Islamic Finance & blockchain - Complex Compliance Environment

Blockchain Uses for Islamic Financial Products for Issuers, Investors, and Stakeholders

Blockchain and Islamic financial products are both defined by heightened degrees of trust and transparency over conventional financial services. One of Islamic finance’s core operational principles is Gharar, which equates to minimizing the amount of ambiguity and uncertainty within financial transactions and agreements. The processes and actions carried out by finance managers must be certified by Islamic scholarly review on an ongoing basis.  

In the same light, blockchain accounting seeks to provide transparency and immutability in data management. This allows someone to prove that an action logged into a system matches the parameters that were set forth in the systems requirements. These blockchain capabilities are also able to track that a required action was not logged, or that there was a log of improper actions. Through the blockchain, the proof and data stream will be kept in perpetuity, giving a company’s clients and potential customers a clear record of the firm’s past actions, and the fewer the errors, the stronger their reputation should be.

Islamic Finance Industry - Compliance with Over 50 Equities Screening Rulebooks

Action tracking is especially important when it comes to the processes and procedures that Islamic equity fund managers have to follow. These managers work with some of the most nuanced aspects of the Islamic finance industry on a daily basis. There are over fifty rulebooks presided over and defined by financial institutions, index providers, regional and national governing bodies, research firms, and shariah scholars that determine which stocks are compliant and not.

One such rulebook from the FTSE Global Equity Shariah Index Series certified as compliant by Yasaar, Limited, is as follows:

Business Activity Screening

Initially, companies involved in any of the following activities will be filtered out as non-shariah-compliant:

  • Conventional finance (non-Islamic banking, finance, and insurance, etc)
  • Alcohol
  • Pork related products and non-halal food production, packaging and processing or any other activity related to pork and non-halal food
  • Entertainment (casinos, gambling, and pornography)
  • Tobacco, weapons, arms and defense manufacturing

Financial Ratios Screening

The remaining companies are then screened on a financial basis. The following financial ratios must be met for companies to be considered shariah-compliant:

  • Debt is less than 33.333% of total assets
  • Cash and interest-bearing items are less than 33.333% of total assets
  • Accounts receivable and cash are less than 50% of total assets
  • Total interest and non-compliant activities income should not exceed 5% of total revenue

The core issue that fund managers deal with, regardless of which rulebook they follow, is that publicly traded companies can go in and out of shariah-compliance on a monthly or quarterly basis, based on the screening rules that they follow (for instance, this has happened to Apple multiple times over the last 10 years). As noted above, shariah-compliance is based on following the rules defined in the agreed upon contract. This leaves fund managers with multiple tasks to fulfill: choosing quality stocks that fit within their mandate, managing those assets, and monitoring if and when those stocks lose shariah-compliance, removing them, and adding new stocks as companies become shariah-compliant.

Added Layer of Compliance

The global equities market has over 40,000 stocks spread between dozens of countries and exchanges. However, core global index providers, such as the FTSE, typically only include 5,000 to 10,000 of these stocks. Moreover, when Islamic screening principles are applied, it cuts down this count by as much as 80%, giving fund managers a manageable pool of assets to trade with. Islamic fund managers have to keep records of all their trades, just as conventional managers do; the core difference is the added layer of compliance that has to be certified by shariah scholars. Blockchain accounting can facilitate this process, and ensure that investment products have a transparent process to gain and retain compliance.

Blockchain accounting and document management systems can be used by investment fund managers to cover all of their initial and recurring tasks to prove value and competency. The process of using Dragonchain’s blockchain to attain and maintain shariah-compliance through provenance tracking would be as follows:

Shariah-Compliance Provenance Step by Step

  1. The fund manager uploads the investment fund’s rulebook and offering documents to the firm’s dedicated blockchain.
  2. The shariah advisor downloads these documents from the blockchain for review, then ensures they comply or provides edits for the fund manager to apply. After this, the shariah advisor uploads the documents to the blockchain.
  3. The manager downloads the documents from the blockchain and then applies the requested changes from the shariah advisor. Then uploads those documents back to the blockchain.
  4. The shariah scholar will download these documents, ensure they are correct, and issue the fund’s certification and approvals through a public blockchain upload.
  5. After the shariah approvals are in place, the fund manager can then begin raising capital from investors and deploy the rulebook-based investment strategy.
  6. As time passes, the fund manager will upload the investment fund’s trade records and performance statistics to create a lasting value chain.
  7. On a quarterly basis, the fund manager and shariah scholars will review all the stocks in the investment fund’s portfolio. In the event that a stock is found to no longer be shariah-compliant after the review, the fund manager will have 90 days to sell the stock and donate any profits from the sale to charity. The entire review action and process would then uploaded to the blockchain, as proof that the fund manager is following the rulebook exactly as stated.
  8. After one year of operations, all of the investment fund’s past actions will be reviewed by the shariah advisor to ensure that no management errors were made and to recertify the fund as shariah-compliant. This process is repeated throughout the investment fund’s entire life.
  9. Using this form of provenance tracking for an investment fund will produce a clear and efficient document library, which eliminates the need for fund managers to compile and email a large number of files to the shariah advisory team at the end of the year.

Gain Credibility and Differentiation

The ability to track and prove daily, weekly, monthly, and yearly performance results, in addition to trading records and a strong shariah compliance record may be the most direct way to acquire new clients. Demonstrating and promoting a track record free of ambiguity will be a valuable means of gaining credibility and differentiation. Storing data on the blockchain may seem like a cost center and a process with a high learning curve to firms considering the idea. However, as the days, months, and years of data tracking go by, the value of that trustable data is able to grow exponentially.

Today the Islamic finance industry has ~$2.5 trillion dollars in assets spread throughout the globe in bank deposits, financing facilities, insurance policies, charitable endowments, and investment programs, with the expectation of a 6% annual growth rate. As the industry grows and more players from around the globe bring products and services to the market, the learning curve, accountability, and transparency, and compliance measures will have to grow at the same pace. This is for the explicit benefit of those that provide the capital for Islamic financial transactions to occur, because profits cannot be delivered without compliance. As it says in the Quran 7:85 - “So give full measure and weight without withholding from people what is theirs, and do not corrupt the world after its reform.”

Dragonchain sees how blockchain can be used to produce more transparency, accountability, and process controls across all industries. With these factors in mind, we have taken the initial steps, with the help of shariah scholars, to design a document management system to provide the industry with an immutable traceability function.  By no means will it be a perfect fit to facilitate the needs of every industry stakeholder, but through end-user customization it, of course, could be.

Be sure to look at our use cases to see other applications of the Dragonchain Platform or schedule a consultation to discuss what you can accomplish with a personalized Dragonchain solution.