investors’ funds from possible losses due to bad and unethical practices. Its development may be seen as a major course-correction in crypto space. A win-win for genuine investors concerned about fundamental risk-return dimensions of projects (in contrast to those seeking abnormal gains in short-term from speculative zero-sum games), as well as for genuine innovators in the crypto space (in contrast to fly-by-night operators), the ILO provides for an ideal intermediation solution for the market.

(Source: Crypto Halal)