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Islamic Finance (islamic finance transactions ((Musharaka (profit-and…

- - - - Murabaha (sale at cost plus)
        
        • Bank buys an asset.
        • Re-sells it to a customer at an agreed price, above the bank’s purchase cost.
        • Payment by the customer can be in instalments over time.
        So has the same effect as funding the purchase of an asset.
        
        Murabaha involves the purchase and immediate re-sale of an item by a bank at a mutually agreed profit. Technically it is a contract of sale in which the seller declares his cost and profit. This type of financing arrangement is used to provide finance for the bank’s customer to acquire an underlying asset.
    - - • Bank purchases a capital asset.
        • Makes it available to the customer for a fixed period and at a fixed rental price.
        The leased asset must not be a consumable item.
      - This is when a party transfers the usufruct (i.e. right of use) or services of a leasable asset to another against rental payment. The concept is similar to an operating lease where the asset reverts back to the lessor at maturity.
    - - • Provider of finance (bank) and user of finance (who provides skills) agree a profit-sharing contract.
        • Profits shared in an agreed ratio.
        • Losses are borne entirely by the provider of finance.
        • Example: investment account with a bank – investor is the provider of finance and the bank is the user of finance.
        
        is an agreement between a bank and a customer to enter into an arrangement where the bank provides finance and the customer provides his skills. Profits are shared in an agreed ratio, but if there are losses the bank accepts the entire loss.
        
        This is when one party contributes capital (known as rab ul-maal) and the other contributes skills (known as mudarib). Profits are shared as agreed by the contracting parties, and losses are borne by the investor.
    - - • An arrangement in which two parties (bank and customer) contribute capital and share profits and losses in an agreed ratio.
        • With diminishing musharaka, the customer gradually buys the bank’s share in the transaction over time: e.g. arrangement for customer to acquire a house
      - is another type of agreement between a bank and a customer where both parties provide some of the finance and they agree to share profits and losses in an agreed ratio.
        
        This is when all parties contribute capital and some may contribute skills as well. Profits are shared as agreed by the contracting parties whereas losses are shared in proportion to capital contributions.
      - Diminishing musharaka.
        
        is an arrangement where the customer gradually buys out the bank’s share of the arrangement over time, and eventually becomes the full owner. Diminishing musharaka is used in arrangements by customers to purchase houses or cars
        
        Diminishing musharaka is a popular asset financing technique, whereby a financier and a client start as joint owners of an asset (e.g. a house or a car). The asset is leased to the client, who pays rent for the portion of asset owned by the financier. The client also gradually purchases the asset. The financier’s ownership in the asset diminishes over time and that of the client increases until the asset is owned outright
    - - • Bank acquires an asset and re-sells to the customer with deferred payment.
        • Sale price need not be spot price for the asset, so bank can include an agreed profit.
        • BBA used to finance asset purchases, including house purchases.
      - • Bai bithaman ajil (BBA) or bai muajjal (deferred payment sale): This is a type of deferred payment sale in which the price and payment details are fixed at the time of sale.
        The deferred price may be reasonably greater than the spot price, but it is treated as
        a fixed debt once agreed upon by the contracting parties. It is subject to the riba-related restrictions stated earlier.
    - - • Bank buys a commodity from a broker and re-sells it to the customer under a murabaha arrangement.
        • Customer sells the commodity back to a broker for the bank’s original purchase price.
        • Cash from the sale put into a bank account and made available to the customer.
        • Customer eventually pays the bank for the commodity purchase.
    - - This is a type of sale—deferred payment in practice—in which the seller purchases a commodity and sells it to a buyer at cost plus. The seller here, unlike with BBA, discloses the cost price as well as the mark-up.
    - - This refers to a deferred delivery sale for which 100 per cent of the payment is made in advance. The exact quality, quantity, date and space of delivery are identified. Salam is mostly executed in agricultural goods or goods that are readily available in the market at the time of delivery. This means that when producers are unable to produce the good, they can replace it with those available in the market. This restriction reduces settlement risk.
    - - This refers to a deferred delivery sale in goods that are manufactured. The payment in this case can be deferred as well and may be made in a lump sum or in instalments.
    - - This is a person or an entity appointed as an agent (wakil) to perform certain tasks against a fee.
    - - This is also referred to as qarz.
    - - Goods or deposits are kept with a party that guarantees their safe return on request.
    - - This is a unilateral transfer from one party to another as a gift.
    - - This is a unilateral buy or sell promise (without consideration) from one party to another. Islamic banks use this contract when contracting on commodities they do not own at the time of contract such as murabaha. Some recent innovations, however, suggest alternative financing structures that are free from promise (wa’d)
    - - This is when a buyer pays part of the price in advance, with the understanding that the money will be forfeited if the buyer decides not to purchase the item.
    - - Because an Islamic bank might not be the end user of the financed commodity, it faces a price risk that the bank’s profit will be determined by the price of the commodity at the time of delivery. One way the bank mitigates this risk is through back-to-back salam, whereby the bank sells the commodity to an interested end user on a salam basis as the ‘producer’ following its salam contract with the original producer. The bank’s profit in this case is the difference between the advance payment received in lieu of the parallel salam and the advance payment made to the original producer.
  - - - • Involve an investment in underlying assets (e.g. real estate) and the sharing of profits from the investment.
        • Similarities with asset-backed securities. Bond issue structured through a special purpose entity or vehicle (SPE/SPV).
        • Investment made under an ijara or musharaka arrangement.
        • Investors receive trust certificates, and share ownership of the underlying assets and the income they generate.
        • Market for sukuk is growing.
        
        Sukuk al-ijara represents undivided shares in ownership of a leasable asset where the rentals provide periodic profit streams. The SPV usually purchases the asset from the originator of sukuk, who later acquires the asset on lease. The sukuk’s holder or holders bear the cost of maintenance of the asset.
        
        Sukuk al-musharaka, on the other hand, represent ownership units of equal value in a musharaka equity invested with the originator. Profits and losses in this case are shared according to the rules of musharaka.
        
        Some of these sukuk are tradable (such as sukuk al-ijara), while others are non-tradable (such as sukuk al-salam) in the secondary market. The latter, non tradable sukuk usually represent debt that can only be traded at par for reasons outlined earlier.
        
        Issuance of sukuk in the global market
        
        First, Islamic banks tend to hold greater excess reserves than conventional banks (one reason being the lack of sharia-compliant investment opportunities). Sukuk provide Islamic banks with an excellent opportunity to invest their excess reserves in Islamic bonds, which offer competitive returns with an active secondary market in some cases.
        
        At the same time, they present conventional investors with an opportunity to diversify their portfolio, as sharia-compliant instruments are claimed to have a distinct asset class. This is because sukuk rely on the income stream generated by a real economic activity in which the holders have ownership rights in the underlying assets. This distinguishes sukuk from conventional debt-based securities.
        
        Second, sukuk allow the private and public sectors to raise funds for productive projects in a sharia-compliant manner. Although the sharia compliance aspect of sukuk allows ‘borrowers’ to tap into halal funds (funds that are available for investment in sharia-compliant projects only), their viability and competitiveness attract neutral investors as well. Finally, sukuk allow financial institutions and corporations to securitise their assets to raise funds and reduce or transfer asset risk.
        
        Whereas most sukuk issued have at least five years to maturity, they are also used to facilitate short-term and medium-term financing. The Central Bank of Bahrain, for example, uses salam-based sukuk for short-term financing with a maturity of 91 days.
  - - - mic banks raise current accounts on the basis of wadia wad damana and qard al-hasan,
      - The bank may invest deposits in current accounts in sharia-compliant projects, but it does not share profits or losses with its depositors. The principal amount in the current account is guaranteed,
    - - investment accounts on the basis of mudaraba and wakala. The mudaraba deposits may be restricted (deposited for a specific purpose or project) or unrestricted (at the discretion of the bank) and may be fixed for a short- to long-term period.
      - whereas the amount in an investment account is not; all losses in mudaraba and wakala contracts are borne by the investor
  - - - is a liquidity tool used by some Islamic banks, where a bank in need of liquidity uses a precious commodity in metal exchanges (e.g. the London Metal Exchange (LME)) to obtain cash from a customer.
        
        (i) The customer purchases a precious metal from the market on the spot price S (from broker A).
        (ii) The customer sells it to the bank on deferred payment basis at price D.
        (iii) The bank immediately sells it to another party (broker B) on the spot price S.
        The bank gets instant cash equal to S; the customer earns D – S.
    - - In this case, it is the customer who needs liquidity and the bank that acts as financier.
  - - - Premiums collected by TOs are, in principle, owned by the policyholders as a group and so is any surplus or deficit from the insurance operation. Participants in this case insure one another on a non-profit basis and make contributions to the takaful pool on the basis of tabarru’ (a conditional and irrevocable donation), which is a non-commutative contract. This sector has attracted Muslim as well as non-Muslim clients and is seen as an important development for the future.
- - - - vs key pillar western system
      - • Prohibition of riba—This includes but is not limited to any type of interest, although a minority believes that this applies only to usury or excessive compound interest. This prohibition further implies the following interrelated principles:
        
        Money cannot earn money—If money is not an asset, it cannot earn money without making any real contribution. Money when directly exchanged with money must be one to-one. This principle underpins a reliance on asset- or service-based transactions, which is why sharia-compliant transactions are also referred to as asset-backed transactions.
        
        Debt to be traded at par-debt—In Islam, debt is treated as money and can be traded only
        at par, even though it might be a result of a real exchange of money for something else
        
        Risk sharing—All parties must share returns (profit or loss) generated by the underlying
        real economic activity, as specified in the underlying sharia-compliant contract. Interestingly, ‘risk’ is an Arabic word that refers to lending money without requiring a return unless there is profitable growth (Seccombe 2012).
      - Islam’s notion of equitability challenges the traditional concept of ‘time value of money’
        
        Islam considers this notion of time value of money inequitable, as the real-time value of money may be positive or negative depending upon the outcome of the underlying economic activity
        
        Islamic finance encourages real exchanges on a risk-sharing basis and requires the exchange of money or debt to be at par.
    - - vs key pillar western system
      - • No contractual uncertainty (gharar)—Gharar refers to any uncertainty that might result in an unfair gain to one party at the expense of the other. This type of uncertainty relates mostly to the essential details of a contract including offer and acceptance, the subject matter, its price and delivery.
        
        This principle is often related to transparency and disclosure in conventional finance. The scope of gharar in Islamic finance is, however, wider than these terms. It prohibits, for example, the sale of a thing that is not owned by the seller at the time of sale (e.g. short selling, which might pass all the transparency and disclosure tests), with careful exceptions under conditions such as salam and istisna. (These terms will be discussed shortly.)
        
        This principle is also used to justify a ban on gambling, as it is related to uncertainty of the subject matter or its price and adds unnecessary complexity in contract structures.
    - - • A ban on investing in harmful business activities—Islam prohibits investing in activities that are considered to be socially undesirable, such as pornography, alcohol consumption and armaments.
        
        The primary reason behind this ban is to protect society or individuals from certain undesirable outcomes associated with the banned activity.
        
        Sharia allows such investments only in instances where it is possible to detach such activities from its effective cause of prohibition and associate clear benefits to society or individuals.
    - - Markets must be left to operate freely, and all exchanges must take place at prices set by natural market forces of supply and demand. Islam bans hoarding, outbidding in auctions with the intention of raising the price and dumping goods to force competitors out of the market.
  - - - The purpose of the quantitative screens is to ensure:
        • the stock dominantly represents a real asset (as nominal assets need to be traded at par); and
        • involvement in non-permissible activities, such as interest, is minimal.
- - - - The Johnson Report made two specific recommendations on Islamic finance:
        
        the removal of regulatory barriers to the development of Islamic finance products in Australia; and
        
        a call for an inquiry by the Board of Taxation into whether Australian tax law needs to be amended to ensure that Islamic financial products have parity of treatment with conventional products.
      - The most pressing need is in mortgage and superannuation products.