Islamic Financial Technology and the Future (Part 2 of 2)

Islamic Fintech, Innovation, and Collective Economics

The fulcrum of collaborative action with Islamic finance is a flexible and agile industry. The industry is guided by Islamic finance thinkers who create directives for financial technology. Finally, entrepreneurs establish a Shariah — compliant financial technology ecosystem, with the use of technology for community service (Anca, 2019). In an ideal system, entrepreneurs form shared communities to improve the lives of people that are supported by online payment systems and connected with technology such as the Internet of Things (IoT). Technology also supports communication such as through mobile apps.

The Islamic Finance Ecosystem

The main aspects of an Islamic finance ecosystem are a “community drive” for business advancement in a “collaborative economy”, novel connectivity options to perform financial transactions, and the application of Shariah principles to direct the new ways of doing business (Anca, 2019). At the basic level, this ecosystem requires producers and consumers of goods and services and “collaborative platforms” to connect the users of the system. Collaborative economies are built to meet the needs of collective ends of the community with collaborative finance operating at its core and benefiting from disintermediation.

Technology in the Financial Ecosystem

The application of technology to the finance sector involved disruptions in the form of loans, fund raising, asset management, and mobile payments. In the future, technological advancements in the fields of 3D and 4D printing, robotics, artificial intelligence (AI), blockchain, autonomous vehicles, and Internet of Things (IoT) are disruptive for the economy. They act as drivers for the venture capital revolution (Anca, 2019). AI has application in predictive financial analysis to automate tasks and improve daily efficiency. IoT helps with data sharing, analysis, and management. Blockchain has applications for managing transactions and records in a comprehensive and decentralized manner.

Islamic Financial Innovation

The Islamic finance sector requires financial innovation. The current system is designed to fulfill the needs of few business owners at the expense of the savings of billions of people. Islamic principles that would help to fix the state of the economy are non-interest, using the financial system for community benefit, and non-speculation. The growth of this industry will depend on educating individuals on big data, technology, and Islamic principles, Shariah compliant independent ventures, and institutional support for fintech innovation. So far, most fintech companies are concentrated in Malaysia, Indonesia, and the UAE. Business models were mainly based on peer-to-peer finance, payments, personal finance trading, currencies, insurance, digital banking, data and analytics, and blockchain to name a few (Anca, 2019). Experts in Islamic finance need to answer how technological innovation can meet financial and economic demands, what fintech instruments are useful, and what are limits of Shariah financial innovation.

Disintermediation — A Key Advantage of Islamic Finance

Financial disintermediation was desirable after the 2008 financial crisis, as one of the factors that led to it was the overuse of complex financial products such as derivatives. This led to new ventures by the young generation who preferred to work without intermediaries. The new ventures had the potential to create a $90 billion investment market by the year 2020 (Anca, 2019). Another advantage was their global network of Internet and smartphone communication technology. Investors and buyers collaborate online and financial transactions are transparent.

Financial intermediation is intended to channel funds to achieve productivity. It also reduces transaction and information costs (Nisar & Farooq, 2019). While financial exclusion was becoming more commonplace due to the emphasis on eliminating gambling, speculative risk, and interest-based transactions, its inclusion increased after the adoption of fintech in the form of smart contracts, Distributed Ledger Technology (DLT), raising the use of crowdfunding, investment advisory, and peer-to-peer financing. These changes will open up more opportunities for equity-based financing, reducing moral hazard and risk premiums, and expanding into new markets.

The Role of Community-Based Economies

Experts argue that community-based finance must be the focus of the future as it channels the savings of billions of people into the needs of the larger community. This is in contrast to collaborative-based finance where only the top few gain at the expense of many (Anca, 2019). Collaborative-based economies create an unstable job market and new opportunities for only a few large companies. Shariah-based fintech can offer a value system with ground rules for operational excellence that targets the well-being of communities.

In all scenarios, the basis of public interest prevails, and the successful working of such communities rests on the demand for ethical financial services based on Shariah principles and the wider goal of the promotion of economic development targeted at the improvement of the community. In relation to public interest or maslahah, scholars must consciously evaluate whether financial speculation is inherent, whether the initiatives alleviate poverty and improve financial inclusion, improve food and water security, solve social problems, and protect the environment (Anca, 2019). These goals can be realized not through the introduction of new products, but by defining a methodology to guide capital seekers, capital holders, and transactions in managing an emerging fintech industry.

Islamic Fintech for Socio-Economic Welfare

Wealth Development

Development and preservation of wealth are important aspects of socio-economic welfare. Fintech can contribute to the development of wealth. These include wealth management, payments, capital markets, crowdfunding, big data analytics, robo-advisory, cloud computing, blockchain, social media, and insurance (Mohammed & Amri, 2019). Wealth redistribution and charity contribute towards socio-economic welfare.

Shariah Contracts

To enforce Shariah contracts, the right approach in this case would be to screen the probitied elements and apply Islamic principles to conventional contracts. To implement this successfully, the elements of hiyal or finding legal justification to apply Islamic law and makharij or the search for solutions to apply Islamic law must be scrutinized and regulated by Shariah scholars for the successful adaptation of conventional Islamic finance products (Oseni & Ali, 2019).

Technology can be applied to reduce risk in mudarabah, musharakah, salam, and istisnaa. Scholars must work with industry experts and IT professionals to find innovative fintech solutions that are Shariah-compliant (Oseni & Ali, 2019). The proposed financial solutions must follow its aqd or rules, pillars or rukn, and conditions or shurut in the contract.

The application of fintech reduces operational costs, shortens transaction chain, provides the ability to access new customer segments, enhances resilience of operational processes, and allows access to new customer segments for improved capital efficiency and increased capital efficiency. It increases the available choices, minimizes transaction cost, and maximizes transaction speed (Oseni & Ali, 2019). It empowers customers as the control over conducting a financial transaction is now with the customer. It also promotes financial inclusion through systems such as mobile technology. In this way, it provides a number of routes to promote public good or maslahah.

Needless to say, fintech transactions must be transparent, and free of cheating, fraud, and hidden costs. They must comply with the goals of mafsadah and maslahah (avoid harm and promote benefit). Market function and consumer protection must be guided by a Shariah regulatory framework to achieve the elements of transparency, reasonable standards, disclosure, reporting, and funding (Oseni & Ali, 2019).

Crowdfunding

An innovative financial intermediation platform that connects fund providers with users is crowdfunding. The largest market for crowdfunding is North America, followed by Asia and Europe, even surpassing angel financing as a source of capital for SMEs, just after venture capital (VC). It may reach a $100 billion value by 2025 and lead all other financing channels. Crowdfunding consists of three main players: the entrepreneur or project owner in need of financing, the investor in the form of a large group of people, and the crowdfunding platform which connects the investor and entrepreneur (Amine & al-Bashir, 2019). The platform operator identifies and presents different projects and finance providers choose the projects they prefer to fund. Fund providers reduce risk by diversifying their investment portfolio. In some models (i.e. second-generation models), the risk management is undertaken by the platform operator whose role is to split the funds and allocate them among the different financers.

Four Models of Crowdfunding and Shariah Compliance

Crowdfunding may be in the form of donations from philanthropic projects or direct financing from equity or debt. It can be classified into four models: donation-based crowdfunding, where funders, who may be charitable institutions or educational institutions, do nor have financial gains; debt-based crowdfunding where lenders give loans with the assumption that the company will pay back, giving them profit; equity investment crowdfunding which is typically in the form of security issuance and although they may not receive the capital, they receive a growth in capital value; and rewards-based crowdfunding where funders receive reward for a capital commitment such as in the form of public recognition. The different models of crowdfunding are P2P, B2B, and B2C (Amine & al-Bashir, 2019).

To be able to successfully implement crowdfunding in the Islamic context, Shariah compliance and legal challenges must be addressed (Amine & al-Bashir, 2019). Out of the many financing models in this context, the equity-based crowdfunding model needs to be evaluated from the Shariah perspective by parameters such as receivable financial ratio and debt. Furthermore, the model needs to be studied against the prevailing laws and regulations to verify the possibility of prohibition or dysregulation of crowdfunding. Experts suggest undertaking Shariah audits to guarantee compliance of the industry.

The different models of crowdfunding can be implemented from the Shariah perspective. The debt-based crowdfunding model can be implemented by several sales contracts including wakalah, murabahah, salam, ijarah, and istisnaa. Debt financing in the form of cash is not Shariah compliant due to the prohibition of riba (interest). To implement this model, a commodity can be lent by way of a murabahah or wakalah contract between the fund seeker and fund provider, and the platform acts as the broker or simsar (Amine & al-Bashir, 2019). In the case when the financing is only possible by the joint ownership of the asset, a musharakah contract between recipient and provider of the funds can be undertaken.

In equity-based crowdfunding investment, wakalah or samsarah may be implemented. In this case, a platform facilitates the purchase of shares of a target company by investors. The platform may function as an agent, buying and allocating shares among investors. In equity-based crowdfunding, the company must be involved in permissible activities in compliance with Shariah (Amine & al-Bashir, 2019). Investment in derivatives, margin trading, or short selling must not be allowed. Further, a guarantee must be undertaken that the company will continue to operate on Shariah principles.

In all the above cases, utmost importance is given to maslahah, and the benefits of fintech including time efficiency and reduced transaction costs must be provided to users. Likewise, any harm from the use of technology is regarded as detrimental by Shariah. Fintech innovation must be free from gharar or risk, fraud, and injustice (Amine & al-Bashir, 2019). The famous scholar Ibn al Qayyim al Jawziyyah in his book Ilam al-muwaqqiin, noted that anything that departs from “justice to injustice, mercy to opposite, and benefit to harm” is not part of Shariah.

Challenges and Risks of Shariah Crowdfunding

The challenges in implementing Shariah compliant crowdfunding are obligations and rights of parties involved and their contractual relationship (Amine & al-Bashir, 2019). Funding may not come easily and the initial project cost may be quite high. Unsuccessful projects may damage business reputation, and lawsuits may occur. Jurisdiction and regulations may sometimes make the implementation challenging. That said, crowdfunding has the potential to reduce waste, improve efficiency, increase automation, and enhance customer service. Companies get access to capital in a timely manner, feedback, professional guidance, and progress tracking.

Crowdfunding has common investment risk, risk of fraud, data protection, and conflict of interest. According to the International Organization of Securities Commissions (IOSCO), other risks include risk of default or failure, terrorist financing, money laundering, information asymmetry (unsuitable for investors who are not able to review accurately), lack of liquidity (due to lack of availability of secondary market), cross-border implications from web and mobile platforms, platform failure, and cyber-security breach (Amine & al-Bashir, 2019). These risks may be overcome by customizing licensing and registration, limiting services, setting disclosure requirements, appointing third-party custodians, and limiting the investment size.

Crowdfunding has been implemented in different countries, leading to different conclusions. For example, in Bahrain, Shariah compliant crowdsourcing financing is implemented as a person to business (P2B) online platform, where people finance businesses to gain financial return over a specified time period. Bahrain regulations prohibit platform operators from advising financers about deals (Amine & al-Bashir, 2019). According to regulation in Malaysia, the offering of a capital market must be accompanied by the appointment of a Shariah advisor who provides guidance, oversees compliance with Islamic rulings, applies reasoning in the absence of ruling, and issues Shariah pronouncement with a “rationale, structure, and mechanism”. Likewise, regulations relevant to a particular country and context are issued by relevant authorities and need to be incorporated into the broader goals.

Smart Contracts in Islamic Finance

Smart contracts have the potential to disrupt Islamic trade finance. Smart contracts require a rethinking of the business model, information flow, and the digitization of services. The objectives of smart contracts include transparency, cost-efficiency, and improved customer experience (Laldin and Furqani, 2019). Trade must include Shariah — compliant goods. Smart systems can aid Islamic finance transactions by automating information collection with sensors and processing data in real time. Smart contracts also require compliance with legal requirements. There are a few setbacks associated with smart contracts including an inability to integrate external data, irrevocability, limited use of distributed ledger technology, and complex skill development.

Waqf or Donations without Reclaiming

Waqf (donating assets without reclaiming) is applicable to agriculture, education, industry, and health, and can successfully address many charitable causes including feeding the poor, sheltering the homeless, promoting education, and enhancing healthcare (Abdel Mohsin and Muneeza, 2019). Waqf covered these activities in the Ottoman period, contributing beyond charity and towards the welfare of the human civilization. After the Ottoman period, the role of waqf deteriorated when properties became unproductive.

Raising funds with fintech such as crowdfunding can help restore waqf properties and benefit the poor and needy. This translates to benefits in many sectors including support of the education sector, alleviating poverty, enhancing the health sector, supporting orphans and other charities, renovating burials, mosques, and other properties (Abdel Mohsin and Muneeza, 2019). Waqf can assume any of the crowdfunding models to achieve these goals: charity crowdfunding platform (donors select from among charity platforms provided online), direct waqf crowdfunding to redevelop waqf properties (donor contributions are channeled through the crowdfunding platform to redevelop properties), and indirect waqf crowdfunding (accumulated funds are invested and revenue generated is channeled to waqf projects). Blockchain and crowdfunding is proposed to be the fintech capable of supporting the development of waqf properties.

Blockchain

Blockchain is a “decentralized public ledger” that has applications in shipping, commercial transactions, and security to name a few. Blockchain with crowdfunding is proposed as a potential technology to support redevelopment of waqf properties (Abdel Mohsin and Muneeza, 2019). Another application of blockchain is identity management as legal identity is important for the functioning of modern societies. Digital identities serve as a means to online and offline resources and link their identities. These identities enable islamic financial institutions with risk and credit assessment and compliance with regulations. Legal identities enforce trusted transactions. Security issues in scaling remain the major challenges of identity systems backed by blockchain. The competitiveness of these systems is limited due to crime and fraud (Akinlaso et al., 2019).

Issues in Implementing Islamic Financing Technology

Although Islamic fintech seems to be a promising solution for the adoption of Islamic finance, there may be several barriers in relation to regulation and Shariah compliance.

• Assessing the validity of cryptocurrency is controversial among Islamic jurists. Regulation of cryptocurrencies is essential, and fraud and abuse in financial transactions must be avoided. The means of evil (Sadd al Dhari’ah) needs to be blocked to avoid the harm (Oseni & Ali, 2019).
• Compromise of investor data must be safeguarded to avoid operational failures
• The effect of hacking on blockchain must be assessed and investments must be protected by implementing liability regimes.
• Islamic finance frameworks must be supported by robust regulatory frameworks to protect the system from misuse, abuse, and manipulation. In this context, customer protection laws need attention.
• Financial issues that affect the economy must be handled by regulatory initiatives for an economy that promotes financial stability. This also protects investors from financial abuse.
• The office of ombudsman (muhtasib) is an important aspect of overseeing finances, the market, and vendors about their compliance with business and avoiding business misconduct.
• Fair distribution of wealth refers to its circulation in the hands of as many people as possible. Investment is recommended rather than keeping wealth idle when it becomes mandatory to give away in the form of poor due (zakat).

The unique aspects of Fintech that can be applied to Islamic finance include ethical screening, Shariah advisory, and structuring of partnership products that are Shariah-compliant. Although information technology is capable of supporting the end-to-end process in Islamic finance, unresolved regulatory and public policy considerations still exist (Oseni & Ali, 2019).

Innovative technology platforms are the need of the day, such as the Investment Account Platform (IAP) for cross-border multi-currency opportunities, Bursa Suq al-Sila (BSAS) for managing murabahah (sales contract) and tawarruq (monetization) transactions in Malaysia, and Commodity Murabahah Trading Platform (CMTP) in Dubai. Besides, agency investments and mobile payments promote financial inclusion (Oseni & Ali, 2019). Another innovation, also promoting financial inclusion is Takaful (Shariah compliant insurance), which may become a means to provide services to the underinsured. Experts believe that there has been greater emphasis on the technology part of fintech as opposed to the financial part. In the current scenario, Islamic financial services require better regulation and must be placed under Shariah governance.

References

Abdel Mohsin, M. I. & Muneeza, A. (2019). Integrating Waqf Crowdfunding into the Blockchain. In Fintech in Islamic Finance — Theory and Practice. (pp. 266–279). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Akinlaso, I. M., Adediran, I. O., Diallo, A. K., & Mahomed, Z. (2019). Blockdentity — A Future Beyond Digital Identity. In Fintech in Islamic Finance — Theory and Practice (pp. 281–302). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Al-Amine, M. & Al-Bashir M. (2019). Ensuring proper Shariah oversight. In Fintech in Islamic Finance — Theory and Practice. (pp. 132–155). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Anca, C. de. (2019). Fintech in Islamic Finance. In Fintech in Islamic Finance — Theory and Practice (pp. 47–61). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Laldin, M.A. & Furqani, H. (2019). Setting the Shariah Parameters. In Fintech in Islamic Finance — Theory and Practice. (pp. 113–119). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Mohammed, M.O. & Amri, M. C. (2019). Fintech in Islamic Finance. In Fintech in Islamic Finance — Theory and Practice. (pp. 93–112). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Oseni, U. & Ali, S.N. (2019). Fintech in Islamic Finance. In Fintech in Islamic Finance — Theory and Practice. (pp. 3–16). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Non-English Terms Used

Aqd — rules of contract

Dhara‘i (Sadd al dhariyah)- blocking the means of evil

Gharar — uncertainty, hazard, and risk

Ijarah — a contract where one party transfers the right to use an item to another party in exchange for an agreed compensation

Ilam al-muwaqqiin — Book written by Imam Ibn al Qayyim Jawziyyah on rulings in Islamic jurisprudence

Imam Ibn al Qayyim Jawziyyah — Medieval jurist, spiritual writer, and theologian of the Islamic Hanbali school of thought (1292–1350 C. E.)

Istisna — sales contract where buyer places an order with the seller for the manufacture of an asset and the contract is completed with the delivery of the asset

Mafsadah — harm and hardship

Maslahah — public good and benefit

Murabahah — sales contract where price of goods required by customers is fixed, including agreed profit margin

Mudarabah — investment partnership with one the parties acting as the capital manager

Muhtasib — the office of ombudsman

Musharakah — joint partnership where two or more parties share labor and capital in a business where all partners share profit in a specific ratio

Riba — charged interest

Rukn — pillars of contract

Salam — sales contract where the seller agrees to defer the supply of purchased goods by the buyer, and the buyer fully pays spot cash.

Samsarah — brokerage

Shariah — traditional islamic law

Shurut — conditions in the contract

Simsar — broker

Tawarruq — finance contract where the customer receives cash at the end of the contract for the needed financing that is achieved through a series of sales contracts

Wakalah — A contract where one party — the principal provides capital, and the agent provides labor and expertise

Waqf — Donating land, building, and other assets for charitable purposes without an intention to reclaim the asset

Zakat — poor due