Islamic finance the core concepts

Islamic finance the core concepts

What is Islamic Finance?
At its broadest, Islamic finance covers all financial activity that enables Muslims to invest in conformity with Islamic law, or Sharia. In practice, Islamic finance involves using traditional investment techniques and structures that comply with Sharia to create arrangements that work in ways that are analogous to modern conventional finance.

Islamic banks and conventional banks that invest some of their capital in Islamic finance through an Islamic finance “window” have a religious board or committee composed of Sharia scholars (the Sharia committee). The Sharia committee examines proposed transactions and, in the case of Islamic banks, reviews the overall activities of the bank, for compliance with Sharia.

Key Principles
Key principles of Sharia relevant to finance transactions include:
Interest (Riba). Sharia regards money as simply a means of exchange, without intrinsic value and holds that money cannot be used to make money. Interest is the classic example of Riba. Payment or receipt of interest is strictly prohibited, and any obligation to pay interest is considered void under Sharia.

Speculation (Maisir). Sharia prohibits and treats as void transactions that rely on chance or speculation, rather than effort, to produce a return. This can create problems in relation to contracts that are seen as tantamount to gambling, which includes some conventional derivative transactions such as swaps, futures and options.

Uncertainty (Gharar). Sharia prohibits and treats as void contracts that are uncertain. All the fundamental terms of a contract (such as subject matter, price and time of delivery) must be absolutely certain at the outset.

Unjust enrichment/unfair exploitation. Sharia prohibits and treats as void contracts under which one party unfairly exploits the other or gains unjustly at their expense.

Unethical purpose. Sharia-compliant finance can be raised only for purposes that are permitted by Sharia and for the benefit of society.

Basic Transaction Structures
The main transaction structures used in Islamic finance are considered below.
In practice, commercial transactions will often combine a number of different techniques to produce the desired economic result and it is not uncommon for large fund-raisings (such as significant infrastructure projects) to incorporate both Sharia-compliant and conventional tranches.

Murabaha techniques are often used for trade finance and are analogous to conventional loans. Like conventional loans, they can be syndicated.

In a basic Murabaha, the financier buys an asset from a supplier and sells it to the customer at a premium. The purchase price is typically payable in installments. The premium is generally based on a benchmark figure, such as LIBOR, plus a margin. The economic effect is similar to a conventional asset finance facility.
Reverse Murabaha can be used where the customer requires a cash lump sum.
The customer buys an asset from the financier as in Murabaha but rather than retaining the asset for use in its business, the customer then sells it, either back to the original supplier or on to a third party.

It is possible to create a “revolving” reverse Murabaha, analogous to a conventional revolving loan facility (that is, a facility which allows a borrower to draw down, repay and re-borrow amounts throughout the life of the facility).
However, the methods for achieving this vary and the techniques are not universally accepted.

It is fundamental to Murabaha and reverse Murabaha arrangements that the financier actually acquires title to the asset in question, taking some commercial risk in relation to it. However, in practice this may be only for a very brief period.

Bai al Salam
Bai al Salam can be used to provide working capital. The key difference to Murabaha is that, while the financier still buys an asset, delivery is deferred.
Usually, the financier will receive a discount for advance payment, typically calculated by reference to a benchmark, such as LIBOR, plus a margin. Financier may at the same time enter into a parallel but separate Bai al Salam with a third party to resell the asset for an increased price (also calculated by reference to a conventional benchmark such as LIBOR), as illustrated in the diagram, or it may simply sell the asset on delivery.

Istisna’a is a technique similar to Bai al Salam and is used to provide advance funding for construction and development projects.

The key practical difference to Bai al Salam is that, instead of buying a finished asset with delivery deferred, the financier pays an amount to fund the manufacture, development, assembly, packaging or construction of an asset to an agreed specification. On completion, it will typically sell the asset to the customer or lease it back to the developer under an Ijara (see below).
The financier’s return usually takes the form of a premium on resale, typically calculated by reference to a benchmark, such as LIBOR, plus a margin.

An Ijara is a lease, often used to provide asset finance. In a financing context an Ijara is invariably preceded by an asset sale or Istisna’a.

In a simple financing Ijara, the financier buys an asset from a supplier and leases it to the customer. The customer pays rent representing an agreed profit, typically calculated using a benchmark, such as LIBOR, plus a margin.
One feature that distinguishes an Ijara from a conventional finance lease is the increased and ongoing risk the financier takes in relation to the asset. In an Ijara, the financier must take responsibility for insurance and major (as opposed to day to day) maintenance of the asset.

Mudaraba is an investment arrangement under which an investor or group of investors (Rab al Maal) place funds in the hands of a fund manager, usually a bank or financial institution (Mudareb), which provides expertise and manages the fund by investing in Sharia-compliant investments in return for a fee, typically based on a share of the profits.

In a commercial context, Mudaraba can be used as a tool to syndicate other Sharia-compliant financing arrangements (although conventional investment agency agreements are usually also Sharia-compliant). More commonly, Mudaraba is used to establish investment funds and Sharia-compliant retail bank accounts.

Musharaka is similar to a conventional partnership or joint venture and is often used in long-term investment projects.

The financier will usually contribute cash and the customer will contribute assets into a joint venture or enterprise. They share in the profits of the enterprise in agreed proportions but must share the losses in proportion to their initial investment. In a financing context, the profit-sharing arrangement is usually structured so that the financier receives his initial investment plus a return based on a benchmark, such as LIBOR, plus a margin.
A variation is the diminishing Musharaka, so called because the financier’s participation diminishes over time as the customer essentially buys out the financier’s share of the joint enterprise. Residential mortgages sometimes use structures that include a diminishing Musharaka.

Sukuk (singular Sakk) are financial instruments, such as certificates, that can be bought and sold on the capital markets.

Sukuk represent an undivided ownership share in an underlying asset or interest held by the issuer. This distinguishes them from both conventional bonds (which represent debt obligations of the issuer) and conventional equities (which represent ownership interests in the issuer itself).
The basic principle is that an ownership share in the underlying asset entitles the Sakuk holder to a proportionate share of the returns generated by the asset. The overall economic effect is similar to a conventional bond.
Sukuk are used in combination with other Sharia-compliant financing echniques to give rise to a Sharia-compliant return on an underlying asset.
Many different structures can be used for Sukuk, but Sukuk al Ijara and Sukuk al Musharaka are the most common.

Key features
In a typical structure, the entity looking to raise funds (the originator) will establish a special purpose vehicle (the issuer) in a suitable tax neutral jurisdiction. The originator will sell the underlying assets to the issuer, which will hold them under an English law trust in favor of the Sakk holders, to whom it issues certificates. The issuer funds the purchase of the assets with the issue proceeds.

While Sukuk are based on assets, the Sakk holder does not necessarily have any claim over the underlying assets in the event that the issuer fails to distribute the holder’s profit share: that will depend on whether the issuer’s obligations are secured on those assets in such a way that they can be made available to satisfy the holder’s claim in the event of the issuer’s default.

This is not typically the case, and the Sakk holder normally relies instead on an undertaking given by the originator to re-purchase the underlying assets at an agreed price on maturity or earlier in the event of default (the purchase undertaking).

This feature distinguishes the asset-based Sukuk that have been issued to date from the asset-backed securities issued by a conventional securitization vehicle. In practice, this means that, unless some additional credit enhancement element is included to improve the rating, Sukuk tend to have the same credit rating as the originator because repayment relies on the robustness of the purchase undertaking.
As might be expected, credit rating agencies do not verify Sharia compliance of rated Sukuk and do not take Sharia compliance into account as a relevant factor in rating Sukuk, unless non-compliance constitutes an event of default.

The terms and conditions of Sukuk are typically governed by English or New York law and are subject to the jurisdiction of the English or New York courts to help create legal certainty within the international financial community as to the nature and effect of the certificates.
However, in practice, some legal uncertainty can remain where judgment has to be enforced elsewhere (for example, in the jurisdiction in which the originator is domiciled). In addition, some of the underlying documents, such as sale and purchase agreements, may be governed by local law.

The Future
Sukuk issuance is the fastest-growing segment of the Islamic finance market and the volume out of the Middle East this year is expected to be phenomenal. However, the Islamic finance industry faces a number of challenges, including: Skills shortage. There are very few appropriately qualified Sharia scholars: it can take up to 30 years before a person is considered qualified, and there is no universal agreement on what makes a person “qualified” in this context.
No global consensus on Sharia. There is no international consensus on Sharia interpretations, especially in relation to innovative products. There are, however, some signs that the market may be settling.

Lack of standardization. Lack of consensus on Sharia, a high level of innovation and low transaction volumes mean that documents for the Islamic finance market (and the Sukuk market in particular) tend to be tailor-made for individual transactions, leading to much higher transaction costs than conventional finance alternatives. These costs should diminish as transaction volumes increase, and various industry bodies are taking steps to speed up the standardization process. Limited secondary market. Until very recently, there has been only a shallow and limited secondary market for Islamic finance products (again, Sukuk in particular) as most traditional investors have tended to hold their investments until maturity.

Need for assets. Much Sharia-compliant finance is assets-based, relying in some way on an income stream generated from assets. In practice, this can limit fund-raising to the assets available.

Restrictions on hedging. Traditional hedging techniques using derivatives are not always Sharia-compliant (for example, some derivatives fall foul of the prohibition of gambling). This means that hedging risks relating to currency, fair value or profit volatility is not easily achieved in Sharia-compliant finance. This can take up to 30 years before a person is considered qualified, and there is no universal agreement on what makes a person “qualified” in this context.

No global consensus on Sharia. There is no international consensus on Sharia interpretations, especially in relation to innovative products. There are, however, some signs that the market may be settling.

Tax disadvantages. The tax treatment of Sharia-compliant structures may not follow the treatment of their conventional finance alternatives. For example, where the financier’s return is structured as a profit share rather than interest, a tax deduction may not be available for the Islamic funding cost. In practice, this can necessitate careful structuring to ensure that Sharia-compliant finance does not become a more expensive fund-raising method than conventional finance.

Sara Catley is an analyst with PLC (Practical Law Company), the UK’s preeminent provider of legal know-how, transactional analysis and market intelligence for business lawyers. Catley would like to thank Andrew Calderwood and Natalya Pilbeam of Herbert Smith LLP, Luma Saqqaf of Linklaters LLP, Simon Sinclair of Clifford Chance LLP and Farmida Bi of Denton Wilde Sapte for their assistance with this article.



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