The role of Smart Contracts in Islamic Finance and Shariah Compliant Financial Products

The role of Smart Contracts in Islamic Finance and Shariah Compliant Financial Products

Dr Farrukh Habib, Shariah Expert and Co-founder Alif Technologies

I invited Dr Farrukh to explain aboutIslamic Finance and Shariah compliantfinancial products which heexplains are basically the same thing. However, before he begins, he points out that Islam is actually a complete code for living that has a comprehensive set of rules and principles for each and every walk of life.

“It’s not only about worship, but it governs public dealings too. In all matters,

Islam provides guidance not only in regard for the man-to-God relationship, but also for the man-to-man relationships.”

“Islam extends to the whole family. It is a complete jurisprudence in the sense that it provides all the principles, including a complete alternative of conventional financial systems which is called the Islamic Financial system.”

I ask about the differences between Western Financial Systems and Islamic, and Dr Farrukh corrects me on my terminology. Western Financial system is better termed conventional finance as it exists in all corners of the world.

Interest typically happens in a lending and borrowing transaction. There are two parties, one is the lender, and one is the borrower and the lender charges an amount on top of the principal which is normally termed as interest.

Riba can be used to describe the money paid on top of the principal, but it can also occur in a sale transaction. For example, one cannot sell 1 KG of dates of superior quality for 2 KG of dates of a lower quality. In this way, the concept of Riba is much wider than the concept of interest and usury.

Dr Farrukh gives another example, where the Prophet Mohammed dictates that gold must be exchanged on a weight for weight basis, regardless of whether the underlying gold is 24 carats on one side and 18 carats on the other side. In fact, there are six commodities that feature directly in these directives and include gold, silver, salt, barley, wheat, and dates.

Tthese rules were created more than 14 centuries ago when money was only beginning to be used.

The necessary switch is that the commodities are exchanged for money and then the money exchanged for other commodities or materials, with the price reflecting the composition of the base element.

Moving onto modern Islamic banks, I ask how these teachings are interpreted into a modern context.

“Islamic banks do not extend loans, because they cannot earn profits on loans, as Riba is prohibited in Islam. But trade is allowed. Trade is the key to understand and to explain how transactions are done in Islamic banking.”

A good example to clarify this approach is the process of buying a house. For most people, this requires a trip to the bank to obtain a mortgage in which the bank loans the principal which the borrower then repays with interest.

The transaction is different with an Islamic bank where they will ask to see the house in question. Say the asking price is half a million dollars, the bank will ask if the new would-be homeowner has any savings. Imagine if they have 20% or $100,000, then the Islamic bank will provide the other $400,000 but this is not a loan, this capital contribution from the customer and the Islamic bank will form a partnership in the house.

Once the partnership contract is put in place, the owner/customer will want to purchase the remaining shares of the Islamic bank in the house and so the owner will start buying the shares in instalments, gradually increasing his/her percentage in ownership of the house.

At the same time, the owner will live in the house. This will involve the creation of a third contract, a rental contract which the owner will pay to the Islamic bank.

With the three different contracts in place, the owner will end up paying the same amount as if they had borrowed the money from a convention bank. However, this is based on the three contracts, one a partnership, one a buying and selling of shares in the house, and one a rental agreement.

While the financial outlays will be similar, the partnership mechanism means the owner begins with owning 20% of the house, and that as time goes on, this ownership percentage grows. In ten years’ time, the ratio may be 60% owned by the owner and 40% owned by the bank. Along this journey, the owner is seen as a partial owner and partner in the deal, which gives them more rights in the process when compared to conventional banking arrangements.

Similarly, Islamic banks can extend cash financing using the principles of trade. In the case of wishing to borrow Pounds Sterling, the amount is agreed with the Islamic bank becoming an agent on the customer’s behalf. They will buy a commodity from the London Metal Exchange (LME) and sell it to the customer on a credit basis.

The customer now owns the commodity, he/she can sell it in the LME on spot basis for immediate cash. Subsequently, the customer now has the cash needed and will need to pay the Islamic bank in money for that commodity. The credit price is 100% of the amount to be paid plus a mark-up (the Islamic bank’s profit) which is usually calculated based on the prevailing interest rate.

“Again, the underlying contracts are different from a loan transaction, with trade being the key issue.”

On the other side, people cannot make money through interest by depositing funds into their accounts. It is again converted into partnerships with the Islamic bank taking these deposits and using them to invest in other shariah compliant ventures. Profits made in this way are then received as profit and distributed among the savings accounts.

However, it is interesting to note that Islamic banks still follow the benchmarks of conventional banks in terms of profit and cost. Hence, the economic affect remains the same, but the legal contracts are different.

Islamic banks also avoid Gharar (excessive uncertainty and risk), Maysir (gambling like financial products and zero-sum games) and dealing in prohibited ventures. Moreover, Islamic finance also incorporates ethical and social principles embedded in Shariah.

Dr Farrukh has been involved in blockchain projects and crypto assets since 2016. His background is in economics, a primary and masters degree from Karachi, Pakistan, then a further masters in banking and finance from the Queen Mary University of London. From there he moved to Malaysia where he completed a PhD in Islamic finance. While in Karachi, he also studied in a religious school seeking knowledge in traditional Islamic Studies.

“A key component of Islamic law of contracts is that it insists on the parties being more ethical and social. Quran suggests that wealth circulation should not be constrained in one sector of society (only among the rich), it must be circulated in the whole society.

“The creation of various Islamic financial products removes the objection of Riba, Gharar and Maysir, but now Islamic finance needs to look at ways of reducing costs, increasing efficiencies and greater financial inclusion. Here is where technology, and in particular decentralised blockchain, can greatly help.”

The existence of smart contracts, where activities and outcomes are algorithmically programmed, will allow for greater automation, flexibility, and speed in Islamic financial products. In turn this will also reduce costs and increase transparency.

Smart contracts can also reduce non-shariah-compliance risk in many ways. For example, due to the trade-based nature of Islamic financial products, not only more than one contract is required to perform a single transaction, but also the sequence of the execution of those contracts is important. Smart contracts can take care of this matter very efficiently.

“Smart contracts will allow Shariah compliance to become more robust.”