The Upside & Downside Of Shariah Compliance in Security Token & Dex-Offerings

Crypto-assets – cryptocurrencies, tokens and coins are popular terms used in the cryptocurrency industry interchangeably. Crypto-assets are considered as the umbrella term for all cryptos. Crypto-assets can be defined as “a digital representation of value that uses cryptographic encryption techniques”. Thus, they are digital in nature and use cryptography to verify that the person spending the crypto-asset is entitled to do so. All this takes place on a decentralised peer-to-peer network and the data is recorded on a decentralised public ledger which is known as blockchain.

After reviewing different types of crypto-assets, the paper begins discussing the different forms of fundraising on crypto-exchanges. An Initial Coin Offering (ICO) is a method of raising funds through the use of cryptocurrencies. ICOs are basically blockchain crowd sales, the cryptocurrency version of crowdfunding. ICOs are commonly contrasted to Initial Public Offerings (IPOs) due to the commonality of wanting to raise funds through offering and issuing something. However, this comparison is quite deceptive and inaccurate. IPOs usually apply to established businesses that sell partial ownership shares in their company as a way to raise funds. In contrast, ICOs are mainly used as a fundraising mechanism that allows companies to raise funds for their project in very early stages.

In contrast with an ICO, an STO investor is assured that they are buying equity, debt, derivative, certificate of interest or a participation of any profit-sharing organisation. While this is no guarantee of profit by itself, it’s comparable to buying stock in a publicly traded company. If the project returns a profit, the investor has a legitimate claim on their share of those returns. An STO isn’t necessarily just for a start-up either. An already-established company could use an STO to issue digital tokens against existing equity instruments, for example, to raise funding for a new product or business line. Whereas the secondary markets for ICO tokens are largely unregulated cryptocurrency exchanges, STO tokens are traded on fully regulated trading platforms.

Initial Exchange Offering

An Initial Exchange Offering, commonly referred to as an IEO, is a fundraising event that is administered by an exchange. In contrast to an Initial Coin Offering (ICO) where the project team themselves conduct the fundraising, an Initial Exchange Offering means that the fundraising will be conducted on a well-known exchange’s fundraising platform, such as Binance Launchpad, where users can purchase tokens with funds directly from their own exchange wallet.

Initial Decentralised Exchange Offerings are something which are still very much in their infancy. This is the latest fundraising mechanism in the crypto space and a new way for token offerings.  Binance recently launched its first decentralized exchange, which allows users to trade cryptocurrencies directly from their digital wallets without a custodian mediating the transactions.

Shariah Compliance Checks

All token offerings should go through the following screenings before Shariah compliance can be determined:

  1. Anti-scam screening
  2. Business activity screening
  3. Financials screening
  4. Token screening

A Shariah board should have a technical advisor who can review the project and token offering from a legitimacy and authenticity perspective. In the absence of a regulator for the crypto-asset industry, it is part of the Shariah governance to screen crypto-assets to detect scams. Any Fatwa on a token offering should reflect the findings of the anti-scam screening process.

The second screening should consider the core business activity or project of the token offering. It is not permissible to purchase the tokens of any offering whose project is primarily non-compliant with Shariah. This applies to all types of tokens being offered; equity tokens or otherwise. In equity tokens, a project offers you equity and an ownership interest in the project which is symbolised by the token in return for your capital.

The token screening is an additional layer to the business activity screening. The business activity screening ensures equity tokens are Shariah compliant. The token screening considers the nature of the various types of tokens and whether they are Shariah compliant and the rules that will apply to such tokens.

The final screening is financial ratios screening. The financial screening criteria apply for security tokens only where investment is being made into equity. The paper concludes that when a token is being offered via an exchange such as IEOs and IDOs, the features and facilities of the exchange should be reviewed to ensure the token is sold in a Shariah compliant manner.