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.