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What are the Main Islamic Finance Contracts?

Aug 31, 2022
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 methods, which constitute the core of Islamic finance: Murabaha (25 % of Islamic bonds in 2020, according to the Islamic Financial Services Board), Ijarah (24 %), Wakala (20 %), Mudarabah (6 %), Musharaka (1.5 %) and Salam (1.8 %).  


Murabaha

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 is called Musawama (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. 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. 

 

Mudaraba

A Mudaraba is a passive partnership contract.  Under a Mudaraba, an investor provides the capital, and an entrepreneur or manager provides the labor.  In exchange of his capital, the investor gets a pre-determined share of the profits.  Losses are borne solely by the investor unless they are due to misconduct, negligence, or breach of contract.

Mudaraba comes from the Arabic word “travel”. 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

Ijarah means “to give something on rent” in Arabic.  Ijarah 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.  Ijarahs include labour contracts where the services of an employee are “rented” in exchange of a wage.

 

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; ii) the buying option must be binding on the seller only.

 

Car financing is a frequent application of Ijarah Muntahia BittamleekThe 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.

 

Musharaka

A Musharaka is a joint venture.  Musharaka comes from the Arabic word “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

The term “Wakala” 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 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 Wakalas: the business authorizes the bank to invest in its funds on its behalf.

Most Islamic Insurance companies (takaful) operate under a Wakala model: the insurance company manages the insurance fund on behalf of its clients in exchange for a wakala fee.

 

Salam

Salam 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)

 

An important variation of Salam contracts, called Istisna, is 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.

 

Conclusion

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.



References and Further Reading

 

Islamic Finance Guru Blog.

 

Aims education course on Islamic Finance, Islamic Banking Notes & Lectures.

 

Schoon N. (eds), Islamic Finance Qualification (IFQ): Level 3 Certificate in Islamic Finance, 2018.