Islamic Finance: Glossary

The fundamental principle of Islamic finance is that money has no intrinsic value. Shariah-compliant investments are structured on the exchange of ownership in tangible assets or services, with money simply acting as the payment mechanism to effect the transfer. The taking or receiving of interest (riba) is strictly prohibited as is speculation and uncertainty (gharar). Transactions involving certain products are also prohibited, including: pork, alcohol, armaments, gambling and conventional finance.

Globally, the Islamic finance industry is constantly evolving, and Sharia-compliant products and structures are being tested and re-examined to ensure they meet current economic demands as they are increasingly being applied to different instruments across various jurisdictions.

Typical Islamic Transaction Structures

Murabaha

Although it was not originally used as a method of providing finance, Murabaha arrangements are perhaps the most widely used Islamic financing technique at present. The Murabaha contract involves the trading of an asset between two parties where the seller of the asset discloses to the purchaser the original cost price of the asset. It is usually referred to as a ‘cost plus’ contract. The transfer of the asset under a Murabaha contract must be immediate (although the price payable by the purchaser is generally deferred). The introduction of deferred payment terms involves the provision of credit, and the profit markup of the seller is invariably benchmarked against a conventional index, such as LIBOR. A financial institution would typically acquire an asset from a vendor and immediately sell the asset on to the client. Although often referred to as a Murabaha contract (in the singular), the financing effect is actually achieved through the use of two separate contracts. The way in which they are executed must be carefully orchestrated to ensure compliance with Sharia.

Ijara

Ijara involves the act of leasing in which the owner of the asset transfers its manfa’a (usufruct or use and enjoyment of an asset) to another person to use for an agreed period and for an agreed rent. The subject of the lease should be valuable, identifiable and quantifiable. Anything which cannot be used without being consumed, cannot be leased (such as, for example, money or perishable food products). As title to the leased asset remains in the financier or lessor’s ownership, the lessor must bear all liabilities arising from its ownership. The period of the lease must be determined in clear terms and the lessee cannot use the leased asset for any purpose other than that contemplated by the lease agreement. The lessee or client’s use of the leased asset must also be Sharia-compliant. As with the purchase price payable under a Murabaha contract, the rent payable by a client under a lease is generally benchmarked against a conventional index such as LIBOR.

An Ijara contract can be either:

  • An operating lease where the client has a right of occupation.
  • A finance lease (Ijara wa iqtina or Ijara muntahia bittamleek) where the client has, in addition, the right to acquire title to the asset.

Mudharabah

Mudharabah is an investment management partnership, where one party provides funds, while the other provides expertise and management, also called the investment manager (mudarib). Any profits are shared between the two parties on a pre-agreed basis, while losses are borne by the provider of the capital. Mudharabah is a common structure for sukuk.

Musharakah

Musharakah is an investment partnership. In a typical musharaka agreement, two or more parties agree to provide capital towards the financing of a commercial venture, share profits according to a stipulated ratio, and share losses on the basis of equity participation.

Sukuk

Sukuk are often referred to as ‘Islamic bonds’, but unlike conventional bonds, sukuk are not debt obligations but represent a beneficial ownership interest in the underlying asset or activities which generate cash flows. Sukuk are financial instruments which sit above a Sharia-compliant underlying structure which generates revenue on behalf of the holder of the instrument. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has defined sukuk as certificates of equal value representing undivided shares in the ownership of:
  • Tangible assets, usufructs and services
  • The assets of particular projects or special investment activity

One of the Islamic financing techniques would typically be used as the underlying structure for a sukuk issuance.

The structure selected would depend on the:

  • Nature of the financing required (that is, whether it is required to finance the construction or acquisition of an asset, or for working capital purposes).
  • Types of assets available to the issuer (or obligor) for use in the Sharia structure

Obligors which have fixed and unencumbered tangible assets (such as land or equipment) would typically choose the ijara financing technique partly because it is straightforward and also because it is suitable for longterm financing. However, mudaraba, musharaka and wakala sukuk also gained popularity because they allowed sukuk to be issued without being wholly reliant on the existence of underlying tangible assets (as in the case of ijara-based sukuk) to generate a return for the sukuk-holders.

Asset-Based Sukuk

Most, but by no means all, sukuk issued to date fall into the category of asset-based instruments. This means that sukuk-holders have beneficial interests in the underlying assets. Payments to sukuk holders ultimately depend on the obligor’s own ability to meet those payments, rather than the value of the underlying asset. On a default, the principal remedy available to sukuk-holders would be to enforce the payment obligations of the obligor pursuant to a purchase undertaking which the obligor has granted in favour of the sukuk-holders to purchase the underlying assets. In the majority of sukuk issued, the price at which the underlying assets are purchased is fixed at the outset and does not depend on the market value of the assets. The terms of the sukuk also state that sukuk holders do not have recourse to the underlying assets to meet any shortfall in payments due to them. This therefore leaves sukuk-holders holding contractual rights against the obligor rather than proprietary rights against assets.

Asset-Backed Sukuk

A small number of sukuk issuances issued to date have been asset-backed,in which the returns due to sukuk-holders depend on the performance of the underlying assets. The sukuk-holders have recourse to the assets which they are able to sell or liquidate if the cash flow from the transaction is insufficient to meet payments due to them. They do not, however, have recourse against the obligor if there is any shortfall in cash flows because the assets fail to perform or fall in market value.

Types of Sukuk

  • Leased-based: Ijarah
  • Partnership-based: mudharabah and musharakah
  • Sale-based: murabaha and salam

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