The development of technology these days has impacted all aspects of humans including finance. Blockchain is one invention that has the potential to simplify the financial system. On the other hand, efficiency has still become a problem in the Islamic financial system.

Blockchain can benefit the Islamic financial system through smart contracts. A smart contract is part of the blockchain transaction whereby it got deployed or executed on the blockchain system1. Generally, there are three main advantages to using the smart contract. Firstly, increased efficiency as a result of the network’s validating transactions, cutting the intermediary2,3. The smart contract provides a high speed of execution of each transaction with automation and high accuracy by eliminating manual errors. Secondly, reduced transaction and legal costs. Miners openly verified and added the blocks of transactions onto the chain which can cut fees that usually occur in the traditional process. The potential cost savings also come from reduced infrastructure, operational and commercial expenses. Other benefits that smart contract could give are greater transparency and decentralization. Transactions utilizing encryption avoid the chance of data being unlawfully accessed. Besides, backups and duplicates of data are available in the blockchain. Hence, safety is certain with smart contracts. Combining Islamic financial instruments and technology has brought out some sophisticated Islamic financial products. There are at least four Islamic financial products and instruments that can utilize blockchain systems through smart contract namely sukuk, takaful, and Islamic social funds (zakat and waqf).

1. Sukuk

The smart contract is used for several Islamic financial instruments such as sukuk, a prerequisite for the faster growth of sukuk is the standardization of Sharia interpretation and legal documentation. This would fuel growth by streamlining the sukuk issuance process, which is still more complex and time-consuming4. Smart contract can be a strategy to handle that challenges and boost sukuk industry.  It would eliminate the need for intermediaries and simplify documentation and compliance checks through smart contract integration, reducing cost and time. Blockchain will also build strong trust relations between issuers and investors as it enhances transparency and eliminates any chance of fraud or speculation in sukuk transactions.

Smart Sukuk eliminates several elements and parties in conventional sukuk such as trustee, registrar, paying agent, calculation agent, arranger, listing agent, transfer agent, security depository. The existing smart sukuk runs on the Ethereum blockchain, which supports smart contract. In this system, smart contract in sukuk encodes business rules directly into the underlying payment currency itself (Figure 1). The blockchain enforces the contract rules regarding payments and transfer of ownership4. This innovation is estimated to reduce costs by 50-70%. The platforms allow for instantaneous clearing and transaction settlement means that sukuk trades could take 30 second instead of five days.

Figure 1. Smart Sukuk Mechanism
Source: Author, adapted from Blossom Finance

Blossom Finance Fintech has replaced the conventional sukuk trading with blockchain essentially. So all the calculating, paying and transferability of the sukuk trading, including primary placement and secondary market trading will happen via the blockchain system. Users who are comfortable using cryptocurrency directly can fund their investments using Ethereum as well, provided they meet the investing criteria5.

2. Takaful

The main advantages of implementing blockchain are efficiency and transparency. Verification of customer data in the process and settlement of claims through the blockchain system is very helpful for takaful companies in increasing efficiency. The smart contract system will reduce administrative costs in running takaful contracts because everything is done automatically. The process of paying premiums and claims will also be faster without taking long. The blockchain system can reduce the claim process from days to just a few minutes6. This technology will also reduce the additional costs required to handle the claims process by at least 30%. The smart contract system will increase the transparency of takaful companies through automatic verification of data and sharing it with all parties involved so that the possibility of misuse will be smaller. Smart contracts will also improve the service quality of takaful companies, customers will be greatly facilitated from submitting takaful applications to claim payment processes. With all these advantages, it is hoped that it will increase the competitiveness of the insurance industry, which is currently still very small compared to other industries such as banking.

Figure 2. Takaful Mechanism with Smart Contract
Source: Author

Takaful blockchain has a scheme that connects customers, takaful companies, and related partners such as health service providers. First of all, prospective customers will register for takaful with the company through a smart contract that has been built. Then, with the same platform, takaful companies will collect data related to prospective customers, including for example medical records obtained from health service providers. If all the required data has been collected and has gone through the underwriting process from the takaful operator, the system can approve the customer's takaful registration. After getting approval, the customer will send a certain amount of funds as a premium via the blockchain to the company. The company will get income from premiums in the form of wakalah fees. The collected funds will be invested by the takaful company so that it can generate some profit. In the general takaful type (for non-individual objects), profits will also be included in the tabarru' fund which will be used for claim payments, while in the family takaful type (individual objects), investment profits will be channeled directly to customers with a certain percentage. Performance fees can also be obtained by takaful operators as an incentive for their performance in investing customer funds. If there are a number of claims submitted by customers, the payment of these claims can be directly transacted via the blockchain.

3. Islamic Social Funds  (Zakat and Waqf)

The absence of transparency and accountability of financial reports is an obstacle in the management of zakat and waqf7, 8. Philanthropic institutions whose sources of income include collecting money from the public, on the other hand, must own accountability as a very significant thing. In social funds management, the purpose of blockchain implementation is to create a single data source, a database/system that everyone can rely on. Contributors such as muzaki and wakif will find it easier to access and supervise the distribution of their social money if smart contracts are used. Furthermore, public confidence in the amil and nazhir will improve. Zakat and waqf institutions do not require costly monitoring audit costs, and a simple monitoring system will benefit zakat and waqf supervisory agencies. This technology increases transparency to the system by allowing donors to track their donations using blockchain traceability and receive notifications when they reach their intended recipients (Figure 3)9. Furthermore, by speeding the value and receipt of funds, the zakat and waqf system with blockchain has enormous potential.

Figure 3. Framework of Blockchain system in Islamic Social Funds Management
Sumber : (Farooq et al., 2020)

In a nutshell, the advantages of the blockchain system could benefit Islamic financial system, especially in the transaction of sukuk, takaful and social funds. Smart contract would increase the efficiency and accountability of these Islamic financial instruments. For the implementation of this technology, on the other hand, Islamic financial institutions have to guarantee the shariah compliance aspect of all processes.