Shariah Sandbox for Islamic Fintech Regulation?
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:
- Circulation of wealth in the society: “….so that wealth is not circulated among the rich in the society only” (Qur’an, 59: 7). Wealth circulation, by definition, includes wealth creation, consumption and distribution. Islam encourages wealth to be employed in productive activities. The funds should not be wasted, left idle (Qur’an, 9: 34) or managed unprofessionally (Qur’an, 4: 5).
- Advocating fair and transparent financial practices: Permissibility (ibahah) is the overarching principle governing commercial and financial transactions. Any contract stipulated and agreed by both parties should be respected and enforced (Qur’an, 5: 1). Further, all agreements and contracts should be as transparent and clear as possible (Qur’an, 2: 282, 17:35, 11:84, 26:181–182, 55:9, 83: 1–3).
- Promoting socio-economic justice: At macro level, the goal is to realize social justice by fulfilling society’s basic needs, elimination of poverty and improving human wellbeing. At a micro level, justice also embraces individual dealings. Economic transactions require mutual consent of two parties (taradi). Shariah also condemns unfair dealings or unjustified actions that would lead to economic injustice or exploitation such as bribery (rishwah), fraud or deception (ghish), cheating (tadlis), uncertainty and lack of clarity (gharar) or unjustified increase in wealth (riba).
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:
- Qadha (Islamic judiciary): This process demands an intensive enquiry and investigation into a case before arriving at any definite position.
- Hisbah (market inspection): This involves interrogation in order to understand the nature of matters before action.
- Qarar (resolutions) and Mi’yar (standards): These processes require several rounds of sharing, review, consultation and comprehensive understanding prior to resolution and conclusion. In contemporary times, these processes have been adhered to for setting the AAOIFI Accounting and Shariah Standards as well as for the Standards and Guidelines developed by the IFSB.
- Fatwa (Islamic edicts): This is an independent scholarly exercise both undertaken at an individual or collective level. This seems to be the preferred mode for most actors in the financial space, especially the early movers and innovators constrained by time and unfortunately of the bad actors as well.
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:
- Reduced time-to-market at potentially lower cost: Delays driven by Shariah-related uncertainty or premature fatwas disproportionately affect first-movers and discourage innovators.
- Better access to finance: Shariah compliance related uncertainty means that Islamic fintech firms may find it harder to raise funds and achieve lower valuations as Islamic investors try to factor in risks that they are not well placed to assess.
- More innovative products reaching the market: Due to Shariah-compliance related uncertainty or due to premature fatwas, some innovations may be abandoned at an early stage and never even tested.
The Shariah Sandbox as a regulatory tool may ensure the following:
- It enables the Shariah scholars and regulators to work with innovators in a unified framework (in four phases: application, evaluation, testing and exit) to gain a comprehensive understanding of the business model, the products and the processes and ensure that the businesses conform to the norms prescribed by the Shariah in all aspects of their functioning.
- It supports the new tech and innovative start-ups which do not explicitly and clearly involve any prohibited element, such as, riba, gharar, qimar; yet there are unanswered questions related to their functioning.
- It permits firms to get Shariah advisory services and test their products in a live environment with the oversight and guidance of Shariah advisors before any fatwa or official Shariah certification is issued.
Mufti Faraz Adam who is perhaps the first among contemporary scholars to advocate a Shariah Sandbox, provides the fiqh basis in following words:
- Any tech or start-up which enters the sandbox would be permitted to raise funds and test their product in a live and controlled environment without necessarily having a robust, end-to-end Shariah compliance certificate; the application phase (itself) would filter out all those clearly engaged in non-compliant activities.
- The classical jurists state a well-known maxim: Permissibility is the original state of financial transactions. This principle means that the starting point of financial transactions is permissibility… The above principle would allow the testing of all such tech and start-ups in a controlled environment which do not have any clear and explicit prohibited activity.
- At the end of the Shariah Sandbox incubation, if the scholars’ reasoning and Ijtihad conclude that the novel technology or product are impermissible or non-compliant, then this should not pose any issue due to application of the fiqh principle: “any action based on a prior reasoning and jurisprudence will not be invalidated retrospectively”.
There are divergent views on sandbox as a regulatory tool.
- Can a sandbox truly promote innovation, or is it nothing but a loophole big enough to drive a truck through?
- Or, might sandboxes become a barrier against financial innovation?
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.
- This paper “Do Regulatory Sandboxes Help Achieve the Goals (Maqasid) of Al-Shariah Better — Case of the Islamic Fintech Sector?” was presented at 5th International Conference on Islamic Finance, HBK University, Qatar, October 09–10, 2022
- Mohamad Akram Laldin & Hafas Furqani, 2013. “Developing Islamic finance in the framework of maqasid al-Shari’ah: Understanding the ends (maqasid ) and the means (wasa’il ),” International Journal of Islamic and Middle Eastern Finance and Management, Emerald Group Publishing, vol. 6(4), pages 278–289, November.
- Mufti Faraz Adam, Reimagining Shariah Governance for Emerging Technologies and Innovative Products, May 31, 2022
- Friedhelm Victor and Andrea Marie Weintraud. 2021. Detecting and Quantifying Wash Trading on Decentralized Cryptocurrency Exchanges. In Proceedings of the Web Conference 2021 (WWW ’21), April 19–23, 2021, Ljubljana, Slovenia. ACM, New York, NY, USA, 10 pages https://doi.org/10.1145/3442381.3449824