More and more banks in the Islamic world — a community of nearly 2 billion people worldwide — are adopting blockchain technology and cryptocurrency. As early as 2016, major Islamic banks such as ICICI Bank and Emirates NBD began researching blockchain's capabilities to reduce transactional costs, according to Coindesk. In 2017, the UAE’s Emirates Islamic became the first Islamic bank to use blockchain technology, namely for fraud prevention. In April, an Islamic scholar declared bitcoin permissible under Sharia law after a study conducted by Blossom Finance, an Indonesian investing firm, investigated the functionality of bitcoin and similar cryptocurrencies, and found that they were congruent with Islamic definitions of money.
Benefits, Boons and Win-Wins With Blockchain and Islamic Banking
Blockchain offers an ideal solution for Islamic bankers because it reduces costs involved in transactions and processes. Although this is something all banks must deal with, the issue is particularly acute for Islamic financial institutions. To understand why, you first must learn some of the key principles guiding Islamic banking.
One is the Islamic concept of riba forbids the payment or collection of interest. Two, Islamic banks are only allowed to create debt when it is backed by goods and services; specifically, transactions must have “material finality,” meaning they must be connected to a real underlying asset, like gold. This stipulation rules out options, futures and most derivatives, which naturally makes working with Western financial firms tougher.
In themselves, these principles do not prohibit or inhibit doing business with non-Islamic banks. But abiding by these principles in practice creates higher transactional costs than most non-Islamic firms are used to. Why? Contractual relationships are very important to Islamic banks, more so than to others, with deals typically involving three or more contracts, several parties, and an emphasis on averting uncertainty, speculation, and interest. As a result, there are more legal and administrative processes, and redundancies, which raise the cost of doing business.
Enter smart contracts. Using blockchain technology, smart contracts are capable of essentially automating the whole contractual process for Islamic institutions, including enforcing the terms of the contract. This is the main reason why Saudi Arabia's Islamic Development Bank (IDB) started working with crypto firms in Oct. 2017. According to SettleMint, one of the crypto startups the bank is working with, the automation that blockchain smart contracts are capable of will reduce administrative and legal complexities, plus eliminate a lot of redundancies associated with Sharia-compliant financial products.
A guiding vision and underlying principle in the development of blockchain technology and cryptocurrency is the decentralization of banking. This vision, however, comes at the cost of making it harder to legitimize, not just in the eyes of financial and government authorities — who stand for centralization — but also for the everyday person.
Islamic banking could benefit blockchain and crypto by giving it more legitimacy. Islamic banking has strict standards for financial transactions that must comply with Sharia law — another example of centralized authority. And yet blockchain tech, the quintessence of decentralization, has been working with more and more Islamic banks across the world.
By demonstrating their ability to comply with Sharia-based regulations, blockchain is earning legitimacy that others in the finance world refuse to give.
The reduction in transactional, contractual costs reduces barriers that might normally discourage investors. Related to this, blockchain tech and cryptocurrencies also offer increased flexibility in dealings with Islamic financial institutions.
As mentioned, Sharia law mandates that banks are able to create debt only when it is backed by goods and services, which some scholars interpret as meaning physical assets. Rather than circumvent this, cryptocurrency firms such as Dubai’s OneGram and the Malaysia’s HelloGold have incorporated it by making it central to their model: Each cryptocurrency unit is backed by some amount of physical gold. Both firms have been approved by Islamic scholars as Sharia-compliant financial products.
Equally important, these firms still maintain the innate advantages of blockchain technology — reduced costs and redundancy, increased automation. Increased flexibility could make investing and doing business much more appealing to those who, in the past, would normally consider themselves outside the world of Islamic banking.
Different Islamic scholars can have varying rulings on what is Sharia-compliant, with some schools rejecting cryptocurrency while many others have approved. Indeed, blockchain and cryptocurrency could bring about many benefits for Islamic banking, and vice versa. Their recent collaboration is creating potential new markets and new business opportunities. And investors of all types can take advantage, with the right approach.