Islamic finance transactions are based on Shariah (Islamic law).
For an Islamic finance structure to be Shariah compliant it cannot contain elements of riba (interest), gharar (uncertainty), maisir (gambling) or investment in prohibited industries such as alcohol, pork products, conventional finance and pornography.
Shariah deems money to have no intrinsic value – it is only a measure of value. Since money has no value itself, there should be no charge for its use. The exposure to risks over specific time periods justifies the earning of returns which could be in the form of profits, rental, fees or commission. The payment and receipt of interest and any obligation to pay interest is void. A financier must take a commercial risk to make a profit.
Uncertainty and gambling
Transactions involving uncertainty or uncontrollable risk leading to speculation are prohibited. This includes speculative trade in shares, short-selling or trading in unidentified items. Derivatives like futures contracts, options, swaps and forward foreign exchange transactions where the rates are determined by interest differentials and fluctuation in currencies are also prohibited.
Shariah does not prohibit general commercial speculation, but it does prohibit speculation similar to gambling (gaining something by chance rather than by productive effort). Conventional insurance is prohibited because it is uncertain whether an insured event will occur or not.
Types of contract
These are the basic forms of Shariah contracts:
- Murabaha (cost-plus sale) – An example would be a bank purchasing a tangible asset from a supplier with the resale based on the cost plus an agreed mark-up. This is usually used to finance property or an infrastructure project. The cost and mark-up must be fixed and disclosed to the buyer. There is no interest rate risk covered within the mark-up percentage.
- Ijara (leasing) – Ijara is where you lease an asset for a specific period and cost from a financier or bank, often with the intention of buying the asset. The financier bears all the risk and a portion of the instalment payment goes toward the final purchase of the asset at the time of transfer of the asset. This is similar to a secured loan and could be used in aircraft, ship or project financing.
- Musharakah (equity participation) – Musharakah is similar to a joint venture. Participants finance a project in agreed proportions in either cash or kind. They agree to a percentage of the returns and risk, sharing the profit and loss of a project in proportion to their investment. A participant providing management or technical expertise may also charge a fee (similar to mudaraba).
- Mudaraba (partnership financing) In mudaraba one party provides labour while the other provides capital. There would usually be an investor, and a manager who provides expertise and manages investor funds according to Shariah principles. Profits are distributed between investors based on agreed proportions. The manager charges a fee, which could be a proportion of the profits.
- Istisna’a (commissioned manufacture) – Istisna’a is a contract to produce a specific product that can be made under agreed specifications at a determined price and on a fixed date. Istisna’a is used to fund major industrial projects or ships and aircraft. A financier will fund a manufacturer directly and take title of the assets before selling or leasing the assets.
- Sukuk (bonds) – A sukuk is a negotiable certificate or note which represents a proportionate interest in tangible assets or a pool of tangible assets. It is the Shariah equivalent to a bond or debt instrument and provides access to Islamic debt capital markets. It is usually used in conjunction with ijara.
The basic types of Shariah contracts may be used in combination. The principles of certainty and freedom of contract (within the confines of Shariah) are hallmarks of Islamic finance.
The growth of Islamic finance provides opportunities for new commercial structures and access to untapped markets. Regulatory regimes for Islamic finance are well-developed in Malaysia and the Middle-East and are developing globally. Islamic finance transactions also provide all investors with alternative ways of participating in ethical forms of investment.