Sunday, 12 February 2017

Digital age smart contracts for Islamic finance

(Edited version of this article appeared in my column in the Malaysian Reserve on 13th Febuary 2017)
The mobilization of funds from the Surplus Fund Units (SFUs) to the Deficit Funds Units (DFUs) in Islamic Financial System must be through contracts permissible by the Shariah such as Mudharabah, Wakalah, Murabahah, Ijarah, Musharakah, Istisna’ and Salam. 

Islamic finance products are structured based on either one or a hybrid of these contracts. Examples of hybrid Shariah contracts include Musharakah Mutanaqisah, Tawarruq and Ijarah Thumma Al Bai’ (AITAB). Hybrid contract structures typically involve multiple contracts and/or multiple parties to complete the transactions.

In order to be Shariah compliant, Islamic finance products must observe the fundamentals of contracts in Islamic law. Three main fundamentals are contractual expression (offer and acceptance), parties to the contracts and subject matter of the contracts. Each of these fundamentals come with certain guidelines. For examples, the offer and acceptance must be unambiguous, the parties must have the competency to conclude the contracts and the subject matter must be ascertained by the parties at the time of the contracts.

In the implementation of Islamic finance products, these fundamental guidelines are translated into a set of legal documentations which must be executed according to the right sequence. In Murabahah case for instance, the contractual expression is in the form of Sale and Purchase Agreements (S & P), the subject matter is clearly specified in the S & P documents and the parties to the contracts are represented by the documents’ signatories. To avoid uncertainty (gharar) of selling something that has not been possessed, the sequence in signing of the S & P documents will have to follow the direction of the transfer of assets (subject matter of the contract) between the financial institution and the customer.

The number of legal documents will be more and the order in which the documents need to be executed will be trickier for hybrid Shariah contract structures as there are more contracts and more parties. Let’s look at Tawarruq (also referred to as Commodity Murabahah) as the case in point. Tawarruq refers to the contract of purchasing a commodity on credit by those who need cash and selling the commodity to another party (not the original seller) for a lower price on cash basis. In addition to Islamic financial institution (IFI) and the customer, at least two other parties known as commodity brokers are involved in the transactions. Assuming the product is Islamic personal financing, the sequence of transactions is (1) IFI purchases commodity from Commodity Broker A, (2) IFI sells the Commodity to Customer on deferred payment, (3) Customer appoints IFI to sell the commodity to Commodity Broker B and (4) IFI sells the commodity on behalf of customer to Commodity Broker B. Step 3 involves an agency contract known as Wakalah.

At present, most of the steps described above are still controlled manually. This exposes IFIs to Shariah incompliant risk. In the event bank disburses the financing amount to the customer before full completion of the above steps, the transaction violates the condition precedent of the contract. In Tawarruq application for personal financing, cash can only be generated out of selling the commodity purchased earlier to another commodity broker on cash basis. In addition, the current processes in handling Tawarruq in financial institutions are time consuming and costly.

Blockchain smart contract technology has the potential to significantly improve the process. Blockchain is a peer-to-peer public ledger maintained by a distributed network of computers that does not require central authority or third party intermediaries. First introduced in 2009, Blockchain is the foundation of cryptocurrency such as bitcoin. The scope of Blockchain technology is much wider and has the potential to improve the overall financial system efficiencies. Smart contract is one of Blockchain applications in financial services industry.

Smart contract is a computer program that can execute contract terms. Fully automated, smart contract can either complement or fully substitute typical legal contracts. The terms of the contracts are coded in computer algorithm as a set of instructions that will be executed based on the conditions specified. Upon meeting the preconditions in each step, the smart contract program will automatically execute the next step until the entire transaction cycle completes.  In fact, the advantage of smart contract is beyond automatic executions of contract terms. Leveraging on blockchain technology, smart contract programs allow immutable, verifiable and secure record of all contracts and transactions which are fully auditable.

In summary, Islamic finance products are structured based on underlying Shariah contracts. The terms and conditions of these contracts are specified in legal documents and these documents must be executed in the correct order to ensure Shariah compliant. At the moment, the controls are manual and the processes are time consuming and costly. Blockchain smart contract, an algorithm based computer program, can automatically execute contract terms and has the potential to significantly improve the overall process.