The $3tn Islamic finance industry is projected to grow by as much as 10 per cent in 2023-24, as higher digitalisation and fintech collaboration are expected to strengthen the industry’s resilience while creating new avenues for growth, according to S&P Global Ratings.

Despite the industry’s slow digitalisation compared to conventional financial services, a new wave of digital pioneers is reshaping how Islamic finance is evolving.

A study by the Islamic Development Bank and the UNDP revealed that Islamic financial institutions are embracing digital currencies and blockchain technologies amid a wave of digitalisation in the industry.

Islamic finance operates on principles that prohibit interest, uncertainty, and involvement in speculative activities. Blockchain technology aligns well with Shariah principles by promoting transparency, reducing fraud, and facilitating decentralised transactions.

“Blockchain technology is becoming increasingly popular in the finance industry because of its ability to improve transaction efficiency, transparency, and security. It is used for tasks such as simplifying payments and money transfers and enhancing clearing and settlement systems,” says Bashar Al-Natoor, global head of Islamic Finance at Fitch Ratings.

Al-Natoor notes that the innovative technology is also used in trade finance for record-keeping, identity verification, and digital securities issuance.

The lack of standardisation in Islamic finance is a significant constraint on the industry’s growth. To attract interest from non-Islamic finance markets and drive growth, the industry is capitalising on technological opportunities and re-evaluating the issuance process while standardising Islamic bond-related standards.

Industry experts anticipate that blockchain technology will enhance transparency and security in financial transactions, while smart contracts can automate Shariah-compliant agreements and ensure adherence to Islamic principles.

Harmonising Islamic finance

Islamic finance has been on the rise for many years across markets in the Middle East and Southeast Asia (MEASA). However, the industry remains fragmented, with uneven rule implementation across jurisdictions, curtailing its growth beyond core markets in the MEASA region.

Standardisation in Islamic finance and the adoption of global best practices have enabled the industry to evolve from being a niche offering to being recognised by the International Monetary Fund and offered by more than 300 financial institutions across 60 countries.

In its 2024 edition of Islamic Finance Outlook, S&P Global said that Islamic finance faces interrelated challenges, including the high complexity of structures and transactions that limit its appeal beyond the industry’s original turf.

The efforts of industry bodies, including the Dubai International Financial Centre, have largely reduced differences in the interpretation and practice of Shariah principles to ensure soundness, stability and integrity of the Islamic finance industry.

Digitalisation is a central theme in finance, and there has been speculation about what innovative technologies such as blockchain, also known as distributed ledger technology, could mean for Islamic finance and its potential to accelerate industry-wide growth.

Blockchain technology promises to modernise Shariah compliance through embedded smart contracts, updated and transparent management of obligatory charitable giving (Zakat) and a more efficient platform for Islamic bond issuance.

Moody’s said in an April report that the innovative technology’s core feature would likely improve Islamic transactions by streamlining processes, increasing transparency, automating enforcement of Shariah-compliant rules, reducing the risk of human error, and facilitating real-time settlements.

With embedded Shariah-compliant terms and conditions, smart contracts could foster adherence to Islamic finance principles, such as profit-sharing (Mudarabah) and cost-plus financing (Murabahah), while mitigating the risk of fraud and reducing transaction costs.

Blockchain can also improve the accountability and auditability of Zakat funds, providing real-time visibility into their use and impact. The innovative technology presents a promising avenue for obligatory charitable giving in Islam that would modernise its collection and distribution processes.

Harmonising standards presents a significant opportunity for Islamic finance. The adoption of blockchain in the industry is expected to streamline and strengthen processes and practices, enhancing the appeal of Shariah-compliant products.

Digital sukuk issuance

S&P Global projected that sukuk issuance would reach $160-$170bn in 2024, down from $168.4bn the previous year and just below $179.4bn in 2022. However, the industry faces numerous challenges, including the high complexity of structures and transactions, which limits the appeal of Islamic bonds beyond their original market.

“Over the past 18 months, we rated around $1.6bn of digital bonds issued by sovereigns, multilaterals, local and regional governments, corporations, and financial institutions. The bonds were mostly issued on private blockchains, with payments made off-chain and via traditional rails,” says Mohamed Damak, managing director at S&P Global Ratings.

Damak explains that though S&P Global has not yet rated any digital sukuk, the Islamic bond market can significantly benefit from the adoption of blockchain.

Furthermore, sukuk issuance is linked with high costs and the risk of human error due to multiple intermediaries involved in the issuance process. But whenever there is a challenge, there is an opportunity, and the advancement in innovative technologies provides opportunities to unlock future growth.

The tokenisation of Islamic bonds using blockchain technology is expected to reduce costs associated with the issuance process, potentially allowing startups and SMEs to enter the field. Moody’s stated that blockchain could provide a more inclusive and efficient platform for capital market transactions in line with Shariah principles.

Damak notes that blockchain can simplify the tracking of underlying assets, offer visibility into the asset, make financial and Shariah audits easier, and, as an innovative technology, simplify the decision-making process.

Prioritising risk management and customer education is crucial for the successful adoption of blockchain and digital assets in Islamic finance, Moody’s cautioned in a report in April, while noting that Shariah-compliant financial institutions must identify and mitigate potential risks such as cybersecurity threats.

Al-Natoor explains that establishing a regulatory framework that encompasses the financial and technological nuances of blockchain is vital, but it remains underdeveloped in many core Islamic finance markets. “This creates additional legal risks, such as the enforcement of smart contracts or the definition of the status of digital assets,” he says.

By leveraging blockchain, sukuk issuance would become more transparent, as all transaction data would be recorded on a tamper-proof and immutable ledger. This would foster trust among investors and ensure Shariah compliance.

The technology also enables fractional ownership and secondary market trading, democratising access to sukuk investments and expanding their reach globally. Going forward, industry experts say that blockchain frameworks for Islamic finance, regulators, and innovation will be essential.

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