Shari’ah law prohibits banks from charging interest on loans to their borrowers. Islamic banks offer financing to individuals and businesses through real economic transactions such as joint ventures, deferred sale, and leasing agreements. To offer credit financing, Islamic banks need a mechanism to discipline debtors to pay on time. A common practice involves charging debtors with late fees, which are then donated to charity. However, because Islamic banks are not allowed to incur any profit and in turn any benefit from these late-payment charges, they are not incentivised to collect these fees and distribute them to charitable organisations in a timely manner. Meanwhile, the debtors see these late fees as an act of charity, meaning that their sense of urgency to pay their debt obligations on time might diminish.
Blockchain originally impacted Islamic finance through optimisations like blockchain-based Halal certification schemes but there’s a growing demand for the technology to automate the execution of Shariah contracts and minimise the risk of procedural errors. It could also improve the traceability and transparency of certain funds in complex humanitarian settings.
Although the technology is still a controversial topic in Islamic finance, both the Middle East and Southeast Asia are home to a growing number of Islamic fintechs.
A digital pioneer
Abu Dhabi Islamic Bank (ADIB), a leading Islamic financial institution, was the first Islamic bank to successfully execute trade finance distribution transactions using blockchain technology.
The cross-border transactions, which were completed with multiple based banks, were made possible through ADIB's partnership with TradeAssets, a trade finance e-marketplace powered by blockchain to help digitise the traditional processes of origination and distribution of trade assets. For the past year, ADIB's collaboration with TradeAssets has enabled it to automate trade finance transactions and conclude transactions successfully with banking counterparts in emerging markets.
Implementing blockchain in credit financing
The Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IsDB) Group has partnered with the blockchain technology firm Blocko to build a blockchain-based innovative credit enhancement system. It would minimise the risks associated with credit financing to businesses and consumers by using new economic incentive models and advanced implementations of hybrid blockchain technology.
“The Islamic finance market is growing rapidly, with projections of a rise from around $2 trillion to an impressive $3.78 trillion by 2022. Yet certain technical and economic challenges have prevented the industry from truly flourishing,” said Dr Sami Al-Suwailem, Acting Director-General of IRTI.
The partnership aims to leverage the E24P blockchain teams’ deep expertise in deploying blockchain systems to further the IsDB’s mission of enabling greater financial inclusion, alleviating poverty, and accelerating the development of the Islamic financial industry.
Phil Zamani, CEO of E24P, said, “the implementation of blockchain systems in complex processes like credit and insurance has long been sought after by financial institutions around the world. Forward-thinking Gulf Cooperation Council (GCC) countries, such as the UAE and Saudi Arabia, have been especially progressive, implementing blockchain projects to accelerate their digital transformation agendas and smart city innovation strategies.”
The new system being developed by IRTI and implemented jointly by IRTI and E24P uses a novel incentive mechanism that encourages early repayment and contributes fees to an insurance pool that covers involuntary credit defaults. Such a system would not be feasible through conventional arrangements but is facilitated through the use of high-performance blockchain technology. Once completed, the system will be of great value to Islamic banks and other financial institutions.
With this system, Islamic banks, and indeed other financial institutions, can ensure that credit assessments are performed in a provably transparent and responsible manner while keeping the data and methodology used appropriately secure and confidential.
The system allows creditors to reduce credit default rate to improve their overall business performance and accelerate efforts in areas of financial inclusion.
According to a recent S&P report, the global Islamic finance industry will continue to expand slowly in 2019-2020 but fintech and blockchain could significantly accelerate the growth. The COVID-19 pandemic has also shown the importance of leveraging technology and creating a nimbler industry. With the right coordination between different Islamic finance stakeholders, the report argues that the industry could create new avenues of sustainable growth that serve the markets.
"Fintech could stimulate growth by making transactions quicker, more secure, and easier to implement. And we believe the social role of Islamic finance could unlock new growth opportunities as core markets implement the UN Sustainable Development Goals, and issuers and investors become more sensitive to environmental, social and governance (ESG) issues," said S&P Global Ratings head of Islamic Finance, Mohamed Damak.