Bitcoin and Islamic Finance: How Digital Assets Fit into a Sharia-Compliant Portfolio

Bitcoin heralded the birth of the first truly global, open, and free financial market in history. It’s not surprising, then, that a lot of thought has gone into how Muslims, who make up nearly a quarter of the earth’s population, will interact with this market.

On one hand, Muslims are concerned with the position of cryptocurrency in Islamic law. On the other hand, cryptocurrency developers and entrepreneurs from all backgrounds want their work to reach a wider global market, and gaining a stamp of approval from Muslim legal scholars can facilitate that process.

So is Bitcoin halal? What role (if any) should digital assets play in an Islamic investment portfolio? These topics are too big to cover completely here. This article is just a starting point for those who want to know more about the intersection of Islamic finance and Bitcoin.

In a Nutshell

“Islamic finance” refers to the rules and regulations of ethical financial dealings according to Islam. The position of Bitcoin and other cryptocurrencies in Islamic finance is still an area of active research. Some scholars ruled that Bitcoin is permissible, while others are against it.

More research needs to be done to define the exact position of digital assets in Islamic finance.

For now, Muslims who follow the views in favor of Bitcoin should consider a few factors when adding digital assets to their portfolios, including their level of knowledge, risk levels, and design principles.

What is Islamic Finance?

“Islamic finance” refers to all types of business and financial practices that are compatible with Islamic law, also known as sharia. Some of its main features include:

• No Interest. Transactions based on interest are prohibited. In Arabic, interest is known as riba, which literally means “additional,” ie. a sum additional to the principal of a loan.
• No Speculation. Gambling and transactions similar to gambling are prohibited. In Arabic, this is known as maysir, which comes from the same root as yusra, which means “ease.” In other words, it literally refers to easy money made without work or investment.
• No Excessive Risk. Transactions that are ambiguous or have a high level of uncertainty or risk are prohibited. In Arabic, this is known as gharar.
• Profit/Loss Sharing. Risks and rewards must be distributed between all parties in a deal, rather than one person shouldering all the risk.
• Links to the Real Economy. Transactions must be connected to real goods or commodities. This means that most kinds of derivatives are not allowed, since they are abstract extensions of real value.

This sounds good in theory, but the reality is a bit trickier. One of the problems that has plagued the Islamic finance industry is so-called “scholars for dollars.”

Some top Islamic scholars are reported to receive “six-figure sums” in exchange for their support. As a result of questionable certification standards, Mufti Taqi Usmani, a leading scholar of Islamic finance, declared in 2010 that 85% of the Islamic bond (sukuk) market was “un-Islamic.”

There are so many vested interests when it comes to finance. So it’s not surprising that someone would try to “game the system.” This means that conscientious investors need to exercise extra caution when shopping for Islamic investments.

Following is a summary of the debate surrounding Bitcoin and cryptocurrencies among Islamic scholars. This discussion can help understand some of the key issues surrounding investment in digital assets from an Islamic perspective.

Is Bitcoin Halal? What Do the Scholars Say?

So far, scholars of Islamic law have had different opinions on Bitcoin.

Opinion #1: Bitcoin is Haram.

Some scholars, like Taqi Usmani, Assim al Hakim, Haytham Haddad, and others, ruled that it is haram, or forbidden. Almost all of them cited uncertainty or gharar as the main justification for their views. In other words, because the future of Bitcoin was unclear, they considered it too risky to be advisable as an investment.

Almost all of the scholars who considered Bitcoin to be haram stated that it “is not backed by anything.” This is linked to the requirement in Islamic finance that transactions have a link to the real economy.

This view may be based on an incomplete understanding of the nature of bitcoin mining. In fact, the value of bitcoin is directly linked to the price of energy, since energy consumption secures the network. Energy consumption is also required for the issuance of new bitcoin, meaning it does not fall into “creating money out of nothing,” which is haram.

To be fair, there is a huge amount of speculation that goes on in cryptoassets, and a lot of people have lost large sums hoping to get rich quickly. There is also no denying that the largely unregulated nature of digital asset markets makes them more susceptible to fraud and manipulation, adding additional risks.

Opinion #2: Bitcoin is Halal.

Mufti Muhammad Abu Bakar, however, published a study where he points out that just because an asset is used for haram activities does not make the underlying asset haram. Abu Bakar is one of a number of scholars who consider Bitcoin investments to be halal.

Mufti Faraz Adam authored a detailed study on bitcoin, which discusses many of the same concerns held by scholars who came out against bitcoin. He concludes that bitcoin investments and profits could be halal.

Likewise, the Fiqh Council of North America unanimously agreed that Bitcoin is halal, although they did not issue a statement on other cryptocurrencies.

Amanie Advisors, an Islamic investment advisory firm chaired by Dr. Mohamed Ali Elgari, a professor of Islamic Economics at King Abdulaziz University in Saudi Arabia, issued a whitepaper which found that Ethereum (ETH) is halal.

They justified this conclusion by the fact that ether, Ethereum’s native currency, is a utility token used to access a service— Ethereum’s application and smart contract platform. Of course, bitcoin can also be viewed as the way to access the Bitcoin network, which specializes in preserving, storing, and transferring wealth.

Opinion 3#: Undecided.

Some scholars, like Salih al Munajjid, took a more cautious approach and did not label Bitcoin as halal or haram. Munajjid clarified that the rulings like obligatory charity (zakat) would apply to Bitcoin, as with gold or dollars, but said that further guidance would depend on the discussions between experts in the fields of Islamic law, economics, and technology.

Islamic Finance and Bitcoin: Do Digital Assets Fit into an Islamic Investment Portfolio?

For Muslims who believe that the case for Bitcoin is stronger than the case against, Bitcoin and other digital assets may be a good investment option.

Bitcoin is trying (quite successfully so far) to fix a problem that is especially rife in Muslim-majority countries— inflation.

Inflation rates across the Muslim world are more than double the global average. This makes it an especially attractive investment option in many countries compared to holding savings in cash.

People in countries suffering from currency instability have long seen the US dollar as a safe haven asset, but the dollar is no longer immune from inflation fears. Gold bullion is still a reliable store of value, but it lacks some of the versatility of cryptocurrency.

In particular, Bitcoin is an attractive option for preserving wealth in areas with corrupt, totalitarian regimes. In the event of geopolitical instability, cryptocurrency may be the only way to get wealth out of countries with restrictive capital controls.

Gold is the most tried and true hedge against inflation, but in certain cases, Bitcoin can offer investors some of the desirable properties of gold with additional versatility.

The fact that digital assets like Bitcoin have the potential to solve so many problems means that their popularity and value are likely to grow in the future. Before investing, however, there are a few things to consider.

Are you investing, or trying to get rich quickly?

Like stocks, purchasing a digital currency is an investment. Buying and holding it supports its value, and the value helps to support the development and adoption of the asset. In most cases, it’s necessary to hold for a period of at least several years for it to be profitable.

Digital currencies are notoriously volatile, and it can be difficult to weather periods of volatility if you are not confident in the fundamentals of your investment. It’s important to research and know what you are investing in.

Most people who have lost large sums of money investing in digital currency did not know what they were investing in and were hoping to get rich fast. This is reminiscent of classical Islamic scholar Ibn Hazm’s description of gharar as a transaction where “the buyer does not know what he has bought.”

Proof of Work vs. Proof of Stake

Most digital currencies use one of two consensus protocols to achieve security; proof of work, or proof of stake. It’s still an open question as to which one is more appropriate for a sharia-compliant portfolio.

As described above, one argument is that proof of work requires work (energy consumption), which gives it a link to the real world. Proof of stake consumes less energy, but can more easily become disconnected from the real world economy, which could be an issue from an Islamic perspective. Some might argue, however, that proof of work wastes energy.

This is a subject of intense debate that might be worth researching before investing.

Major proof of work currencies include Bitcoin (BTC), Dogecoin (DOGE), Litecoin (LTC), and Monero (XMR). Proof of stake currencies include Ethereum (ETH), Cardano (ADA), and Polkadot (DOT).

Digital Assets with Built-In Interest

A number of digital assets have interest built-in on the protocol level. It’s difficult to consider these as halal investments by any standard.

Assets that fit this description include Maker’s Dai (DAI), a decentralized stablecoin pegged to the dollar, and a number of other Decentralized Finance (DeFi) tokens that involve “yield farming.”

Yield farming is a way of providing liquidity to decentralized markets by offering incentives to users to act as market makers. Mufti Faraz Adam believes that most yield farming practices are currently interest-based.

Assets that include these features include Uniswap (UNI), Sushiswap (SUSHI), Pancake Swap (CAKE), and Aave (AAVE), among others.

How High Risk Is It?

Islamic scholar Sami al-Suwailem described gharar with a slightly different wording: “that which admits two possibilities, with the less desirable one being more likely.” 

This understanding of gharar could apply to high-risk investments in general. There are thousands of small-scale and unknown cryptocurrencies. Some of them can increase in value very quickly, but these smaller currencies are notoriously dangerous.

It’s probably best to stick with assets with established track records and who are backed by credible experts in investment and technology.

The Beginning of a Long Journey

Fundamentally, digital currency represents a new method of human organization. Decentralized protocols like Bitcoin can align incentives for large groups of people, worldwide, and get them working together. This technology has huge potential to be used for either good or evil.

This article is just an introduction to investing in digital assets in light of Islamic finance. There’s a long road ahead when it comes to understanding how to ethically invest in and use digital currency. Ideally, correct application of the principles of Islamic finance can preserve and grow wealth, as well as having a positive influence on the development of this emerging asset class.

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Source: https://www.bitcoinmarketjournal.com/bitcoin-and-islamic-finance/