The Main Financial Instruments

The Main Financial Instruments
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today 24th December 2014

The Main Financial Instruments

The Islamic finance industry has developed a wide range of Shari’ah-compliant financial products. To ensure that they meet this specification, they make use of contracts acceptable under traditional Islamic legal doctrine and also adapt conventional financial contracts so that they comply with the tenets of the Shari’ah.

There are two main types of product: profit and loss sharing instruments (PLS) and mark-up contracts; and financial certificates that are similar to bonds, which are known as sukuk. For some instruments, there is an open discussion as to whether they are Shari’ah-compliant.

Profit and Loss-Sharing Contracts – Musharakah and Mudarabah

Islamic doctrine considers PLS contracts to be closer to the dictates of the Shari’ah. Being based on risk participation, they are not only halal (Shari’ah-compliant), but also preferable to other types of contracts. The most used contracts are those of medieval origin, namely those involving mudarabah and musharakah.

The musharakah contract was used in the Middle Ages to facilitate the joint ownership of property (sharika al-milk) or of a commercial enterprise (sharikat al-’aqd). It is a contract in which two parties agree on the capital shares that both confer to a project. Both parties are involved in the implementation and management of the project and profits are divided according to the terms agreed in the contract. Meanwhile, losses are allocated in proportion to the capital contributed.

Under a mudarabah contract, the owner of capital (rabb al-mal; the bank or the customer) gives money to the applicant (mudarib; the entrepreneur or the bank in the case of indirect financing), who is committed to managing the amount given with a view towards making a profit. This, in turn, will be divided between the parties on a percentage basis, as specified in the contract: it is a share of total income and, as such, no fi xed sum. The same operation can also be used for indirect financing: the agent who has received the capital can conclude a mudarabah contract with a third party that will then invest it in productive activities (double-tier mudarabah). Mudarabah contracts are commonly used for the management of mutual funds and the structuring of sukuk.

The difference between the two types of contracts is that, under a mudarabah contract, capital is wholly given by the bank, which also pays for losses, whereas, with a musharakah contract, both parties participate financially in the project. Moreover, in the former case, the management of the project is in the sole responsibility of the mudarib, while it is shared in the latter case. In addition, the assets purchased with the investment remain the property of the bank under a mudarabah contract, while their ownership is shared in the case of a musharakah contract. In practice, the use of a musharakah contract is limited because it is, by nature, a long-term instrument, while most of the deposits collected by Islamic banks have a short-term maturity. Its limited diffusion is also partly due to the lack of support shown by small businesses, which are reluctant to have external interference in their business management. Both of these tools are suitable for financing joint ventures and also for project financing.

Indirect Participation or Mark-Up Contracts – Murabahah and Ijarah

There are also forms of non-participatory financing (these do not involve any PLS), which are most often used in practice, particularly for consumer credit and short and medium-term financing: the most popular involve murabahah (sale term) and ijarah (leasing) contracts.

Contracts of this type, which are also known as “trade-based” or “asset-based” contracts, entail a fee or a mark-up on the price of the goods that are bought with the funds supplied. In this case, the remuneration does not explicitly refer to the temporal dimension and is thus considered the compensation for a commercial service (in the case of a murabahah contract) or for the use of a good (in the case of an ijarah contract). However, the cash flows generated by the contract tend, in fact, to replicate those that are typical of a conventional bank loan.

These operations are also generally associated with indirect forms of collateral, such as the ownership of the goods underlying the transaction. The murabahah contract is the one most commonly used. Under this, one party buys an asset and sells it to the other party at a higher price, which is agreed upon conclusion of the contract and is payable at the end. The following contracts are also similar:

  • bay ’al-mu’ajjal – instant sale of an asset in return for the payment of money (made in full or by instalments) at a future date;
  • bay ’al-salam – deferred sale of an asset with an immediate payment of the price involved;
  • bay ’al-istisna’ – similar to the bay ‘al-salam contract, but involving a different object (industrial goods that have not yet been completed);
  • commodity murabahah (or tawarruq) – the customer enters into a murabahah transaction with a bank, requesting it to purchase a particular commodity (e.g. metals).

In the other common type of non-PLS contract, i.e. the ijarah (leasing) contract, a party (usually the bank) purchases an item and leases it to the other party (the client).

Under Islamic law, the lease is equivalent to the sale of the right to use the good against the payment of a fee, set at the time the contract is concluded and related to the way the good will be used (thus, the gain of the bank takes into account the results achieved by using the leased asset). The seller and the buyer must agree on the mark-up. The object of the contract must have a real usage and the user must be able to benefit from it. Ownership of the underlying asset remains with the bank: this bears the risk associated with lending goods for the duration of the contract. Some types of ijarah contract (e.g. the ijarah waiqtina contract) include the right of final purchase and allow for the transfer of ownership of the product.

Finally, there is also financing free of charge (qard hasan), which is intended for individuals or companies in financial difficulties, and is merely a form of charity.

Sukuk

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines “sukuk” as certificates of equal value representing undivided shares related to the ownership (and not debt) of tangible assets, usufruct and services or to the ownership of the assets of particular projects or a special investment activity, extending even to contractual rights, which are held in trust for sukuk-holders. To be Shari’ah-complaint, sukuk must be capable of being owned and sold legally, in accordance with the rules of the Shari’ah.

In recent years, Islamic investors with a clear preference for investments that use funds consistent with their religious beliefs have increasingly subscribed to sukuk issuances. In fact, the growing preference for Shari’ah-compliant investments among Muslim populations has been a key growth driver for the global sukuk market and for Islamic fi nance as a whole and has been translated into the development of fully fledged institutions, such as Islamic banks, Islamic insurance operators and Islamic fund managers.

Angela Di Maria, European Central Bank Islamic Finance in Europe

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  • Habibur Rahman Masud

    nice