To date, only a handful of financial institutions have used blockchain to issue conventional bonds and none to issue sukuk. Some market participants argue that blockchain was created a decade ago, but has not had much impact on the financial system. However, in our view, 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.

We have long believed that, at the very least, 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 (see "The Future Of Banking: Blockchain Can Reshape The Financial System," published Oct. 26, 2016, on RatingsDirect). Since blockchain technology enables the creation of a shared digital transaction ledger, banks can use it in their payment, trade finance, money transfer, and post-trade services. Having a real-time, standardized view of transaction data without needing multiple reconciliations would remove many of the inefficiencies that hinder the financial system, and could reduce costs
considerably.

A few small bond issuances have reportedly involved cryptocurrencies and the public Ethereum blockchain. Only Telefonica Deutschland and the World Bank have reportedly used blockchain to issue conventional bonds, the former to issue a €50 million debenture bond that was part of a €200 million offering placed in January 2018. The World Bank's use of the technology was for a two-year A$110 million offering in August 2018 that was created, allocated, transferred, and managed through its lifecycle via a distributed ledger. According to the bank, investors showed a strong appetite for the transaction, including official institutions, fund managers, and banks. So how might sukuk issuance benefit from blockchain?

Sukuk Cash Flows Should Become More Transparent

Sukuk are trust certificates issued by a special-purpose vehicle, and their proceeds are generally lent to a sponsor (corporate, financial institution, insurance company, sovereign, or local or regional government). Sukuk are issued for the purpose of raising funding according to Islamic principles (Sharia). As per these principles, sukuk issuance requires one or several underlying assets. Investors in sukuk transactions are remunerated via the contractual obligations of the sukuk sponsors, the performance of the underlying assets, or a combination of both. Most of the outstanding sukuk fall in the first category, since this method of remuneration mimics the characteristics of fixed-income products and attracts fixed-income investors.

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 we believe blockchain and smart contract protocols could make a difference. For example, in an Ijara transaction (similar to a lease), cash collection is relatively straightforward and depends on a single economic agent, the sponsor acting in its capacity as servicing agent. However, in complex transactions, such as when external parties lease the underlying assets, tracking cash flow movements may be more difficult. As a result, some stakeholders might question the Sharia compliance of such transactions if, for example, the sponsor goes beyond its contractual obligations and injects additional liquidity to avoid acceleration of repayment or default. 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. When we rate such sukuk, we consider the likelihood of total loss events. Our assessment could therefore change if the underlying assets change. We require issuers of rated sukuk to provide us with updates of underlying assets in a timely fashion to allow us to revise our assumptions if necessary. 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. This is one way that blockchain could reinforce the compliance of sukuk transactions with Sharia, minimizing the risk of default due to Sharia non-compliance.

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. One example is early-dissolution events, which generally include a default on one periodic distribution amount; the sponsor's breach of any covenants; or a total-loss event. Currently, the issuer or sponsor, through various transaction participants, notifies investors by electronic or non-electronic channels using the register of sukuk holders, which may not be up to date. The sukuk is then typically dissolved at the request of a certain percentage of sukuk holders in an extraordinary meeting (virtual or physical). The current process therefore not only lacks transparency vis-à-vis the market, but can also be inefficient.

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. It also means that information is available only to a few parties and can be used to interrupt payments to investors if that serves the interest of the party holding the information.

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. If, for example, one of the lessees of underlying assets in an Ijara sukuk does not pay on time, that information would be easily available since the block documenting this payment will be absent from the chain. As such, the sponsor can take corrective action more promptly.

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. 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.

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.

Related Research
- Why The Global Sukuk Market Is Stalling In 2018, June 19, 2018
- The Future Of banking: Islamic Finance Needs Standardization And Fintech To Boost Growth, April 16, 2018
- The Future Of Banking: Cryptocurrencies Will Need Some Rules To Change The Game, Feb. 19, 2018
- The Future Of Banking: Blockchain Can Reshape The Financial System, Oct. 26, 2016
- Glossary Of Islamic Finance Terms: August 2015 Update, Aug 10, 2015

This report does not constitute a rating action.
Source: www.spglobal.com/ratingsdirect October 24, 2018

Laurent Leloup
Fondateur Finyear (Finance Daily News)
Fondateur Chaineum (ICO & STO Advisory)
Auteur de "Blockchain, la révolution de la confiance"
Traducteur, conférencier.

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