This article first appeared in Personal Wealth, The Edge Malaysia Weekly on April 29, 2019 - May 5, 2019

Traditionally, it has been difficult for retail investors to access bonds and sukuk due to their high cost and huge lot sizes. But this is changing as more players are exploring the use of blockchain to increase access to the fixed-income space.

Matthew Martin, founder of microfinance investment fund Blossom Finance, is one of them. Earlier this year, he introduced SmartSukuk, the first blockchain-based sukuk, which microfinance institutions (MFIs) in Indonesia can access to raise funds.

“Our thesis is that this technology will make sukuk issuance much cheaper and simpler as well as more available to investors and issuers. We see microfinance as the perfect test case for that because MFIs typically cannot access the capital markets to raise funds. But broadly, this can be used for any shariah-compliant instrument,” says Martin.

The potential for blockchain to transform the bond and sukuk space was noted in an S&P Global Ratings report, The future of banking: Blockchain may be the sukuk industry’s missing link, last October. The rating agency wrote that blockchain and smart contract protocols could increase the transparency of cash flows and underlying assets, remove inefficiencies in the financial system and reduce costs.

The only other time blockchain has been used for sukuk issuance was last November. Abu Dhabi-based Al Hilal Bank announced that it used blockchain to sell and settle a small portion of its US$500 million five-year sukuk in the secondary market.

On the other hand, the World Bank created the first public bond to be managed using blockchain last August to test how the technology could transform the industry. According to Reuters, the prototype deal — managed by the Commonwealth Bank of Australia — was viewed as a step towards moving bond sales away from manual processes to faster and cheaper automation.

“On a broad level, blockchain is just a special type of computer. It is not as powerful as a smartphone, but it has several unique properties,” says Martin.

“First, it is available anywhere in the world with internet access. Second, the computer records any changes that are made in a ledger system that can never be altered. Third, no single person controls the computer.

“Fourth, blockchain is never offline because some computer is always running in some part of the world. Finally, you can transmit value through the computer even without knowing who is running the computer.”

The cost of issuing sukuk is high due to the many intermediaries involved. So, sukuk issuers prefer to offer larger lot sizes so they can recoup the fees paid to intermediaries. SmartSukuk’s advantage is that it can lower the cost of issuance, thus making small lot sizes more financially viable.

Martin thinks small lot sizes can also increase the liquidity of the sukuk market. “The interesting thing today is that the sukuk market is not that liquid because everyone hoards the good papers. We think introducing smaller-ticket papers that are truly profit sharing will create a genuinely more liquid instrument. We also have market makers who say they want to provide liquidity for our platform,” he says.

The mudarabah structure of some of the SmartSukuk is another factor that can improve liquidity, he adds.

Mudarabah is a profit-sharing contract. If there is a loss due to genuine business conditions, it is absorbed by investors. But if there is a loss due to fraud, breach of contract or bad faith, parties such as Blossom will litigate on behalf of the investors.

That also means the coupon payment is not fixed. Martin expects that some investors may want to sell their holdings when the payment drops during certain months. “But someone else is perfectly happy to pick them up, knowing that the target annualised return is still high. We anticipate that the variable monthly or quarterly profit sharing will increase trades because it is not a fixed rate,” he says.

If Blossom is able to create a secondary market, the trading lot size will be even smaller, he adds. “It can be as small as one rupiah. Imagine if you can trade a one-rupiah lot versus the RM5 million lot size that is very typical today. This will certainly enable trades to happen more frequently.”

Blossom will also offer sukuk based on istisna, which is a project and asset lease contract, and on murabahah, which is based on asset purchase.

Martin had a pre-launch of two sukuk in the first quarter of this year, one targeting traditional market sellers or micro-businesses and the other at a portfolio of MFIs.

In the last quarter, the minimum lot size was US$7,000. He hopes to reduce it to US$100 for future issuances. Currently, his blockchain structure is only used for sukuk that supports social impact investment opportunities through MFIs.

From blockchain-powered remittance to SmartSukuk

Martin launched Blossom Finance in Indonesia four years ago after observing the demand for funding from MFIs in the country. Global investors can invest in MFIs to support market vendors and micro-entrepreneurs who find it hard to get financing while reaping a return.

According to its website, the investments typically yield 6% to 8% per year, with the principal investment capital returned after 6 to 12 months. When Martin first started, he only used blockchain for remittance purposes.

“SmartSukuk was part of my plan when I started the company. I started with the thesis of using technology to increase the availability of Islamic finance tools for smaller-ticket projects and smaller businesses and corporations,” he says.

“Unfortunately, at the time, the technology did not fully exist. So, we started with a crowdfunding model to understand the Indonesian market, with the aim of eventually using smart contracts to make Islamic finance more efficient.”

His team spent 2016 and 2017 researching the smart contract technology necessary to support a SmartSukuk structure.

One way Martin is using blockchain to change the sukuk issuance process is by writing the rules of a sukuk-issuing document. The rules will be written using a computer programme running on blockchain in a smart contract.

For instance, in an ijarah-based sukuk (asset-based leasing), the assets are tokenised in the blockchain. The issuer then sells the tokenised assets to investors and leases them back until the maturity of the note.

“We can put all those terms for an ijarah-based sukuk into a smart contract. The benefit here is that once you put in those rules to a smart contract of any size, any money that transits through that sukuk is automatically distributed to the right people at the right time in the right amount. That is really a game changer,” says Martin.

Another key benefit is the interoperability of blockchain sukuk on a variety of global platforms that already support digital assets, he adds. “Since all of our SmartSukuk support the ERC20 standard, they are already compatible with a variety of custodial solutions and tradeable on a variety of secondary markets. This is an important step towards more efficient cross-border Islamic capital markets.”

The ERC20 is a technical standard for smart contracts on the ethereum blockchain.

Blossom will also use blockchain to record all transactions on the ledger. “SmartSukuk maintains a ledger system based on fiat currency. If the issuing currency is ringgit, then it will be a ringgit-denominated ledger system,” says Martin.

“When the investor puts money in, the currency briefly transits into cryptocurrency before it is paid out in local currency. That is quite important because it makes sure that all the balances of the coupon holders are automatically recorded and tracked.”

He adds that there is an algorithm in place to protect investors from any cryptocurrency volatility. “It only transits into cryptocurrency for a maximum of 30 seconds. The smart contract is set up so that as soon as the money comes in, it goes to an exchange and is converted into local currency at any time.”

This function removes the need for some of the intermediaries in the process, such as a registrar or paying agent, thus saving on costs. “I am not talking about eliminating the sophisticated lawyers or consultants who structure the sukuk. I am talking about the small financial and technology intermediaries,” says Martin.

“We replace them with blockchain essentially. So, all the calculating, paying and transferability of the sukuk trading, including primary placements and secondary market trading, will happen via blockchain technology.”

Users who are comfortable using cryptocurrencies directly can fund their investments using ethereum as well, provided they meet the investing criteria of Blossom.

Martin anticipates that most of the sukuk on the SmartSukuk platform will be unrated due to the small lot sizes. Currently, the company is in talks with agencies to rate some of the papers. But Blossom can still provide capital protection through a government takaful company in Indonesia. “In a way, the sukuk is rated by proxy because you are buying a sukuk with protection and the protection is rated,” he says.

According to Martin, the company has the support of the Indonesian central bank and financial services authority, which approved its operating model as a foreign company providing foreign loans in the country. “They love what we are doing because it is increasing access to financing for smaller corporations and businesses in a very transparent way,” he says.

Blossom Finance acts as the arranger of SmartSukuk deals by screening the MFIs and finding investors. “That may change for future deals. We are really a technology company and not a financier or an investment bank. I think in the future, you will see us working with other ecosystem players to broaden the reach of this technology,” says Martin.

Currently, the company is selectively listing investors who want to be part of the pilot. Only investors from US-sanctioned countries, US non-accredited investors and Indonesian investors are not allowed to use the platform. These restrictions are due to Blossom’s operating status in Indonesia.

Blossom’s advantage is that it can help foreign investors find good MFIs in the country to support. So far, it has selected about 300 MFIs to be in its network. Every three months, it reports the progress made by the beneficiaries of the MFIs to investors.

“The MFIs are really grassroots organisations. It is very difficult for them to work with foreign investors and conduct business in English to arrive at commercial terms. We are taking care of all that on behalf of the investor by finding the best partners and projects,” says Martin.

This is done by meeting the MFI management teams, doing risk assessments, creating a financial score and obtaining an accreditation score by a third party.

All the sukuk issued will be in line with the UN’s Sustainable Development Goals, which is a goal of Martin’s. He says the company is also exploring projects related to green energy, education and financing for women.

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