Islamic Finance – Key Principles and Investment Types

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Islamic finance, also known as Islamic banking or sharia-compliant finance, represents a banking or financial activity that complies with the Islamic law (sharia). It is a rapidly growing industry, with a year-on-year growth of 10-12%. The total amount of sharia compliant financial assets is estimated to be over USD 3 trillion, including here mostly banks, financial institutions, and capital markets.

Table of Contents

Principles of Islamic Finance
Types of Financial Arrangements
Investment Options

Principles of Islamic Finance

  • Paying and charging an interest (riba)

Islamic laws consider lending money with interest as a contract where only the lender is winning, at the cost of the borrower. Thus, it is mandatory that one does not make a profit from money alone. Interest is known as riba, which is haram (forbidden). 

  • Investing in business that do prohibited activities

Investing in activities which are prohibited by Islam is forbidden (haram). This includes industries such as alcohol production, gambling, pork, and pornography production.

  • Speculation (maisir)

Maisir is usually referred to as ‘speculation’ or ‘gambling’ in Islamic finance. It is forbidden to get involved in contracts where the ownership of goods depends on an uncertain future event.

  • Risk and uncertainty rules (gharar)

Islamic rules forbid participation in contracts that have an excessive level of risk and uncertainty. A few restricted instruments are derivative contracts (a form of insurance), options, futures, and short selling. They are not allowed by Islamic laws as they are ambiguous, and their future existence is uncertain. 

Types of financial arrangements:

  1. Profit-and-loss sharing partnership (mudarabah)

    Mudarabah is a profit-and-loss partnership where one party is the financier of the business (rab-ul mal) and the other provides the work and management needed to implement the project (mudarib). Profits and losses that arise from this type of agreement are shared in a previously established ratio.

  2. Profit-and-loss sharing joint venture (musharakah)

    Musharakah is a type of joint venture where all the partners add capital, and profits and losses are shared on a pro-rata basis. In addition, all of the associates can participate in managing the business. This type of agreement is generally used in investment projects, purchasing, and building real estate. There are two main types of musharakah:

    • Diminishing musharakah: it is generally used for real estate purchases and construction. In this type of agreement generally, the bank owns most of the property, and the buyer gradually pays the bank in exchange for its equity parts.
    • Permanent musharakah: it is generally used for big investment projects, such as road infrastructure. This type of agreement does not have an end, and it will keep going as long as the parties will continue working together. 
  3. Cost-plus (Murabaha)

    In a Murabaha contract, an intermediary and a buyer agree on a cost-plus price for the items that are being sold. For example, the intermediary (generally a bank) buys a house and then agrees on its price with a potential client. The acquisition can be made by paying predefined installments, or by a lump sum. This type of agreement offers the intermediary a way to mark a profit without the need of interest, which is haram. 

  4. Leasing (ijarah)

    In an ijarah agreement, the lessor (owner of the good) leases the object to the lessee (user). In exchange for the right to use the object, the lessee pays the lessor an agreed rent. During the period of the leasing contract, the lessor permanently holds propriety rights on the good. A few assets that can be leased include: motor vehicles, equipment, and real estate. 

Investment options:

  • Equities

Equity investment is allowed by Islamic finance only if the companies are not involved in forbidden activities. In addition, some investors can choose to avoid purchasing shares of firms that hold interest-bearing debt and receive interest. Islamic investors can only buy shares and invest directly, with the use of other instruments being forbidden. Here are a few stock brokers that offer Islamic finance equity trading. 

  • Fixed-income securities (sukuk, known as Islamic bonds)

Sukuk is an Islamic finance alternative to conventional bonds. Practically, they are financial certificates that offer part-ownership of an asset (e.g. office building). As compared with a bond, the sukuk is asset based, rather than asset backed. In addition, instead of the coupon payments offered by bonds, sukuk holders receive payments from the profits or rent generated by the asset. Similarly, both bonds and sukuk have predefined maturity dates. 

One of the most famous examples of the use of Islamic finance in Europe is the construction of the Shard in London. This is the tallest building on the continent, and it was financed using sukuk. A consortium of Qatari based investment banks and funds raised over GBP 400 million for it, mostly by issuing Islamic bonds. 

  • Forex

Islamic forex trading accounts (halal trading account) are offered to Islamic investors that wish to fully respect the Quran and follow Islamic finance principles and rules. Within these accounts, interest can neither be paid nor received, and the transactions have to be closed immediately, being paid at the same time. CFD trading is not available for an Islamic trading account. Considering the previously mentioned requirements, few forex brokers offer an Islamic forex account. This is because the profits are lower than with a retail forex trading account. Here are a few forex brokers that offer halal forex trading.

4.8 rating
75% of retail investor accounts lose money when trading CFDs
4.3 rating
Plus500 is a CFD broker. 76.4% of retail CFD accounts lose money
4.0 rating
75% of retail investor accounts lose money
4.0 rating
80% of retail CFD accounts lose money

References:

https://www.worldbank.org/en/topic/financialsector/brief/islamic-finance

https://www.investopedia.com/articles/07/islamic_investing.asp

https://www.investopedia.com/terms/i/islamicbanking.asp

https://corporatefinanceinstitute.com/resources/knowledge/finance/islamic-finance/

https://www.dummies.com/personal-finance/islamic-finance/what-is-islamic-finance/

https://en.wikipedia.org/wiki/Islamic_banking_and_finance

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