Islamic Finance Concepts

April 29, 2024
min read

Islamic Finance - Basic Concepts

Islamic finance refers to financial services that comply with Shariah law, the Islamic religious law. Some key principles of Islamic finance include:

  • Prohibition of interest (Riba): Interest charges are forbidden. Income must be derived from permissible sources like trade, investment or asset rental.
  • Prohibition of speculation (Gharar): Transactions must be based on real underlying economic activity and associated risks. Speculation is forbidden.
  • Contracts relating to Gambling (Qimar)
  • Prohibition of investments in forbidden (Haram) sectors: Investments in sectors like alcohol, gambling, tobacco, weapons, etc. are not allowed.
  • Risk and profit/loss sharing: Gains and risks are shared between the parties involved in a financial transaction. This is unlike conventional finance where risks are transferred.
  • Asset-backing: Financial transactions must be backed by real assets or services that generate legitimate economic value. Money cannot be traded for money.

Islamic finance aims for fair distribution of risks, rewards and responsibilities within society. Promotion of equitable distribution of wealth is encouraged, and excessive inequality is discouraged. Some common Islamic finance instruments and contracts include:

  • Sukuk - Islamic bonds. Provide fixed income and comply with Shariah.
    • Note that sukuk is plural. The singular is sakk (but sukuk is often used to refer to both the singular and plural).
  • Murabahah - Cost plus finance. The seller discloses costs and a fixed profit margin is added. Provides financing for asset purchases.
  • Ijarah - Leasing. One party leases an asset to another party for a rental fee. Provides asset financing.
  • Mudarabah - Profit and loss sharing partnership. One party provides capital while the other provides expertise and management. Profits (or losses) are shared at a pre-agreed ratio.
  • Takaful - Islamic insurance. Risks and associated costs are shared between participants based on cooperation and mutual assistance.
  • Waqf - Religious endowments. Philanthropic foundations set up to serve public welfare and community development.
  • Islamic banking - Banking services based on Shariah principles like profit/loss sharing investment accounts and zero-interest loans.

Key Prohibitions under Islamic Finance

Prohibition of interest (Riba)

The prohibition of riba (interest) is one of the central tenants of Islamic finance. Riba refers to unjustified increase, excess or addition in financial transactions. In conventional finance, this is analogous to interest - where money grows over time without the owner putting in any effort or taking on any risk.

Some key reasons why riba/interest is prohibited in Shariah law:

  • 1. Money has no intrinsic value to generate more money by itself. Shariah recognizes money only as a medium of exchange, not as a commodity that can be bought and sold for profit in and of itself. When money generates more money over time without any effort, assets or risk, it is seen as unjustified by Islamic principles.
  • 2. Interest charges tend to favor the wealthy and exacerbate inequality in society over time. Those with money can lend it out at interest, while those without money pay for using it. This systematic transfer of wealth from the poor to the rich is seen as unjust.
  • 3. Interest charges introduce unnecessary intermediation in the economy. Money passes through financial institutions simply due to the time value of money, rather than financing any real economic activity or asset creation. This is seen as unproductive activity by Shariah standards.
  • 4. With interest, the capital owner no longer shares in the risks of economic activity. The borrower bears all the risk of loss, while the lender gains either way due to interest charges. Shariah promotes profit and loss sharing to align risks and rewards. Interest prevents this risk sharing.
  • 5. Interest results in undesirable focus on lending and borrowing purely due to the material benefit of interest charges over time rather than the productive investment of capital in the economy. Investments should be made based on fundamentals rather than interest incentives.Some alternative arrangements allowed under Shariah include:
    • Profit and loss sharing (PLS) methods like mudarabah and musharakah where risks and rewards are shared.
    • Trade-based sales like murabahah where a fixed profit amount is declared rather than interest.
    • Leasing arrangements (ijarah) where rental fees are charged for the use of an asset, but ownership remains with the lessor.
    • Islamic banking services based on PLS investment accounts and Shariah-compliant financing.

Prohibition on uncertainty (Gharar)

Gharar refers to excessive uncertainty, risk or speculation in contracts and transactions. It is prohibited under Shariah law because it can lead to dispute and unjustified loss. Some key rules around gharar include:

  • 1. Full disclosure: Contracting parties must have complete and transparent information regarding key terms like price, quantity, quality, delivery, etc. before entering into an agreement. Any ambiguity or obscurity (ladala) is forbidden.
  • 2. No speculative risks: Transactions must be based on assets or activities that generate legitimate economic value. Purely speculative risks where gain or loss depends predominantly on chance rather than inherent value are a form of gharar.
  • 3. Ownership and delivery: Sellers must actually own, possess and deliver the subject matter that they are selling before contracting to sell to another party. This prevents speculation on risky prospects that have not yet come to fruition.
  • 4. Unavoidable events: Normal commercial risks or uncontrollable external events (like natural disasters) do not fall under gharar and are acceptable. As long as parties act in good faith, events beyond their control can be excused. Gharar relates more to unnecessary uncertainty that parties introduce into their contracts and transactions.
  • 5. Excessive uncertainty: A level of ambiguity that would likely lead a reasonable person to dispute or reject a contract is considered excessive gharar. Normal market risks and uncertainties are acceptable, but open-ended speculation is not.

Some examples of prohibited gharar transactions include:

  • Short selling: Selling assets that the seller does not own in hopes of buying them later after prices have fallen. This introduces too much uncertainty around delivery and speculation.
  • Futures trading: Trading future contract units that do not exist yet based on committing to buy or sell at a future date. The subject matter (assets) and price are unknown, creating gharar.
  • Options trading: Selling the right to buy or sell an asset at a given price within a time window. Again, the trade is based on risky speculation rather than existing assets.
  • Many types of insurance: Especially where policyholders can receive large payouts grossly disproportionate to premiums paid in. The uncertainty this creates is seen as gharar by many scholars.
  • Selling fish in the sea or fruit on the trees: Where the subject matter does not yet exist or does not belong to the seller. Such uncertain delivery and risky speculation is prohibited under Shariah law.

Prohibition on gambling (Qimar)

Gambling or Qimar is prohibited under Shariah law because it involves excessive risk and uncertainty (gharar), as well as speculation rather than productive economic activity. Some specific types of gambling contracts that are forbidden include:

  • Maisir - Games of chance where one party wins at the expense of others without any productive economic activity involved. This includes things like lotteries, casinos, etc. Any game where monetary gain is generated based primarily on luck and chance rather than skill or effort would qualify as Maisir.
  • Mulamasa - This refers to speculative sales where the subject matter of the contract is intentionally obscured or unclear. The uncertainty casts doubt over key terms like price, quantity, quality or delivery of the item - yet parties still contract in hopes of making a speculative gain. This excessive risk and speculation makes such contracts tantamount to gambling.
  • Munabadha - This refers to speculative transactions where goods are sold before taking possession or control of them. Parties hope to sell on for a profit before the goods actually change hands. Again, the speculative nature and risk around ownership and delivery make this forbidden under Shariah law.
  • Hashah - A pebble game where monetary gain is determined primarily based on the outcome of how pebbles fall, rather than skill or effort. This kind of game of chance is prohibited as a form of gambling.
  • Laghar - Dicing for stakes. Gambling games where monetary gain or loss depends on how dice fall, rather than skill or productive activity. This is seen as a forbidden game of chance under Shariah law in general, the common element in all these prohibited contracts is excessive risk, uncertainty and speculation - where gain or loss is determined predominantly by chance rather than legitimate skill, effort or actual value creation. They are seen as a form of gambling because one party gains at the expense of others without investing skill or useful work. Money is seen as making money without a clear legitimate economic purpose.

Prohibition on forbidden activities (Haram)

Haram refers to forbidden activities and items according under Shariah law. Islamic finance prohibits investment in haram sectors and commodities. Some major prohibitions include:

  • Alcohol - Production, distribution and sale of alcoholic beverages is forbidden. Investing in companies that derive a substantial portion of revenue from alcohol is also haram.
  • Pork - Pig farming, distribution and sale of pork products is prohibited. Again, companies focused on this sector would be seen as haram investments.
  • Gambling - Gambling, casinos, lotteries and other games of chance that generate money from pure speculation are forbidden. This would exclude investments in gambling operations.
  • Weapons/Defence - While security and self-defence are accepted, manufacturing weapons of mass destruction or indiscriminate harm is seen as morally problematic by Shariah standards. Defence investments may be forbidden by some scholars.
  • Tobacco - Due to health issues and addictive nature of smoking, tobacco production and sale is prohibited. No investment would be allowed in tobacco companies according to majority opinion.
  • Adult Entertainment - Prostitution, pornography and related industries are considered immoral and haram under Islamic teachings. No investment or partnering would be possible in such sectors.
  • Riba - While not an industry in itself, riba refers to interest which is forbidden. Any investments or banks focused primarily on interest-based lending would be excluded. Partnerships with conventional banks may also be limited.
  • Gharar - Again, while not a distinct sector, excessive speculation and uncertainty are prohibited under Shariah. Investments that introduce gharar would be haram, such as highly leveraged hedge funds that engage mainly in speculative trading.
  • Non-Halal Products - Islam provides certain guidelines around food, cosmetics and other products that are permitted for consumption and use. Investments in companies focused on pork derivatives, alcoholic cosmetics or other non-halal items would be prohibited.

The prohibition on haram prevents Islamic investors and funds from partnering with or gaining exposure to forbidden commodities and activities. It aims to promote moral, ethical and socially responsible investment according to Islamic values.

Islamic Finance Structures

The main types of sukuk structures that comply with Shariah law include:

  • 1. Ijarah sukuk - This is based on an Ijarah contract, which refers to a lease agreement. In an Ijarah sukuk, the issuer sells certificates representing ownership of real assets to investors. The returns come from the lease payments from the asset. The ownership of the underlying asset remains with the investor until maturity.
    • From a Shariah perspective, in an ijarah sukuk structure the sukuk holders must acquire the ownership rights over the tangible assets, from a practical perspective this is often not possible because of legal impediments in most jurisdictions, such as the inability to register the immovable assets in the name of thousands of sukuk holders. As a result, under the ijarah sukuk structure, the SPV holds the tangible assets in trust for the sukuk holders. This means that the legal ownership of the tangible assets will remain with the SPV, and the sukuk holders merely acquire the beneficial ownership of the underlying tangible assets.
  • 2. Musharakah sukuk - This is based on a Musharakah contract, which is a joint partnership agreement. In a Musharakah sukuk, the issuer forms a joint-venture company with investors. All partners contribute capital, and profits/losses are shared according to a pre-agreed ratio. Ownership in the Musharakah venture and its assets are shared between the issuer and investors.
  • 3. Murabahah sukuk - This is based on a Murabahah contract, which refers to a sale where the seller discloses its cost and profit margin. In a Murabahah sukuk, the issuer buys an asset and sells it to investors on a deferred payment basis, with a fixed profit margin. Investors make money from the profit margin. Ownership of the asset remains with investors.
  • 4. Wakalah sukuk - This relies on a Wakalah contract, where one party authorizes another party to act on its behalf. In a Wakalah sukuk, investors appoint the issuer to invest their funds in Shariah-compliant investments. The issuer acts as an investment agent for a fee, and investors earn a return from the profits of the investments.
  • 5. Hybrid sukuk - These combine two or more of the above structures. Most sukuk issued today are hybrid sukuk, mixing elements of Ijarah, Wakalah and Murabahah contracts. They aim to provide flexibility to meet issuers' and investors' needs.Those are the primary forms of sukuk according to Shariah principles. The specific structure used will depend on the purpose and underlying assets involved in an issuance. But they must all comply with Islamic religious guidelines.

Sukuk al-Wakala (or Wakala sukuk)

Sukuk al-Wakala = Sukuk (financial certificate) where another party is entrusted to act on their behalf as agent (Wakeel), through a Wakala (agreement).

  • Principal (the investor) appoints agent Wakeel to invest funds provided by principal into a pool of assets or investments.
    • Wakeel lends its expertise and manages those investments on behalf of the principal for a particular duration, for an agreed upon profit return.
    • Principal and Wakeel enter into Wakala agreement, that governs the appointment of the Wakeel, Scope of Services, and Fees payable to the Wakeel.
  • Typically the Issuer will set up a SPV to act as the Sukuk issuer.
    • SPV enters into Wakala (agency) agreement with Wakeel (agent).
    • Wakeel invests Sukuk proceeds into a pool of Shariah-compliant instruments (see below section on different Shariah standards).
    • SPV holds the assets or investments in trust for the Sukuk holders who each own a proportionate interest in the assets in accordance with the value of their investment.
    • SPV receives a specified amount from the profits generated from the investments. The originator, as Wakeel, receives a fee for its investment management duties and any profits generated in excess of the specified amount.
    • SPV uses the amounts it receives to make periodic distribution payments to the Sukuk holders.

Traditionally also required to have linkage to underlying Tangible asset (e.g. commodities, vehicles, real estate etc). In other words, an Islamic finance transaction will typically involve the sale of an asset, the lease of an asset or a joint venture or partnership in an operation or new business venture.

  • In the Shariah Standard No. (17) on Investment Sukuk issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Sukuk is defined as “Certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activities.”
    • The AAOIFI standard (from the Middle East) is commonly seen as the “gold standard” that has the strictest requirements for Shariah-compliance. Specifically, it does not permit the proceeds from sukuk to be invested into intangible assets (such as shares of companies.
    • Under Malaysian Shariah standards, Intangible assets (i.e. investments into shares) are also permissible.
  • The main difference between the Mudaraba Sukuk structure and the Wakala Sukuk structure is in respect of the profit sharing mechanism. Unlike a Mudaraba, in which profit is divided between the Mudarib and Rab-al-Maal based on pre-agreed ratios (which are then passed on to the Investors), in the Wakala Sukuk structure, the principal and the wakeel agree upon a profit return to the investors. Any profit in excess of the agreed profit for the account of the principal will be retained by the wakeel as a performance incentive.
    • Mudaraba Sukuk structure often used for “equity-like” investments.
    • Wakala Sukuk structure often used for “bond-like” investments.

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