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What is DeFi? Is it halal?

If you've delved a little into crypto, chances are that you’ve probably heard the word ‘DeFi’ being thrown around. 

In this article, we're going to explain DeFi for you in simple terms. We're also going to give the Islamic perspective on whether DeFi is haram.

Definition

DeFi is a shortening of the term Decentralized Finance.

Decentralization is the key factor for supporters of crypto generally. It's about taking the power away from centralized entities like banks and governments. The argument goes that with modern technology including blockchain, we no longer need these central authorities to act as the infrastructure for flows of money across the world from person to person.

DeFi is much more than just cryptocurrencies and crypto-exchanges.

The end goal is a series of technologies, networks, softwares, and protocols that seek to upend traditional financial institutions (‘TradFi’) in hopes of bypassing traditional middlemen and trust mechanisms to make an internet-based financial system.

Before we dig deeper into what DeFi actually is and whether it’s halal, it helps to know what the current centralised financial system (TradFi) looks like and how it works.

Traditional Finance (TradFi)

The global network of centralized finance comprises various banks, institutions, and networks.

In the current system, your money is held by banks whose overarching aim is to make money. They do this by lending out your money.

The biggest banks in the UK are all publicly listed companies who are beholden to shareholders and their bottom line.

However, these established institutions are finely regulated and have existed for decades, allowing governments to craft legislation over time to protect consumers and prohibit illegal activity.

Protocols, systems and regulation

Banks act as middlemen to the world’s money. Through the communication network SWIFT, thousands of banks around the world communicate with one another. 

When you want to transfer money to a bank account abroad, banks use the secure SWIFT system to communicate using a series of codes that allow settlement between accounts.

Banks keep your money safe. But since banks also want to make a profit, they lend the money you deposit to others to turn a profit. 

However, this does not mean your money could disappear, as banks are tightly regulated. Banks in the UK are regulated by the Financial Services Compensation Scheme (FSCS), which means if the bank can’t give you your money back, you can claim compensation from this government scheme.

Banks also allow you to use your money to pay for things. When you buy something online or in a shop, an entire process is happening behind the scenes.

Because banks and traditional payment mechanisms are legacy systems, they have been widely accepted so now you can use your credit or debit card anywhere in the world to buy almost anything.

In the TradFi system, all these transactions are watched over by various bodies including the Bank of England since they are so integral to the functioning of the economy on a daily basis.

Our current financial institutions are so entrenched and established that they must be kept working smoothly for society to continue to live and operate every day.

This provides a sense of trust and certainty in these institutions that would be harder to find elsewhere.

The Bank of England has set up the Prudential Regulation Authority (PRA) to create policies for financial institutions and to supervise them, and has set up the Financial Conduct Authority (FCA) to ensure fair outcomes for consumers.

You can also borrow money through a credit card, which usually comes with a hefty interest cost if you don’t pay the bank back on time. Products like loans and mortgages allow you to buy more expensive assets whilst also making the bank a lot of money.

This illustrates some of the benefits of TradFi and centralised institutions. Because they have existed for decades they must comply with legislation and regulation.

But this also means you play completely by their rules and their profit-seeking incentives.

Criticisms of TradFi

TradFi - for all its importance - has its detractors.

Firstly from an Islamic perspective, the TradFi system is entrenched in riba. Muslims have long lamented this but often felt powerless against the machine.

Well for the first time, maybe the machine can turn.

DeFi advocates believe that centralized financial systems are too powerful. They claim that banks serve themselves first rather than serving you.

The criticisms seem fair as well. 

In a traditional bank you must provide your identity and name to open an account. While this brings with it the benefit of oversight and participation in mainstream finance, it also means more surveillance and barriers to access.

Ordinary people like you and me are increasingly skeptical and worried about just how much information is held about us by all sorts of organisations. 

We're in 2022 and still sending sensitive documents like copies of our passports and signatures over (unencrypted) email to the largest institutions int he world.

One of the other main criticisms is the lack of control that you ultimately have over your own money. Any transfer, withdrawal, or investment is subject to the institute’s policies and systems. 

Not to mention the forum posts like this one that pop up every single day with someone's bank account being frozen with the owner of the account being left unable to pay bill, having no access to any money and the bank unwilling to tell them why they froze it and how long it will take to unfreeze. 

In addition to that, every step of the way, from a trade to a deposit, the bank or institution is motivated by how much money they can ultimately make from your decisions.

You are at the mercy of the institution’s waiting times and protocols. And it’s not completely transparent for you to see what’s going on behind the scenes with your money. You don’t really know how banks are profiting off of your cash and investments. You don't truly know either what your money is funding.

Islamically, this has always been central to many people's doubts over banking institutions in particular. The very idea that our own money could indirectly be used to fuel war against other Muslims around the world is enough to send pulses racing.

Centralized markets and institutions are not always open for business. Markets close and banks have closing hours. This doesn’t apply to DeFi where the markets are always open as long as you have access to an internet connection.

Banks and institutions are subject to mismanagement and corruption due to human nature, which DeFi advocates argue can be done away with by relying on transparent computer code. Code doesn't have emotion or greed.

There are countless stories of bankers being paid millions and not caring about the consumer. This problem would not exist with DeFi.

In TradFi systems, your data and privacy are at the hands of the institution just like your money. The main arguments DeFi proponents use is handing control back to the individual.

Decentralized Finance (DeFi)

DeFi seeks to eliminate the need for large institutions and middlemen by allowing people to transact through the power of software and the internet.

The premise is that you can trade and transfer money from anywhere using your internet connection. Instead of relying on banks and institutions you rely on software and blockchain technology.

This essentially means instead of trusting a bank’s database, you place your trust in a decentralized and distributed financial database not controlled by any one single entity.

That means that your information is not stored in one place prone to interception or corruption. It's chopped up and scattered over lots of places. And code can call upon all of the information when it needs but only when needed. The code determining everything is open source and inspectable.

DeFi seeks a peer-to-peer (P2P) future. This means two parties can agree on something directly without the need for a third-party to get involved. Traditionally, a third-party was needed for admin and trust purposes. DeFi does away with the middleman through the use of technology.

The major benefit of a P2P system is complete control over your money and assets, not having to give up your data and privacy, and gaining efficiencies and cutting down costs.

The way this is executed is through the use of smart contracts. Smart contracts allow transactions between two anonymous parties with certain triggers built in to the code.

The terms of the agreement are set into lines of code which can self-execute once conditions are met. Once certain conditions are met, transactions take place. These transactions are fully transparent and verifiable through the blockchain. If X condition happens, Y will happen.

With DeFi you don’t need to provide your identity nor must you deposit your money into a bank account, you can hold your own money in your own crypto wallet.

DeFi proponents imagine a future where anyone with an internet connection can trade as free individuals with lines of transparent code enforcing voluntary agreements. An efficient, peer-to-peer network without large institutions setting rules and profiting.

We're in the nascent stages of DeFi right now. That's why this all might seem good in theory but unlikely to every take off.

But the same was true of the internet at one point.

How big is DeFi?

It is hard to put an exact number on DeFi due to its decentralized nature.

Some estimates use total value locked (TVL), which measures the total value of crypto held in DeFi projects. There are varying estimates according to which data source you use (since it’s all decentralized). According to one source, DeFi is currently worth around $77 billion using the TVL measure. Whilst another source values DeFi at just under $200 billion.

Another way of measuring how big DeFi is would be to look at growth in decentralized exchanges (DEXs). DEXs allow people to swap cryptocurrencies with one another. In 2021, the value of DEXs grew by 550%.

There were 5 million transactions made just in DEXs in August 2021, with an average transaction size of $26,500.

The DeFi space is seeing double and triple digit growth every year. At this point in time the total value may be dwarfed by TradFi, but given its growth rate, it won’t be long before DeFi attracts a similar value to traditional financial products.

Criticisms of DeFi

DeFi is an emerging technology. It is so new that there isn’t even a single coherent vision of the DeFi space.

With new technology comes con-artists and ponzi schemes. One of the major problems with DeFi is a lack of regulation and oversight, which results in numerous scams and con-artists waiting to take advantage of people without sufficient knowledge.

Another problem with DeFi is that it’s not adopted by society due to how new and unregulated it is. 

A major function of money is to be able to transact with it for your daily needs. However, if you walk into your local supermarket or try to shop online, you’ll very quickly find that no one really accepts crypto payments. 

Without mass adoption, DeFi remains a niche and enthusiast space which means it’s not fit for use for most people going about their daily lives.

This problem is very clear when it comes to setting up your wallet and getting started with DeFi.

Apart from centralised crypto exchanges, setting up your own system requires a good level of technical know-how that most people may not want to expend effort on. And if you do go for the centralised platforms, then you have to hand over as much of your data as with a TradFi institution.

With a bank you can apply online and expect them to take care of admin and infrastructure, DeFi lacks the centralisation necessary for this ease of use.

All of this can snowball into a scenario where you lose the keys to your crypto wallet and lose your money forever. Around 20% of all Bitcoin is lost due to lost private keys, representing around $4billion.

The other major concern with DeFi and all of crypto is its complete reliance on software and code to do the job in a bulletproof way. However software is prone to hacks, bugs, glitches and being coded in a way that doesn't deal with a particular edge case. This has led to multiple famous hacks, and the very recent collapse of Luna.

The counterpoint to this though is that these are solvable problems and there are a lot of smart people in the world who will work on this and create the huge companies of tomorrow. (Side note: these are the companies we scour for every day in our work with IFG.VC).

DeFi v TradFi Comparison

 

DeFi

TradFi

You hold your money

Your money is held by banks

Smart contracts executed by code and software

Payments settled by institutions governed by legislation, protocols, and networks

Not widely adopted means not as practical in everyday life

Widely adopted and is the system on which society runs, so you can use your credit/debit card and bank transfers everywhere

Lack of regulation and oversight as an emerging technology

Tightly regulated and overseen with consumer protections

Markets are always open

Markets close

Transfers and trades only take minutes

Payments can take days depending on the processes of the institution and how far your money is going

Anyone can access it with an internet connection, pseudonymously 

You must apply through banks and institutions and provide your real identity

Less user-friendly: User must have some knowledge of technologies to set up infrastructure and admin (without relying heavily on companies)

More user-friendly: Users can rely on the bank/company infrastructure and mostly rely on them for admin and infrastructure purposes

Protocols and systems are mostly transparent, available for users to inspect

While policies and terms are transparent, users must trust the behind the scenes processes and cannot see the inner workings of the institution

Peer-to-peer (P2P)

There are almost always middlemen and third-parties involved

You are responsible for keeping your private keys safe or risk losing your money

Banks bear responsibility and are overseen, and FSCS protection means consumers are compensated in event of banks going bust

Is DeFi Halal?

The bottom line is that there is nothing haram about DeFi per se. In fact, at its core, it is arguably more Islamic.

Like with most crypto-related matters, you need to look at what is going on in the particular project you are participating in. 

One critical thing with DeFi is many people are put off because of the use of the word 'interest'. We've covered this in more detail in our article on staking.

But broadly speaking, the key thing to remember is that people might be using the term 'interest' in DeFi without actually meaning it. So it could be perfectly fine. Once you read the staking article you'll have a much better eye for what is genuine interest and what is not.

The most important point to keep in mind is that there is no one blanket rule that can cover every single project. If you are in doubt about the permissibility of a project make sure to get it screened by a scholar trained in Islamic finance.

We outline our general view on cryptocurrency here.

Essentially, cryptocurrencies are not inherently impermissible, They have ‘value’ to them and can be considered ‘mal’ (wealth) and a digital asset, so are permissible to own and trade, in principle. Any projects or currencies in which you acquire or charge interest are of course impermissible.

A big part of current DeFi is the concept of crypto staking. This is where you lock up some of your currency to add more coins to the blockchain, getting rewarded in the process. This is not impermissible in principle as we outline here.

Because DeFi is an emerging technology ecosystem, definitions are not fixed and underlying mechanics can differ from project to project. 

Liquidity mining and yield farming are more technically sophisticated ways of earning money through crypto, we cover whether they are halal here. Generally, liquidity mining is permissible whilst yield farming can be problematic, especially when its underlying mechanics are lending money for interest. Again, getting the project screened by a scholar is the safest path.

A good place to start learning is our Complete guide to Crypto for Muslims.

 

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