Chapter 7 - Financing and credit risk Part 2
What is an ICO ?
An Initial Coin Offering (ICO) is a new way for organisations to raise capital. Like an Initial Public Offering (IPO), an ICO raises finance from investors. However, there are two key differences: (a) Instead of receiving shares, an investor receives a new type of coin or token (b) Payment is made in a cryptocurrency such as bitcoin or ether
The justification for the use of Islamic finance may be either religious or commercial reasons; here we focus on commercial reasons: They are?
Availability of finance. The impact of the credit crash on Islamic nations, eg wealthy Gulf countries, has been less than in many other parts of the world. The Gulf countries own approximately 45% of the world's oil and gas reserves. Islamic finance may also appeal due to its more prudent investment and risk philosophy. Conventional banks aims to profit by taking in money deposits in return for the payment of interest (or riba) and then lending money out in return for the payment of a higher level of interest. Islamic finance does not permit the charging of interest and invests under arrangements which share the profits and losses of the enterprises.
Product based on investment financing (ie no equity participation). What is there to note about debt based finance?
Debt-based finance is also possible but, even here, no interest can be charged; the products ensure both parties involved share risk (eg late payment fees can be applied by the bank but any such fees must be given to charity), and no money is actually loaned (the finance is linked to an asset being purchased on behalf of the client).
Types of tokens/coins?
Investment tokens - Equity tokens which offer a share in the company Asset tokens - Represent a physical asset or product; eg allowing investors to purchase difficult-to-store physical assets such as gold online. Utility tokens - Provide users with access to a product or service; eg Filecoin raised over $250 million, its tokens enable access to its decentralised cloud storage service The future value of these tokens depends on the success of the venture.
Two main products that are offered by Islamic banks that facilitate equity participation are?
Mudaraba Profits are shared according to a pre-agreed contract. There are no dividends paid. Losses are solely attributable to the provider of capital, eg a bank. The entrepreneur (the mudarib) takes sole responsibility for running the business, because they have the expertise in doing so - if losses are made the entrepreneur loses their time and effort. Mudaraba contracts can either be restricted (to a particular project) or unrestricted (funds can be used in any project). Musharaka Profits are shared according to a pre-agreed contract. There are no dividends paid. Losses are shared according to capital contribution. Both the organisation/investment manager and finance provider participate in managing and running the joint venture. Profits are normally shared in a proportion that takes into account the capital contribution and the expertise being contributed by the bank and the entrepreneur/joint venture partners. Losses are shared in proportion to the % capital being contributed by each party. Under a diminishing musharaka agreement the mudarib pays increasingly greater amounts to increase their ownership over time, so that eventually the mudarib owns the whole venture or asset
Product based on investment financing (ie no equity participation). What are the products?
Murabaha - The financial institution purchases the asset and sells it to the business or individual. There is a pre-agreed mark-up to be paid, in recognition of the convenience of paying later, for an asset that is transferred immediately. No interest is charged. Ijara - The financial institution purchases the asset for the business to use, with lease payments, period and payment terms being agreed at the start of the contract. The financial institution is still the owner of the asset and incurs the risk of ownership. This means that the financial institution will be responsible for major maintenance and insurance, which is different from a conventional finance lease. Salam - A commodity is sold for future delivery; cash is received from the financial institution in advance (at a discount) and delivery arrangements are determined immediately. Note. Sharia scholars have concerns about derivatives products (eg futures) because they are not based on real economic activity (unless they are held to delivery) Istisna - For funding large, long-term construction projects. The financial institution funds a project; the client pays an initial deposit, followed by instalments during the course of construction. At the completion, ownership of the property passes to the client
Mechanism for an ICO?
One of the attractions of an unregulated ICO is its simplicity, the issuer raises money by issuing a 'white paper' providing details of the concept that the venture intends to build, and details of the tokens that will be issued in exchange for cryptocurrency. The white paper is available via the venture's website, which also provides the mechanism for payment of cryptocurrency to the venture's account (typically bitcoin or ether). It is now more common for payments to be made into an escrow account (an account established by an independent third party), to provide greater assurance of the venture's validity. Most ICO sites include instructions for how investors should go about buying their bitcoins or ether - the assumption being that they don't already own any cryptocurrency (ACCA, 2018).
Advantages of an ICO
Since 2017, there has been a dramatic increase in ICO activity, due to: (a) Its speed and ease of use as a source of finance for new ideas, compared to traditional methods (b) Investor interest, often based on a speculative expectation of rapid, high returns
ICO - Regulatory status
The attitude of regulators to ICOs differs around the world; in some countries (China and South Korea) ICOs are banned. In general, regulators are less concerned with ICOs that do not offer investors the reasonable expectation of profit eg where an ICO aims to simply develop technology or where investors receive utility tokens to exchange for future services (these ICOs currently tend to be outside the definition of a 'security' and therefore are not normally of interest to regulators) ICOs that in some way offer future income streams are likely to be judged to be securities (eg equity tokens or tokens that can also serve as a 'payment voucher' for an underlying service). These ICOs are likely to have to fulfil the related regulatory criteria for an issue of securities (full prospectus etc). There may also be a risk that if this has not been done then fines may be levied (which may be severe), or the regulator puts a stop to the ICO
What is there to note about the Sukuk bonds
The other key product that allows equity participation is a sukuk bond. Although these are often referred to as Islamic bonds, the sukuk holders share risks and rewards, so this arrangement is more like equity. The sukuk holder shares in the risk and rewards of ownership of a specific asset, project or joint venture. Sukuks require the creation of a special purpose vehicle (SPV) which acquires the assets. This adds to the costs of the bond-issuing process, but they are often registered in tax-efficient jurisdictions, eg Bahrain. The prospectus for a sukuk must clearly disclose its purpose, its risk and the Islamic contract on which it is based (mudaraba, musharaka, ijara (see below)) - all of which will be crucial in obtaining sharia compliance (which must be disclosed in the prospectus too)
Disadvantages of an ICO
To investors Fraud risk - ICOs tend to be launched by start-ups. Organisation details are often vague with just a website, and no specific geographic location. White papers may make wild claims about the potential for the project being financed Valuation risk - Valuation of tokens is highly speculative, in addition the entities involved are generally start-ups. Security risk - If a token repository is hacked and tokens stolen, investors typically have no recourse To the issuer Value of cryptocurrency - For example, the value of bitcoin fell by over 50% between mid-December 2017 and early Feb 2018 Risk of money laundering - The anonymity of transactions makes ICOs a target for investment from funds belonging to organised crime. Risk to investor - As discussed earlier, this may reduce the availability of funds and the price that investors are willing to pay. Risk of regulation - This is illustrated by Protostarr, which abandoned its ICO in 2017 after being contacted by the US SEC to discuss its status.
Islamic finance - Products based on equity participation? What is there to note about Islamic equity market in general?
To tap into the Islamic equity markets, a company must be sharia compliant. To achieve this, there are two key screening tests: (a) Does the company engage in business practices that are contrary to Islamic law, eg alcohol, tobacco, gambling, money lending and armaments are not acceptable. (b) Does the company pass key financial tests, eg a low debt-equity ratio (less than approx 33%); in theory any interest-based transaction is not permitted, but in reality it is accepted that this is not realistic To establish social justice, Islam requires that investors and entrepreneurs share risk and reward; there are two main products that are offered by Islamic banks that facilitate this (remember that Islamic banks cannot lend money out in a conventional way in exchange for interest repayments). Despite being offered by banks, both products actually create equity participation.