First, about SmartCredit.io – SmartCredit.io has been at the forefront of DeFi for 5 years. It offers P2P DeFi solutions as opposed to Peer-to-Pool-to-Peer (P2P2P) solutions.
The main reason is that P2P2P is a much more regulated activity than P2P. P2P2P means pooling assets, and this is a heavily regulated financial activity that usually requires a banking license.
P2P (like SmartCredit.io ) is a much less regulated activity because P2P is a marketplace where borrowers and lenders meet.
However, there is one more advantage of P2P—the P2P systems allow one to enter Islamic banking, which other Web3 companies that follow the P2P2P paradigm cannot do.
This also means that the traditional DeFi cannot serve Islamic Finance. This means that Web3 Finance is split into two clusters:
- Web3 Decentral FInance, utilizing the P2P2P paradigm
- Web3 Islamic Finance, utilizing the P2P paradigm
This article analyzes both clusters.
What is DeFi?
DeFi is decentralized finance in which users control their assets via their wallets. The difference between central finance and DeFI is that DeFI is self-custodial—DeFi providers cannot access users’ private keys, and only wallet owners (private key owners) can trigger the transactions.
DeFi emerged with:
- Decentral Borrow/Lend systems
- Decentral Exchange systems
Decentral Borrow/Lend uses Money Market concepts, where lenders pool their assets together. An oversimplified utility function sets the interest rate automatically. The interest is then shared between the lenders and the platform.
Because of asset pooling, these are P2P2P systems—every user interacts with the pool. Borrowers borrow from the pool, and lenders add funds to the pool.
Decentral Exchanges (DEXs) use Automated Market Maker systems. These are not order book systems but pooling-based systems. But what about the price? The price is set with a simple hyperbolic function—there will always be a price; it’s the position on the respective hyperbolic function.
But again, DEXs do asset pooling. They pool the assets of the liquidity providers, and the liquidity providers get a part of the revenues. This means assets are pooled, and interest is paid to the asset providers.
In both cases, we do have:
- Asset pooling
- Asset providers receive payments (interest) on their assets.
From one side, this means—regulatory speaking—creating a securities product that must be registered in any jurisdiction where it is marketed.
On the other hand, these products cannot be used for Islamic Finance because of the asset pooling.
What is Islamic Finance?
Islamic Finance is Sharia-compliant banking; it sets many limitations to the typical “Western” banking. The most known limitations are:
- It is P2P – asset pooling is not allowed
- The lender has to bear the risk, i.e., no return without the risk
- Interest is not allowed
While “Westerners” are used to their style of banking, a blossoming parallel ecosystem of Islamic banking serves more than one billion people.
However, until now, there have been no Web3 solutions to this blossoming ecosystem. This means the Islamic population is not using the usual DeFi borrowing/lending solutions because of non-compliance.
This means Web3’s reach and impact could be much higher if Islamic Finance were included. However, Web3 DeFi cannot be used for Islamic Finance.
Why DeFi cannot serve Islamic Finance today?
Islamic Finance requires P2P (peer-to-peer) systems. However, today, DeFI lending/borrowing is built on P2P2P (peer-to-pool-to-peer) systems. This P2P2P architecture is not suitable for Islamic Finance.
Islamic Finance requires the source of the funds to be known. However, pooling the assets on the lender’s side means no single individual can be identified.
We saw earlier that interest is not allowed in Islamic banking. Plus, both the lender and borrower have to share the risk.
A summary – here are the key reasons why DeFI cannot serve Islamic finance today:
- P2P systems instead of peer-to-pool-to-peer systems are required
- Interest is not allowed in the Islamic Banking
- The lender has to share risk in the Islamic Banking
These criteria imply that none of the DeFI systems can be used for Islamic Banking today.
What is required for Islamic Finance?
Let’s dive in:
Interest is not allowed in Islamic Finance. However, a service fee can be included. This means the service fee is charged to the borrowers instead of charging interest.
The loan transactions will be structured as sell-and-buy-back transactions. The borrowers sell their assets at a discount to the lenders (that’s the loan), and later, they buy back the assets at the pre-agreed price (the loan payment). If the borrower decides not to pay, the lender will keep the asset, which they bought at a discount.
Special rules can protect lenders—lenders buy borrowers’ assets at a discount, and later, borrowers can buy back their assets at the predetermined discount rate. But what happens when the asset price sinks below the predetermined discount rate? In this case, the contract is terminated, and the asset ownership is transferred to the lender.
In Islamic banking, the lender has to share risk because there should be no return without sharing the risk. However, a Loss Provision Fund can be established to cover unexpected risks. For example, a small part of every borrower’s service fee would be allocated to the Loss Provision Fund, which would cover unplanned expenses.
The interest rates change to the discount rate differences—the borrower first sells his asset at the discount rate R1 and then repurchases it at the discount rate R2. The difference between R1 and R2 is the borrower’s interest rate.
The borrower should know from whom the funds are coming, and the lender should know to whom the funds are going. Asset pooling is now allowed, and peer-to-peer (P2P) is required.
What does this mean?
This means that Islamic Finance needs to be implemented as a P2P system, with an automated or manual interest rate setting system, a service fee system, a Loss Provision Fund to balance potential losses, and a liquidation system if the borrower decides to terminate the loan.
What’s required for the success of Web3 Finance?
Our analysis showed that traditional DeFi does not match the requirements of Islamic Finance.
At the same time, there is a vast underserved market for Islamic finance.
We propose to split Web3 Finance into two clusters:
- Traditional DeFI with the AMMs and Money Markets, which pool the assets
- Islamic Finance, which is strictly P2P and where assets are not pooled
This means we propose “Web3 Finance = DeFi + Islamic Finance.”
Today, we have “Web3 Finance = DeFi,” which does not enable the very interested Web3 enthusiasts in Islamic Countries.
In the future, we need to add “Islamic Finance” to this formula, which would trigger massive growth in Web3 Finance!
Additional Information
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