Financial Regulations & Innovation Regulations are rules concerning what individuals, businesses, and organizations can and cannot do. With innovation taking place at a breakneck speed…
Financial Regulations & Innovation
Regulations are rules concerning what individuals, businesses, and organizations can and cannot do. With innovation taking place at a breakneck speed in the financial services sector, regulatory agencies need to understand the benefits and risks of innovation. While developing appropriate policies, guidance, and/or regulations to reap those benefits, regulators must (1) protect consumers, (2) ensure good market conduct and (3) safeguard the financial system.
What is a Regulatory Sandbox? A fintech regulatory sandbox is a legal classification that creates a space where participating businesses won’t be subject to onerous regulations. The regulatory relief is usually for a limited amount of time — long enough for the regulators to identify the appropriate and perhaps reduced number of regulations for the sector. Since the UK pioneered the idea in 2014, several other countries have adopted similar sandbox policies, including Abu Dhabi, Denmark, Canada, Hong Kong, and Singapore.
MaS-Driven Regulations in Islamic Economy
In the Islamic fintech sector, as in other parts of the Islamic economy, it is the goals (Maqasid) of Al-Shariah (MaS) that should drive the formulation of regulations and rules of behaviour of individuals and firms. Islamic scholars generally find the five-fold classification of MaS quite useful and practical while recommending regulatory and policy action. These maqasid can be classified at the fundamental level into protection and nurturing of deen (faith), nafs (self), aql (intellect), nasl (posterity or progeny) and maal (property). A few contemporary scholars (Laldin and Furqani, 2009) delineate the following specific maqasid to shape the Islamic financial system. These goals include:
Rule-Making Mechanisms
While the maqasid should guide the process of setting regulations in an Islamic economy, scholars (Faraz Adam, 2022) have identified the following mechanisms or processes for setting the regulations:
Ethics and Efficiency Trade-Off
Financial regulations often involve a tug-of-war between concerns about ethics and efficiency. Financial system efficiency is measured in terms of efficiency achieved in wealth creation. While a financial system must be efficient, it must also be ethical and fair to all participants. The idea of ethics or fairness in the financial system is generally discussed within a framework of entitlements or rights of savers and investors. Shefrin and Statman (1992) identify seven classes of fairness relevant to a financial system — freedom from coercion, freedom from misrepresentation, right to equal information, right to equal processing power, freedom from impulse, right to trade at efficient prices, and right to equal bargaining power. The authors then consider specific financial regulations in US and demonstrate how their formulation often involved a tug-of-war between concerns about efficiency and ethics and led to a trade-off between the two.
How do the above norms of financial market ethics differ from the same in the context of an Islamic economy?
Islam provides a fundamental freedom to contract (Allah has made trade lawful. 2:275). This basic norm however, does not imply unbridled freedom to contract. Exchange is permitted only when undertaken in permissible commodities or property (maal). Similarly, the freedom to contract may also be sacrificed when there is a conflict with other norms requiring specific injunctions, such as, freedom from interest or contractually stipulated increase in debt (riba), excessive uncertainties due to inaccurate and inadequate information (gharar and jahl), fraud or deception (ghish), cheating (tadlis), gambling (qimar) or similar conditions, price control and manipulation (ihtikar and najash), over-valuation (ghubn) and other elements resulting in unfair exploitation of either party at the micro level and/or unwelcome consequences at a macro level. Further, in the event of a tug-of-war between concerns about efficiency and ethics the latter should dominate the former.
Case of Digital Assets or Tokens
While the design and maintenance of the tokens differ, proponents of tokens highlight various potential benefits or efficiency-enhancing features. Blockchain-based tokens enable participants to make transfers without an intermediary, without geographic limitation and with finality of settlement. These involve substantially lower transaction costs compared to other forms of payment. Also, these enable all market participants to publicly verify the on-chain transactions. Other often-touted features of tokens include personal anonymity and the absence of government regulation or oversight. Along the ethical dimension, a number of serious concerns have been raised regarding the token markets. One, these markets provide for substantially less investor protection than in our traditional securities markets with correspondingly greater opportunities for fraud and manipulation. The markets make it possible for funds movement across national borders leading to amplification of risks that a single market regulator may not able to effectively pursue bad actors or recover funds. Promoters in these markets usually emphasize the secondary market trading potential of these tokens and prospective buyers are being sold on the potential for tokens to increase in value. There are accompanied by unethical practices, such as wide-spread misinformation campaigns often through social media, wash trading, and other manipulations and frauds. Some of the practices have given rise to new terms, such as, “shilling”, “scalping” and “pump-and-dump” involving serious ethical dilemmas that need close scrutiny.
There is also growing research evidence on widespread market manipulation in the decentralized exchanges where crypto assets are increasingly traded. For example, a recent study found that over 30 percent of all traded tokens on two sampled exchanges were subjected to wash trading — a very conservative estimate according to the researchers — and constitutes the lower bound of the actual event of wash trading activities (Victor and Weintraud, 2021). An estimate puts the amount of money lost from crypto money fraud in the world at a whopping 7.8 billion dollars (Chainanalysis). And as far as the Islamic tokens are concerned, there have been no success story so far; only 5 of 25 Islamic cryptocurrencies have survived (Michael Gassner).
Issues with Fatwa as a Tool of Shariah Regulation
The Islamic edict or fatwa appears to be the preferred mode of most actors in the financial space, especially of the early movers and innovators constrained by time and unfortunately of the bad actors as well. At the risk of bringing some negativity into such a discussion, we have observed in recent times, some Shariah scholars rushing to proclaim crypto trading as haram or halal without adequate research. An example perhaps is the sweeping fatwa by a national body of ulema declaring all forms of crypto transactions as haram (on grounds of being gambling-like transactions) effectively placing even blockchain technology under suspicion. What is more alarming perhaps is to proclaim clearly deceptive transactions (such as wash trading) in worthless tokens as halal by the Shariah Board of a company that claimed to be a first mover in the Islamic defi space.
Shariah Sandbox as a Regulatory Tool
Should we consider Shariah Sandbox as an alternative to fatwa-seeking? The potential benefits of a Shariah sandbox could be significant from:
The Shariah Sandbox as a regulatory tool may ensure the following:
Mufti Faraz Adam who is perhaps the first among contemporary scholars to advocate a Shariah Sandbox, provides the fiqh basis in following words:
Concluding Remarks
There are divergent views on sandbox as a regulatory tool.
Indeed, there are far fewer sandbox success stories than there are critiques of unsuccessful sandboxes. A Shariah sandbox on the other hand is a yet-to-be-tried Shariah regulatory tool. It is hoped that a well-designed and executed Shariah sandbox replacing the premature fatwas would most certainly bring in more benefits. It would help achieve the Maqasid of protecting and nurturing wealth creation by facilitating innovation while protecting the investors and consumers by avoiding the pitfalls of riba, gharar, qimar and other all forms of unethical market conduct deemed prohibited by the Shariah.
Notes
References
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