Islamic banking aka non-interest banking is a system of banking based on the Sharia law or principles of Islam driven by Islamic economics. Two principles fundamental to Islamic banking are sharing profit/loss and prohibition of payment and collection of interest by investors and lenders. In Islamic terms, interest is termed as ‘riba’ and the Sharia law prohibits it. Islamic banking has its roots in Islamic principles and the Shariah and all banking institutions follow these Islamic morals. Islamic rules governing transactions are known as Fquh al-Muamalat. Within Islamic banking, financial transactions constitute a culturally distinct way of ethical investing. For example, investments that involve gambling, alcohol, pork and other items that are forbidden are prohibited. Across 51 nations including the US, there are more than 300 Islamic banks.
The Islamic world has over 2 billion across the globe who are now adopting cryptocurrency and blockchain. Prominent Islamic banks like Emirates NBD and ICICI started researching the capabilities of blockchain as early as in 2016 in an effort to lower the transactional cost, says Coindesk. Emirates Islamic of the UAE was the first among Islamic banks that used blockchain technology in 2017 for fraud prevention. In April, the same year, Bitcoin was declared permissible under the Sharia law by an Islamic scholar, subsequent to study undertaken by Blossom Finance an investing firm in Indonesia, who delved into the functionality of Bitcoin apart from similar crypto currencies and concluded that they were in agreement with the definition of money under Islamic laws and economics.
The aspect of compliance with Sharia law can be interpreted differently by different scholars of Islam with some schools approving and some others rejecting crypto currency. But in more recent times, it is becoming clearer that crypto currency and blockchain can bring significant benefits for Islamic banking and the financial industry. A collaboration between blockchain and crypto currencies is paving way to potentially new markets and new opportunities in commerce. With the right kind of approach investors of every type can take advantage of this emerging scenario.
It is a win win for all participants
Blockchain represents an ideal solution for Islamic banking since it reduces the cost of processes and transactions. Though all banks have to deal with this scenario, for Islamic financial entities, the issue is even more acute. Some key principles that guide Islamic banking should be brought into focus to understand the importance of blockchain in Islamic banking.
The first such principle is the concept of riba which forbids collection and payment of interest under the Islamic law. The other principle allows creation of debt by Islamic banks only when such debt is backed by services or goods and more specifically, every transaction must carry a “material finality”. This means that real asset like gold must be connected to every transaction to be compliant with the Islamic law. This stipulation thus closes the door on futures and options and nearly all derivatives, making it naturally tough to work with Western financial institutions.
These principles, by themselves, do not inhibit or prohibit engaging in business with non Islamic banks. But, in practice, the transactional cost of complying with these principles is higher compared to what most of the non-Islamic banks and financial bodies are accustomed to. For Islamic banks , contractual relationships are on top of everything else, and more so compared to others, particularly in the context of most deals involving three or even more contracts, multiple parties and emphasis on staying clear of speculation, uncertainty and interest. Consequently, there are more administrative and legal processes as well as redundancies adding to the cost of doing such business.
But, when similar contracts use blockchain technology, smart contracts can essentially automate the entire contractual process for the Islamic institutions, including the enforcement of the terms of every contract. This is the major reason for the IDB, or Islamic Development Bank of Saudi Arabia started working with crypto currency firms in 2017. SettleMint is one such crypto startup that the bank is working with and they say that the automation offered by blockchain smart contracts can reduce legal and administrative complexities while eliminating significant amount of redundancies in relation to financial products that are Sharia compliant.
Decentralization of banking is the underlying principle and guiding vision that helped the development of cryptocurrency and blockchain technology. However, the cost of this vision is the barriers it has to cross in order to be legitimate, not only for the government and financial authorities who are votaries of centralization, but also for the common man.
Islamic banking can benefit crypto currencies and blockchain by giving more legitimacy for these products. Interestingly, the stringent standards laid down for financial transaction under the Sharia law that should be complied with by Islamic banking institutions also focus on centralized authority. Yet, the blockchain technology which has decentralization at its core has been working harmoniously with an increasing number of Islamic banks across the globe.
Blockchain is also gaining legitimacy by demonstrating its ability to be compliant with the regulations under the Sharia law, which others in the fintech industry refuse to provide. The barriers that usually discourage investors is addressed by reduced contractual and transactional costs. Increased flexibility in dealing with Islamic financial bodies is another factor offered by crypto currencies and blockchain.
OneGram of Dubai and Hello Gold of Malaysia have incorporated the covenants of the Sharia Law to the core of their model. Each unit of crypto currency is backed by a certain amount of gold. Islamic scholars have also approved both these firms as financial products that are Sharia compliant. Further, it is also equally important that these firms also continue to maintain the inherent advantages of blockchain technology – increased automation, redundancy and reduced costs. Enhanced flexibility can also make doing business and investing significantly more appealing to those who would have considered themselves distanced from Islamic banking in the past.