Islamic Instruments In Decentralized Finance
A match made in the most unlikely places
Introduction
Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. Islamic finance can be seen as a unique form of socially responsible investment. Islamic financial instruments vary from traditional forms and are not very different from traditional financial instruments. This article focuses on one financial product called Sukuk. Sukuk is a financial instrument that provides returns similar to conventional bonds. It has served to cater to the capital requirements of big corporations and governments while circumventing interest to adhere to the Shariah law.
Sukuk can be touted as Shariah-compliant bonds that rank among the most successful and the fastest growing financial instrument in the Islamic economy. This article seeks to fill this existing gap and introduces a novel, exploratory analysis of Sukuk tokenization. The funding needs of small and medium enterprises remain largely unmet through Sukuk on account of the high costs involved, among other reasons.
Asset Tokenization
Underpinned by blockchain technology, the tokenization of assets refers to the process of issuing a blockchain token (specifically, a security token) that digitally represents a real tradable asset. A security token can be used to create a digital representation of an asset, meaning that a security token could represent a share in a company, ownership of a piece of real estate, or participation in an investment fund. The latter being most significant in this article's context. The "token economy"offers the potential for a more efficient, more accessible, and transparent transacting environment that eliminates some of the popular issues around issuance and fund activity throughout the investment period.
Although some of the most common issues around security tokens come to arise after scrutiny from regulators, tokenized securities in form of Sukuks can potentially fall under a common microfinancing license in some jurisdictions. Some companies opt into handling the compliance issues at a token level, thereby checking if a trade is compliant, taking into account who the buyer and seller are, and where the trade occurs. This might not be required if the issuer (micro-finance institution) has the appropriate licenses.
Decentralized Finance
In another world altogether called Defi, an unconventional suite of financial instruments was born. These instruments are different from most financial products in the way they are conducted and tracked. Among these financial products are liquidity pools.
Liquidity pools are one of the foundational technologies behind the current Defi ecosystem. they are an essential part of automated market makers, borrow-lend protocols, yield farming, and so many other more interesting financial instruments. A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions. Liquidity pools are the backbone of many decentralized exchanges, Users called liquidity providers (LPs) add an equal value of two assets in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.
The Smart Sukuk
Smart Sukuk structure is one of the most recent and significant structures for future Sukuk issuances. In the era of crowdfunding and Fintech, the Smart Sukuk seems to be the future of Islamic fundraising for infrastructure and Business developments. Smart Sukuk has different features from conventional Sukuk; it is obvious that Sukuk markets are the most favorable in Islamic Finance. However, it is also clear that it is customarily issued by powerful institutions and government agencies, therefore Sukuk becomes very costly in terms of issuances.
The smart Sukuk structure has endeavored to use blockchain technology and boost efficiency, transparency, reduce the cost and make it possible for small and medium enterprises SMEs, social impact projects, groups, and associations to issue their own Sukuk using the new technology. The main significance of Smart Sukuk is standardizing and automating the accounting, legal and overhead payments of conventional Sukuk offerings all these will be fully backed by a licensed legal entity in the issuing country.
In terms of fees, a Smart Sukuk product should not charge any upfront fees or costs to the institutions or investors as it is normally practiced in the conventional Sukuk. Rather, the issuer will take a 20% share of the investor’s profits called a carried capital interest. This means that the issuer makes money only if investors made money, and the issuer may lose money if the investors failed to make any profit in the deal, and this is exactly the Islamic system of sharing profit and losses collectively.
Unlike conventional bonds — which are based on debt with an interest payment — a Sukuk is a shariah-compliant financing structure typically based on a profit-sharing payment or ownership of an asset. Sukuk is securitized, meaning it is tradable on secondary markets much like a stock can be traded on a stock exchange or a crypto stock exchange. Islamic finance prohibits interest payments on loans and the sale of debt; Sukuk markets evolved as a way to securitize Islamic modes of financing such as profit sharing, a structure very similar to what we've seen in decentralized finance.
Sukuk In Defi
Investors in a Sukuk are issued a share of ownership, which represents their fractional ownership in the underlying asset or structure with the terms of the Sukuk ownership. Holders of Sukuk receive periodic payments from the fundraising/issuing institution. Investors can hold a Sukuk until maturity/redemption, or they can sell their ownership in the Sukuk to a third party. This subsequent sale to a third party is known as “secondary trading” and is what distinguishes a Sukuk as a “securitized” asset. Normally, the issuer would make periodic payments, and the funds are automatically distributed back to the Smart Sukuk Token holders via the blockchain according to the rules of the smart contract — without the need for conventional banks or intermediaries. But what if the issuer is also the money-generating product? In Defi, secondary market trading fees are distributed to investors or liquidity pool investors fairly in a form of interest on their capital. This means that Sukuk investors will own their underlying assets in their own custody but opt-in to earn interest by collecting a proportional portion of fees generated by their capital on decentralized exchanges.
Decentralized Finance here has helped reduce the friction of Sukuk issuance and has offered new means of generating income and sharing losses. We only scratch the surface of the wide range of possibilities of Islamic finance in the Defi world, in a future article, we will explore other Islamic financial instruments such as Zakat, Sadaqat & Takaful and how they can interact within the context of liquidity pools in decentralized finance. Make sure to give us a follow to get notified.
