Tokenization and Islamic Finance: Financial Ethics in Practice

Apr 25, 2020

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Islamic finance is equity-based, asset-backed, ethical, sustainable, environmentally and socially responsible finance. It promotes risk sharing, connects the financial sector with the real economy, and emphasizes financial inclusion and social welfare. [1] With its emphasis on accountability and transparency, blockchain technology and tokenization shares surprising commonalities with Islamic finance.

The global financial system has become more centralized with the development of the global banking system. This centralization has also led to immense concentration of wealth. According to an OECD report, 10 of the world`s top financial corporations have assets over $2 trillion, this is more than the combined GDP of all OECD member nations except the top 6.[2] The Credit Suisse Global Wealth Report states that the 1% of the world`s richest own 44% of global wealth. [3] According to Oxfam, the unequal distribution of wealth has grown between 2009 – 2018 and the number of billionaires who now own wealth equal to the world`s 50% poorest has fallen from 380 to only 26 individuals.

Fiat currencies were created in the 70s when U.S President Richard Nixon dropped the gold standard. [4] This allowed central banks to control currencies more flexibly and allowed them to use monetary policy to control money supply, inflation and debt in an economy. Commercial banks lend out many times more than what they hold in their reserves. Fractional reserve banking allows banks to increase debt while the money supply remains the same. [5] The effects of the recent financial crisis were discussed in a previous article.

Debt & Interest Based Financial System

The current conventional financial system works almost fine when everything is running normal but as soon as any external or internal shock hits the system, it becomes unstable and the ultimate price of debt accumulation has to be paid by the people. According to a report from Zillow, American homeowners lost $3.3 trillion in home equity during the 2008 financial crash and one in six homeowners couldn’t pay their mortgage on time. [6] 401(K) account holders who were saving up for retirement lost around 2% of their retirement savings due to the financial crash. [7]

The concept of usury (Interest) has been condemned by prophets, priests and philosophers of many cultures and religions in the past. [8] Plato, Aristotle, Cicero and Plutarch all condemned the usage of usury. The “Lex Genuciae” reforms in 340 BC Rome outlawed interest altogether. All three Abrahamic faiths namely Judaism, Christianity and Islam prohibit usury.

Fundamentals of Islamic Finance

The conventional financial system focuses only upon the economic, financial and material aspect of transactions without considering the moral, ethical and social dimensions. However, Islamic finance focuses upon business ethics, wealth distribution, social and economic justice. [9] Islam prohibits the charging of interest because interest is considered unjust as it results in exploitation of the debtors and according to Islamic teachings taking advantage of debtors is unjust. [10] Therefore transactions dealing in interest are prohibited.

Asset Backed Finance

Islamic finance is different from conventional finance because it focuses on asset backed financing. [11]

Islamic finance prohibits indulgence in speculation or gambling and entering into contracts that include high level of uncertainty. Speculation is prohibited because the result of a speculative contract is contingent upon the happen or not happening of a future event upon which the parties to the contract do not have any control. [12] Based on this explanation, leverage and options trading, derivative contracts and short selling are prohibited in Islamic finance as these activities have an element of uncertainty, excessive risk and most are speculative in nature.

Islamic finance also emphasizes on the sharing of profit and loss. The partners in a business or parties to a contract must share the risk and reward of the transaction or contract.

According to Raja Teh Maimunah, MD & CEO of Hong Leong Islamic Bank the financial crisis of 2008 could have been averted with Islamic finance because the tenets of Islamic finance focus on funding the real economy. [13] The 2008 financial crisis was caused by deregulation of the banking industry that allowed banks to indulge in questionable trading practices. [14]

Asset Tokenization and Islamic Finance

Asset tokenization is a method that converts the rights to an asset into a token. [15] The tokens are issued on a blockchain platform that supports smart contracts, so that the tokens can be freely traded on various exchanges. Gold, precious metals, and real estate or intangible assets such as shares and securities are all examples of assets classes that can be Tokenized. The benefits of tokenization were discussed in a previous article as well as how it will disrupt the financial industry.

According to Shariyah Review Bureau, tokenization can be structured in a manner that is in compliance with the rules of Islamic finance. [16] Mufti Faraz Adam, who serves as an advisor at the Shariyah Review Bureau and runs his own consultancy firm called Al Amanah Finance Consultancy stated that asset backed tokens represents a beneficial ownership on an underlying asset. In his opinion tokenized assets are similar to investment in Sukuk bonds as the tokens represent interest in the underlying assets, beneficial ownership and constructive possession. Constructive possession is implied by the possession of the token. [17]

Tokenization & Islamic Finance in the Industry

The Singapore based Algorand Foundation was recently certified as a Sharia compliant, blockchain based financing platform by the Shariyah Review Bureau (SRB). Giving a statement on the certification of the Algorand foundation, Yasser Dahlawi, CEO of SRB said “We are thrilled by the technical achievement of the Algorand network and a future of highly scalable and secure blockchain that will help Islamic financial markets to enter the emerging borderless economy.” [18] Algorand will continuously collaborate with the Shariyah Review Bureau to assess the decentralized applications built using their platform for sharia compliance. [19]

Blossom Finance, a Sharia compliant microfinance provider introduced its Smart Sukuk platform. Smart Sukuks (Islamic Bonds) are just another example of a Tokenized Asset class evolved to securitize Islamic modes of financing such as profit sharing through asset ownership for a given tenure using blockchain technology.

“Tokenized assets reduce intermediary costs, which makes global finance more accessible regardless of size or borders,”
Matthew Martin, CEO of Blossom Finance [20]

Indonesian Islamic microfinance cooperative BMT Bina Ummah raised $50,000 funds through first ever primary sukuk issuance on the public blockchain platform of Blossom Finance. According to BMT Bina GM Arif Yuliyanto, the funds raised through the sukuk are long term stable funds that have increased financing available for the members.

The Islamic finance market is worth over $2 trillion [21] and the MENA region is fast emerging as the hub of sharia backed blockchain platforms. In the first quarter of 2019 alone, investors in UAE invested $67 million in 47 STO`s, amounting to more than half of global investment in tokens, furthermore the government of UAE, in line with their paperless initiative [22] is planning to use the technology for all government records by the end of this year. [23] This shows the potential future market for asset tokenization, especially in the MENA region and it is expected to assist the Islamic finance to become more efficient.

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