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Managing Partner, Stron Legal Services
Anyone can use Islamic finance products and services — you don’t have to be Muslim.
Evolutionary biologists claim that modern humans were able to eradicate all their competitors and became the dominant species on this planet due to their extremely strong ability to adapt. With a change of climate packs of mammoths (the main source of food for that day for homini) became a rarer find. The Sapiens had answered by developing farming whilst the Neanderthals answered by continuing to do exactly the same thing which had not been working so well any longer and, as a result, had become extinct.
We cannot say with certainty exactly how everything happened back then, but what I can definitely agree with is that adaptability has always been essential for survival, security and growth. It underpins the ability to look for alternative solutions at least for the most vital problems and especially when the old ones start to fail.
The same applies perfectly to the world of finance, with Islamic finance serving as the [not really so] new, alternative solution.
Sharia law prohibits Muslims from entering into financial agreements and especially ‘agreements for money’ and, as a result, most Middle Eastern economies were unable to fully access Western capital/money markets. But the modern economy cannot function properly without lending and, therefore, Middle Eastern economies had to … adapt and develop a viable alternative to prohibited lending.
The said alternative is currently growing by 15-25% per year and is controlling approximately USD 2.5 trillion.
The main core principles of Sharia law related to finance are prohibiting the charging (and payment) of interest and prohibition on participating in speculation (maisir, which means gambling) or excessive risk contracts, hence transactions with derivatives are treated as gambling, which is, in turn, a prohibited activity.
Thus, the main task that the first Islamic bankers came face to face with was to develop a financial system based according to principles that are drastically different from the above. The said principles can be compacted into the following:
Material finality of transaction, i.e. the transaction must be in substance real and its object cannot be risk itself. Thus, for example, sale and purchase agreements are allowed whilst cash-settled derivatives are not. The mentioned problem of differentiation can be seen as, in essence, similar to the differentiation between gambling contracts (contracts for differences) and financial contracts (in the given case — derivatives). Muslim seems to have decided not to recognize the difference. In order to deal and manage with the problem of differentiating like from like Islamic banks usually incorporate specialized Sharia law departments or committees; and
Profit and loss sharing i.e. Islamic banks do not provide interest-based lending. By contrast they conclude profit and loss sharing agreements — mudarabah (partnership) or musharakhan (joint venture) whereunder one partner (rab-ul mal, effectively — the lender) provides capital to the other partner (mudarib or the laborer, effectively — the borrower), who is responsible for managing and/or investing the said capital.
The said practice works both ways — i.e. an investor/depositor (rab-ul mal) may provide his/her funds to the bank under a mudarabah (i.e. de facto enter into a savings deposit contract) and thus the bank will be mudarib, the one responsible for managing the capital and who will share profit with its investor later on.
According to the said agreements the profits are split according to a ratio pre-agreed in advance.
Nota bene this model of banking makes a more poised financial system than the traditional one, since investors (depositors) will, in case the bank’s venture does not work out, suffer loss and other consequences jointly with the bank.
There might be other peculiarities related to financial transactions such as when partners co-own a property and one partner will make rent payments to another partner (payments for the use of property in contrast to paying for using money) and purchase payments (payments purchasing part of the property in contrast to returning borrowed funds) until the property is purchased by the former completely (i.e. until the loan is repaid).
A keen reader might have already noticed similarities with modern day investment banking practiced by equity-specializing investment funds. The similarities became even more obvious in the case of musharakhan (joint venture analogue), which can be permanent (in contrast with diminishing).
However, provided that not all Islamic finance products are based on the profit-share paradigm, there are many other financing contracts that are permissible under Sharia law but not strictly profit-share in nature. The following products might be highlighted among them:
- murabaha (cost plus) refers to a sale of goods and/or services with a pre-agreed amount of profit. Thus, 2 different contracts exist, one between the bank and the buyer and another one between the bank and the seller. The bank will buy the underlaying goods from the seller and sell them to the buyer with a fixed margin.
- ijarah (leasing) refers to a transaction between a leaser and lessee. The leaser (the bank) would own the property and lease it to the lease in exchange for rent payments. In one case the lessee will keep the property after the contract’s maturity in the other — the property will return to the bank’s ownership.
- bai’ muajjal (deferred payment sale) refers to a transaction whereunder the bank purchases certain property at the customer’s request and then resells it to the customer at a pre-agreed margin (which must be made obvious to the customer) in exchange for allowing deferral of payment.
- bai’ salam (forward sale) and istisna (contract manufacturing) closely resemble forward contracts — a special contract to buy or sell property/goods at a fixed price on a future date. These contracts must specify the exact date of delivery and the exact price. Under these contracts such objects as gold, silver or currencies cannot be sold/purchased in order to dismiss any possible conflict.
- tawarruq (micro-financing loan) is used when the customer needs to raise cash quickly. Under tawarruq the bank purchases a certain liquid commodity (such as grain or metal) from a supplier and sells it to the customer, who is allowed to pay the purchase price to the bank in installments e.g. over the course of 12 months. Then the customer, upon receiving ownership of the commodity, instantly sells it back to the bank for a price in total lower than the price the Customer agreed to pay back within 12 months but raises the cash instantly.
- Rahn (collateral) is a contract whereunder the borrower transfers an asset (the collateral) to the bank as a security (pledge) in order to secure a financial obligation to pay a sum and the bank is permitted to be paid in the said asset/collateral. The Rahn can be Al-rahn al-heyazi (where the property is physically transferred to the bank) or Al-rahn ghair al-heyazi (where the collateral is not transferred and is kept by the borrower) or Al-rahn al-musta’ar (where the collateral is provided by a third party).
- Takaful would closely resemble a traditional insurance transaction. In order to be Sharia compliant Takaful companies are incorporated in the manner similar to European cooperatives (cooperative banks and/or cooperative pension funds) wherein the insured becomes the member (or [one of] the owner[s]) of Takaful and is obliged to contribute money to a pool of funds managed by the Takaful in exchange of the repayment or reimbursement [by the Takaful] in the event of a loss.
Ideally, the proceeds of the said management must be distributed amongst its members (the insured), but in practice most Takafuls do not give voting rights to the insured or severely limit them and the said proceeds are distributed to selected and specified members of the cooperative (who would be an equivalent in the given case of shareholders/beneficial owners)
If truth be told, Islamic financial products can appear similar to the ordinary banking products since, at the end of the day, they serve the same goals and try to solve the same problems.
But what is important is that in essence the subject matter of the practiced agreements is different, and thus requires different conduct by the parties. Whilst in essence where fixed interest rates are practiced floating rates (based on performance) are de facto used instead. This (as well as loss-sharing issue) requires and promotes more transparency, reporting and control between parties. Moreover, in the case of international financing the principles employed by Islamic banks are likely to lead to extensive works and attention to the field of taxation and anti-hybridization rules. For example, when payments which are in essence interest on the deposit are in the form of profit distribution from a joint venture, i.e. legally in the form of dividends.