Step two: common Islamic products
By Kaushiq Kodithodika, Advent
A Shariah-compliant portfolio may be made up of:
– Islamic-based permitted (halal) investments
– Qualifying ‘conventional’ securities and cash
The Islamic-based permitted investments are covered by a number of standard contract types.
Mutual Investment Contracts
The principal transactions within this group are the mudaraba and musharaka. In the mudaraba arrangement, the bank will provide funds to the entrepreneur who will supply labour or expertise. The bank may invest its own funds in which case it is the investor (Rab ul-Mal), or it may act as agent (mudarib) on behalf of other bank clients who wish to invest funds in which case the bank aggregates the investment funds and places them with the entrepreneur. Profits will be shared according to a pre-defined ratio while losses are borne purely by the investor(s).
The musharaka is a similar partnership arrangement, but the bank does not act alone in investing in the project. In a musharaka there are other direct investors, which may include the entrepreneurs themselves. Profits are shared according to a pre-agreed ratio, but losses are shared on the pro-rata of the capital investments.
This sharing of profits in an agreed ratio enables the bank to take a higher proportion of profits in order that its investment may be returned earlier, enabling the bank to exit the arrangement earlier than other investors. This arrangement (called a diminishing musharaka) can be used by a client to finance the start-up of a business or the purchase of real estate where the bank’s share of the ownership gradually reduces.
This group of transactions are used by banks to provide assets, or the use of assets, directly to their clients. The most common types are the murabaha (cost plus sale), the ijara (lease), and the salam and Istisna’a forward finance transactions.
The murabaha is the most common Islamic form of financing. In this the bank acquires an asset on behalf of the client, and in turn the client will buy the asset back from the bank over time. The client and bank agree at the time of contract on the amount of profit that the bank will make. This contract can be used at a retail level, say to buy a car, or at a corporate level, for example to acquire real estate. In its reverse form murabaha is used as a method of time deposit. In this arrangement, it is the bank that does the “buying” and the investor that “sells.” Most commonly the investor “buys” a stated commodity which is then “sold” to the bank for selling price plus profit. The bank’s payment will be deferred for an agreed time. In this way the investor deposits money with the bank which is then repaid plus profit at a given time in the future, avoiding interest.
The ijara lease is similar to a conventional lease in form but presents some significant differences. The bank acquires the asset (plane, manufacturing equipment, etc.) and gives the client the right to use the asset (called usufruct) in return for agreed lease payments. Ownership of the asset remains with the bank, which is also responsible for its maintenance.
In an ijara wa iktina, payments contain an element of capital repayment so that at the end of the agreed lease period the capital amount is fully repaid and ownership transfers to the client. The salam and Istisna’a contracts are considered exceptions under Shariah because they involve the purchase of something that at the time of the contract does not exist. The existence and possession of the item by the seller is normally a mandatory condition for a contract of sale, but these two types of contracts are for the growth (salam) or manufacture (Istisna’a) of the items. In both of these types of contract the price paid may be less than the current market price. The description, quantity, quality and time and place of delivery must be clearly agreed in the contract.
This group of contracts are those where the bank acts on a fee-earning basis. Examples of accessory contracts are agency agreements(wakalah) where the bank is appointed agent for the performance of specific duties such as buying or selling shares, or trust agreements (amanah) whereby the bank is appointed trustee and takes on a duty of care, or where it provides a guarantee (kafalah), whereby a third party becomes surety for the payment of debt if unpaid by the person originally liable.
Shariah-compliant communal investment vehicles
Additionally, there are many Islamic communal investment vehicles such as unit trusts and other Shariah-compliant investment funds, many of which specialise in property investment or other halal purposes. Such funds are structured, priced and traded in generally similar ways as their conventional counterparts.
Shariah Equity Funds
Shariah equity funds most commonly invest in the shares of listed Islamic companies whose business purposes are of course halal. Conventional listed companies may or may not be included, but if they are they will need to comply with stipulations detailed in this paper.
Shariah Real Estate Funds
Shariah-compliant investment in real estate funds can often involve investment in leased commercial properties, where the fund leases out property and receives rent-most often through an ijara contract.
Shariah Private Equity or Venture Capital Funds
Shariah encourages investment and risk-taking in real economic ventures. Therefore, provided that it is not debt-based and the purpose of the business is Shariah-compliant, venture capital or private equity can come from Shariah funding. Investments may be based on any of the Shariah-compliant contract types, but this must be transparent in the valuation and trading of the fund.
Sukuk are a very popular form of Islamic investment. They are sometimes colloquially referred to as “Islamic bonds” although they are quite different in many ways. They do however have similar financial characteristics to conventional bonds-funds are invested, a certificate (sukuk, singular: suk meaning certificate) is issued, the investor receives income and at maturity the certificate is redeemed. Under Shariah law, the amount of income should not be guaranteed and neither should the value at maturity.
In a typical sukuk structure, a Special Purpose Vehicle (a company specially created for the purpose) will take ownership of an asset. Investors provide funds to the SPV and in return they get sukuk certificates which actually represent ownership of the SPV. The SPV puts the asset to a lawful purpose (for example, developing a port and waterfront residential premises) and in doing so creates profits which are in turn shared with the sukuk holders. At the end of the term the SPV sells the original asset and repays the sukuk holders.
The underlying transactions which generate the profits can be based on any combination of the Islamic contract types shown over the page. Sukuk can be held until maturity or can be traded (if permitted) on several of the emerging sukuk markets.
The world of Islamic finance is a dynamic one in which new instruments or variations are constantly emerging. Some of these instruments can go on to become industry standards, while others may fall out of favour or be criticised by scholars. An investor may encounter various types of certificates other than sukuk-mudaraba, musharaka, fixed or floating ijara-each based on one of the Shariah-compliant contract types. Not all certificates are tradable and particularly those that represent a debt will be designated as non-tradable.