Food for Thought
Smart Contracts for Islamic Financial Transactions
Dr. Farrukh Habib
Contracts play a significant role in performing various transactions among ourselves. While dealing with other people, we need a contract to have a voluntary arrangement that is enforceable by law as a binding legal agreement. Through a contract, we can determine the explicit intention and expectations of the contracting parties. Traditional contracts are written, executed, concluded and enforced manually, and in the financial sector, in particular, we observe the delicate nature of financial transactions. Consequently, contracts for financial transactions are drafted cautiously, making them a highly sophisticated piece of work. Likewise, their execution is also carefully done.
Considering some other inevitable factors like fraud, manual processes, differences in jurisdictions, and time and space; the traditional financial contracts have many limitations because of its antiquated and inefficient processes. For example, according to a survey done by Markit in 2015, average settlement for a syndicated loan in the US takes more than 20 days; while in Europe, it takes around 48 days. FBI reported in 2016 that the total cost of non-health insurance fraud is more than USD40 billion per year. Australian Securities Exchange estimated in 2016 that end-to-end costs in Australian equity markets are USD4-5 billion. Ultimately, these costs are borne by the issuers of the securities and the end-users. These are some of the rising concerns with traditional financial contracts in the era of real-time commerce.
In trying to overcome the problems of traditional financial contracts, many experts worked on computerized programs that can work as contracts. Nick Szabo in the early ’90s worked along the same lines and reworked it for the next several years. He tossed the term “smart contracts” for such computer programs. His work described how it would be possible to establish, on the internet, contract law and related business practices through the design of electronic commerce protocols among contracting parties who are strangers to each other. Szabo describes smart contracts as:
“A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”
The idea of smart contracts was fascinating. However, due to issues like the absence of a viable platform, cybersecurity breaches, cross-border recognition, execution and enforcement of such computer algorithms as contracts, it did not get due recognition and was not considered a pragmatic solution.
However, when Bitcoin was created by Satoshi Nakamoto in 2009, it also introduced blockchain technology as the underlying platform of the Bitcoin system. In 2012, basic smart contract capabilities were successfully tested on blockchain. In 2014, various financial institutions set up their labs to develop Proofs-of-Concept (PoCs); and smart contracts solutions based on blockchain had started being introduced. In this way, blockchain technology opened the opportunity for smart contracts to play its long-awaited role.
With the present blockchain-based implementation, smart contracts are mostly used specifically for general purpose computation that takes place on a blockchain or distributed ledger. By definition:
“A smart contract is a computer program or algorithm that automatically executes when predefined conditions are met.”
The general objective of a smart contract is to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and enforcement), minimize both malicious and accidental exceptions, and minimize the need for trusted intermediaries. In this way, a smart contract can reduce fraud loss, arbitrations and enforcement costs, and other transaction costs.
There are two main factors which make it possible for smart contracts to run on a blockchain or distributed ledger technology platform. The first factor is the creation of Byzantine fault-tolerant algorithms that allow parties to anonymously form a consensus on a decentralized distributed network. At the same time, the decentralization feature ensures that the distributed network remains highly secured.
There is no single or official solution for Byzantine fault tolerance within a blockchain system. But various protocols have been developed to address this issue. For instance, Bitcoin solves this problem through Proof-of-Work (PoW) protocol; while the Ethereum network achieves consensus through Proof-of-Stake (PoS) protocol.
The second factor is the Turing-completeness of a blockchain system. Turing-complete is a term used to identify a computer or software that can solve any problem that a Turing machine can. In a layman’s term, this means that it can execute any algorithm. As a built-in feature, some blockchains make the creation of customized, sophisticated logic possible. This feature allows smart contracts to run on such blockchain systems.