Fintech and Islamic finance: Blockchain’s Proof of Work vs Proof of Stake
Finally, the long-awaited book on Fintech in Islamic Finance, which I am honored to have contributed is ready for delivery:
https://www.taylorfrancis.com/books/e/9781351025584
In my contribution I looked at how the underlying economics of increasing returns and zero marginal costs impact business models, with then causing challenges on the legal and Islamic legal side for instance regarding smart contracts and artificial intelligence. Fintech opens to contribute to Islamic finance, as it allows to disrupt debt driven financing towards equity, if guided in the right direction. Jonathan Lawrence of KL Gates in charge for Fintech and Islamic finance at his law firm was my co-author.
BTW: If any reader knows about blockchain solutions for financial inclusion, especially for the Muslim world, please point me in the right direction. I would love to see this discussed on the next Global Donors Forum 2020 in Geneva, which is the biannual convention of Muslim Philanthropists.
Now, as cryptocurrencies making big headlines again with Libra, the Geneva based cryptocurrency, of Facebook, Paypal, Visa, Mastercard et al, the question of permissibility comes up again. Regarding Libra I wish to further read the background papers before commenting deeper. Generally, having an asset backed cryptocurrency, which is forced to be regulated, is a great leap forward, unfortunately the assets backing will be most likely in interest bearing securities, hence once up and running, not attractive to practicing Muslims. Subject as always to further analysis.
At the time of publishing the blockchain technology behind cryptocurrencies was basically Proof of Work. Participating computers in the network had to solve a crypto puzzle to validate a transaction, a technique, which solved the challenge from a central ledger (bookkeeper like a bank) to distributed ledgers allowing for a decentralized bookkeeping.
As every method this innovation had some shortcomings: High energy consumptions, vulnerability if somebody provides 51% of the computer participating and others. For this very reason alternative approaches were sought after, and one found named Proof of Stake.
Bitcoin uses the Proof of Work method, regarding the overall discussion on bitcoin from an Islamic point of view please visit my blog: http://www.islamicfinance.de/?q=node/10961 ; the same aspects and concerns apply to Ethereum, the crypto currency now shifting to Proof of Stake methodology.
As this is a pretty new development and one could expect broader applications, it is a challenge and duty to review the various aspects. An amusing side remark: The next Ethereum update is called “Istanbul”. This should add strength to understand it from an Islamic point of view.
My further thoughts are solely on the blockchain technology of Proof of Stake, and not about the permissibility or impermissibility of the Ethereum based currencies.
In Social Media the question arose whether Proof of Stake is impermissible as the validators receive “interest” for the stake/deposit they provide and there is an obvious element of chance to have allocated the reward:
Sudais Asif: https://www.researchgate.net/post/Proof_of_Stake_Interest_Money_and_Islam
Nida Khan:
https://www.linkedin.com/feed/update/urn:li:activity:6552591449563643904/?commentUrn=urn%3Ali%3Acomment%3A(activity%3A6552591449563643904%2C6552622480266145792)&replyUrn=urn%3Ali%3Acomment%3A(activity%3A6552591449563643904%2C6555389832745492480)
Across original documentation on github, the name of interest is consistently used. Hence, if this interest is in fact interest on money, akin to the prohibited “Riba” then participation as Validator would be for Muslims impermissible.
Harm/Obregon/Stubbendick have reviewed Ethereum vs. Bitcoin from an investor point of view and describing the Proof of Stake mechanism as follows:
«In a proof-of-stake model there will no longer be miners, but validators. There will no longer be cryptographic challenges, the difficult mathematical problems that miners must solve. Validators will be required to own ether and in order to validate a block they will be required to put their owned ether on the line to certify that a block is valid. This way, if there is malicious behavior or a validator does something invalid they will lose their stake, their owned ether.
Another difference will be the method of reward. Instead of rewarding miners for creating blocks validators will earn a transaction fee for each transaction and smart contract they validate. This will be much more energy efficient and will put a focus on bandwidth rather than hashrate (number of calculations per second). It will also help to put focus on collaboration rather than competition because the faster everyone can reach consensus (which is necessary to complete a block) the more transactions they’ll be able to complete, resulting in higher profits (Janin, Ethereum For Investors Part II, 2015). The parties that want the transaction or smart contract executed will also pay a fee (called the gas price) in order to have it completed and added to the blockchain.»
In order to understand the Islamic legal implications, one needs to know the parties involved, and the contracts used, as well as their sequence, which is always a key element of the analysis.
The parties in an Ethereum set up are so far, I understood: 1. Sender of currency 2. Beneficiary of payment 3. Validator and 4. Community of all such cryptocurrency holders.
Transfer:
Parties 1 and 2 wishing to transfer the Ether currency (let’s assume it fits the term currency, which again is subjected to further analysis, see again: : http://www.islamicfinance.de/?q=node/10961 ). They are paying for this matter a service fee in Ether. Basically Party 1 enters a service contract for validation of Ether being then owned by Party 2. Party 3 receives a reward as a transaction fee for this service. No major issue to this point, as the provision of payments services of this kind are accepted by Islamic scholars (some may object non-asset backed currencies though). The classification which Islamic contract is applicable is revisited at the end.
Collateral/Guarantee:
Party 3, the validator and any other validator trying to validate the transaction must provide a stake/deposit to ensure proper execution and no malicious behavior occurs. Providing such a collateral as guarantee is also acceptable from an Islamic point of view. Receiving any Ether for putting Ether as collateral would classify as Riba/Interest, provided it is paid by the party receiving this collateral. Despite research I could not yet figure out a) who receives the Ether stake b) is that Ether utilized (loan agreement) or c) is any payment given for providing the stake? Any insights and references are highly welcome.
The business case of the Validator looks as follows:
“Total Incentive to Stake = Validator Rewards + Network Fees - Cost to run a Validator”
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/eth-2.0-economics/
The Validator reward was discussed before, now what are the the network fees?
Network Wide Interest or Fees?
“For staking your ETH and attesting to correct blocks, you will be rewarded with additional ETH through a network wide interest rate as well as receive a portion of network transaction fees. Details can be found here.”
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/proof-of-stake/
Again, the “I” work = Interest. If we read further, the network wide interest rate is a functional relationship to manage the number of validators by distribution a higher fee if there is a low amount of them, and a smaller fee, if the number of validators go strongly up:
“In order to incentivize those that have ETH to stake in the network, there must be some type of reward. It's unlikely that many people would stake their ETH for no reward. Serenity accomplishes this by paying validators a reward for every block they successfully propose and attest. This reward is a sliding scale based on total network stake. So, if total ETH stake is low, the issuance rate goes up and as stake rises, it starts to fall.”
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/eth-2.0-economics/
The crucial question from an Islamic point of view is whether the distribution of the network fees is on a transaction-oriented basis or a stake basis or a mix thereof? If the reward is as well for the size of the stake, one needs to verify who pays this, for what, because basically this would like a lot like forbidden interest at first glance. At a second glance, this is less apparent, if the stake is blocked and not utilized, and the rewards are charged for provision of a validation service only.
If anybody found further hints, what is meant by network wide interest rate, please comment with some links/evidence!
But to make things more complicated, there is yet another dimension now mentioned above: While parties 1 and 2 may pay for a transfer, party 4 the community/network has inbuild inflation. Additional to the transfer fee there is Issuance. I assume for the time being that this Issuance is related to the Network Wide Interest.
Issuance:
The validator receives two types of transaction fees, one from the party asking for the service, one from the network, which issues Ether coins for the service as reward. Hence, the whole network pays a fee indirectly with the issuance of new coins in favor of the validator. Is such a reward is paid to subsidize one for a common service acceptable? Probably yes. But calling for more arguments and thoughts.
Choice of Validator – element of chance:
Many validators have provided their stake to ensure their services, but among them for each transaction only one is chosen to be compensated by a random algorithm. The question arises whether this could be impermissible gambling, qimar/maysir or invalidates a transaction due to excessive uncertainty (gharar)?
The money at stake is lost for performance violations not by a random event. Hence there is no payment by the validator to receive a random compensation, which is a typical element to identify gambling. What is at random, is the acceptance of his service, which could be considered similar to any free market activity. There is one difference to a normal business, which faces the market, that is that the buyer doesn’t decide, who provides the service to him. It is as if the buyer of the service offers it to anybody, who accepts the reward, which resembles the classical contract of Jualah. Now in Jualah the transaction fee itself is fixed. In Ethereum the reward may differ between validators and if so, needs further analysis if this could eventually impact the permissibility or possibly render the Jualah contract defective.
Gharar, excessive uncertainty, is usually deemed within a contract, a defect. In this case, once the contract is conclude price and service as key elements are well in order. The uncertainty refers to whether or not the contract will be entered into, which is commonly not identified as Gharar.
As such quite a few new aspects to review and no final answer yet. Nevertheless, the above considerations should help to initiate further research and involve more interdisciplinary discourse of the subject matter.
It is crucial that the Islamic finance community increases its effort to discuss and foster new Fintech solutions, as they may offer new opportunities to reach out to the poorest, and also to change or get around the tax and regulatory driven promotion of debt.
Links:
https://github.com/ethereum/wiki/wiki/Proof-of-Stake-FAQ
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/proof-of-stake/
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/eth-2.0-economics/
https://www.economist.com/sites/default/files/creighton_university_krake...
http://simonjanin.ch/downloads/Ethereum_for_Investors-Opportunities_and_...
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