Blockchain, Fintech, and Islamic Finance

Building the Future in the New Islamic Digital Economy

Hazik Mohamed, Hassnian Ali

• Publisher: De Gruyter
• Year: 2018
• ISBN:
  9781547400980
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Banca y finanzas islámicas

While creating new forms (Shari'ah-compliant standards) to operationalize Islamic values and ethics into the current conventional economic system and banking products is crucial to sustain the Islamic economy as it is today, we also need to develop new strategies to cope with the next economic evolution. The digital revolution in financial services is under way, and digital disruption has the potential to shrink the role and relevance of today's banks, while simultaneously creating better, faster, cheaper services that will be an essential part of everyday life. This forward-looking book discusses the crucial innovation, structural and institutional development for financial technologies (fintech) in Islamic finance.

The authors explain concepts in fintech and blockchain technology and follow through with their applications, challenges and evolving nature. The book provides insights into technology which will enable and enhance actual prescribed Islamic behaviors in modern economic transactions. Case studies highlight how to cope with modern transactional behavior with the advent of global online/mobile markets, shorter attention spans, and impersonal trade exchange.

Chapter 1
Introduction

The Rationale for Financial Disruption

The global financial and economic crisis has done a lot of harm to public trust and confidence in governing and financial institutions, as well as the principles and the concept itself of the market economy. It has also eroded a lot of public trust in corporations. The climate of global financial uneasiness can partly be attributed to the global meltdown of 2008 where governments and other regulatory agents failed in their responsibility to monitor and steer unrestrained speculative and damaging financial activities. Outside of the instrumental complexities of collaterized debt obligations and credit default swaps, the repeal of the Glass-Steagall Act,2 or macroanalysis of global imbalances (in levels of savings and investment), prominent voices have echoed in unison on the erosion of trust and confidence in the global financial system. The main theme of financial reform in the aftermath of 2008 was basically to encourage greater responsibility after (ex post) and accountability for risks taken prior (ex ante), in the form of not bailing out the bankruptcies, and limiting the increasing complexity of financial instruments, transparency, and answerability for derivative trading to prevent investment managers from making enormous bets with other peoples’ money, among other improvements.

In response to the deteriorating fiscal and banking conditions in some countries, and increased financial fragmentation, major governments like the European Union (EU) and the United States had supplied liquidity at very long maturity and at low rates to counter the impending risks for their banks. As the monetary policies struggled to deliver their intended outcomes, credit and economic growth were falling, leading to rising unemployment and reduced consumption and investment. The public grew more restless, with increased resentment and decreased confidence in the ability of their governments to tackle the depressed markets.

This frustration worsened with the bailouts of “too big to fail” entities, and have resulted in very smart individuals creating ways to invent their own trust mechanisms through technology. If you look at bitcoin, for example, its blockchain technology was born out of the need to keep people honest in the absence of a central authority and designed to be public and allow anyone to participate. The design sacrificed efficiency in order to ensure that theft would not pay because rewriting the ledger would require so much computational power. Subsequently, with verifications coming in from various nodes all over the world, a system like the blockchain has developed a mechanism of trust where two people who have not met and do not know each other are able to make a transaction through a technology that has done the checks and instilled a level of trust that is required in such transactions, by eliminating fraud and margins for fraudulent activities. This is one of the major reasons that disruptions, especially in the financial industry, are occurring and at a massive scale. Creating a system that is harder to tamper with and easier to audit will lead to great benefits in an industry that is being increasingly regulated by central authorities. Beyond such rationale, other additional benefits lie in operational advantages like cost reductions, improved efficiencies, transparency, and productivity.

Ethics and Technology

Two fundamental concepts in the Islamic worldview that would have significant implications on economic (including financial) behaviors are the concept of man as khalifah (vicegerent) and ‘abd (servant/slave). The Qur´an (Surah al-Baqarah, Qur’an 2:303) mentions that the human being has been created to be a khalifah, a vicegerent on earth to establish God’s commandments,4 a unique position (with a mission) not granted to other creations. To be a khalifah, the human being is endowed with a delegation of authority from God to fulfill “consciously” (not by force) the divine patterns on earth. He is granted free will to either implement or annihilate these divine patterns through his actions. He is the only being that can act contrary to his nature (i.e., not fulfilling God’s primordial command), while no other creations be it animals, plants, or angels can do so. Human beings are free to use the bounties and blessings conferred upon them (taskhir), but at the same time, they must carry out their duty toward God mainly as an ‘abd (who serve and worship Him) and khalifah (who holds amanah as God’s representative on the earth) to isti’mar, that is, to prosper the earth and to create a moral social order on earth. All man’s actions, including his economic activities, should be viewed in this complete commitment to God by obeying the prescribed framework.

Another example that shapes the relationship of the ethical concepts that make up the ethical foundation of Islam is the belief of the connection of dunya (the present world) and akhirah (the hereafter). Muslims are advised to be very conscious of this correlation in every action they take and choices they make. When all economic goals are only directed to the happiness of human beings in this world, institutions are likely to suffer from immoral sentiments that are opposed to upholding divine laws meant to benefit human beings. In conventional economics, a rational individual is free to maximize his utility as much as possible without any moral, social, or religious commitment. Consideration for a “hereafter” reward and punishment of the consequences of economic choices and decisions made are not included in such a theory. Instead, an Islamic or more enlightened or universal concept of justice and responsible viceregency would constrain an individual maximization of utility in view of the greater good.

The presence of al-jannah (Heaven) and al-jahannam (Hell) provides “the form of the moral conscience” whenever a man chooses to do anything in this world. It is the very source of moral values. Man, as long as he lives as a member of the Muslim community, is morally required to always make choices that are connected with good and to avoid those that are connected with harm. In fact, these universal principles also apply to all other religions and value systems.

However, behavioral economics informs us that our choices are also governed by our emotions as well as situational factors and the environment. Even with deep moral precepts, our actions are highly influenced by our moods, feelings, and peer pressure, which may be irrational to moral decision making. As such, if the prescribed behaviors of the Economic Man can be mechanized in a system that uses technology to overcome our irrationality, those behaviors that harm the integrity of the financial system in the long run can be prevented. Technological advancement may have the ability to limit5 poor decisions and detect and prevent fraud and deception early before a collapse in trust and confidence occurs again.

Digital Transformation and Development

The computing power of digital systems is becoming stronger, faster, and cheaper at an exponential rate and it is in line with one of the most famous laws, Moore’s Law,6 that predicted it. Digital Islamic revolution, digitalization, and digital transformation have become the most frequently used words in this last decade, but especially in the last few years. This term of digital transformation has no universal definition due to its diversity and it encompasses many dimensions like digital supply chain, digitalization of services and products, and so on. There is a plethora of definitions of this term, used to describe the offline-to-online migration of commercial operations and businesses, including those found in many published research works. Solis, Li, and Szymanski (2014, p. 7) defined this term in a concise way in these words: “the realignment of, or new investment in, advanced technology and business models to more effectively engage digital customers at every touchpoint in the customer experience lifecycle.” There are also different terms used in different countries with the same concept like “smart industry” and “industrial value chain initiative” in Japan, “industrial internet” in North America and “Industrie 4.0” in Germany and so on (Matzner et al., 2018, pp. 3–21).

What started as a digital transformation has not been restricted or limited to a specific industry but has spread to a number of industries, seeking similar improvements and benefits. This has influence and clout in each and every industry like the health care industry (Belliger & Krieger, 2018), manufacturing industry (Liere-Netheler, Packmohr, & Vogelsang, 2018; Rüßmann et al., 2015), engineering, construction, and architecture industries (Boland Jr., Lyytinen, & Yoo, 2007) and at the top of the list, the banking and financial industry (Kenser, 2018).

The agenda of digitalization has not only received considerable attention from different industries and businesses, but governments and regulatory authorities have also had to keep up with the disruption and changed business environment and markets. They have begun to give importance to and keep abreast with the new era of digitalization in order to be able to remain relevant in their fiduciary and “watchdog” duties. The most recent and latest example of this is the newly formed German government, which emphasized it in their list of most dedicated items (Liere-Netheler et al., 2018). Unsurprisingly, other governments are following suit as studies have shown that the use and adoption of information communication technologies (ICTs) by the large number of population has a very positive relationship with the gross domestic product (GDP) of the respective countries (Mićić, 2017).7

Digital transformation is imperative for the financial services industry to remain competitive and achieve longevity in the market. The survival of financial institutions is connected with the adoption of innovation, and in embracing digital transformation, to radically improve efficiency and performance within the organization (Scardovi, 2017). Digital transformation and new technology adoption have changed the way of doing business and channels that offer banking and financial products and services are more intuitive and trustworthy. These new ways may be very different from the past and have resulted in reshaping the existing models of businesses and the creation of new innovative ones. In doing so, the transformations have created new industry and market leaders.

According to Forbes (2018) ranking of the top 100 brands, the top five brands are from the area of technology. These five top brands are valued at US$585.5 billion. Table 1.1 provides the Forbes ranking and growth of these five giants.

Table 1.1: Forbes Ranking (2018), Top 100 Brands

In a wider trend, the anecdotal evidence shows that the technological conglomerates have been surpassing other industries from the last decade and also in Forbes rankings in terms of number of brands and value. The most recent report also shows that the number of technology brands (20%) and their value (US$872.6 billion, 40%) are much greater than other industries (see Figure 1.1). The value of the financial services industry is only US$160.2 billion with thirteen brands. This difference of number and value of brands in the tech and financial industries is due to the difference in strategy toward innovation and digitalization.

Figure 1.1: Forbes (2018) 100 Most Valuable Brands List

It was inevitable that technology would meet finance and spawn fintech. The use of technologies like algorithmic machine learning, collecting massive amounts of data and interpreting them for decision-making or “crystal-ball” predictions (predictive analytics), and distributed ledgers (blockchain) in financial industry will give rise to innovative business models with increased levels of efficiency, productivity, cost-effectiveness while also improving on customer-centricity. The most important thing and also a great challenge for both fintech platforms and financial institutions is to adopt and implement a very pertinent, practical, and transparent strategy for digital transformation within the organization as well as in external engagements. This is not only essential to harness the opportunities afforded by such advancements in technologies, but it communicates the vision of the organization moving forward into the new digital economy.

Shifts in Customer Behavior

A customers’ journey is the way the customers choose to satisfy their wants and needs and will typically encompass many different processes (Buckley & Webster, 2016). Digital transformation is changing the customers’ behaviors in unimaginable ways, and this changing ...