Is blockchain the future of the sukuk industry?

To date, only a handful of financial institutions have used blockchain to issue conventional bonds and none to issue sukuk. However, this technology and the increasing prevalence of peer-to-peer services are opening up opportunities for small innovative market participants to challenge established financial groups.

In a recent report titled ‘The Future of Banking: Blockchain May Be the Sukuk Industry's Missing Link,’ S&P Global Ratings says that it believes blockchain and smart contract protocols could change the global sukuk industry for the better.

The report further noted that blockchain presents an opportunity for financial institutions to minimize costs by streamlining back-office operations, shortening clearing and settlement times, facilitating payments, and even generating new revenue streams.

So how might sukuk issuance benefit from blockchain?

Sukuk cash flows should become more transparent

Sharia scholars and investors have often criticized the opacity of the sukuk issuance and returns process, and difficulty in tracking the underlying assets or cash flows generated without regular external financial disclosure and post-issuance Sharia audits.

This is where blockchain and smart contract protocols could make a difference. Blockchain can allow the recording of cash flows in a transparent and easily reconcilable way that shows the source and timing of payments. Overall, this means cash flows would be easier to trace, enabling prompt corrective action if needed.

Digital ledgers can simplify tracking of underlying assets

Generally, for complex sukuk supported by several underlying assets, the legal documents specify terms and conditions related to pricing of asset substitution, but rarely mention the nature of the underlying assets beyond their Sharia compliance. This can cloud investors' view of exposure to certain risks, such as those related to total-loss events.

Some sukuk documentation also contains clauses that limit investors' recourse in case of a total-loss event. Neither the market nor investors receive this information unless such changes disrupt repayment.

If blockchain were brought into the equation, digital ledgers would allow real-time tracking of underlying assets, including any alterations, such as from substitution or removal. The technology would also help ensure that the assets are used solely for a specific Islamic finance transaction, since according to Sharia; assets tied to a specific transaction cannot support any other transaction.

More reliable information will aid decision-making

Under certain transactions, the sukuk issuer or sponsor is required to inform investors when certain events take place and request their consent or instructions for actions that follow.

Blockchain and smart contract protocols could help here by allowing for a real-time register of sukuk holders, since each transaction is documented by a new block in the chain. It can also smooth the information flow to investors, whose decisions would be documented in a transparent way.

Moreover, the technology could enable the automatic execution of certain clauses in sukuk documentation, either partially or fully, for example the triggering of early dissolution if a certain percentage of investors agree. This would ultimately help speed up the orderly resolution of sukuk and, in some cases, prevent lengthy and uncertain legal proceedings since the parties' original understanding and intent will be documented in smart contracts.

Blockchain can strengthen financial and Sharia audits

Sukuk are subject to Sharia audit only when a Sharia-compliant institution sponsors them. The auditors, as part of the general audit of a sponsor, also examine Sharia compliance of the sukuk transaction to ensure it is according to the original Fatwa.

If the sukuk is issued by an entity that is not subject to Sharia audit, then it is rarely audited. This opens the door to risks of the sukuk becoming non-Sharia compliant during its lifetime.

Using blockchain would minimize this risk considerably, since information would be easy to compile and accessible to external Sharia auditors, making sukuk a more credible instrument and less prone to post-issuance compliance issues.

Blockchain could also ease the reconciliation of financial flows and enable early detection of any issues related to them.

The Validation Challenge: Proof of work or proof of stake?

For the implementation of blockchain to become a viable option for sukuk issuance, 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.

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 are a limited number of parties with predefined responsibilities.