Raghuram Rajan – one of the most prominent economist and 23rd Governor of RBI (Reserve Bank of India) suggested in his 2008 report on the Financial Sector that interest-free banking (Islamic banking) should be practiced on a large scale. This was recommended with an intention to provide access to people from economically backward society with little to no access to banking services.
While Islamic Banking is prevalent in Islamic countries, several non-Muslim countries such as United Kingdom, China, Germany and United States are also offering Islamic windows in their conventional banks. So, what is it that provides it a widespread appeal? Is it because the system is based on high ethical principles or because it encourages the Muslim community – hesitant of investing in conventional banks, to come forward and invest in Shariat compliant projects thereby mobilizing huge amount of capital? Whatever may be the reason, the fact that Islamic banking is gaining traction both within and outside the Muslim community, cannot be denied.
However, these principles aren’t easy to abide by in practice as doing so may lead to higher transactional costs than most non-Islamic firms are accustomed to. This is because Islamic Banks lay a lot of importance on contractual relationship, which typically involves several contracts (more than three), parties, with lot of stress on preventing speculation, ambiguity and interests. In other words, Islamic contracts are anytime more complex than that of a conventional bank as it caters to entire system of transactions. Consequently, the number of legal and administrative processes increases, which further raises the cost of doing business.
Furthermore, Islamic Banking requires abidance with the stringent standards for financial transaction that complies with the Sharia Law. For instance, banks can create debt only when it is backed by underlying assets such as gold.
Role of Blockchain in the Islamic Finance Industry
Integrating Blockchain technology across the Islamic finance industry has opened doors of opportunities for banking and finance organizations. In fact, incorporating blockchain in Islamic Banking will revolutionize the way payments, remittances and other transactions are conducted. The smart contract functionality of the Blockchain technology automates the entire contractual process including the enforcement of terms and conditions of the contract for Islamic Banking and Financial institutions. These self-executing programs electronically encode the terms of the contract and execute only when the conditions are met. As a result, all the associated legal and administrative intricacies, as well as redundancies involved in Islamic banking or financial products can be alleviated.
What makes the inclusion of this technology more appealing is that the contracts that are once uploaded on the Blockchain become immutable, secure and easily verifiable. Consequently, operational risks ascending from counterparty risks get mitigated obviously. In short, smart contracts automates and streamlines the processes and operations of banking and financial institutions complying to the Shariat Law. This will help them realize reduced transactional and contractual costs within a short processing time while eliminating the risks of duplication and fraudulence.
Moreover, since Bitcoin or any other cryptocurrency doesn’t involve ‘Riba’ i.e. lending or debt as in traditional banking, they could be categorized under the asset class that are created through mining and are thus compatible with Sharia-based regulations. This has earned this technology the much-required legitimacy, which others had refused to provide.
The Islamic finance industry is guided by the principles of trust, equality, and fairness. Blockchain has become a perfect medium to integrate and operationalize these values by exponentially streamlining the operations, as well as business processes of the Islamic banking system. Furthermore, Blockchain significantly increases the chances of improving the transactional activities due to its’ inherent ability to provide trust and transparency along with security and protection in various transactional activities. With apparent similarities between the characteristics of Blockchain and ethics of Islamic finance, its’ usage and incorporation would certainly open doors of opportunities for Banks and financial institutions following the principles of Shariah.