Walking the walk: Islamic finance titans take on crypto

From Malaysia to Bahrain, some of the most influential Shariah finance players are taking a decisive stance against cryptocurrencies and their related activities by regulating the volatile asset class that is taking the world by storm. IFN Fintech reviews the developments which have unfolded in recent months and explores their potential implications as well as significance.

Busy first quarter 
It has been a busy first quarter for regulators in key Islamic financial jurisdictions. In Asia, one of the world’s largest Islamic finance markets, Malaysia, and the most populous Muslim nation, Indonesia, put their foot down and began regulating the trading of crypto assets. In the Middle East, the Kingdom of Bahrain – one of the most ardent proponents of Islamic fintech – finalized its regulations on initial coin offerings (ICOs), Shariah finance heavyweight Saudi Arabia is exploring the prospects of rolling out a common digital currency with the UAE, which simultaneously is working on introducing a more robust ICO regulatory framework. 

Let’s delve deeper. 

At the end of February, the Central Bank of Bahrain (CBB) released the final rules on a range of activities related to crypto assets including licensing, governance, minimum capital, control environment, risk management, AML/CFT, standards of business conduct, avoidance of conflicts of interest, reporting and cyber security for crypto asset services. The regulation also covers supervision and enforcement standards including those provided by a platform operator as a principal, agent, portfolio manager, adviser and as a custodian within or from the Kingdom.  

It comes as no surprise that consumer protection drives the direction of the new rules. The regulator emphasizes the need for enhanced due diligence when onboarding new clients, spells out requirements to ensure that all encrypted safe custody accounts or wallets can be retrieved, mandates providers to ensure keyman risks are adequately managed including by having the necessary insurance covers and to also ensure that clients are educated and given clear instruction on the use of safe custody wallets. 

Shortly after the rules were finalized, the first crypto exchange operating in the CBB’s fintech regulatory sandbox graduated from the program. RAIN Financial, a Shariah compliant exchange, will be applying for a proper license – and should it be approved, would be the first exchange to be regulated under the new framework which also dictates rules relevant to order matching, pre and post trade transparency, measures to avoid market manipulation and market abuse.  

Having an Islamic crypto exchange as the first digital exchange to complete the fintech sandbox program lends further credence to Bahrain’s Islamic fintech ambition and capabilities. It builds upon the fact that the Kingdom was the first in the region to issue crowdfunding and peer-to-peer financing rules, which also included dedicated provisions to accommodate Shariah compliant platforms. The Gulf nation’s commitment to carving itself as a regional fintech hub, for both the conventional and Islamic sectors, was amplified early last year when the apex bank led the way in establishing a dedicated Fintech and Innovation Unit.  Since the formation of the unit, multiple initiatives have been spearheaded including new guidance on digital finance advice rolled out this year; more policies are expected this coming year as the Kingdom strives to not only keep pace with, but also lead, innovations taking place in major financial centers. 

“The CBB’s introduction of the rules relating to crypto assets is in line with its goal to develop a comprehensive [set] of rules for the fintech ecosystem supporting Bahrain’s position as a leading financial hub in the MENA region,” affirmed Khalid Hamad, the executive director of banking supervision at the CBB. 

Ringfenced within its own bubble by US-led sanctions, Iran is serious about using cryptocurrencies to circumvent restrictions surrounding the use of the greenback to conduct international businesses and enter the global financial system. 

Despite an ongoing ban on the use of global digital currencies to make payments within the Republic (a measure put in place to cushion the fall of the Iranian rial), the Hassan Rouhani administration began recognizing cryptocurrency mining as an industry last September and even voiced plans to introduce a national virtual currency to facilitate international transactions with countries it is on friendly terms with.  

The Islamic Republic, one of only two in the world which adopts a fully-fledged Islamic financial system, at the end of January published an early draft of its cryptocurrency regulatory framework. 

The proposed rules are significantly consequential and would even overturn the government’s previous ruling prohibiting financial institutions in the Republic from dealing with digital currencies. Under the proposed guidance, the Central Bank of Iran (CBI) would recognize ICOs as an authorized capital-raising channel and thus opening a significant avenue for domestic corporates to raise funds as well as for local investors to participate in. Tokens, cryptocurrency wallets, cryptocurrency exchanges and mining processes would also fall under the remit of the Iranian apex bank. 

While the regulator is positioning its move as a step in the right direction, the crypto community are, as expected, wary over the implications of certain measures seen as restrictive. In particular, the ban on international cryptocurrency payment methods, which would impact crypto traders. This restriction however only applies to non-rial backed tokens. The framework, which is a work in progress (the regulator has assured feedback from the community will be taken into consideration) also dictates that only certified banks can operate digital tokens and the currencies can only be traded on licensed crypto exchanges while the central bank holds monopoly power over rial-backed and regional cryptocurrencies. 

For a country which had ostensibly closed its doors to crypto currencies following a nationwide ban on crypto-mediated payments in 2018, it was a welcomed surprise that the Republic of Indonesia in February released rules on the trading of crypto assets, signaling its acceptance of the digital asset. 

But on the other side of the coin, it also demonstrates the unstoppable force and hold of virtual currencies among its 264-million strong people: despite the central bank ban, several Indonesian merchants are said to have engaged start-up Pundi X for its crypto point-of-sale terminals; Pundi X is building its business on the expectation that the prohibition would be lifted by 2020. While the ban triggered the dissolution of at least two crypto exchanges last year, one of the largest digital currency platforms in the Republic, INDODAX, was confident that it would be able to grow its registered user base to 15 million by the end of 2018 – outnumbering the user pool registered with the country’s official stock exchange. 

It would be remiss for the country’s financial regulators to ignore the phenomenal popularity of crypto assets which brings us to the Commodity Futures Trading Regulatory Agency, or Bappebti’s decision to have all cryptocurrency futures exchanges registered and approved for operations. This means that crypto assets are officially treated as commodities that can be listed and traded on the nation’s futures exchange.  

While the move to allow the trading of cryptocurrencies can be viewed in a positive light, some industry practitioners have their reservations that certain provisions are hampering growth. Under the new rules, apart from the expected requirements of robust cyber security and risk assessment processes, futures exchanges and clearing houses need to also have a minimum paid-up capital of IDR1.5 trillion (US$106.2 million) and must maintain a closing capital balance of at least IDR1.2 trillion (US$84.96 million) while approved futures traders and storage service providers are expected to hold at least IDR1 trillion (US$70.8 million) in minimum paid-up capital and IDR800 billion (US$56.64 million) in closing balance. 

Market participants have decried these capital requirements as being unfairly high. For comparison, the minimum paid-up capital requirement for a rural bank in Jakarta (the highest bracket) is IDR5 billion (US$354,005), the commitment from peer-to-peer financing platforms who wish to be registered with the financial regulator is IDR1 billion (US$70,801) and IDR2.5 billion (US$177,002) if one wants to be licensed. In contrast, futures traders of ‘traditional’ commodities are required to commit a paid-up capital of only IDR2.5 billion. 

Nonetheless, Bappebti’s move, and its intentions to roll out regulations on digital currency exchanges, wallet providers and mining companies, taxation and prevention of money laundering and terrorism financing through virtual currencies, in close collaboration with other Indonesian authorities including the central bank and Otoritas Jasa Keuangan, the finance industry’s regulating body, are positive indicators toward a potentially more conducive and secure operating environment for digital currencies. These could also encourage greater utilization and acceptance of Shariah tokens: Indonesia is after all the home to one of the earliest Islamic start-ups (Blossom Finance) to power financial transactions using distributed ledger technology and bitcoin. Local entrepreneur Sofia Koswara is also behind NoorToken, a digital currency marketed as being compliant to Muslim laws. 

After months of keeping the industry in limbo, the Securities Commission Malaysia (SC) finally issued its regulation on crypto exchanges at the end of January. Malaysia’s regulations on digital currencies have long been anticipated especially after Finance Minister Lim Guan Eng stirred some concerns mid-January by stating that anyone caught operating unauthorized ICOs or digital asset exchanges risk being sent to jail for 10 years and fined RM10 million (US$2.45 million) under Order 2019 which would be effective the 15th January 2019. 

“Many industry players were taken by surprise with a sudden blanket statement on the ruling for all digital currencies and digital tokens. Some exchanges responded by temporarily shutting down operations while awaiting clarification,” peer-to-peer cryptocurrency and blockchain platform NEM shared. 

The SC was quick to respond, releasing a new framework a fortnight after the minister’s statement was made. The new rules have been parked under the Guidelines on Recognized Markets, the same guidelines which apply to equity crowdfunding and peer-to-peer financing platforms.  

Expressing its gratitude over the swiftness by the SC in responding to industry feedback, NEM further explained: “The landing would have been much softer if the government had engaged with the industry first before any ratification. The ramifications can be significant, especially when the underlying technology is a necessary solution to it, more so when the very same technology can be used to power solutions that may not fall under the purview of the above Order.” 

Not covering ICOs, the revised guidelines regulate crypto exchanges, or digital asset exchanges. Unlike its Indonesian neighbor, Malaysia has taken a laxer approach suggesting its willingness and commitment to develop the asset class as an alternative fundraising avenue. Key requirements include RM5 million (US$1.23 million) in paid-up capital; approval by the SC on every digital asset prior to listing; formation of at least one trust account in a financial institution licensed in Malaysia; trade to be executed using the local currency or any other legal tenders; clear mechanisms for trading; clearing and settlement as well as clear, concise and fair investor disclosures; and a robust risk management system.  

“The new framework is part of the SC’s efforts to promote innovation while ensuring investor protection in the trading of digital assets,” said SC Chairman Syed Zaid Albar. He added that while there is a framework to facilitate the trading of digital assets, investors are reminded to be mindful of the risks when dealing in digital assets such as sudden price fluctuations and liquidity risks. 

In less than a month after the SC released its framework, the central bank issued the Anti-Money Laundering and Counter Financing of Terrorism Policy for Digital Currencies (Sector 6) which has taken into account feedback received during the public consultation period on the exposure draft released on the 14th December 2017. The policy aims to ensure that effective measures are in place against money laundering and terrorism financing risks associated with the use of digital currencies and to increase the transparency of digital currency activities in Malaysia. 

Regulation on ICO is expected to be unveiled in March and this would be closely watched by the community including the Islamic sector as several Shariah fintech platforms are mulling ICOs, including Kuala Lumpur-headquartered HelloGold which successfully raised funds through its token offering in 2018. 

The Central Bank of Kuwait is understood to be mulling the introduction of a national cryptocurrency and payment system sometime this year or next, although no concrete decision has been made. To be known as the Kuwaiti National Payment System, the new mechanism, which would be engineered with the help of banks and payment service providers, would reportedly include an electronic currency, e-banking services and an automated clearing house.  

Saudi Arabia 
While Kuwait is still in early stages of consideration, Saudi Arabia jumped ahead announcing a common digital currency project with the UAE on the 29th January. To be known as ‘Aber’, the Saudi Arabian Monetary Authority (SAMA) and the Central Bank of the UAE (UAECB) will jointly explore and experiment using distributed ledger technology for cross-border financial settlements. SAMA explained that the proof-of-concept will help the two Arab nations understand the dimensions of blockchain technology and its practical applications which would help them in navigating the dynamics of issuing a digital currency for international use. 

“Furthermore, it will establish an additional means for the central financial transfer system of the two countries and enable banks to directly deal with each other in conducting financial remittances,” explained the Saudi regulator, adding that Aber could be used as an additional reserve system for domestic central payments settlement in case of disruptions to existing systems. 

Under the project, which is part of a broader bilateral strategy designed by the Saudi-Emirati Coordination Council to facilitate mutually beneficial economic integration, the electronic currency will be restricted to a handful of banks in each jurisdiction. 

“In [the] case that no technical obstacles are encountered, economic and legal requirements for future uses will be considered,” SAMA said.  

This could be a promising step toward a wider adoption of digital currencies, which the Kingdom had previously said were Haram. 

The UAE 
As the UAECB continues work with its Saudi counterpart to launch a common digital currency, the Securities and Commodities Authority (SCA) of the UAE earlier this year has confirmed plans to roll out regulations for ICO by June 2019.  

It is understood that the regulator has engaged legal firms to draw up parameters for a sandbox and will be working with the emirate’s two exchanges – Dubai Financial Market and Abu Dhabi Securities Exchange – on the rules governing the offering of ICOs.  

The country is no stranger to digital currencies: the Financial Services Regulatory Authority of the Abu Dhabi Global Markets released rules on virtual currencies back in 2017 while homegrown company Adab Solutions is preparing to officially launch the First Islamic Crypto Exchange this year. 

Right direction? 
The exponential growth of the crypto community and pervasive presence of digital currencies in the global financial system have demanded the attention of governments. Compared to a year ago when most major Islamic finance markets were still assuming a wait-and-see approach, many are now taking a proactive stance to assert control over the erratic volatile asset class that could cause systemic discord, if it hasn’t already. 

The keenness of these major Muslim markets in embracing digital currencies may also revive hope for an internationally-accepted single Islamic currency, known as the Islamic dinar, which some view as a more efficient form of medium for trading and financial transactions for the Muslim community.

Striking the right balance between regulation to ensure financial stability while protecting consumers and overregulation is however tricky; more so if one were to espouse Shariah compliance in its cryptocurrency venture, which in itself is a divisive topic among Islamic scholars. Shariah finance practitioners and Islamic fintech start-ups note the moral obligation and the societal pressure to “do things right” when taking the Shariah route because failure of any one entity or instrument would irrationally be perceived as the failure of the whole Shariah finance system.  

In February, an outfit called Crypto Islamic Bank which has been marketing its services, which include mining, wallet, exchange, trading and asset management, as Shariah compliant was blacklisted by the Swiss Financial Market Supervisory Authority.  

“There are more claiming that their cryptocurrency is Islamic without any real proof certifying the compliance of the crypto to Shariah laws – and this would impact the work of the rest who have gone through the tedious process ensuring every mechanism and structure of any digital currency project is permissible in Islam,” commented one industry participant. “In the case of Crypto Islamic Bank, there were many red flags: the company was not transparent – it did not disclose its management team, did not share its roadmap, nor secure any approval from any jurisdiction to operate. Shariah compliance aside, there were many distressing signals about this entity.” 

With a growing number of “Islamic” cryptocurrencies hitting the market, the pressure is heavier on regulators and Shariah scholars to not only ensure the validity of these digital money but also faithfulness to the scriptures; and consumers also need to be aware and educated on differentiating scams from legitimate initiatives.  

While those operating in this space cautiously welcome regulation of virtual coins, the community has made a clarion call for regulators to consider the voice of the industry before taking any drastic moves to ensure a balance between effective regulation and stifling overregulation can be struck. 

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