Blockchain may gain traction in sukuk industry

Blockchain could increase transparency of cashflows and underlying assets, says S&P Global Ratings


Blockchain may gain traction in the global sukuk industry after the World Bank deployed the technology in the issuance of a conventional bond two months ago.

Islamic finance players may certainly pay more attention to blockchain — which is already abuzz in almost every nook and corner.

The meeting of blockchain and Islamic finance was captured in a recent report by an international rating agency, suggesting that blockchain and smart contract protocols could change the global sukuk industry for the better.

S&P Global Ratings Inc said blockchain could increase the transparency of cashflows and underlying assets, while enhancing investors’ decision-making through a greater supply of information.

S&P believes that the technology is opening up opportunities for small innovative market participants to challenge established financial groups (Pic: Bloomberg)

“These technologies could also pave the way for more robust Shariah and financial auditing of sukuk after issuance, thereby reducing the risk of default because of non-Shariah compliance,” said S&P global head of Islamic finance Dr Mohamed Damak in a statement.

Some quarters are already making preparations to capture a slice of the sukuk market, armed with blockchain technology.

One such firm is Indonesia-based Blossom Finance, which is preparing to roll out blockchain-based sukuk in the coming months to fund microfinance projects in the Muslim-majority country, according to a Reuters report.

The deal would be smaller than most other sukuk, but using blockchain would help keep issuance costs low — while attracting a large pool of retail investors, the report quoted its chief strategy officer Khalid Howladar as saying.

“Technology allows you to on-board customers in a far cheaper way than you could ever do before,” he said at an industry conference in Bahrain, hosted by the Accoun- ting and Auditing Organisation for Islamic Financial Institutions last week.

The company is working on what it badges as “smart sukuk” that has the capability to support a variety of structures.

The firm noted that sukuk has thus far been limited to governments and large institutions due to the high issuing costs and complexity. Its smart sukuk platform, which leverages on ethereum blockchain smart contracts, is supposed to address those factors as it will allow the firm to increase the efficiency and reach of sukuk issuance globally.

“Smart sukuk standardises and automates much of the legal, accounting and payment overhead of conventional sukuk offerings — all backed by fully licensed legal entities in the issuing jurisdiction,” according to information available at the firm’s website.

World Bank Move

Players like Blossom Finance should be thrilled with the World Bank bond-i (blockchain-operated new debt instrument), said to be the world’s first bond to be created, allocated, transferred and managed through its life cycle using distributed ledger technology.

The two-year bond raised A$110 million (RM325.6 million), marking the first time that investors have supported the World Bank’s development activities in a transaction that is fully managed using blockchain technology, the World Bank said in a statement released in August.

The World Bank mandated the Commonwealth Bank of Australia as the arranger for the bond on Aug 10. It was part of a broader strategic focus of the World Bank to harness the potential of disruptive technologies for development, it said.

In June 2017, the World Bank said it launched a Blockchain Innovation Lab to understand the impact of blockchain and other disruptive technologies in areas such as land administration, supply chain management, health, education, cross-border payments and carbon market trading.

The International Finance Corp, the World Bank’s lender to the private sector, has issued sukuk in the past, including a £100 million (RM535 million) issuance in August 2015. This leaves open the possibility of a blockchain-powered sukuk from the global outfit, though it had yet to signal any such move.

Missing Link

In its report titled “The Future of Banking: Blockchain May Be the Sukuk Industry’s Missing Link”, S&P noted that only a handful of financial institutions have used blockchain to issue conventional bonds — and none to issue sukuk.

The rating agency believes that the technology and the increasing prevalence of peer-to-peer services are opening up opportunities for small innovative market participants to challenge established financial groups.

“We have long believed that, at the very least, blockchain presents an opportunity for financial institutions to minimise costs by streamlining back-office operations, shortening clearing and settlement times, facilitating payments, and even generating new revenue streams,” the rating agency said in the statement.

Since blockchain techno- logy enables the creation of a shared digital transaction ledger, it said that banks could use it in their payment, trade finance, money transfer and post-trade services.

Having a real-time, standardised view of transaction data without needing multiple reconciliations would remove many of the inefficiencies that hinder the financial system, and could reduce costs considerably, it said.

For the implementation of blockchain to become a viable option for sukuk issuance, the S&P report noted the validation method has to be easy to implement and cost effective.

“Proof of work is the most common algorithm used to validate blockchain transactions and operates in a linear fashion, with the validator able to move forward only after solving a mathematical problem.

“For sukuk, this could result in a large number of potential validators and a significant amount of time and effort to validate transactions. Moreover, the cost of remunerating the validators could well be higher than for participants in the current sukuk issuance process,” it said.

It also said proof of stake is an alternative algorithm where the parties validating transactions are chosen in a random manner based on a certain number of predefined characteristics.

“Delegated proof of stake, which is a variant of proof of stake, uses a limited number of parties to propose and validate transactions on the blockchain. This model appears more appropriate for sukuk, since there is a limited number of parties with predefined responsibilities,” the report said.