Blockchain & Crypto Asset Opportunities for Islamic Finance

Blockchain technology and Islamic Finance are presently two of the most exciting financial trends to read-up on. Though it might not get as much press as crypto, Islamic Finance has similarly enjoyed a recent period of enormous growth.

Differing in a few critical ways from conventional finance, the core principles of Islamic Finance include the prohibition of interest (Riba) & excessive speculation (Maysir), as well as the minimization of uncertainty (Gharar), all with the intent to protect both parties in a transaction. By way of these principles, the industry is well positioned to be augmented by the underlying technologies of such cryptoassets as Bitcoin (BTC), Ethereum (ETH), XRP, and Stellar Lumens (XLM). Below discussion on this matter includes the following:

  • Islamic Finance: What is it?
  • Why is Islamic Finance important?
  • How does it work?
  • Blockchain solutions for Islamic Finance
  • Final thoughts

Given that most folks reading this might be a bit less familiar with Islamic Finance, the content skews towards covering the basics of that topic, before shifting to look at a few opportunities & interesting companies solving challenges in the industry with blockchain. Let’s dive in!

Islamic Finance: What is it?

Guided by organizations such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Islamic Finance is a set of rules & standards used to provide finance & banking services that are compliant with Islamic jurisprudence. As mentioned, the system prohibits/minimizes interest, speculation, and risk in order to protect transactional parties. Additional objectives include making those transactions more equitable by sharing risk & reward, and when there is reward, using that to benefit those less fortunate than you (Zakatbecause of this latter focus, Islamic Finance is often included in umbrella conversations about “ethical investing). All of these objectives are derived from Islamic (Sharia) Law, which of course is based on the Quran.

For instance, the prohibition of interest is rooted in Quaranic precepts against usury and other predatory lending practices. That’s not to say that Islamic Finance is devoid of the concept of investment return, however. Indeed, much of the guidance on Sharia-compliant business structures & securitization methods focuses on Profit-Sharing arrangements and other ways to equitably distribute investment gains. Though by no means exhaustive, some of those structures/methods include the following:

  • Musharaka: a joint venture or equity partnership between a financier and the operator of a venture, who’s contract specifies profit (or loss) sharing between each participant, determined ex-post, based on each’s capital contribution. Variations include Mudaraba, by which the operator only contributes labor (sort of an Islamic version of sweat equity).
  • Ijara: similar to a lease or renter’s contract; variations involve whether or not the lessee owns the asset (or has the right to purchase it) at the end of the contract.
  • Takaful: the Islamic Finance version of an insurance pool.
  • Murabaha: a versatile, cost-plus contract used to provide non-interest-bearing mortgaging and other financing capabilities. A subset includes Tawarruq, a.k.a. “Commodity Murabaha”.
  • Sukuk: a Sharia-compliant financial certificate. Though often referenced as being the Islamic Finance version of a bond, Sukuk can actually be structured via many of the aforementioned methods, some of which are trade-able on secondary markets.

Additional structures, methods, and products exist for many other use cases. We’ll take a closer look at Murabaha further on below, but first: a bit more context.

Why is Islamic Finance important?

While there are many reasons why Islamic Finance could be considered an important trend, I think it stands out mostly for two reasons. First, from a moral perspective, Islamic Finance holds great potential to alleviate poverty in predominantly Muslim countries and other developing regions. Most of the cases made for this assertion focus on the high degree of unbanked Muslim households. These argue that offering more Sharia-compliant financial products will encourage more Muslims to enter formal banking systems, where they can begin to build wealth via savings accounts and personal loans. Furthermore, the requirement of Zakat makes Islamic Finance an interesting vector for development agencies looking for additional sources of funding to programs aimed towards poverty alleviation.

Beyond these potentials, Islamic Finance should be important to both Muslims & non-Muslims alike, given the sheer growth of the industry itself. Although distinctly Islamic forms of banking & commerce have existed since the earliest days of the religion, the modern foundations of Islamic Finance didn’t come about until the early-to-mid 20th Century. During that time, a wave of decolonization in predominantly Muslim countries spurred a revival in Islamic economic philosophy, culminating in the establishment of the first modern Islamic bank in Mit-Ghamr, Egypt in 1963. Significant developments in the industry continued over the next 50 years. In the last decade alone, the industry grew 10% -12 % annually to over USD $2 trillion in size. Despite some recent slowdown, global Islamic Finance assets are projected to top USD $3.7 trillion by 2022. Given estimates that the world-wide Muslim population will grow by 70% (vs. 32% overall) over the next 40 years, and continued innovation in the field itself, Islamic Finance should be considered a very important industry to follow.

How does it work?

Back to the specific types of contracts present in Islamic Finance, let’s take a close look at Murabaha. Though each structure could warrant it’s own article, Murabaha is very important to understand because of it’s prevalence across all different segments of banking. As we’ll additionally discuss later, it is a strong candidate for augmentation by blockchain, given the number of intermediaries it can involve.

Again, the basic premise of a Murabaha transaction involves a “cost-plus” contract, whose installments pay down the original principal + agreed-to profit amount. Inasmuch as many of these products are marketed to be ethical yet still competitive with conventional products, that profit amount will be similar to conventional market rates of return. This is certainly not without controversy. A great deal of effort is made by Islamic Finance practitioners to ensure that profit rates are properly derived from the risk premium & other cost aspects of the underlying asset/transaction (vs. just benchmarking off LIBOR), and are otherwise consistent with the intent behind banning riba.

Regarding that intent, the Islamic perspective is that money is just a medium of exchange, and should have no intrinsic value. The idea follows that investment income should come from an actual asset, rather than just making money from money (interest / riba). Along these lines, Murabaha utilizes asset transfers between parties to synthesize the repayments/returns of a conventional financial product. It’s fairly easy to guess how this might work for home mortgages and loans for other durable goods, but less so for other loans or securities. Let’s look at both. First up: a “Pure” Murabaha-based home purchase

Pure Murabaha

As touched on in one of the above referenced/linked articles, “Pure” Murabaha is differentiated from “Commodity” Murabaha by merit of the underlying asset passing into permanent ownership of the purchaser. The same number of parties exist in a Murabaha transaction as would a normal asset purchase of this size. So, for our example, should a purchaser seek to buy a home using this method, the process would occur via the following:

 

Often, the mortgage and Murabaha agreements will be the same document. While the structure will be Sharia-compliant, many Murabaha agreements underwritten in the US and other Western countries often use terms that are secular, but still differentiated from conventional, interest-based financing. For instance, instead of principal & interest, you’ll see an “acquisition payment” and “profit payment”:

 

 

At all points of the transaction, the financing and resulting returns are tied directly to a real, underlying asset.

“Commodity” Murabaha

For financing needs that are less tangible (or not tied to a single asset), the Tawarruq variation of Murabaha can be used to provide cash via the transfer & liquidation of a trade-able commodity. In this scenario, a customer works with a bank & 3rd party commodity brokers to obtain and then immediately sell a commodity in order to receive funds:

 

Used between banks to address short-term liquidity needs, Tawwaruq often uses agricultural products (palm oil is quite common) or other permissible commodities (ref paragraph 55) to achieve the necessary asset-backing. After the commodity is sold, the funds are immediately available and subject to cost plus repayment terms similar to a pure Murabaha contract.

Aside these simple examples, there are a ton more nuances & complexities to these products that I’ll obviously not be able to cover here. If you’re interested in learning more, I highly recommend checking out these sources:

All of them are good reads, and were of great help in creating the flow-charts above. Now that we have the what, why, and how established, let’s look at some of the exciting opportunities for Islamic Finance with crypto!

Blockchain solutions for Islamic Finance

Thanks to the crypto bull market of the last year (1y still up, by a tremendous amount!), there are no shortage of articles describing specific cryptocurrencies, explaining the technology, or discussing the general characteristics of blockchain. Regarding those characteristics, the nature of blockchain tech being distributed, decentralized, and immutable make it an interesting new option for those faced with the unique implementation & operational challenges found in Islamic Finance. Here are a few of the areas in which I believe it will help the most:

Risk Management and Derivatives

Touched on earlier, one of the core precepts stressed in Islamic Finance is the minimization of uncertainty (Gharar). The immutability of blockchain and cryptoassets make it possible to account for this with technology, as seen with Blossom Finance, an Islamic fintech startup based out of Indonesia. Per CEO Matthew J. Martin, Blossom uses Bitcoin to move funds in a manner that “ensures ownership of underlying assets with 100% mathematical certainty.” This is consistent with a common view emerging amongst some Sharia scholars that cryptos are particularly well suited to provide for mutual risk-sharing between transaction parties.

From there, the next logical application would be in the realm of Sharia-compliant derivatives. Unlike the Western financial revolution ushered in by the publishing of the Black-Scholes-Merton model in 1973, the additional consideration of dealing with Gharar has made the development of Sharia-compliant derivative products slightly more difficult. Progress has occurred nonetheless, finally resulting in the 2010 publication of the “Tahawwut Master Agreement” by the International Swaps and Derivatives Association (ISDA), providing guidance for the creation of Islamic derivatives. Matching the blockchain standardization efforts taking place in conventional finance, the technology could potentially be used to quickly and efficiently handle the extra steps necessary to execute an Islamic derivative.

Contract and Custody Management

Broader than derivatives (essentially contracts themselves), blockchain would be of tremendous use in managing the additional contractual terms and transactional parties present in many Sharia-compliant financial products. Consider the steps in the Commodity Murabaha structure we examined earlier: in practice, the purchase-transfer-liquidation of the underlying commodity results in a number of custody issues that you wouldn’t normally have in a conventional (non-asset backed) product.

The obvious application of smart-contract technology would be extremely helpful in the tracking & execution of each party’s payment or delivery obligations. Insofar as the additional custody management aspects, take for example organizations like the Dubai Multi Commodities Centre (DMCC), who offer electronic, multi-commodity trading designed to support the issuance of Commodity Murabaha-based financing. Significant complexitiesexist in the warehousing arrangements of such transactions, often resulting in scholarly criticisms of the difficulty in verifying custody (similar problems exist in Halal supply chains, as well). General tokenization methods present in many blockchain solutions would go a long way towards providing greater transparency into those arrangements by making it easier to verify custody and control/ownership of the assets in question.

Liquidity Management

Brokering and underwriting many (if not most) of these transactions are Islamic banks. As you might infer from our discussion on Sharia-compliant financing structures, there are notable differences between conventional and Islamic banks. Due to the inherent complexity of the instruments involved (RE: Ijara Sukuk) and relative lack of participants, there have not been true Islamic equivalents of money markets or other reliable secondary-market sources of liquidity for much of the history of modern Islamic Finance. The result has been considerable liquidity management difficulties, with most studies showing Islamic banks holding excess cash as a means to hedge against market downturns.

The lack of secondary markets are an obvious impediment to the whole system of Islamic Finance, made even worse by potential cross-border complications. There have been several efforts over the last few years to build solutions, both towards organizing the requisite secondary markets, and then using blockchain to make them more efficient in areas like the cross-border issue.

Where many of the instruments in those secondary markets would be Sukuk, firms like Blossom are using Ethereum and other distributed application platforms to issue “Smart Sukuk” that greatly standardize, streamline, and automate the various administrative details of such offerings. Where the wider, conventional, cross-border remittance challenges are concerned, companies like Ripple have begun to roll-out solutions for banks and other major liquidity providers utilizing the XRP token and other  The benefit of Ripple’s technology has been of great interest to Islamic Banks, resulting in the formation of a number of strategic partnerships over the last year. Additional players in the space include Stellar (Ripple competitor and IBM partner), who recently received certification as being Sharia compliant, underscoring the increasing adoption of blockchain technology by the Islamic Finance industry.

Final Thoughts

If you’re still reading up to this point, many thanks! Aside from the fact that the blockchain – Islamic Finance opportunities I describe above are limited in scope (there are many more!), and from just my own perspective, I wrote all of this under the assumption that those reading it would have more of a default-familiarity with cryptos than Islamic Finance (hence the content skew). For those of you who have an actual background in Islamic Finance, here are two really good articles that approach these topics from the other direction:

Regardless, I hope this article was useful in drawing parallels, and would love to hear thoughts & feedback from experts in both fields! Thanks for reading,

-ML


Matt Lunkes is a Solution Architect and crypto asset enthusiast. A previous version of this article was published via LinkedIn, and can be found here.

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