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Islamic finance offers many alternatives to conventional finance products, aimed at Sharia-conscious investors and businesses.
These methods establish transactions in line with Islamic values, which include the prohibition of interest and equitable risk-sharing between parties, as well as profit and loss sharing.
Today’s article focuses on the most frequently used models, which constitute the core of Islamic finance. It includes: Murabaha, Musharaka, Mudarabah, Ijarah, Wakalah, Salam and Istisna.
As per the Islamic Financial Services Industry Stability Report 2023 by IFSB, the Sukuk issuance by structure in 2022 included, Murabaha (24.8 %), Ijarah (16.9 %), Wakala (27.3 %), Mudarabah (5.3 %), Musharaka (0.8 %) and hybrid (17.7 %) and others (7.2%).
Murabaha is derived from the Arabic word ribh, which means profit. It is also referred to as “cost plus profit financing” or “profit disclosed sale”. Murabaha is a straightforward financing solution for start-ups and SMEs in need of making expensive purchases.
In its most basic form, a Murabaha is a sale with a pre-agreed markup. For example, a business asks an Islamic financial institution to buy a $10,000 machine. The Islamic financial institution then sells this machine to the business at $11,000, i.e., with a pre-agreed markup of 10%.
The delivery of the machine is immediate, but its payment can be deferred. The price of the machine, the markup, the delivery date, and the payment date are all specified in detail before the sale.
An important variation of a Murabaha contarct is called Musawamah (bargaining sale): contrary to a Murabaha, the price is negotiated, and the buyer does not know the seller’s price or the amount of profit he is making.
In the above example, that would mean that the business does not know the actual price of the machine at which the seller bought it. The price at which the business buys the machine from the Islamic financial institution is the result of the negotiation between the two parties.
A fundamental difference between a Murabaha and a conventional loan is that a Murabaha is not a loan of money but a sale contract, backed by an asset.
The compensation in Murabaha is in the form of price received as consideration for the goods, unlike the interest on conventional loan. Furthermore, unlike conventional loans, if any penalty is charged on late payments by the Islamic financial institution, it does not become a part of its income in a Murabaha contract. Instead, the penalty charged on late payment is given in charity.
A Mudaraba is a passive partnership contract. Under a Mudaraba, an investor (i.e. Rab ul Maal) provides the capital, and an entrepreneur (i.e. Mudarib) or manager provides the labor.
In exchange of his capital, the investor gets a pre-determined share of the profits. capital losses are borne solely by the investor unless they are due to misconduct, negligence, or breach of contract by the Mudarib.The Mudarib loses his efforts and time in case of a loss.
Mudaraba comes from the Arabic word “daraba” which means "traveling for business". The founding example of Mudaraba is the partnership between the Prophet (peace be upon him) and his future wife Khadija: she provided the capital while he (peace be upon him) managed the caravan trade and traveled to Damascus to sell her goods.
Today, Mudaraba is one of the typical forms of Islamic private equity/venture capital for sharia-compliant start-ups.
Ijarah means “to give something on rent” in Arabic. Ijarah can be used for two different situations. One might relate to the usufruct of assets. In such a case it can be considered asIjarah is similar to a conventional leasing contract: a business can use an asset (e.g., a piece of equipment) for a fixed period in exchange of a fixed rent. Another situation can be the one which Ijarahs include a labour contracts, such thatwhere the services of an employee are “rented” in exchange of a “wage” as consideration.
A common Ijarah product is the Ijarah Muntahia Bittamleek, which means “a lease that ends with ownership of lessee” in Arabic. It is very similar to a financial lease in conventional finance, except in two key dimensions:
i) it must be based on two separate contracts: a contract of lease and a contract of sale at the end of the lease period (or a unilateral promise of gift by the lessor)
ii) the buying option must be binding on the seller only.
Car financing is a frequent application of Ijarah Muntahia Bittamleek. The Islamic financial institution purchases the car and rents it out to a business for a fixed period, agreed at the time of the contract. Upon completion of the Ijarah period, the car can be sold at a token amount to the business or can be gifted.
A Musharaka is a joint venture. Musharaka comes from the Arabic word "shirkah” which means “being a partner” and its literary meaning is “sharing”.
A Musharaka contract is similar to a Mudaraba contract with the difference that in Musharaka “sharing”.
A Musharaka is similar to a Mudaraba with the difference that both partners provide both capital and labor. Profits are shared according to a pre-agreed ratio. Losses are shared based on capital contribution.
Musharaka is frequently used in home financing as an alternative to conventional interest-based home mortgages. It often takes the form of a home-purchase plan called Diminishing Musharaka (declining balance partnership).
Under this structure, the buyer and the Islamic finance institution buy a property jointly. The buyer then progressively buys the Islamic finance institution’s portion of the property.
For example, a buyer approaches an Islamic finance institution for the purchase of a $150,000 property that has a monthly rental value of $1,000. The buyer buys 20 % of the property ($30,000) and the Islamic finance institution buys the remaining 80 % ($120,000).
The share of the Islamic finance institution is further divided into eight equal units, each unit representing 10% of its ownership of the house ($12,000 for each unit). The buyer commits to buying one unit of equity each month.
Therefore, the buyer makes a monthly payment to the Islamic finance institution of $12,800. This monthly payment has two parts: rent and equity. In the first month, the buyer pays $800 in rent (80 % of the rental value) and $12,000 in equity.
At the end of the first month, the buyer has increased his ownership of the property: he now owns 30 % while the Islamic finance institution owns 70 %. In the second month, the buyer pays $700 in rent (70 % of the rental value) and $12,100 in equity. This process goes on until the buyer’s share of ownership has reached 100 %.
“Wakala” is an Arabic term with its literal meaning including “performing a task on behalf of other”.
Linguistically, it means protection or preservation means protection in Arabic. Under a Wakala, a business appoints an Islamic financial institution to carry out a legally defined set of activities on its behalf in exchange of a predetermined fee (known as the wakala/agency fee).
Wakalas have many practical applications. Any labor contract where an employee represents their employer can be structured as a Wakala: a lawyer representing his client in court, a broker trading assets on behalf of a company, etc. Bank deposits can also be based on Wakalas: a case where the business authorizes the bank to invest in funds on its behalf with a pre-determined agency fee charged by the bank for its investment management services.
Most Islamic Insurance companies (Takaful) operate under a Wakala model: the Takaful company manages the insurance fund on behalf of its clients in exchange for a Wakala (agency) fee.
Salam is an exceptional form of sale contract in Islamic finance. refers to the purchase of a commodity for deferred delivery in exchange for immediate payment.
For Salam contracts to be sharia-compliant, the quantity, quality, and delivery date of the commodity must be clearly specified in the sale contract.
Salam contracts were originally designed for farmers. When the Prophet (peace be upon him) migrated to Medina, he noted that people used to pay in advance for dates that would be delivered one year later, but without knowing the quality, measure, weight of the commodity, or the time of delivery. He, therefore, ordered that “whoever pays money in advance for dates (to be delivered later) should pay it for known specified weight and measure (of the dates).” (Sahih Bukhari, hadith 441)
Istisna is an “order to manufacture” contract and is aAn important variation of Salam contract.s, called Istisna,
It is also one of the exceptional sale contracts specifically designed for the manufacturing and the construction sectors: the buyer places an order with the seller to manufacture an asset and the sale is completed upon delivery of this asset to the buyer.
The price and specification for the goods to be manufactured need to be fixed in advance.
However, unlike the Salam contract, the price in Istisna contract does not need to be necessarily paid full in advance but can be deferred to a future date as per the agreement of the parties and can be paid in instalments.
Islamic finance provides investors and businesses with a myriad of financing methods. They follow clear ethical guidelines that ensure fair transactions with equitable risk sharing, which makes them attractive alternatives to conventional financing structures for sharia-conscious investors and businesses
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
