Integrating Blockchain in Islamic Finance

Blockchain is called blockchain because data is stored in blocks and the data is connected in a chain. A very simple explanation is that blockchain is a digital record that is split into pieces, called “blocks,” which are stored in multiple places. Essentially, blockchain enables record-keeping that is secure, accurate, and fast.

Blockchain is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network. An asset can be tangible (a house, car, cash, land) or intangible (intellectual property, patents, copyrights, branding). Virtually anything of value can be tracked and traded on a blockchain network, reducing risk, and cutting costs for all involved. A ledger is a system to record and store information, as such, books and documents have been traditionally referred to as ledgers. Many types of data can be stored on the ledgers such as:
• Identification data
• Various statuses such as employment
• Memberships and subscriptions
• Criminal records
• Economic data
• Ownership evidence
• Cash balance owned by someone
• Assets and liabilities
• Profit and loss statements

While any conventional database can store this sort of information, blockchain is unique in that it’s decentralised. Rather than being maintained in one location by a centralised administrator – think of an Excel spreadsheet or a bank database – many identical copies of a blockchain database are held on multiple computers spread out across a network.

The key concepts underlying blockchain

The following are the key underlying concepts which give blockchain the edge it has:
• Cryptographic Hash – A hash is a cryptographic function that transforms any input data into a fixed-length string of numbers. This adds another layer of security to the data.
• Immutable Ledger – meaning the information cannot be changed or hacked. Each mined block references the previous block. Therefore, if any one block’s information is changed, it changes the overall hash of that particular block, but that impacts the following blocks as they had a hash based on the unchanged data in the previous blocks
• P2P Network – This highlights the ability for multiple participants to be involved in governance, and not just one single authority. Blockchain does not need any third-party authority to oversee the blockchain’s operations as the ledger is distributed among all its members.
• Consensus Protocol – Since there is no third-party authority validating the data, there needs to be a mechanism to ensure that the data is genuine. Different networks use different mechanisms to validate that data, and these mechanisms are called consensus protocols. The users of a blockchain need a mechanism to ensure they all agree on the validity of the chain at present before they move on and add further blocks with new data to the chain.

Blockchain from a Shariah Perspective

Blockchain is merely a system for storing and processing data and transactions. It’s potentially an alternative accounting and record keeping system. Technology is neutral from a Shariah perspective as it is only an enabler. Adopting new software or technology is lawful and permissible. The default state is of permissibility in such matters. The Islamic legal maxim states:

“Permissibility is the state of all things by default.” [al-Ashbah Wal-Naza’ir]

However, the Shariah governance will be pertinent in the following areas:

1. Investments in assets and companies using blockchain technology

The assets and any such company would go through a complete Shariah review. Further, there should be focus on what this particular consensus algorithm is validating and what the blockchain is serving, what it is keeping a record of and facilitating. The Shariah review should consider whether the processing endeavours of nodes is actively facilitating Shariah non-compliant activities. The overall output cannot facilitate a non-compliant activity or service.

2. Companies developing digital infrastructure using blockchain

The business screening of such a company should consider if the blockchain being developed is specific to any prohibited sector or supports any sin sector.

3. Protocols of a blockchain

A Shariah review should focus on the process of an algorithm, transaction fees, distribution of rewards, nodes’ rights, nodes’ input and the overall governance protocols if any. A process can be developed in a Shariah non-compliant way wherein one party is unjustly disadvantaged, or the process is ambiguous and creates discord. Likewise, fees can be unwarranted, unfair or unjustified. Fees can also be structured in a Shariah non-compliant manner. Rewards in a system can potentially be distributed in a Shariah non-compliant mechanism and can lead to a gambling scenario. The rewards’ distribution mechanism must be analysed to ensure a gambling scenario has not been orchestrated. Further, the rights of participants in any system can be constructed in various ways. Shariah has principles to ensure that any participant in any system is not taken advantage of and nor are they treated unfairly. Thus, the rights of nodes need to be reviewed to ensure they align with the Shariah principles of justice and fairness. Finally, if any blockchain or consensus protocol has specific terms, those terms must be analysed to ensure that no Shariah right is infringed or breached.

Potential Use cases in Islamic Finance

1. Remittance

The Islamic community is spread across the world with strong relations with family and friends in other parts of the world. Given that Muslims number over a billion and are only growing across the world, there is an interconnectedness wherever you are. According to World Bank data, the global money transfer market in 2020 was worth over $700 billion. In turn, Allied Market Research forecasts that this market should reach a value of over $930 billion in 2026, with a compound annual growth rate (CAGR) of 3.9 per cent.

Blockchain can be used by allowing individuals to send payments through a bridge asset on the blockchain. This would potentially allow more efficient transfer of wealth through borderless digital transfers.

2. Sukuk

Sukuk have a future with blockchain. The digitisation of sukuk issuances on blockchain may remedy certain inefficiencies in the Sukuk value chain. Blockchain may add further transparency of the underlying Sukuk assets and cash flows, in addition to reducing costs and the number of intermediaries. The issuance of blockchain-based Sukuk could result in savings for the issuers in the reduction of costs of the “middlemen” and agents that intermediate the process of issuance. This disintermediation should facilitate more efficiency, and thereby reduce costs.

Dr Sami al-Suwailem mentions:

“There is no free lunch, as economists emphasize, and the transition to crypto Sukuk will involve costs. However, the benefits in terms of diversity, stability, and performance, seem to overweigh the costs by a reasonable margin.”

Smart contracts can further support the Sukuk process. A smart contract is a computer program that helps to facilitate the transfer of assets subject to compliance with an established set of parameters established at the outset. Instead of relying on paper-based agreements, a smart contract could potentially authorise the issuance of a Sukuk to a buyer subject to that buyer inputting the correct data which meets with the Sukuk issuer’s Shariah and financial compliance requirements.

3. Waqf

Waqf requires good governance and best practice given the sensitivities and potential of abuse. Transparency can greatly assist in the management of a Waqf fund. As such, blockchain can play a key role in tracking and giving visibility to stakeholders of the Waqf. The faster the information is received and the more accurate it is, the better. Blockchain is ideal for delivering that information because it provides immediate, shared and completely transparent information stored on an immutable ledger that can be accessed only by permissioned network members. A blockchain network can track Waqf contributions, investments, allocations, and the associated cash flows. And because members share a single view of the truth, the Waqf stakeholders can see all details of a transaction end to end, giving everyone greater confidence, as well as new efficiencies and opportunities. Blockchain Waqf solutions can grant permissioned participants greater visibility across the entire value chain of Waqf.

4. Shariah governance and Shariah audit

Optimal Shariah governance relies on transparency and information symmetry between the auditee and Shariah auditor. An audit involves an assessment of the Shariah compliance of the transactions in a period which is supported by evidence that is relevant, reliable, objective, accurate, and verifiable. The acceptance of a transaction into a reliable blockchain may constitute sufficient appropriate audit evidence in terms of the sequencing of transactions, the terms and conditions and actual implementation of any financing. Of course, a transaction may still not provide sufficient evidence as there could be side agreements which are “off-chain” or not all the data and process is engaged with the blockchain.

Despite these complexities, blockchain technology offers an opportunity to streamline the Shariah audit experience. With blockchain-enabled digitisation, auditors could deploy more automation, analytics and machine-learning capabilities such as automatically alerting relevant parties of Shariah compliance risks on a near real-time basis. Supporting documentation, such as contracts, agreements, purchase orders, and invoices could be encrypted and securely stored or linked to a blockchain.

5. Takaful

The adoption of blockchain will bolster data security and enhance trust among different parties involved in Takaful. Further, the presence of a shared and immutable ledger will allow for faster and more efficient management of claims by companies using intelligent contracts. Companies may be able to underwrite the risk more efficiently with shared public databases. The claims management process could further be streamlined by enabling clients to monitor the process in real-time, avoiding uncertainty and a lack of transparency.