Islamic Finance and Blockchain Pt. 1
Exploring areas of intersection between Islamic Finance and Blockchain
By Andrew Tu and Maaz Uddin
Just as blockchain technology shows great promise for the financial services industry in general, it could also significantly improve processes within the Islamic finance industry. In this first article, we will be introducing Islamic finance and discussing several potential use cases for blockchain (which many within financial services prefer to call decentralized ledger technology) within the Islamic finance industry.
Introduction to Islamic Finance
Islamic finance is financing activity that complies with the Shariah (Islamic law), which prohibits riba, or usury, and investment into businesses that provide un-Islamic goods and services, such as pork and alcohol. Because of the prohibition on interest, Islamic financing models should differ significantly from Western models. (There is a minority opinion that usury is not equivalent to interest, but that is beyond the scope of this article.) Ideally, Islamic finance is designed to be ethical and emphasize profit and risk sharing, with a focus on social good maximization rather than profit maximization. However, for a multitude of reasons, the usage of true profit-loss-sharing contracts, namely musharakah and mudarabah, has decreased significantly, while fixed-return financial contracts such as murabahah are the primary methods of Islamic financing.¹ The modern Islamic finance industry is in its infancy in comparison to Western finance, having developed mostly in the wake of the Islamic revivalist movements of the 1970s. However, the roots of modern Islamic finance lie in the Islamic Golden Age, during which entrepreneurs and traders of the then flourishing Caliphate developed many different financial and economic models.² As of the end of 2017, the Islamic finance industry was estimated to be around $2.1 trillion, making up 1–2% of global financial assets.³ Due to recent negative economic developments in the GCC countries, as well as Turkey and Iran, the rate of growth of Islamic finance is expected to slow to 5% in 2018, slower than the double-digit rate growth of the previous decade and around the same rate of growth as traditional finance.⁴
Now, let us explore three different types of financial contracts/products: musharakah, mudarabah, and takaful.
Musharakah
Musharakah is an agreement between two or more parties to combine their assets, labor, or liabilities for the sake of making profits. This contract can be seen as a predecessor to the Western joint-stock company. Musharakah can be used as a structure for takaful (Islamic insurance), sukuk (Islamic bonds), Islamic mortgages, and equity. Musharakah mutanaqisah (diminishing partnership) is a type of musharakah commonly used in home financing, in which one of the partners promises to gradually buy the equity share of the other partner until the title to the equity is completely transferred to him.⁵ In this type of contract, a home buyer pays the bank a down payment, and the bank and buyer act as partners in an equity sharing contract. The bank leases its share of the property to the buyer, who gradually buys back the bank’s share of the property.⁶
In this contract, the shares of the house could be represented by security tokens. The home buyer puts money into a smart contract, which grants him a certain number of security tokens equivalent to the percentage of equity he owns in the property. Meanwhile, the bank owns the rest of the security tokens, which charge the home buyer rent on a monthly basis. Additionally, one could imagine security tokens being used for the purchase of commercial property within a musharakah model, in which property buyers acquire a certain number of security tokens, which pay out a monthly dividend generated by the property’s rent. This allows for more liquid real estate markets, in which real estate funds and individual property investors can easily buy and sell equity tokens on secondary markets.
Mudarabah
Mudarabah is a contract based on a fiduciary relationship between a capital provider (rabb al-mal) and an entrepreneur (mudarib). Under a mudarabah, profit is shared while financial losses are borne solely by the rabb al-mal, provided that such losses are not caused by the entrepreneur’s misconduct, negligence, or breach of specified terms.⁷ Mudarabah can be seen as a form of private equity or venture capital, in which the financier provides funding for the entrepreneur in return for his work.
A mudarabah structure could also employ security tokens that represent shares of the company. In the case that there are multiple capital investors, each individual investor obtains an allocation of tokens equal to the investment made. If the investor fails to make the required capital payments, these tokens must be sold within a certain time frame. The profit within the mudarabah is distributed according to a mutually agreed upon ratio. Security tokens allow for the automatic disbursement of profit every month or every year. If the mudarib chooses to inject his own funds to a mudarabah venture, he is entitled to the profit based upon his capital contribution to the commingled fund, while the remaining profit is distributed based on the agreed-upon profit sharing ratio. This essentially means that there is a two-tiered system, the first tier being a musharakah contract and the second tier being a mudarabah contract. Within the security token model, upon new funds being committed to a smart contract, new security tokens are minted that belong to the mudarib.
As mentioned earlier, both musharakah and mudarabah are used infrequently within the Islamic finance industry, despite scholars’ intentions for them to be the default within the market. Islamic banks have not often used these PLS contracts due to increased risk relative to fixed-rate contracts. Perhaps increasing their liquidity through blockchain technology could incentivize banks to use them more.
Takaful
Finally, takaful is a Shariah-compliant alternative to conventional insurance in which a group of entities agree to handle the injuries resulting from specific risks that all parties are vulnerable to. The process involves all participants pooling funds, which are used to indemnify any participant who encounters injury, subject to a specific set of rules and a given process of documentation.⁸ The participants of this insurance fund can assign the management of the fund to a company or a committee of policyholders, who assume the responsibility of investing it through mudarabah or wakalah (investment agency contract). There are several types of takaful models, the two primary ones being the mudarabah and wakalah models.⁹ In a mudarabah-takaful model, the surplus profit of the insurance fund is shared between the operator and the fund-participants. Meanwhile, in a wakalah model, the insurance provider takes a fixed fee, rather than a percentage of the surplus profit, from the fund.
There are several potential uses for blockchain within takaful, including KYC, back-office automation, and underwriting of micro-insurance. As with most blockchain use cases, these use cases face obstacles to adoption, most notably the issue of oracles during claims processing. How can a smart contract know whether the policyholder’s property was actually damaged or that the policyholder passed away? The smart contract must trust some endpoint that presents a significant point of failure. As such, for blockchain to meaningfully provide automation of claims, there must be a way of disincentivizing lying on both the side of the policyholder and the side of the processor. However, although larger ticket sizes may require manual administrative claims processing, the smaller ticket sizes in micro-insurance may justify the use of blockchain for automation.
In one scenario of life-insurance takaful on blockchain, all parties that want to participate in the takaful contract send funds to a smart contract that aggregates the money into a single insurance fund. The smart contract allocates these funds to halal investments, such as an Islamic index fund. When someone passes away, the beneficiaries send proof of death (from the Bureau of Vital Statistics or the Department of Health), alongside proof of identity, to the smart contract, which then processes the claims and disperses the benefits to the designated parties. This scenario encounters the previous issue of needing a proper means of verifying the claims, a major security risk for the smart contract. However, there could potentially be a permissioned system in which only government agencies, the insurance company, policyholders, and beneficiaries can access the takaful contract. With such a permissioned system, and possibly within only certain types of insurance, this technology could significantly disrupt the takaful industry, as the number of intermediary processes necessary would decrease significantly, potentially allowing for takaful participants to pay fewer funds out in profit-sharing or wakalah fees.
Conclusion
The Islamic finance industry could benefit from blockchain technology, as exemplified in the above three models. It is clear, however, that there will need to be improvements in oracle systems and consensus mechanisms (especially in permissioned blockchains) for the successful use of blockchain technology in financial services. In the next part of this series, we will be discussing actual implementations of blockchain in Islamic finance.
Thanks to Joseph Plaza and Matthew Martin for examining the blockchain and finance aspects of the article and to Hamza Khwaja for editing the style and grammar.
Citations
- Khan M. Mansoor and M. Ishaq Bhatti. 2008. Developments in Islamic banking: The case of Pakistan. Houndsmills, Basingstoke: Palgrave Macmillan, p.49
- Jairus Banaji (2007), “Islam, the Mediterranean and the rise of capitalism”, Historical Materialism 15 (1), pp. 47–74, Brill Publishers.
- https://www.spratings.com/documents/20184/4521646/Islamic+Finance+2018+Digital-1.pdf/
- Ibid
- http://aaoifi.com/shariaa-standards/?lang=en
- http://www.ijmar.org/v3n2/16-005.html
- http://www.bnm.gov.my/guidelines/05_shariah/Mudarabah.pdf
- http://aaoifi.com/shariaa-standards/?lang=en
- https://mpra.ub.uni-muenchen.de/40010/1/Takaful_models_n_global_practices.pdf
