Blockchain and Smart Contracts: A Risk Management Tool for Islamic Finance

Abstract

Islamic finance ecosystem could leverage from blockchain technology in order to improve business processes and streamline operations. The characteristics and conditions of blockchain are in alignment with the principles of Islamic Law as it creates the possibility of coordinating institutions’ transactional activities within a strong mechanism of trust and transparency. Blockchain technology allows businesses to build decentralized models and opens new horizons for them to conduct transactions and make agreements. And one of the technologies that is proposing an alternative to the traditional model is smart contract. Smart contracts are closer to Islamic contracts with an undiluted focus on avoidance of any kind of uncertainty regarding settlement of the contracts. One would witness a sharp reduction in the element of gharar with contracting between unknown parties that meet on the internet, when Islamic contracts take the form of self-executing digital or smart contracts, with “electronically coded” terms of executions. The contractual terms will execute only if the pre-configured conditions are met. This will automate the entire contractual process for Islamic institutions. The Islamic contracts will now be easy to verify, immutable and secure, mitigating gharar in the form of operational risks arising from settlement, as well counterparty risks. The adoption of Smart contracts by the Islamic finance industry is the most natural thing to do, not just to gain a strong foothold in this technological revolution, but also to be able to fully comply with the Shari’ah in a transparent way. The Shari’ah laws can form the conditions of a smart contract. Honesty, transparency and trustworthiness are qualities that should make a financial transaction in the Islamic finance industry, and smart contracts are inherently all of these. In the era of faster globalization, risk management is of essential importance for banks. As credit risk being the most significant risk in Islamic Finance Institutions’ (IFIs), we stressed our attention in this paper on it and as per our opinion we believe that the new ledger technology will add value for IFIs in terms of reducing it. Blockchain and particular Smart contracts would help reducing credit losses; provide more transparent and accurate credit ratings for capital allocation, which could lead to minimization of the required capital allocation for credit loss, as well better and cheaper administration and facilitation of collaterals. All the above will improve IFI’s profitability and shareholders value. Not only the Islamic banks will abide fully with Shari’ah rules, but they could gain more international customers seen as the more reliable choice. The purpose of the study consists of analyzing the role of blockchain and smart contracts as a tool for risk management. We used AlInma bank as a case study to show the impact of using new FINTECH in Islamic finance. The main findings of the paper show that using blockchain and smart contracts as a tool of risk management reduces costs for IFIs considerably. The paper is organized as follows: section one will present the introduction and literature review. Section two describes Blockchain technology and Smart contracts and finally we focus on how risk management could benefit from these technologies in Islamic financing. The rest of the sections will present and discuss the use of blockchain in risk management.