Decentralized Finance: The Next Game of the Islamic Finance Industry

Decentralized finance or DeFi is an emerging digital financial infrastructure that might become a new playground for the Islamic finance industry. DeFi products enable financial services accessible to anyone with an internet connection, and the users are mainly the owner of those financial transactions. Theoretically, DeFi eliminates the approval requirements from the central bank or government agency on any financial transactions. So far, tens of billions of dollars in the cryptocurrency have flowed through DeFi applications, and the amount is continuously growing.

DeFi and Bitcoin are entirely two different things. While having Bitcoin is like buying and holding gold or silver, not like trading in the stock exchanges. It is similar to stock picking, in which every token represents different projects or business opportunities. However, DeFi has a strong relation with blockchain, the decentralized, immutable public ledger on which Bitcoin is based, which allows all computers (or nodes) on a network to keep a copy of the transaction history.

The popularity of Defi nowadays has raised the question about its Shariah-compliant status among Muslims. Before answering this question, let’s understand the definition of Decentralized Finance.

What is a Decentralized Finance?

Decentralized finance refers to financial products and services available to anyone with an internet connection who can use Ethereum. The markets are always open with DeFi, and there are no centralized authorities to block your payments and access to any financial transactions.

However, Bitcoin was the first DeFi application. It allows you to have the ownership and control of the value and send it anywhere worldwide. This financial disruption enables many people who do not trust each other to agree on a ledger of accounts without a trusted intermediary.

How Does DeFi Work?

DeFi provides financial services using cryptocurrencies and smart contracts, eliminating the need for intermediaries such as guarantors. By utilizing DeFi technology, people can execute lending (in which users can lend out their cryptocurrencies and receive interest instantly); receiving loan; making p2p lending without a broker; saving cryptocurrency and earning higher interest rate than a bank, and buying derivatives.

Decentralized apps (dApps) allow two or more parties to do the transactions directly using blockchain technology and smart contracts without the involvement and costs of intermediaries. Theoretically, it is a fair, accessible, and open digital marketplace. However, in reality, this is not always the case.

Fintech companies use DeFi technology to provide savings accounts, loans, securities trading, and insurance. Additionally, people can use DeFi services and dApps in coins, stablecoins, tokens, digital wallets, DeFi mining (liquidity mining), yield farming, staking, trading, borrowing, lending, and saving using smart contracts.

What is Smart Contract?

A Smart Contract is a computer code that serves as a digital agreement between two parties. It runs on a blockchain stored in a public database and cannot be changed. Because the blockchain processes smart contracts, the technology will send them automatically without the involvement of a third party.

Creating a smart contract starts from creating the algorithmic codes stored in the blockchain. Once it is created, it can never be modified (immutability) and validated by all network users (distribution).

As an example, you could create a smart contract stating that you will pay $100 to another person under a specific condition. When the blockchain processes the smart contract, everyone in the blockchain network has access to and can read the code; but none can change it. Besides, smart contract helps to govern the decentralized apps (dApps); which are not managed or owned by any company or individual.

Islamic perspective on Decentralized Finance

Since blockchain and smart contracts technology is relatively new, many people wonder whether such technology or its application is Shariah-compliant.

Basically, from the Islamic point of view, things are permissible until the evidence of their prohibition exists. This principle follows the legal maxim that states:

الأصل فى الأشياء الإباحة حتى يدل الدليل على التحريم

The basic principle about things is permissibility until evidence indicates that it is forbidden

Sharia is adaptable and open to any innovation to help achieve its goals (Maqasid al-Sharia). It adheres to a fundamental rule in transaction organization that states that anything is permissible as long as no text prohibits it.

Looking back on the concept or the smart contracts, we can say that they are within this framework. Smart contracts meet the Shariah values in terms of their transparency. They can also be a great tool to avoid practices that distort morality, such as maysir (gambling), dharar (harms), tadlis (cheating), and gharar.

Furthermore, the algorithmic codes can secure the transactions. Thus, not only protecting the interest of the parties, they can lead to an environment of trust and sincerity, which are the primary goals of Shariah. Although the application of smart contracts is still in the early stage, some Islamic financial products can utilize decentralized finance technology, such as Islamic banking, takaful, Sukuk market, microfinance, and crowdfunding. These new features will help with this, especially since blockchain and smart contracts operate in a decentralized system, providing Islamic financial institutions with independence from the pressures of traditional finance’s regulatory dominance.

That’s Not Always the Case!

It’s easy to talk about good things about this concept. However, in reality, the application of decentralized finance needs to go through a rigorous sharia review process. The convenience of technology can make us negligent about the obligation to adhere to the Shariah principles.

To ensure the use of the technology does not violate sharia rules, it is necessary to have a special competent team that monitors and evaluates its use, activities, objectives, and applications to comply with sharia rules. Then based on this review, the implementation of blockchain and smart contracts can be concluded as sharia-compliant or not.

Decentralized Finance, the Next Game in Islamic Finance Industry

The main purpose of the Shariah rulings is to protect the interests and wellbeing of individuals and society. There is a wide range of flexibility as long as there is no conflict with Shariah’s objectives. In fact, Shariah was designed to encourage ease, flexibility, innovation, progress, and development. It allows people to reap the benefits of technological advancements as long as those flexibilities adhere to Islamic values.

This blockchain technology provides new opportunities as well as challenges for Islamic finance. The use of blockchain technology can support the development of Islamic finance, but there are also new challenges that Islamic finance scholars and players face ensuring that every product meets sharia standards. The potential issue that may arise in applying blockchain in Islamic finance is the non-Shariah compliant risk. Therefore, the Shariah scholars and experts should really monitor the harmony of technological developments with Shariah rules.

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