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“Deposits in Islamic Accounts have been growing 10 per cent per annum over the past 10 years, and now total USD175bn.”
“Islamic finance has become a major global industry with over 300 institutions involved in both Muslim and non-Muslim countries and international financial markets. Assets managed in accordance with Islamic law are worth over USD200bn.”
‘Islamic Finance – Innovation and Growth’, Euromoney Books
As these quotes show, Islamic finance is becoming increasingly important in the world economy. This article provides an introduction to the basic principle of Islamic finance and the development of new Islamic financial products in the last two decades, and seeks to consider where Islamic finance goes from here.
Basis for Islamic finance
Although it may seem obvious, it can often be overlooked by many of its practitioners that the basis of Islamic finance is the religion of Islam, submission to one God. Such submission, for the believer, requires adherence to the divine rules and rules derived from the interpretation of divine sources, in every aspect of his or her life including in the financial sphere.
Broadly, the sources of Islamic law (the Shari’ah) to which a believer must adhere are four:
- The Holy Quran – the literal word of God as revealed to his final Messenger, the Prophet Muhammad (may peace and blessings be upon him).
- The Sunnah of the Prophet Muhammad (may peace and blessings be upon him) – the actions and sayings of the Prophet Muhammad (may peace and blessings be upon him) as authentically reported in hadith.
- The Ijma – the consensus of opinion which scholars have reached by interpreting the divine texts (the Quran and the Sunnah). On some issues there may be complete consensus of all scholars and on such issues no deviation is permitted. On other issues, including many in the field of Islamic finance, the consensus my be less far reaching and there may be different, but equally valid, positions which can be taken.
- Qiyas – Qiyas is the process of analogical reasoning from a known injunction to a new injunction. According to this method, the ruling of the Quran and Sunnah may be extended to a new issue provided that the precedent (asl) and the new issue (fara’a) share the same operative or effective cause (aillah). The aillah is the specific set of circumstances that trigger a certain law into action. Qiyas often forms the basis of Islamic rulings made on modern day Islamic financial products.
Islamic finance has in recent times been developed as a response to specific prohibitions provided for in Islamic law. These prohibitions are agreed upon by the scholars and derived from specific verses in the Quran or specific authentic hadith:
- Interest, riba, usury and the like – the Shari’ah abhors the concept of money on its own making money. Therefore, interest, riba, usury and the like are prohibited. Allah the most high says, “Those who devour usury will not stand except as stand one whom the Evil one by his touch hath driven to madness. That is because they say: ‘Trade is like usury,’ but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (the offence) are companions of the Fire: They will abide therein (for ever).” (the Quran, Surah Al-Baqara, verse 275).
- Gharar or uncertainty – it is authentically reported from the Sunnah that the Messenger of Allah (may peace and blessings be upon him) forbade uncertainty; for example, the Prophet (may peace and blessings be upon him) said, “Whoever buys foodstuffs, let he not sell them until he has possession of them” (reported in the hadith collection of Bukahri).
- Gambling or speculation (maysir) – the Shari’ah prohibits speculation. The prohibited speculation under the Shari’ah is not general commercial speculation, which is normally evident in most commercial transactions. Rather, it is one involving an effortless gain similar to a gambling scheme or activity. Allah the most high says, “O ye who believe! Intoxicants and gambling, (dedication of) stones, and (divination by) arrows, are an abomination, of Satan's handwork: eschew such (abomination), that ye may prosper.” (the Quran, Surah Al-Maeda, verse 90).
The response of these involved in the Islamic finance industry to these prohibitions has been to develop so called ‘Islamic’ alternatives to ‘conventional’ financial products (i.e. those financial products involving interest, uncertainty and/or speculation). The most important and commonly used of these modern Islamic financial products are outlined below.
Modern Islamic financial products
- Ijara. This encompasses the leasing of machinery, equipment, buildings and other capital assets. The financial institution will purchase the asset in question and lease it to the ultimate customer for an agreed rental which may be fixed in advance or determined by a pre-agreed and certain formula. Often the ijara will be accompanied by a raft of other documentation including: the purchase agreement by which the financial institution purchases the asset; a service agreement by which the lessee is appointed to maintain and insure the asset; and, in the case of a financial lease (ijara wa iqtina), undertakings under which the asset is sold to the lessee at the end of the lease.
- Mudarabah (participation or trust financing). This arrangement involves two parties, the managing trustee (Mudarib) and the beneficial owner (Rab al Maal). Where mudarabah is used as a method of financing, the financial institution will provide funds to the customer who then acts as Mudarib. The Mudarib will retain a fixed percentage of the profits. The Islamic financial institution’s reward is a fixed share in the balance of the revenue generated by the investments. There is no guarantee that the Islamic financial institution’s investment will be returned or that a profit will be generated.
- Musharakah (equity financing). This is very similar to the mudarabah contract, except that the customer puts up part of the equity. The Islamic financial institution and the customer provide financing for a specified project in agreed proportions. All parties have the right to participate in the project but the parties also have the right to waive such rights. Furthermore, in the event of loss, both parties will bear the losses in proportion to their participation. Profits and losses are shared in direct proportion to the respective contributions of the participants. The Islamic financial institution may receive an agreed management fee.
- Murabaha (cost-plus profit financing). The murabaha technique is used extensively to facilitate the trade finance activities of Islamic financial institutions. The financial institution purchases and takes title to the necessary equipment or goods from a third party (either directly or through an agent). The financial institution then sells on the equipment or goods to its customer at cost plus profit. All of the above contracts are undertaken at the request of the customer. Deferred payment terms may be agreed and the arrangement may be secured. Such arrangements are not considered to be contrary to Shari’ah law as, by taking title to the equipment or goods, the bank is assuming a risk and engaging in a sale transaction which entitles it to profit. As the price of the equipment or goods is fixed, the customer is not affected by fluctuations in the base lending rate.
Other forms of modern Islamic financial products include:
- Bai al-Salam (payment for future delivery) which in its simplest form is the advance payment in full of the purchase price by the purchaser for specified assets which the seller undertakes to supply to the purchaser at a later date; and
- Istisna’a (construction financing) where the financial institution funds the manufacturer during the construction of the asset, acquires title to that asset on completion and immediately passes title to the developer on agreed deferred payment terms.
A variation on istisna’a is often used in project financing where the financial institution takes title and delivery of the asset and leases the asset to the developer under an ijara wa iqtina.
An important development in terms of increasing the liquidity of the Islamic financial markets has been the development of sukuk. Sukuk has often been misleadingly referred to as an ‘Islamic bond’. In fact, whereas a bond is a commercial paper which evidences a debt, a sukuk provides the subscriber with ownership or part ownership in an underlying asset (evidenced in the form of a sukuk certificate which may or may not be tradable). Thus sukuk holders receive a return based upon the performance of that asset, whether that return is from lease payments (as in the cases of an ijara sukuk), or payments under contracts which the sukuk special purpose company has invested as part of a musharaka (partnership), to name but a few examples of how a sukuk might be structured.
The development of sukuk provides an indication of where the Islamic finance market is heading. From relatively simple lease-based sukuk the market has developed, in response to demand from customers and institutional investors, ever more complicated structures involving a diverse range of assets. For example, in 2006 the Saudi Arabian petrochemicals company, Saudi Basic Industries Corporation (Sabic) launched a groundbreaking sukuk in which the investors’ return is derived from marketing contracts, a share of which for a specified period of time (20 years) were brought from Sabic by the sukuk holders. The sukuk is structured so as to provide that the marketing contracts will revert back to Sabic at the expiry of the sukuk, and so as to encourage the sukuk holders to reduce their interests in the marketing contracts at certain times earlier than the expiry date of the sukuk.
The Sabic sukuk was the first sukuk to be approved by the Shari’ah board of a Saudi Arabian bank and under the listing rules of the Capital Markets Authority. The acceptability of such structures to Saudi Shari’ah boards is particularly important as Saudi Arabia is perceived to have the strictest interpretation of Islamic law. Thus it is commonly assumed that transaction structures which are acceptable to Shari’ah scholars in Saudi Arabia are likely to be acceptable in other areas of the Muslim world, whereas the lack of complete consensus among Shari’>ah scholars in many areas of Islamic finance makes the opposite less likely to be the case.
Islamic alternatives to derivatives
Islamic finance has also developed alternatives to ‘conventional’ derivative instruments such as futures, swaps and options.
Futures and forwards
So-called ‘Islamic’ products which aim to achieve a similar effect to ‘conventional’ derivative products are often controversial and, for the most part, have not been perceived as being acceptable in many parts of the Muslim world, particularly in the more conservative GCC markets. Bai Salam (payment for future delivery) contracts have, for example, been used to achieve the same result as futures. However, the historical intention and rational for the permissibility of Bai Salam, as an exception to the general Shari’ah principal that a promise to do something in the future is not binding and that sale can only be of goods that exist at the time of sale, is based upon the premise that you will obtain possession of pre-identified goods, not currency, at a point in the future for your upfront payment. It has been pointed out that with futures and forwards this is often not the real intention of the contracting parties, that the subject of the future/forward will be money rather than assets and, furthermore, often both the payment and the purchase will be deferred, which is not permissible (in the view of most scholars) under Islamic law.
Nevertheless, it seems that these objections may be overcome where the subject of the future is goods rather than money. It has been reported that Dubai-based Mashreqbank is structuring an Islamic energy futures contract for trading on Dubai’s new energy bourse during 2007. The contract will be based on Bai Salam, and involve the sale of commodities at a future date for a spot payment. The development of a workable Islamic futures contract would open up a new, short-term avenue for Islamic financial institutions to invest depositors’ money, in an area where there is currently a shortage of suitable instruments. Similarly Islamic financial institutions and Shari’ah scholars have been working on creating an Islamically acceptable form of options.
Options
The first problem with the standard option contract from a Shari’ah perspective is the uncertainty that exists with regard to whether or not the option will be exercised. The second problem is that if the option contract is judged to be permissible, the question then arises as to whether that option can itself be sold to a third party, as is the case in the market for warrants for example. Thirdly, Shari’ah scholars have agreed that selling what one does not own is a prohibited commercial activity, and the possibility that such an activitiy can be synthesised through the use of options also calls into question their validity under Islamic law.
There is a fourth problem, that options may be seen as a form of unlawful speculation. Under the Islamic concept of bay al-urban, a deposit is paid on an item that a prospective buyer may purchase at a later time. Should the buyer not complete the purchase, the deposit is lost. This contract has been used as a justification for Islamic options by some writers who argue that the deposit can be seen as the premium paid by the buyer of a call option. The problem is that Shari’ah scholars do not widely allow Bay al-urban.
An alternative framework is provided by khiyar, which is allowed by the Islamic scholars. Under this framework, the buyer of an item has the right to undo his purchase if the seller specifically allows this as part of the terms of the sale. This is, in other words, an option to cancel a previously agreed sale. All buyers have a right to cancel a sale following purchase but before leaving the presence of the seller (khiyar al-majlis). The seller may also expressly give to the buyer an option (bay al-khiyar), where the buyer may leave the presence of the seller for a specified period of time before returning to cancel the sale and take back the money that was paid.
Using khiyar to structure Islamic options does however present difficulties. The conventional option normally relates to an exchange that is yet to take place with future delivery applying to both the payment and the underlying asset, whereas in the case of khiyar the exchange of one or both counter values is effected immediately. The development of an Islamic law compliant version of an option is something we can expect to see further progress on in the coming few years.
Swaps
Swaps are another area in which Islamic finance has increasingly been developing capacity. Islamic financial institutions have been keen to develop structures in which they can swap both currency exchange and ‘profit’ risk. ‘Islamic’ swaps have been developed based on the principles of murabaha and ijara discussed previously in which two Islamic finance participants swap either a currency of profit rate risk through transactions which have underlying assets.
An example of this can be seen in the reported USD230m currency profit rate swap between Citibank Malaysia and Dubai Financial. In the world’s first cross-border Shari’ah-compliant foreign exchange hedge transaction, Citibank and Dubai Financial will undertake a series of commodities trades (i.e. murabaha transactions) in different currencies, with the hedge insulating the Citibank from variations in foreign exchange rates. We can expect to see further similar transactions as Islamic finance institutions seek more complex risk management instruments of a Shari’ah-compliant nature.
Opportunities and challenges
The opportunity for growth in the Islamic finance market is dependent upon two interlinked criteria: demand, and the ability of practitioners to develop new products which fall within what is permissible under Islamic law. Islamic finance, in order to grow and challenge so called ‘conventional finance’, must develop through the innovation of new products. This is however Islamic finance’s greatest challenge. The staggering growth of this market has, largely, been consumer led. The last couple of decades, despite the obvious difficulties Muslim communities have faced, have also seen a growing desire among many Muslims to return to the fundamentals of their faith along with growing economic empowerment. Such a trend is evident across the Muslim world, particularly in the oil-rich Middle East, and also among wealthy, young, professional Muslims living in Europe and the United States, many of whom have become key players driving the Islamic finance market.
Islamic finance must grow and innovate in order to meet the demand of consumers and clients, while bearing in mind that it is the fact that it is Islamic in nature which is the motivating factor behind both the sources of Islamic capital and the consumers of such capital. The development of Islamic finance, in the authors’ view, depends not just upon avoiding what has been prohibited by Islamic law but also in promoting Islamic values. In particular, an Islamic system of financing, and therefore Islamic financial products, should promote the values of fairness, justice, and equality. Islamic finance prohibits the idea of making money just by having money because it is fair that with reward also goes risk and partnership. Islam does not view as just a system where the debt of others is traded when the Quran calls for it to be forgiven as an act of charity.
The ‘Islamic’ financial products we have today are, for the most part, Shari’ah-compliant. The challenge now is to build on this and develop Shari’ah-based financial solutions to meet the needs of Muslims, and wider society. This means not just reworking conventional products but developing new products and solutions from a blank sheet based on Shari’ah principles. In some cases Islamic finance may have to say that some conventional products are simply not possible in an Islamic context. However, Islamic finance should be able to offer better thought-out alternatives; alternatives where the intention as well as the form is in accordance with the principals of Islam.
