Eliminating Trust Issues in Islamic Interbank Monetary System by Blockchain Technology

Introduction

Banks need to hold liquidity (cash) for a given period for liquidity management or managing the asset and liability mismatch. To achieve this, banks borrow money from other banks via money markets. This incurs interest whereby the banks agree on a rate of interest depending on the maturity. This practice is prohibited in Islam.

In the case of Islamic Financial Institutions (IFIs), they collect deposits and raise funds from individuals or companies, and government bodies or private sectors, to finance the deficit. The deposits or liabilities of the bank are normally held on a short-term basis (Saiti et al., 2016). Furthermore, the money deposited in normal savings and current accounts can be withdrawn upon the customers’ demand. On the other hand, the financing or receivables which are recognised as assets will normally be for a longer term. The question that arises in this regard is how IFIs can manage the duration gap between its liabilities and assets?

In order to address this important issue, IFIs adopt several Islamic contracts such as partnership based (like Mudarabah and Musharakah), sale-based (Murabahah and Tawarruq) and service-based contracts (for example, wakalah). In the case of partnership contracts, Islamic banks agree on a predetermined profit-sharing ratio. The bank that accepts the funds agrees to pay some of its profit from its investments to the investee bank. For example, the Mudarabah Interbank Instrument (MII) is an instrument where the depositor is the rabbul-mal (capital provider or investor) while the counterparty is the mudarib or entrepreneur. The profit ratio will be predetermined by both parties, while the investor will bear losses. The tenure of MII ranges from as short as overnight up to a year. On maturity, the principal plus profit will be paid to the investor.

Bacha (2008) argues that there is an agency or incentive problem in this structure as it is to the receiving bank’s advantage to ‘declare’ a lower profit rate. To solve this problem, the Malaysian Central Bank (BNM) revised the rules by setting a minimum benchmark rate for the MII. With this revision, the minimum rate of return for the MII was set to equal the prevailing rate of the Government Investment Certificate (GIC) plus a spread of 0.5% (Bacha, 2008). The benchmark rate serves to ensure that only banks with reasonable rates of return participate in the MII. This approach reduces the uncertainty in the profit rate as it is calculated as follows:

• 1.

  The prevailing rate on the Government Investment Certificate (GIC) of the same tenor + 0.5% (annualised), if the declared profit is lower; or

• 2.

  The declared profit adjusted for PSR; if it is higher than the GIC + 0.5% annualised;

This practice is similar to the fixed interest rate in the conventional financial system, which may trigger several Shariah issues. For example, waqf is facing challenges in enhancing its governance structure to ensure Shariah compliance as well as economic efficiency. A potential alternative approach to address the Shariah compliance issues that arise from lending and borrowing in the Islamic interbank money market is blockchain technology. Abojeib and Habib (2019) examined the importance of such innovation in Islamic finance, particularly Islamic social finance. They argue that Islamic social finance is facing several challenges that could be solved by such innovations. In this chapter, we argue that blockchain technology is better able to address the issue of understating the profit or advantage to one party and propose how it overcomes the issue in the Islamic interbank money market. The remaining sections are organised as follows. Section 2 will explain blockchain technology, section 3 proposes how the blockchain technology overcomes the trust issue in the Islamic Interbank System and section 4 concludes the chapter.