Bitcoin, Fiat, and Islamic Finance
An Economic, Ethical, and Historical Analysis of Sound Money in the Context of Islamic Teachings
Harris Irfan & Allen Farrington
EN
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introduction
An economic model emerging from faith principles that promote patience and self-discipline, sustainability and preservation of wealth, and that discourage high time preference and wasteful consumption, is not compatible with a modern, neoliberal concept of financialisation, the creation of money through the act of lending, and the consequent proliferation of debt and financial services throughout the economy.
Instead of acting from first principles, modern so-called Islamic banks have made the fatal error of developing their products to compete with the interest-based conventional banking industry. Instead of offering banking as a custodial service, holding customer wealth on trust, and then offering separate wealth management and investment services that share profits in real industry, they operate as fractional reserve banks—they take in customer deposits whilst simultaneously lending far more than they take in, thus creating new money in the process. This creation is an act of alchemy; the money created by the loan they make never previously existed and, indeed, one might reasonably conclude that fraud occurs every time a bank lends money. This excess of money on money is the very definition of the Islamically proscribed sin of riba, or usury. The products Islamic banks offer their customers are miraculously sanctified by dint of being governed by halal or Shari’a-compliant contracts.
The Islamic banking industry has doomed itself to repeat the mistakes of the conventional banking industry. Rather than emphasising a return to the roots of the Islamic economic model (profit-sharing in the real economy) as it once promised in its early experimental phase some sixty years ago, instead, its current business model celebrates the financialisation of the economy leading to more debt and more financial services.
Overlaying these faith-compliant contracts on a base that requires the money supply to be inflated through the act of lending cannot be the social outcome intended by the Islamic economic model. Islam is not alone in this view. When Jesus violently evicted the money changers from the Temple of Herod(1), he was raging against their practice of charging pilgrims an unfairly high weight of foreign silver coinage in exchange for their Temple tax of a half shekel coin. This debasement of money was no different in concept to the modern debasement of the money supply through bank lending and central bank printing. Jesus would have hated modern bankers, too.
It wasn’t supposed to be this way. When the Egyptian economist, Ahmed El-Naggar, established the first modern Islamic financial institution in the town of Mit Ghamr in 1963, his vision was a return to prophetic economics, in which the financier took deposits and invested these deposits in local industry, then shared the profits with depositors. The foundation of this economic model was trade: Finance was merely a lubricant to the real economy, not its master. The Prophet Muhammad (peace be upon him(2)) was himself a mudaarib, a manager of other people’s capital, taking in investments to engage in the caravan trade, risking the harsh environment of the desert and the dangers of banditry, buying real goods on his travels and returning to the city to sell them in the market, and then splitting the profits according to a pre-agreed formula with his investors. This was the purest form of Islamic Finance.
But as the Mit Ghamr experiment was rolled out across eight social savings institutions in Egypt, it began to morph into a replication of fiat fractional reserve banking. In 1975, the first wholesale Islamic bank and the first multilateral were established in the region. Both had set out with the intention of commercialising Islamic Finance, but both fell into the trap of reverse engineering conventional debt-based financing. At a time when Gulf monarchies were beginning to embrace Pax Americana, perhaps it was deemed tolerable for their financial institutions to develop their own cultural identity but not so much that they might isolate themselves from their most important strategic partner, and—besides—the lure of printing money was too powerful to ignore. Islamic banking was sucked into the orbit of the fiat monetary system.
Modern economics is a dogma, and one that ignores economic history. This dogma is the reason why Enron was feted as “America’s Most Innovative Company” by Fortune for six consecutive years, then collapsed spectacularly in a fog of hidden debt and toxic assets in off-balance sheet special purpose vehicles. The same dogma celebrated the financial securitisation industry, reasoning that chopping up poor quality loans, each with a potentially high rate of default, and then pooling them into collective loan vehicles called “collateralised debt obligations” somehow miraculously made them a good credit. When fantasy caught up with reality and the pooled bad credits imploded on themselves, the world endured the misery of the Global Financial Crisis.
Despite this and other obvious failures, the banking lobby labels criticism of money creation through the act of lending or the structuring of intangible derivative instruments that are far removed from the real economy as extreme or unbalanced. Economists are like the Christian priests of the Middle Ages, delivering the word of God in Latin to obfuscate and confuse, allowing them to stand between and control the people and truth.
The failure of our financial and monetary system during the Global Financial Crisis and the subsequent bailout of banks, which required an injection of trillions of dollars in new money, is still playing out today. Rather than seek to treat the disease, our monetary system seeks only to temporarily, periodically, and iatrogenically relieve the symptoms. Those priests use Latinesque neologisms such as “quantitative easing” and “injecting liquidity” to disguise the fact that wealth is being stolen from ordinary citizens through inflation to balance out the boom-bust cycles that are themselves caused by credit creation unshackled from real wealth or, it must be noted, real money. The gap between the rich and the poor widens, the transfer of wealth from the global south to the global north increases at an exponential rate, and our world becomes increasingly polarised and disharmonious.
Does the fault lie with the banking and monetary system, or rather with its managers? The public electorate appears to believe it is the latter: By electing new governments and appointing new central bankers promising more prudent “management of the economy,” they put their trust in new managers to correct the troughs in the economy. However, government and central bank policy has been consistently ineffective. In the late 1980s, for example, higher UK interest rates did not curb growth in the money supply and did not reduce inflation as neoclassical economic theory suggested it would. The logical conclusion is that the fault lies with the system.
Veneration of GDP and modern valuation methods leads to a market society that prefers exchange value instead of experiential value. As a result, our time preference increases. We want stuff now, and we want a lot of stuff. The resilience and sustainability of society decreases because we consume and prepare only for the immediate future. We prefer to spend money and replace things more frequently because infinitely printable money devalues fast. We spend money on socially useless ventures and build obsolescence into new products. We don’t mend broken things; instead, we throw them away and buy new things. We pollute and desertify. This is high time preference, a borrow-spend-consume model that distorts a true culture into a mere economic zone—a joyless place that will ultimately leave us numb and spiritually unsatisfied.
Is a different approach even possible? Can we systematically embed the encouragement to save and invest for the future, where we value long-term sustainability, where money does not devalue so fast that we make stupid and hasty investment decisions, and where we instead conduct careful due diligence on underlying real economic activity? What if we could develop a financial and monetary system that stops debt from being so all-pervasive that the marketplace is dominated by a few giant actors with access to even more artificial credit that makes them not only big, but, in fact, too big to fail?
It seems unlikely that such a system could be developed. The world is complex and imperfect. Human beings are greedy and unpredictable. A system that works for the powerful few is not one that is likely to change, or one those powerful few will allow us to change. But what we hope to show you is that we already have the tools to effect that change. One of those tools is an economic model that relies on a values-based code of justice and equity. The other is a monetary system that cannot be manipulated and inflated, that is censorship-resistant, secure, and finite.
Before diving in, allow for a short and more personal introduction from each of the present coauthors, so as to understand our perspective and appreciate what we are trying to achieve:
“I am the cofounder and CEO of Cordoba Capital Markets, an Islamic trade finance platform, and an advisor to Onramp MENA, a multi-institutional Bitcoin custodian. In the early 2000s, I cofounded the Islamic Finance team at Deutsche Bank, where we invented sophisticated Shari’a-compliant financial instruments, including the now-ubiquitous “benchmark-sized sukuk” or Islamic bonds.
Several years ago, when I was still an investment banker, I used to deliver lectures on the subject of Islamic Finance. I had spent over a decade with Deutsche Bank, and I felt rather smug about the socially useful impact my work was having in the field of ethical finance. I was wrong about the social impact. Even though I imagined myself a champion of the Islamic Finance industry by designing what I believed to be brilliant new products, persuading big banks to sell these products to the Muslim demographic, and generally evangelising the concept of halal, interest-free banking, I was in fact fooling myself. Islamic banking is an oxymoron. Even if a financial product is legally structured using Shari’a-compliant contracts, if the basis on which that instrument is offered is via money creation through the act of lending by a fractional reserve bank, then the two concepts cannot logically coexist.
As a practising Muslim, I believe that riba (usury) is a sin so heinous that we are warned to “beware of a war with Allah and His Messenger”(3) for transgressing this sin. My intention had always been to reflect prophetic economics—a return to the roots of trade just as the Prophet (pbuh) himself practised—in the financial instruments I designed. Despite many years of effort, I concluded it was simply not possible to reflect “true” Islamic Finance through the medium of banking. I quit the industry to establish a non-bank financial intermediary to implement what I believe to be a purer model, one that shares the risks and rewards in real trade activity.
An ethical financing model requires a monetary system that is not infinitely printable and that cannot be manipulated. We don’t live in such a world today, but I believe a solution does exist …”
- Harris Irfan
“I am the cofounder of and General Partner at Axiom, a venture capital firm focused on the Bitcoin ecosystem, and cofounder and CEO of Flux, a Bitcoin-Native Asset Manager. Prior to moving into the Bitcoin space, I worked in institutional asset management. I gradually came to realise that, while pricing and providing primary capital to businesses is obviously a socially worthwhile enterprise, in the modern version of this industry, this task is very much secondary to perpetually chasing the corrosive power of inflation for beneficiaries who are merely trying to “save.” This simple task, as core to the prudence of an individual as to the health of a civilisation, is simply not possible with fiat money and without gargantuan intermediation. Most of “asset management” is hence a market reaction to fill this need. And yet, while ballooning into a largely parasitic complex that enriches its own participants first and foremost and provides ersatz savings poorly and as an afterthought, it seems the industry as a whole contributes to credit creation just as much as it solves it. It is scarcely less iatrogenic than fiat banking.
Insofar as my interest in Bitcoin is social as opposed to technical, it is to try to contribute to solving these problems and return to a fairer, more stable, and frankly more sane financial system on a hard money standard: one in which financial intermediaries are optional, not essential, and whose purpose is to allocate primary capital to worthwhile endeavours, not to misallocate it in the creation of endless credit bubbles.
As Harris and I will explore in this piece, while I am not myself Muslim, I have come to believe that Islamic Finance is what will naturally and necessarily emerge on top of Bitcoin, to the extent financial intermediation still is useful and worthwhile, yet, perhaps curiously, regardless of the intentions of its proponents. The short version of this thesis is that Islamic Finance was ideated around the Dinar of the Islamic Golden Age—one of history’s hardest and most tenured monetary standards—and that the appreciation of real scarcity, of uncertainty, and long-termism that this forces on its participants naturally came to be codified in its ethical system. That this doctrine already exists for us to inherit, study, and implement is nothing short of a blessing. The long version is all that follows …”
-Allen Farrington
1 - Matthew 21:12-13, Mark 11:15, Luke 19:45-46, John 2:12-16.
2 - Hereinafter, we omit the term of reverence “peace be upon him” (or “pbuh”), a rough approximation of the traditional Arabic phrase salla Allahu ‘alayhi wa sallam—or the blessings of Allah and peace be upon him—when referring to the Prophet. This is to facilitate a little more fluidity of prose for non-Muslim readers, though of course Muslim readers would voice this phrase whenever the Prophet is mentioned.
3 - Qur’an, 2:279.
part 1: islamic finance
i) The Tenets of Islamic Finance
If one were to read a textbook on Islamic Finance, it would probably start by explaining that the principles of Islamic Finance are derived from the two primary sources of Shari’a, or Islamic law. The first source would be the Qur’an, the word of God transmitted through what Muslims believe to be His last and final messenger, the Prophet Muhammad. The second would be the recorded sayings and actions of the Prophet, and approved actions of his companions, collectively known as the books of hadith.
Broadly speaking, but not as an inviolable rule, the Qur’an tends to set out a code of morality, the general principles of a way of life. The hadith, on the other hand, are often practical examples of how to apply these general principles. After the Prophet’s death, scholars codified various bodies of jurisprudence—or fiqh—based on these two sources. One of those bodies of fiqh was the jurisprudence of transactions, or fiqh al mu’amalat. And it is from this body of work that the early Islamic Age witnessed the development of financial instruments that enabled long-distance commerce and cross-border finance.
At this point, the textbook would proceed to define a series of words that sound confusingly similar to a non-Arabic speaker, all describing various types of commercial contracts that supposedly underpin the commercial and financial arrangements found in modern Islamic Finance. In the real world, however, Islamic financial institutions will ignore almost all of these theoretical constructs and instead focus on the very few that most closely approximate to a loan with interest to transact most of their business.
Far more instructive is to go back to the sources of Shari’a. What do the Qur’an and books of hadith say about our relationships with our family, with our neighbours, our communities, travellers, and strangers? How should we behave with one another, transact with one another? What is a permissible type of trade? What is impermissible?
If we were to do this, we might come to the following conclusions (in no particular order):
Give generously in charity, protect orphans and the needy, look after the traveller.
Be fair in your dealings; don’t take advantage of the weak and the vulnerable.
Riba (interest) is haram (impermissible). That’s a biggie. We’ll talk more about that later.
“Take pains in real economic activity:”(4) The interests of humanity are best served through real trade skills, industry, and construction, and not through financialisation.
Allah created money “so that [it] may be circulated between hands and act as a fair judge between different commodities.”(5) Money is a medium of exchange, not a commodity to be traded.
It is better to share risk rather than transfer it, as asymmetric arrangements lead to socially poor outcomes.
You have a right to pursue wealth, but this life is temporary and a test, so be mindful of God, harm no one, and be a steward of the planet.
Prices are in the Hand of God. Price regulation and centralisation of the market creates injustice.
Combining these points in various ways, Islamic Finance is remarkably astute on the real risks associated with entrepreneurship. It could even be said that it mandates humility in the face of economic uncertainty because the idea that you can know what is going to happen is not just impossible (in the Hayekian sense) or foolish (in terms of common sense) but is blasphemous. Only Allah knows all, and so to act as if you know what is going to happen is deemed morally wrong. Given you can’t know what is going to happen, you must make an informed decision and take responsibility for it. Hence, if you somehow stand to benefit no matter what happens, you are seen as having unacceptably disregarded a personal responsibility to effect positive change in the world. You don’t have to take on any particular responsibility, but if you want an uncertain reward, that should only follow from having skin in the game.
Adapting this essentially ethical insight to practical application sheds valuable light on the importance of riba, which is much more nuanced than its common (Western) characterisation as “interest:” If you lend to a business and you intend for your payback to come from interest payments following that business’s profitability but before disbursal to shareholders or reinvestment, you will get your payback no matter what happens. It doesn’t matter if the business does well or poorly; it doesn’t matter who is taking what responsibilities and making what decisions—you will be paid back.
This is the source of the violation as it seems impossible to avoid violating at least one of the tenets described above: Either you are claiming to know the future—you know you will be paid back because you know what is going to happen—or you are avoiding responsibility—you don’t know the future but it doesn’t matter because you will profit no matter what happens. This is perceived as “risk transfer:” Between those providing the capital for an enterprise, the risk is being transferred from one party to another rather than being shared.
ii) The Implementation of Islamic Finance
So what should Islamic Finance look like?
If Islamic economics intends that entrepreneurship should be encouraged and rewarded, but without tyranny or exploitation, then Islamic Finance must look to its roots in trade. When the caravans exited the city walls of Medina to acquire textiles and spices, returned to the city and traded their goods in the market, the profits thus made were split between the managers (who endured the very real physical risks of trading) and their investors.
When both parties—managers and investors—have skin in the game, both are incentivised to choose their ventures and their partners wisely. The Prophet himself was a mudaarib, a manager of people’s capital. So impressed was one of his investors with his character and (perhaps also) his managerial abilities, that she proposed marriage to him. Khadijah, one of the wealthiest merchants in the city, saw in him not just a capable business manager but an ideal life partner, someone with extraordinary dynamism, honesty and honour.
This investment management arrangement is known as a mudaraba. Its first requirement is that the venture being invested into should be lawful and halal, or religiously permissible. Thus, for example, the venture may not engage in the trading of alcohol or run a casino. The venture must be sufficiently defined to minimise gharar, or uncertainty. An example of gharar might be the sale of a pregnant cow: The calf may be stillborn and therefore one cannot know for certain what goods are being provided at maturity of the investment. Another example might be “if the weather is good tomorrow, I will pay you x; if it is bad, I will pay you y.”
Of course, market outcomes are uncertain, but this is considered an acceptable and, indeed, a healthy risk for participants in an economy. It encourages entrepreneurship, the development of new technologies and human advancement. It incentivises due diligence and calculated risk-taking, thus minimising poor investment decision-making. And, as we shall see later, it works best when money is not itself a commodity to be traded, when instead it is a medium of exchange and store of wealth, when the nature of money itself leads to low time preference and long-term planning.
This sharing of risks between manager and investor is reflected in the split of profits (or losses) from the venture, the antithesis of the asymmetric master/slave relationship between borrower and lender. You do well, I do well. If I fail, you share my pain. Now stakeholders are partners, spreading risk throughout an economic ecosystem.
And finally, the parameters of the venture must be clearly defined. The definition must be a real economic activity that cannot be detrimental to society, one that enables the manufacturing of real goods and services and not the development of intangible financialisation, the proliferation of debt and derivatives. (Financial services are an allowable venture, of course, providing they are Shari’a compliant).
Now what happens when we massage the mudaraba (or its sister contract, the musharaka, an investment partnership) into a contemporary Islamic Finance instrument? Let’s consider one of the most popular instruments, the sukuk, or Islamic bond.
Just like a conventional bond, a sukuk is a sophisticated capital markets instrument, typically listed on an exchange, entitling the holder to a stream of income payments from the issuer. In a bond financing, that issuer would be a borrower, and the stream of payments would be interest on the bond (“coupons”). In a sukuk issuance, the issuer is not, in theory, a borrower. Like the traditional, prophetic arrangement, the issuer is a partner, sharing in some returns in a real business activity with sukuk investors.
Like a bond, the sukuk is issued from a special purpose vehicle, often an orphaned company set up in an offshore financial centre for tax minimisation purposes, with independent administrators and directors acting on behalf of investors, often under a declaration of trust. This vehicle takes beneficial interest in the underlying activity that is being financed. That activity may be, for example, the provision of mobile telecommunications airtime. Investors finance the working capital to enable the provision of mobile phone services and earn their returns from a split of the profit from mobile phone contract fees paid by end customers.
The issuance vehicle presents the full terms and conditions in a sukuk prospectus to investors and enters into a subscription agreement with them, whilst simultaneously entering into a back-to-back mudaraba agreement with the telecoms company, specifying how capital should be deployed and how profits should be split. The telecoms company is thus the mudaarib.
Crucially—and in stark contrast to a conventional bond—to avoid giving effect to a conventional debt-like arrangement, the mudaarib cannot guarantee the return of capital to investors. Capital may be repaid only to the extent the underlying activity has been successful enough. That is the risk that investors must evaluate for themselves in the due diligence phase.
We call this type of sukuk a “sukuk al-mudaraba.” There are many other types of theoretical constructs based on different types of underlying contractual arrangements, such as leases or agency-type agreements. But underpinning them all is the idea that the instrument must take risk in a real activity, it must share that risk between investor and manager, and the manager must not guarantee the return, come hell or high water. This last point will prove to be important in our evaluation of contemporary Islamic Finance.
4 - Ihya’ul-uloom, Al-Ghazali through Qal’awi, Al-Masarif-al-Islamiyyah (Dar al-Maktabi 1998), p. 52, as quoted in Usmani.
5 - Al-Ghazali, v.4 (1997), p. 348, as quoted in Usmani.
part II:
fiat is haram
i) The Tenets and Mechanics of Fiat Finance
To be clear, there is no such actual, discrete, or self-declared thing as “Fiat Finance.” While moderately tongue-in-cheek, by this term we intend to refer to the contemporary and ubiquitous international financial system. It follows straightforwardly that this system is in stark contradiction to the tenets of Islamic Finance, to which, in this subsection, we will compare and contrast. In the following subsection we will describe how US geopolitical hegemony has resulted in this system being imposed on most of the rest of the world also, and hence how contemporary so-called “Islamic Finance” is really nothing of the sort.
Fiat Finance is predicated on three rough tenets: fractional reserve commercial banking with debt-based fiat money rather than commodity money, central banking politically supporting this commercial banking system, and a normalisation of interest-based financial engineering.
Fractional reserve banking disjoins the creation of money and credit from real resources. It discourages the proper pricing of capital in light of the appetite of savers to divert resources to more risk-seeking endeavours and the obfuscation of the opportunity costs of deployment. Whilst the literal translation of the word “riba” is excess or surplus, implying money charged on money is haram, one may reasonably infer from this that ex nihilo money creation is also haram, and many Shari’a scholars endorse this view. Not only does money creation allow for those closer to the money spigot to become unjustly rich faster than those further away, but it also means banks have no incentive to share risk while they continue to profit handsomely from mere risk transference.
As if this wasn’t already bad enough, it is especially so if combined with the contemporary norm of collateralising with real property maintained in use. Both early Christianity and Islam recognised that money lenders often demanded collateral to support their interest-based loans, which inevitably led to debt peonage, the bonding of one’s own self and family, as slaves if collateral could not be raised. One might reasonably argue that Fiat Finance has created a modern version of debt peonage to banks.
Central banking removes any vestige of financial risk from the risky activity of commercial banking, given its political purpose is to ensure any and all banking losses stemming from fiat money’s unavoidable nature as primary debt can be socialised. That is to say, the financial sector profits from successful loans and the saving public loses from unsuccessful loans.
Aside from dire effects on capital allocation, this process egregiously contributes to ever-increasing concentrations of wealth in the financial sector, causing it to parasitically grow entirely out of sync with the value it provides to society. Nonetheless, this is argued to be politically necessary—and believe it or not, even socially necessary—due to the nature of fiat savings and payments and the dual (some may say “conflated”) role of fiat commercial banks as credit originators and deposit takers. Not only is modern, digital fiat money created as debt but, given physical cash is significantly less efficient as a means of payment than electronic bank transfers, “money” predominantly exists as bank liabilities. The common-sense and commonly held view that fiat money in a bank is a bailment is unfortunately entirely fallacious: It is in fact an unsecured loan, for all intents and purposes “insured” by the central bank via the threat (or perhaps promise) of a stealth tax on savers. Savers can protect their slice of this involuntary loan book by taking custody of cash themselves. However, they are then locked out of virtually all modern financial services beyond in-person payments, and the value of their cash is entirely as unprotected from inflation as if it were still “deposited” with a bank.
In The Problem with Interest, Tarek El Diwany charac-terises the absurd social ramifications of the bursting of fiat credit bubbles as follows:
"When new loans are not forthcoming, old loans become unrepayable. Under these circumstances, everyone is trying to repay their debts, but a sufficient quantity of money with which to do so simply does not exist. At least one person must go bankrupt and be ‘removed from the game’. Life becomes an aggressive competitive struggle to avoid being the one who is left standing when the music stops. The policies of government, the actions of businessmen and the daily life of ordinary people are all affected by this ongoing struggle in a deep and disturbing way. The economic survival of all three groups depends in large part on the bankers’ willingness to extend loans of newly manufactured money.In those periods of recession that occur when the quantity of new loans is insufficient to allow repayment of old debts, the state finds itself obliged to pay welfare benefits to the unemployed, to cut tax rates and so on. The money that the state requires to undertake this expenditure can be manufactured by the state itself or it can be borrowed from the banks in the form of bank money. Quite why the state would want to borrow money manufactured by the banks at interest when it could manufacture state money interest-free is one of the unanswered mysteries of our time. Yet this is what happens most of the time in most of the countries of the world.”
Of course, central banking in its modern form, and fulfilling the above-described roles, is only possible due to the fiat and non-commodity nature of the money issued by commercial banks. There are no physical constraints on the creation of bank reserves. It is quite literally zero cost; ironically, it is often glibly characterised as “printing money,” although even this is overestimating the cost because no paper is involved with modern, digital fiat money.
Although logically distinct, there is a clear and only barely functionally distinguishable incentive to use the “interest rate” (scare quotes because it isn’t really interest) offered on central bank reserves as a political tool to artificially price credit more cheaply than the market would if sourced from savers. Hence this tool is mindful of bank equity holders’ tolerance for leverage and respectful of the real scarcity of capital. The purpose being to “stimulate” economic activity: i.e., to encourage the direction of resources towards short-termist consumption to transiently fake economic health for political reasons while consuming real capital to the detriment of long-term wealth and well-being.
In this respect, central banks are anathema to the Islamic concept of khilafa, or vicegerency, from which we derive the word Khalifa—or Caliph—God’s steward on earth. In Islam, every human being is considered a khalifa, entrusted with the responsibility of upholding the harmony of the universe and preserving the earth. Fiat Finance, in contrast, incentivises short-termism by inflating away the value of money and thus misdirecting resources. It deploys mathematical models such as discounted cash flow analysis that calculates the net present value of, say, a farming project as being more valuable if we desertify the land within a few years rather than deploy long-term, sustainable farming methods.(6) We build in obsolescence into consumer goods and architecture, choosing to dispose of, destroy, and replace rather than preserve and maintain.
This all sets up an environment of incentivising innovation not in long-termist capital accumulation, but rather quasi-political gaming of money creation. Instead of taking real entrepreneurial risks with skin in the game, the intelligent, ambitious, and financially savvy are instead encouraged to figure out how to arbitrage access to perpetually inflating credit bubbles to capture risk-free spreads. This is about as far removed as is possible from the entrepreneurial, real economy, risk-sharing principles inherent in the mudaraba we describe above. A financial system dependent on money creation or the charging of money-on-money rewards banks, private equity firms, and government institutions with a greater purchasing power than the public. These Cantillionaires amass wealth not by creating valuable goods or service but by creating money itself and shifting risk onto others.(7)
ii) Contemporary Islamic Finance
So, what are we saying? That Islamic banks and the modern Islamic Finance industry are not Islamic? Well, not exactly. Let’s say it’s complicated.
There’s theory and then there’s reality. The theory of Islamic Finance projects a world of different tribes and ethnicities living in harmony, trading with each other, and sharing knowledge, culture, technology, and ideas. The reality in which it exists is a century of military and economic domination by one world power, leading to a homogeneity of cultural practices, foremost amongst which are the neoliberal economics of the primacy of exchange value above all else as the measure of human progress, the maximisation of shareholder profit, and the use of one dominant form of money: infinitely printable, manipulated by a small group of people, and designed to maintain an economic system characterised by the proliferation of debt.
The US dollar is the sole global reserve currency today. The US may run a massive balance of payments deficit without the financial consequences to which almost any other nation would be subject. A constant demand for its currency is guaranteed by the need for the rest of the world to hold its currency for international trade. Across the world, central banks hold their reserve assets primarily in the form of US Treasury Bonds, a promise to pay that allows the US to finance its hegemony. Challenge that status quo and face military consequences. This economic and military dominance persists because the US can keep on printing and borrowing in perpetuity.
Should any actor wish to step into this arena to propose an alternative financial system, such an alternative shall be tolerated only if it adheres to and supports US hegemony. So, sure, Islamic banks are free to use mudaraba or any other risk-sharing contractual structures they choose from the classical manuals of jurisprudence, but only if they remain fractional reserve institutions with central bank reserve accounts ultimately reliant on the US Federal Reserve, having the right to create new money through the act of ex nihilo fiat lending. It’s no wonder the predominant form of Shari’a-compliant contract used by Islamic banks is the commodity murabaha (sometimes referred to as tawarruq), a legal ruse designed to mimic the effect of a loan with interest.
An obvious parallel can be drawn to the Middle Ages, a legal trick used by European financiers to circumvent the Church’s ban on usury. Knowing that they would not be allowed to lend at interest, medieval financiers cleverly wrote three separate contracts, each indiv-idually perfectly compliant with Church law, but in aggregate creating a synthetic loan with interest.
The first contract was an investment made by the financier into the recipient’s venture, agreeing to share the profits. The second contract stipulated that the financier would sell future profits on the investment for a price agreed upon today. The third agreed to insure losses on the investment. The net effect was that the borrower paid a fee to the lender for money “invested” by the lender in the borrower’s venture.
The Church could see no harm in each contract indiv-idually and so was unable to outlaw these three-in-one contracts, or contractum trinius. Eventually, the Church turned a blind eye to the charging of interest and financiers abandoned their subterfuge. By 1917, the Vatican itself was investing in interest-bearing bonds, and today the ban seems like a quaint relic of a primitive society.
The contemporary Islamic banking industry’s focus on form over substance has resulted in commodity murabaha becoming the Islamic economy’s equivalent of contractum trinius. Islamic banks may follow the letter of the law, but in ignoring the wider impact of the practice of fractional reserve banking, they have lost sight of the spirit of the law, something theologians will sometimes analogise to maqasid al-Shari’a, the objectives of Islamic law.
We estimate at least nine-tenths of all corporate and personal credit facilities in the Islamic banking industry worldwide use the tawarruq structure. No wonder customers have voted with their feet: In the UK, we estimate between 2% and 4% of Muslim households hold a bank account or mortgage with Britain’s only retail Islamic bank. They may not have a scholar’s understanding of fiqh al mu’amalat, or the finer points of murabaha vs. mudaraba, but they intuitively know a deception when they see one.
The problem of form over substance applies not just to bank lending arrangements through tawarruq, but also to the capital markets. In theory, a sukuk should be an investment certificate, giving the investors a right to participate in a stream of payments from the “borrower” (we’re going to use that term for now and you’ll see why we’ve done so as we progress). Investment banks acting as sukuk arrangers work with their clients to identify a real asset or a service to underpin the financial arrangement.
Let’s say the company wishing to raise funds holds unencumbered property assets. These can be used as the “underlying” for the sukuk. Property assets can typically be rented out, and thus the ideal Islamic financing in this scenario would be a sale and leaseback. The underlying property would simply be transferred into a special purpose issuance vehicle—either through legal title transfer, but more likely through a master lease and sub-lease arrangement(8)—and then leased back to the company. Thus, the company has now raised funds through the “sale” of the property to investors and pays them a periodic income (the coupon) based on the rental value of the property. At maturity of the sukuk, the property is transferred back to the company and sukuk investors are repaid their capital value.
This sounds all very real economy and risk-sharing. There’s a real asset. The company monetises that asset and manages it on behalf of investors. Investors take risk on the asset. So far, so good.
But there’s one fundamental problem with a typical contemporary capital markets sukuk issuance: The company raising capital enters into a Purchase Undertaking with investors. This additional contract specifies that when the sukuk matures, the company guarantees to buy back the sukuk at its par value. Irrespective of the underlying contractual structure—whether it is an investment management arrangement like a mudaraba, or a lease arrangement (called ijara)—the company has guaranteed to buy back its bond. It’s a bond because the risk to investors with this additional Purchase Undertaking is the credit of the obligor (in other words, the company itself, not the asset it transferred into the issuance vehicle). The Purchase Undertaking has now stripped away the market risk of the underlying and replaced it with the credit risk of the borrower itself.
To further blur the line between a sukuk and a bond, the pricing of a sukuk is benchmarked not to the market value of the underlying, but to conventional interest rates, usually the London Inter-Bank Offer Rate (LIBOR). This in theory is not necessarily a problem: Shari’a scholars tend to agree that one may use a mathematical formula to calculate the price of goods as long as the goods being sold are themselves halal. The classic example is that of two brothers: Brother A sells alcohol in his shop, whilst Brother B’s neighbouring shop sells soft drinks. The brother selling soft drinks benchmarks his price against his brother. So, as A raises his prices by 5%, so does B. The benchmark itself does not render the transaction haram.
However, in the case of contemporary sukuk, there is no relationship between the pricing of a sukuk and the underlying asset. For example, in 2014, the United Kingdom issued a £200 million sovereign sukuk by transferring three properties it owned in Whitehall, London, into a sukuk issuance vehicle. Investors ef-fectively took beneficial ownership of the buildings and rented them back to the British government. The British government guaranteed to buy back the buildings at par value at maturity of the sukuk and paid an annual rental rate of 2.036%, “in line with the yield on gilts of similar maturity.”(9) This rental value bore no relationship to the market rental value for properties of that nature.
Ultimately, investors had entered into a guaranteed bond issuance, priced at a conventional rate of interest. There was no market risk on the underlying, only the credit risk of the United Kingdom and a performative shuffling of papers to give the impression of asset risk-sharing.
Even when there is a much publicised and manifest relationship between the sukuk and market perfor-mance of the asset, sukuk arrangers tend to render the underlying asset irrelevant to repayment of the sukuk. A good example of this is the acquisition of the British global ports operator, P&O, by the Dubai government in 2005—the very first time a sukuk was instrumental in a multi-billion-dollar acquisition financing.
The sukuk was structured as an exchangeable—another first for the industry—that is, one that converts into the shares of the underlying company. Like a “pre-IPO exchangeable bond,” in which a bond pays a fixed rate of interest to the bondholder and the principal is repaid when the borrower floats its shares in a future public offering, the shares created in an initial public offering (IPO) of the underlying company would be used to repay this acquisition sukuk.
The Dubai government entity making the acquisition—the Ports, Customs and Free Zone Corporation (PCFC) —issued a pre-IPO exchangeable sukuk al-musharaka (in other words, a sukuk based on the investment partnership arrangement of a musharaka, similar to the mudaraba we described earlier, in which the investor and investee are partners in a venture, sharing the risks and rewards). This sounds promising: The acquiror has agreed to finance the acquisition on the basis that sukuk holders participate in the success or failure of the acquisition. If the asset performs and a qualifying IPO takes place, investors will be rewarded with shares of the company.
There were a couple of snags, however, both insisted upon by the investment banks that arranged the financing. The first was that the sukuk would not pay out a coupon during the lifetime of the financing but instead would accrue a rate of “profit.” This rate would be set at the time of launch of the sukuk and, rather than being benchmarked against the underlying asset, it would be set against a conventional bond benchmark (just like the UK sovereign sukuk). So, if PCFC failed to float its underlying companies to repay the sukuk, it would have to repay a greater amount of cash to sukuk holders. Just like interest on a loan, in other words.
The second snag related to the manner in which the principal would be repaid to sukuk investors. As is normal for sukuk transactions, the notes issued to investors would be “limited recourse” obligations of the issuer. In the event of a default by PCFC, note holders would have recourse to those assets specified in the investment partnership arrangement (the musharaka). Investors would also have the benefit of a Purchase Undertaking, a guaranteed buy-back of the sukuk. If this undertaking was on the basis of the market value of the underlying assets on termination of the sukuk, then all is well and good. Investors would have taken a market risk under a true partnership arrangement. However, this was not the case: Instead, the redemption of investment units in the PCFC sukuk was specified to be at the initial issue value. An investor buying the sukuk at $100 would receive $100 worth of shares at maturity.
Ultimately, despite the best intentions of the structuring team to create a risk-sharing, asset-backed financing, one that accorded closely with the fundamental principles of Islamic Finance, the sukuk had instead been massaged into an instrument that accrued a rate not based on any underlying performance and would be repaid at par value irrespective of the market value of the asset.
We’ve now explored both tawarruq/commodity murabaha as a proxy for loan financing as well as sukuk as a bond-like capital markets instrument. The former financial product is one dominated by Islamic banks, the latter by the global investment banks. In both cases, the constraints of Fiat Finance have led to an Islamic Finance industry that puts form before substance. Whilst the letter of Shari’a may have been followed in the design of permissible legal contracts, the spirit has not.
The purpose of a fiat bank is to make loans and, in the process, manufacture new money. A fundamentally morally fraudulent foundation may not be the fault of the Islamic banks, despite the overlay of ostensibly halal or Shari’a-compliant contracts, but they certainly aren’t addressing the core problem.
If one wished to remove the ability of banks to manufacture money from nothing merely by the act of extending credit, thus forcing financiers to improve their investment decision-making, to become partners with their clients, to spread risk more evenly throughout the economy, then the nature of money itself must change. A form of money that can only be created through effort, that is scarce and finite, and that cannot be manipulated by a small group of people or governments, would be a tool of the real economy and not its master. It would act, as noted by the famous twelfth-century theologian Abu Hamid Muhammad ibn Muhammad Al-Ghazali—more commonly known as Al-Ghazali—“so that they may be circulated between hands and act as a fair judge between different commodities and work as a medium to acquire other things.”(10)
6 - See, for example, The Problem with Interest, Tarek El-Diwany (Kreatoc Ltd, 2010), pp. 13-16, based on an idea from Michael Lipton, University of Sussex, 1992.
7 - Common parlance in Bitcoin (and goldbug) circles referring to The Cantillon Effect, after Richard Cantillon, widely believed to be the first economist to analyse that newly issued money, is not dispersed equally throughout time and space and hence those who receive it in circulation first benefit to the detriment of those who receive it later.
8 - Master lease/sub-lease structures are typically much more prevalent than a full sale with legal title transfer due to punitive stamp duties on title transfer.
9 - “… the Joint Lead Managers announced … that the price guidance had been tightened to flat to gilts (0bp) …”, https://www.gov.uk/government/news/government-issues-first-islamic-bond, Government Issues First Islamic Bond, 25 June 2014.
10 - Ihya’ul-uloom, Al-Ghazali, v.4 (1997), p. 348, as quoted in Usmani.
part III:
Bitcoin is halal
i) The Mechanics of Bitcoin
Time is a scarce, precious commodity. Muslims believe in taking advantage of time in such a way as to invite blessings, or baraka, into their lives. An example of such a blessing might be that they are able to accomplish many things in a short space of time. They believe they generate baraka in their time by, for example, following the prophetic example of “using the morning hours” (being productive from the moment they wake), avoiding sins, spending time with family, acts of gratitude, daily recitation of the Qur’an, incorporating remembrance of God in daily routines, and keeping the company of productive people. All of these are considered to be acts of a wholesome life.
A monetary system that respects the natural scarcity of time, shifting our incentives away from borrowing, spending and consuming as fast as possible and towards saving and investing for our future is one that has the characteristics of sound money, as we described earlier.
Muslims have traditionally favoured gold as sound money. They value its commodity-backed nature and its scarcity. Living under the gold dinar standard for 700 years during the Islamic Golden Age, Muslims had time and space for higher pursuits. They had baraka in their time. Their contributions to mathematics, philosophy, medicine, astronomy, architecture, and even trade during this period are sometimes overlooked, but it might reasonably be argued that European progress following the Enlightenment owes a debt to its neighbouring civilisation.
If we consider periods of human history when gold was a common global currency (Rome at its height, Byzantium, the Islamic Golden Age, and the second half of the nineteenth century), we also find that trade was borderless and fluid, with minimal tariffs and restrictions. There were periods of political stability as well as scientific and creative progress.
A decentralised, non-fiat money with a high stock-to-flow ratio that cannot be manipulated or controlled by a small group of people is a sound money that results in low time preference, which in turn leads to human progress. Humankind has space and time for higher pursuits.
Today, gold suffers from centralisation and censorship risk. It remains scarce and finite, and is thus inflation-resistant, but it has practical disadvantages. It is not easily portable or divisible, necessitates storage and insurance costs, and cannot be readily transacted with a counterparty halfway across the world in the blink of an eye.
Bitcoin has all the advantages of gold and few of the disadvantages. It has a high stock-to-flow ratio, is electronically portable, instantaneously transacted across vast distances, easy to secure, censorship-resistant, and decentralised. Some might argue it lacks tangibility and that this is a requirement of Shari’a-compliant money, pointing to the famous hadith:
“Ubadah bin As-Samit and Muawiyah met at a stopping place on the road. Ubadah told them: 'The Messenger of Allah forbade selling gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates'—[one of them said: 'salt for salt,' but the other did not say it]—‘unless it was like for like, hand to hand. And he commanded us to sell gold for silver and silver for gold, and wheat for barley and barley for wheat, and to hand, however we wanted.' And one of them said: ‘Whoever gives more or asks for more has engaged in riba.’”
Those who argue that the above hadith implicitly endorses only certain types of commodity-backed money have missed the point: It is specifically an injunction against riba, charging money on money, and against the deferred payment of currency (forwards). These six items happen to be examples of currency; they’re just not necessarily good ones (four of them are perishable!). Fiqh (Islamic jurisprudence) requires that money must, as a minimum, have the characteristics of wealth, legal value (or, according to some scholars, social concurrence), and the ability to be exchanged for goods and services.(11) Bitcoin has all these characteristics and, additionally, is also sound just as gold was once sound. It is therefore an even more Islamic form of money than the traditional money of the Islamic Golden Age since it is even more suited to encouraging low time preference.
As for its tangibility or its commodity-like nature, it indeed does have tangibility, even more so than the digital money we use today, which we consider to be a “real” thing, and which has existence in the form of digits in a computer. Just because a thing lacks corporeal essence does not automatically render it imaginary.
One could argue Bitcoin does have a kind of corporeal essence due to its issuance via the proof-of-work mechanism intrinsic to mining. Albeit a little abstract, this process links Bitcoin to the physical world in a way that is arguably a stronger connection than any other asset having a digital instantiation could possibly have. One could even argue that proof-of-work when paired with the difficulty adjustment—the key components of mining and hence of network security and, ultimately, the lynchpin of decentralisation—is the innovation of Bitcoin. This is what prevents double spending and overcomes the otherwise costless replication of digital information that would appear to make the idea of “digital scarcity” nonsensical, absent this technological breakthrough.
While this process is often characterised as making Bitcoin “energy-backed,” we feel this is a distracting framing. Referring to a “money” as “backed by [some commodity]” is inheriting the terminology of banking and assumes the money in question is some variety of fiduciary media. But Bitcoin is the commodity. The relevance of energy is the link to the physical world such that the truly desirable aspect of this novel money can be realised: that its cost of production, realised mostly via the costly consumption of energy, is very, very close to its market value. We won’t explain the details further here, but the difficulty adjustment (referenced just above) is frankly an innovation of pure genius that introduced an economic characteristic that has never before existed nor could possibly have existed: that this balance of cost and value is not some fluke, nor was it calibrated by any human calculation, but will always be true, such that the amount of the commodity in existence is knowable for every point in the future, forever. With only very minor caveats required, seigniorage on the issuance of Bitcoin as money is fundamentally impossible.
Far from being a “waste of energy” as it is often portrayed, there are two powerful and distinct arguments in favour of recognising Bitcoin as an environmental boon—what we might term the “industrial” and “psychological” arguments.
The industrial argument is to recognise that Bitcoin mining can only be sustainably carried out with access to the cheapest power in the world. The idea that Bitcoin mining is “diverting energy” from hospitals, orphanages, and the like, is illiterate. Any use case for power that anybody in the world is willing to pay for will definitionally outbid a hypothetically “competing” miner. In fact, properly understood, it seems inevitable that the marginal cost of power at which it is profitable to mine will converge on zero in the not-too-distant future. This means that mining will only consume energy that would otherwise have been wasted, be it methane flared in transmission, mismatched hydro, wind, or solar due to intermittent demand, heating of air or water or, indeed, a range of industrial heating processes. The removal of the requirement for transmission infrastructure to make stranded energy resources viable also makes development of energy resources dramatically more efficient.
The psychological argument is to recognise that a high time preference naturally leads to a disregard for the environment. This could manifest specifically in the habitual consumption of single-use pollutants rather than sturdier, more durable, and more reusable materials, or construction with sub-par materials requiring demolition in 30 years rather than 300. Or we might observe a more general forced selfishness and myopic obsession with the present that renders such abstract notions as “the environment” much lower priorities than they might otherwise be were people afforded the time and space to think about the future and the consequences of their decisions. By assuring savings and removing uncertainty, we would argue that Bitcoin accords strongly with the Islamic concept of vicegerency (stewardship of the planet).
Bitcoin’s creation through proof-of-work—what Nick Szabo ingeniously termed “unforgeable costliness”(12) —is in stark contrast to the costless creation of fiat money through ex nihilo debt. Even the Bank of England itself readily admits that more than 97% of all money in the economy exists as bank deposits, and banks create these deposits simply by making loans:
“In the modern economy, most money takes the form of bank deposits. But how these deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”(13)
Fiat money is thus intrinsically riba. Bitcoin is not birthed in debt; instead, it represents cost and work performed. Were it to replace fiat money, banks would not be able to create it from thin air. They would not be able to inflate away the value of money and thus Bitcoin would not only be anti-riba, but it would also be anti-inflation.
There is a final, Islamic aspect to Bitcoin—that of checks and balances on the power of government. Islamic scholarly tradition has long held that the ruler and the law should be separated.(14) The classical jurist, Imam Abu Hanifa, is reported to have turned down a judgeship offered to him by the governor of Kufa, reasoning that:
“If he wanted me to restore the doors of the Wasit Mosque for him, I would not undertake to do it. What should I do when he wants me to write that a man should have his head cut off and seal the document? By Allah, I will never become involved in that!”(15)
Similarly, Islamic tradition holds that the tyranny of a ruler is curbed by restricting his ability to centralise the economy: The ruler and money should be separated. Some Muslims argue today that Bitcoin cannot be Islamic because it is not sanctioned by a government as being money, or that there is no undertaking by a government to “back” it. But there is no scriptural evidence that a state must endorse money for it to be halal.
Certainly, there have been instances in Islamic history when a state or ruler operated a mint that verified the authenticity of bimetallic currency. But since Bitcoin’s atomic state is in verifiable units of currency,(16) requiring no single, centralised entity to authenticate it, the need for a state-owned mint no longer exists. And, more particularly, Islamic economics explicitly requires that markets must be free to establish price levels according to supply and demand, and not set centrally by government. This last point is one that surprises many Muslims, despite a clear precedent.
Shortly after the establishment of the Prophet’s city-state of Medina, rising food prices exacerbated the hardships of an ongoing famine. The Prophet was duly petitioned to set a price cap on agricultural commodities and, in contrast to established conventions and seemingly at odds with Muhammad’s reputation as a man of compassion and mercy, he refused. Such was the popular opposition to his stance that the people appointed a deputation to persuade him to reverse the decision. The Prophet withdrew to solitude, as was his practice, to pray and seek guidance. Though he prayed to be granted the authority to set prices, he did not receive an answer.(17) His response to the people established a then-radical concept of price deregulation, one that would shape the Islamic Golden Age, placing prices in the hand of God, not the hand of government, and encouraging a business culture of market risk and entrepreneurism:
“The people said: Messenger of Allah, prices have shot up, so fix prices for us. Thereupon the Messenger of Allah (pbuh) said: Allah is the one Who fixes prices, Who withholds, gives lavishly and provides, and I hope that when I meet Allah, none of you will have any claim on me for an injustice regarding blood or property.”(18)
Note the word “injustice.” Manipulation of money creates an injustice. Money is an essential tool of the market, just as Ghazali had explained. Bitcoin’s decentralised nature, its separation from the state, means that it is resistant to manipulation and that it is censorship-resistant. People can use it or not as they wish. They cannot be prevented from using it at the whim of a ruler. The ruler does not determine its supply or its price relative to other things. Today, Bitcoin is used in troubled economies and conflict zones around the world as freedom money, a moral money for the benefit of all, not a privileged few. It does not require to be channelled via fiat banking rails controlled by a foreign power. Its value is in the Hand of God.
ii) Islam and Sound Money
One of the reasons it is tricky to pin down exactly what Islamic Finance is if your starting point is Fiat Finance is that the idea of putting them side by side and comparing them doesn’t make much sense. Islamic Finance isn’t a list of what is and is not allowed; rather, it is framework for deducing what should and shouldn’t be allowed based on certain ethical principles. That said, these principles are not entirely subjective or arbitrary. Furthermore, we think these principles align with Bitcoin remarkably well, and that this shouldn’t be a surprise if we consider that the source was the prevalence of gold coinage when Islamic Finance originally evolved.
By 622 CE, the Prophet Muhammad had become more than merely an irritant to the dominant families of the city of Makkah. The faith he proselytised was not just a threat to their polytheistic beliefs—it also threatened their grip over the lucrative business of pilgrimage to the city’s famous idols. His preaching had alienated Makkah’s ruling class, and his once successful business was now under boycott. He escaped assassination and fled to the city of Medina, arriving as an impoverished refugee.
Upon arrival, his first act was to establish a mosque, and the second to establish a market, setting out the rules of fair trade. The economic policies he established brought balance to the dynamic between wealth creation and social cohesion, promoting entrepreneurship, free markets, zero taxes, transparency, competition, consumer protection, and equitable distribution of wealth. Within a decade, not only had the religion of Islam been established across Arabia, but so too had the Medinan economic model. Perhaps it was the pragmatism of the faith—that ethical wealth creation was itself an act of worship—that helped Islam flourish. Within a century, this same model would be rolled out across the Silk Road from China to North Africa and the Mediterranean.
Jurists in the years after the Prophet’s death would codify many of the economic principles first established in Medina, creating organisational frameworks and financial instruments that would become the lifeblood of the Islamic Golden Age. Endowments for educational institutions, state treasuries for pensions and social benefits, trading houses and venture capital firms established at waypoints along the Silk Road, travellers’ cheques for cashless shopping, branch banking and cross-border financing arrangements—all of these were made possible under one monetary standard: the gold dinar.
This monetary standard did not arise overnight. The solidus (the Byzantine gold coin) dominated the region’s money supply due to the robustness of Byzantium’s centuries-old gold standard and the rudimentary nature of Arabian coinage. Despite burgeoning markets, the absence of local coinage hampered cross-border trade and added to transaction costs. Successive Islamic rulers after the Prophet’s death gradually developed an indigenous Islamic currency.
At first, forms of money other than bullion were proposed, including tokens made of camel hide. But eventually, rulers realised they needed a hard currency with precedent, one saleable across time and space. Rulers minted the dinar to rival the solidus, and Byzantine monetary dominance was ended.
The historian Benedikt Koehler describes the emergence of the dinar in some detail, concluding:
“As the monetary base expanded, so did the economy. Repercussions of the new currency rippled across the Islamic Empire and beyond, promoting intraregional as well as intercontinental trade. Islamic dinars circulated throughout Europe and were used as a means of payment in England, the Baltic, and also by the Vatican’s treasury. Gold coins put purchasing power into the hands of Muslims and helped evolve a market that encompassed the realms of Islam and Christendom …”(19)
We don’t think it is a stretch at all to describe Islamic Finance as “finance as it would be on sound money.” The primary ethical consideration that sound money imposes is responsibility. There is no lender of last resort; no socialised losses and privatised gains; and no ex nihilo collateralised credit creation. You have to take responsibility for your actions and try to provide real value in use.
More psychologically, even, than ethically, sound money encourages thinking long-term. It relieves its holder from desperate, selfish, materialistic panic over the hamster wheel of debt serfdom and allows her to care about bigger, more transcendental issues. Perhaps the most important of these issues is the well-being of others. Clearly, this quickly goes well beyond the financial and provides support to all the ethical tenets on which Islamic Finance rests and the spirit of the law on which it is judged.
iii) Bitcoin Finance and Capital Markets
It is very early days for “Bitcoin capital markets” as such, but we are happy to see sprouts of Shari’a-compliant commercial finance building on Bitcoin’s unique properties as money. As above, the accordance with Islamic Finance is often entirely accidental but follows naturally from Bitcoin being genuinely hard money. The obvious starting point will be the decoupling of deposits and investment such that “credit creation” ceases to be an aberrational fiat privilege. Savers will save and investors will invest. As such, “banks” will either take and manage deposits or will be asset management enterprises, investing on equity or equity-like terms and sharing the risk with the entrepreneurs they back. As there will be no incentive to “chase yield” and politically arbitrage artificial credit expansion, these functions can be cleanly separated, and much can be disintermediated from the financial industry altogether.
An initial consideration of potential opportunities to deploy capital follows from a mildly technical detour into the contrast between Bitcoin and fiat payments. Fiat payments are built, by and large, on top of multilateral credit relationships between commercial banks and, ultimately, central banks. These are private ledgers rooted in credit, which gives rise to an odd mix of very cheap unilateral adjustment of the ledger and very expensive credit risks in ensuring credit adjustments are “atomic,” in the sense of: Bank A adjusts one balance up and another down if and only if Bank B adjusts the equivalent balances down and up, respectively. El Diwany addresses this oddity in The Problem with Interest:
“It is critical to note that nowhere in the issue of either an IOU or state money need an interest charge arise. For example, traders who buy and sell from one another are at perfect liberty to use IOUs that do not carry an interest charge in respect of the delay in receiving payment. Neither does gold bear interest in order to exist. It does not have to be borrowed in order to exist. It simply exists. Similarly, the state’s paper money need not bear interest in order to exist. It simply exists as soon as it is printed. However, bank money credited to an account has its origin in a loan transaction and will therefore inevitably bear interest as a condition for its existence.”
On the other hand, Bitcoin is pure equity. It is nobody’s liability, and it is not “backed” because it requires no backing, as Lewis puts it, cited in an earlier footnote, Bitcoin is Money and Currency. This flips the above considerations. On the one hand, the only relevant “ledger” is public—the blockchain—and, in order to guarantee its permissionlessness and decentralisation, costly to update. Unlike private bank ledgers, which can be unilaterally edited at zero cost, the cumulative transaction fee expense contributed by Bitcoin network participants is what enables proof-of-work as the consensus mechanism governing ledger updates. On the other hand, all Bitcoin payments are debits, and furthermore, by harnessing the system’s native cryptographic properties, can be made truly atomic.
This has given rise to various interoperable payment networks built on top of Bitcoin. The most mature and most developed is the Lightning Network, but other newer protocols such as Ark, statechains, and a handful of Zero Knowledge Rollup proposals are in different stages of design, development, and implementation. Asset issuance schemes rooted in Bitcoin’s UTXO-set and tapping into Bitcoin’s security, such as RGB and Taproot Assets, ought to be considered here as well, to the extent they enable atomicity in payment facilitation. The technical distinctions between these protocols are beyond the scope of this paper, but we will say for now that all mentioned have roughly enough of the same high-level technical properties to inherit roughly the same economic consequences that fit into our discussion.(20) These technical properties amount to: i) debit-only payments requiring locked up capital and deferral of settlement of net balances relying on some combination of Bitcoin’s native cryptographic properties and the economic incentives of actors, and ii) payment atomicity, following from the same.
In simpler (and more naturally financial) language, and in all such cases, this means roughly the following: Rather than payment facilitation relying on bilateral, ex nihilo, and fundamentally riba credit extensions, which in principle can only possibly be performed by private institutions, it can instead be offered and competed for in a free market by anybody willing to put up the necessary capital. This could be in the form of funding a Lightning node and opening channels to increase the overall connectedness and liquidity in the network, or funding an Ark Service Provider to cover the transactional aggregate for a given payments window.
While superficially “making money from money,” we would argue this (economically novel) functionality is not an excess of money on money (“riba”) given the return is generated operationally. After all, the capital is put at risk and is offering a service (payments) that others are willing to pay for. While natural to express the return on capital to a Lightning node runner as “yield,” it is crucial to appreciate that this does not follow from the making of a loan at interest. It is really payment for a valued service; it just so happens that the working capital required to provide that service takes the form of money. This might seem unusual and, in a sense, it is: It follows from Bitcoin’s technologically novel properties. It is arguably not only a necessity of payment facilitation in a system in which all payments are costly debits capable of cryptographically enforced atomicity, but also is arguably even more in keeping with the Islamic tenet of free markets setting prices. After all, fiat payments also come with a cost, but that cost is set by privileged banks and inescapably intertwined with credit. Bitcoin payment networks, be they Lightning, Ark, or something else not yet live or not even invented, have a cost set openly and competitively in the market.
This throws up the natural equivalent to the so-called “risk free rate” in traditional finance (which of course really means free of risk to the issuer of currency at zero cost): Nik Bhatia’s “Lightning Network Reference Rate.”(21) While there is some unavoidable technical risk in allocating Bitcoin to Lightning, there is no economic risk as there is no credit and no liabilities. There is a cost, of course, but the idea, as in all capital markets, is that the return on offer sets the price appropriate to incentivise the marginal allocator.
Pushing this technical argument further, we recognise that, as these Bitcoin payments networks grow, there will be a demand for Bitcoin on the part of businesses that wish to connect to these networks, earning their return on capital from payment facilitation or, indeed, anything at all! Without too much of a technical diversion, this rationale is cleaner in Lightning given its truly peer-to-peer nature than it is for Ark or Zero-Knowledge Rollups, which are client-server models and have different flavours of “operator.”
To the extent these businesses need to raise capital to acquire Bitcoin that they don’t have at the outset, one might expect them to borrow it at interest. Perhaps this could even involve the Lightning Reference Rate in the setting of the interest rate as a kind of risk-free or even LIBOR/SOFR equivalent. While this will almost certainly happen (and probably already has), we do not think it is the optimal financial model, for reasons that follow naturally from Bitcoin being truly hard money and hence which tie nicely with the principles of Islamic finance.
Consider first the capital allocator’s perspective: The functionalities described require giving up custody of Bitcoin, which, unlike for costlessly reproducible fiat, is about the riskiest financial activity one can engage in. The price that would be demanded to compensate for this risk is likely to be very high. In particular, if the payback is capped, as with interest, this in theory pushes the acceptable price even higher.
Next, consider the borrower’s perspective. Such a high rate would likely be attractive to any borrower looking to deploy the capital competing in a global, open, and more or less commoditised market in which price is the only real differentiator. Furthermore, a fixed rate of return is arguably extremely dangerous if denominated Bitcoin for similar reasons. This concern will naturally lessen as more financial activity is naturally conducted in Bitcoin. But in the interim, while Bitcoin is still monetising, agreeing to a fixed outflow of a hard money with a strictly fixed supply, while a business’s expenses and liabilities are still mostly denominated in weaker fiat currencies, introduces a very probably unacceptable FX risk. The alternative of issuing more equity to buy the required Bitcoin, while horribly capital inefficient if viewed out of context, is arguably still the least bad option due to the risks imposed by Bitcoin-denominated debt being even more ruinous to the capital structure of the business than the implied dilution.
In contrast to these pitfalls, we argue that a profit-sharing model in accordance with Islamic Finance is significantly more attractive and capital efficient to all parties. For the capital provider, the fact of sharing in the upside compensates for the risk of loss. For the recipient, while the outflow will be in Bitcoin, it will not be fixed but will be a function of the business’s success. Note the rationale here is geared towards minimising the risk to the capital structure of a given business and is not explicitly ethically motivated—and yet what naturally emerges is precisely the Islamic risk-sharing model.
This risk-sharing model is hardly to be seen in the traditional Islamic Finance industry because the industry is dominated by Fiat Finance. However, we now see the emergence of smaller fintechs, like Cordoba Capital Markets (CCM), which has the advantage of being able to think from first principles about the Islamic economic model without the constraints of a fractional reserve framework. CCM’s profit participating note (PPN) addresses the criticisms of sukuk being too bond-like by attaching the financing directly to the underlying asset and its performance. Whilst bankers are apathetic to the PPN, investors such as family offices and entrepreneurs (who make real things in the real economy) have been enthusiastic. As the PPN gains traction in the fiat space as an alternative to tradfi bonds, the natural next step would be to recreate the same instrument as Bitcoin-native.
One clean summary of this entire paper might be that we do not think it is a coincidence that the Islamic risk-sharing model would emerge from a Bitcoin-native financing model; rather, it is to be expected: Islamic Finance gives us a millennium-old playbook for how we ought to expect Bitcoin capital markets to develop and operate. As a final tease before we conclude the piece, the two Bitcoin-native products alluded to in theoretical terms above—keeping custody of Bitcoin and allocating to provide liquidity in payment networks, and receiving financing in Bitcoin for operational purposes on a profit-sharing return basis—are precisely what Flux is in the process of bringing to market. We believe these will be the first ever truly Bitcoin-native asset management products and, therefore, will naturally be in accordance with the principles of Islamic Finance.
11 - See, for example, Bitcoin: Shariah Compliant?, Mufti Faraz Adam (Amanah Finance Consultancy Ltd, 2017), pp. 23-28.
12 - Shelling Out: The Origins of Money, Nick Szabo, available: https://nakamotoinstitute.org/library/shelling-out/
13 - Money Creation in the Modern Economy, Bank of England Quarterly Bulletin 2014 Q1.
14 - We make a distinction here between the “law” and the “judiciary.” It is generally accepted that the Prophet and the four Rightly Guided Caliphs who succeeded him were each ruler of the Ummah and also the principal judge. However, in all cases, the ruler may not deviate from God’s law, hence the checks and balances affected by the presence of ‘ulema (scholars).
15 - The Four Imams, Muhammad Abu Zahra (Dar Al Taqwa, 2010), p. 139.
16 - A point astutely articulated in Parker Lewis’ recent Bitcoin Is Money (&) Currency, available: https://x.com/parkeralewis/status/1895550178184110217
17 - Early Islam and the Birth of Capitalism, Benedikt Koehler (Lexington Books, 2014), p. 11.
18 - Sunan Abu Dawud 3451, Book 24, Hadith 36.
19 - Koehler, p. 103.
21 - The Time Value of Bitcoin, Nik Bhatia, https://timevalueofbtc.medium.com/the-time-value-of-bitcoin-3807b91f02d2, since implemented by Amboss’s Magma marketplace and styled as LINER (“Lightning Network Rate”): https://bitcoinmagazine.com/business/amboss-unveils-liner-index-for-enterprise-lightning-adoption
20 - There is room for technical nuance or even debate here around what, precisely, constitutes a “protocol” as opposed to a “metaprotocol,” or different schemes for identifying and numbering “layers.” This discussion is beyond the scope of this paper.
part IV:
conclusion
A society governed by corporations—a corporatocracy —is one that maximises profits at the expense of all else, creating and maintaining a global economy that has been, for most of the past century, fuelled by war or the threat of war. It either subjugates weaker nations through the sale of goods and services funded by borrowing in a currency much stronger than their own (leaving them to repay the debt from soft currency revenues that otherwise would be diverted to healthcare, education, or the like), or it subjugates resource-rich nations by forcing the sale of their mineral resources in that one strong currency, whilst cleverly requiring the resource-rich nation to buy its debt securities (a self-funding trade that can apparently survive in perpetuity).
All of this is made possible through the alchemy of Fiat Finance. Money printing is the weapon that maintains the power of the few over the many. Fiat Finance has led to a “death economy” characterised by frequent and periodic market crashes and bailouts. It does not plan for the future, it does not care for the planet, it reduces human beings to expendable debt peons. Any leader of a weaker nation who refuses to play the game will quickly find him or herself replaced.
But trust in the US dollar as the ammunition of corporatocracy is rapidly declining. If the past few years of high inflation have not been persuasive enough to warrant a change, then perhaps recent acts of the current administration might accelerate that decline. The US is now perceived even by its friends as erratic and hostile, ready to launch a trade war with allies who are compelled to consider the previously unthinkable: an alternative reserve currency. The share of the dollar in currency reserves remains high but is rapidly falling.
Conventional alternatives don’t look compelling. The renminbi might be useful for trade with China, but capital controls and illiquid domestic capital markets make it unwieldy as a reserve currency. The Eurozone is fragmented, its economy lacklustre, and the euro is no match for the dollar. Gold is impractical, a counterfeitable and hypothecatable shiny rock that one must store in centralised vaults or transport across oceans under armed escort.
Bitcoin is already being adopted by nation states in secret and in public as a strategic reserve asset. Whether a nation or the people believe it is a good form of money is almost becoming moot: Game theory is taking over. With all the evidence at hand, not to create a Bitcoin reserve might seem wilfully negligent.
Institutional and sovereign adoption may make Bitcoin maximalists uncomfortable, but such adoption is unlikely to materially impact Bitcoin’s decentralised status. Its network effect is now so powerful that it can remain freedom money, free from manipulation and censorship.
What does this mean for Bitcoin as a foundation for Islamic Finance?
Muslims believe in a spiritual investment in this world (dunya) for their hereafter (akhira). This is an ultimate expression of low time preference. During the month of Ramadan, Muslims train their bodies and their ego (nafs), an exercise in self-discipline, a focus on spiritual, mental, and physical health. They consider their minds and bodies a gift from God, recognising that hedonistic pursuits, mindless consumerism, and material values will not help them in the next life.
A monetary system that encourages deferred gratification, saving and investing for the future, long-term, socially impactful endeavours, and sustainability is one that aligns naturally with the Islamic concept of sabr (patience). If the economic system in which we participate is one that recognises the importance of all stakeholders by sharing risk amongst participants, by minimising contractual uncertainty, and by negating the ability of money to become a tradeable commodity in and of itself, then that would be a system aligned with core Islamic values.
Islamic banks would no longer be money creators, overlaying halal contracts on a fractional reserve foundation, merely to replicate the effect of conventional banks. Rent-seeking through the ownership of money by necessity would have to be replaced by investment in real economic activity. The quality of investment decisions must be higher under such a standard. No longer can one throw twenty darts at a board in the hope that one sticks. Now each one must register a score.
The contractual structures deployed by Islamic financial institutions would no longer be reverse-engineered debt contracts. Financing arrangements would naturally gravitate towards risk-sharing, investment partnerships like musharaka and mudaraba that allow flexibility for businesses seeking to expand, and upside for investors seeking to share the reward. Finance would once again be rooted in trade.
And if that is not enough to convince one that Bitcoin is consistent with Islamic economic values, the mere fact that one must expend energy to mine and secure it, removing the possibility of ex nihilo creation and inherently rendering it anti-riba, should be the decisive argument.
Despite the effort expended over six decades in developing the Islamic banking industry, it seems likely that it may have been a non-Muslim (or perhaps group of non-Muslims) who invented the most Shari’a compliant monetary system, with superior sound money characteristics to gold, encouraging Islamic values such as low time preference, property rights, economic justice, free markets, the reduction of consumerism and waste, and potentially even the elimination of riba.