Part II Islamic Law and Contracts in Practice, 7 Murabaha and Tawarruq

This chapter focuses on the murabaha structure, which is probably the most commonly used Islamic finance structure in modern Islamic banking. The simplicity of structure in its current application has promoted its use as a popular and flexible Islamic financing instrument. Indeed, the use of the murabaha has been extended beyond a widespread application as a standalone instrument to a composite component of Sukuk issuance in modern application. The murabaha contract is understood within the Islamic tradition to have a pre-Islamic origin evidenced in pre-Islamic literature and characterized as a fiduciary contract with the objective to assist less knowledgeable buyers in the determination of the fair price of unfamiliar goods. Today, murabaha is commonly used as a mode of finance, in its variant structures, for the acquisition of assets, commodities, and goods in the ordinary course of trade. The structure is also used as a corporate finance tool for working capital and liquidity management. The chapter then considers commodity murabaha (tawarruq) and its application.

Part I Introduction, 1 Status of the Global Islamic Finance Industry

This introductory chapter provides an overview of Islamic finance. Modern Islamic finance did not come out of nowhere. It appeared as the result of specific historical circumstances in the 1970s, and later evolved through a complex process of trial-and-error. It was also shaped by broader competitive and political–economic factors. Although religion was by definition central to Islamic finance, other variables—political, economic, social, cultural, and demographic—also played a significant role. No longer confined to the outer fringes of global finance, Islamic finance has also gone mainstream. Most major financial institutions are now involved in one way or another in Islamic finance, as are global consulting, accounting, and information companies. Within the Islamic world, Islamic financial institutions have become major economic players.

Part I Introduction, 2 Sources and Principles of Islamic Law

This chapter examines the sources and principles of Islamic law. A broad understanding of the sources and principles of Islamic law is prerequisite to an examination of the legal foundations of Islamic finance. Islamic law comprises a complex and vast body of doctrine that has taken shape in extremely varied circumstances for well over a millennium as part and parcel of an evolutionary process still vigorously underway. The chapter then describes the technical terminology employed by Muslim jurists across the entire field of Islamic law. All the technical terminology is in Arabic but exact or rough equivalents can be found in other legal systems. The chapter also looks at the legal concepts relevant to Islamic finance from a historical perspective as the point of departure for an exposition of the Islamic law of contract, for which they provide the conceptual underpinnings.

Part II Islamic Law and Contracts in Practice, 12 Shari’a-Compliant Funds: Principles and Practical Considerations

This concluding chapter explores Shari’a-compliant funds. The Shari’a-compliant funds sector is concentrated in three distinct ways, each of which exemplifies constraints on its ability to grow. First, the sector is still largely concentrated in two regions of the Islamic world: the Middle East and Southeast Asia. Second, the sector is also concentrated in a small number of asset classes. Thus, it does not as yet provide its investor base with the broad spectrum of exposure to geographies, asset classes, strategies, and return profiles that are the hallmark of a mature investment management industry. Third, the Shari’a-compliant funds sector lacks significant diversification across managers, with a handful of large managers still dominating the market. The chapter then looks at the basic tenets of Islamic finance and their application to Shari’a-compliant funds. It also considers the various types of Shari’a-compliant funds, as well as the process of establishing and operating a Shari’a-compliant fund.

Part I Introduction, 4 Dispute Resolution and Specialized ADR for Islamic Finance

This chapter assesses dispute resolution in Islamic finance. Simply referred to as ‘IDR’ (Islamic Dispute Resolution), this Shari’a-based form of Alternative Dispute Resolution (ADR) not only provides desperately needed subject matter expertise in Islamic finance dispute resolution but at the same time accommodates Islamic legal values and traditions in resolving the disputes that inevitably arise in the context of Islamic finance. As with construction arbitration, or labour arbitration, or any other subject-specific ADR process, IDR for Islamic finance is simply another mode of private commercial adjudication. Moreover, from the viewpoint of the State, it is much less threatening than a parallel system of Shari’a courts, which may reach decisions over which the State has no ultimate say. In fact, contrasted with such a parallel system, absent an amicable settlement—in which case the State would have no stake or direct interest anyway—the ultimate adjudication by an IDR intermediary would be subject to review and affirmation by the courts as an arbitral award. Rather than popular or state resistance to the idea of IDR, currently the greatest obstacle to increased and more widespread implementation of IDR for Islamic finance disputes is insufficient expertise and extremely limited facilitative legal and institutional frameworks.

Part II Islamic Law and Contracts in Practice, 10 Takaful

This chapter examines takaful (Islamic insurance), which is one of the fastest growing sectors of the global insurance market. Takaful is a form of insurance structured so as to satisfy the requirements of the Shari’a. It is based on the concept of mutuality, whereby each participant (the equivalent of an insured) makes a donation (tabarru) to a takaful fund. In its commercial form, the takaful fund is managed by a takaful operator on behalf of the participants and is therefore similar to a conventional mutual insurance company. However, the concept of takaful is fundamentally distinct from conventional insurance whereby the insurance company sells a policy protecting the insured against certain defined risks for a specified amount of money. Such conventional insurance arrangements involve no element of mutuality. In contrast, takaful is structured on the basis of mutuality and is intended to create an arrangement that is mutually beneficial for both the takaful operator and the participant.

Part II Islamic Law and Contracts in Practice, 8 Derivatives and Islamic Finance

This chapter studies how conventional derivatives—especially futures, options, and swaps—have been or may be based on bay’ salam, bay’ ʻurbun, and other traditional Islamic transaction structures. Bridging the gap between traditional Islamic transaction structures and conventional derivatives continues to be among the most urgent challenges facing the global Islamic finance industry, not least to provide Islamic financial institutions with a crucial tool for risk management. Salam and ʻurbun clearly illustrate the nature of the challenge to create Shari’a-compliant derivatives. Paradoxically, it is their deviation from the standard conditions for a valid sale contract that allow them to function to some extent as proxies for conventional derivatives. Among jurists, a consensus (ijma’) emerged as to the validity of salam, although special conditions were imposed not only to minimize gharar (uncertainty) and the kindred contractual defect of jahl (lack of knowledge), but also to reduce the possibility of riba (unlawful gain). There is still considerable debate among the various schools of law as to whether ʻurbun constitutes a valid sale contract under the Shari’a.

Part II Islamic Law and Contracts in Practice, 9 Istisna’ and Ijara

This chapter discusses how the contracts of istisna’ and ijara, alone and in combination, have found common modern application. The combination of istisna’ and ijara contracts in particular has found prominence in the project finance and asset finance sector, where in practice they operate like their conventional counterparts. Istisna’ is a contract of sale of specified items to be manufactured or constructed with an obligation on the part of the manufacturer (contractor) to deliver them to the customer on completion. Meanwhile, ijara is a term that means to give something in return for a rent. The ijara contract occurs principally in two situations. First, with respect to the provision of services. And second, with respect to the transfer of usufruct (or right of use) of an asset. In the second application, ijara is comparable to a conventional asset lease.

Part I Introduction, 5 Corporate Governance for Institutions Offering Islamic Financial Services

This chapter addresses the issue of corporate governance for Islamic financial institutions. It sets against the backdrop of English law the various responsibilities that the Shari’a casts on believers in the management of their own affairs and those of others for whom they have taken—usually by contract—an obligation. As has been recognized by, for example, the Islamic Financial Services Board (IFSB), in reality many of the issues that have been addressed as matters of governance in the more developed markets of the West, have not, until recently, been particularly pertinent in Islam. The perception remains in the minds of many scholars and believers that given the all-pervading tenets of the Shari’a and their high moral content, dictating honesty and fair dealing, the essentially procedural mechanisms of Western governance are not of compelling relevance. Of course, when seeking to engage in activity in those jurisdictions where such systems are required, then it is appropriate to accommodate them. It is also increasingly accepted that adherence to such procedures might be a price worth paying for being seen as having institutions and markets that are of a truly international calibre. Indeed, this is a priority of such bodies at the IFSB.

Part I Introduction, 3 Islamic Financial Institutions

This chapter discusses Islamic Finance Institutions (IFIs), which are established on the principle that there should be no separation between temporal and religious matters. Compliance with the Shari’a is in theory the governing law for all aspects of a practising Muslim's life, including financial and business transactions. Recognizing that, under the Shari’a, money does not have a time-value separate from the value of goods that are exchanged through the use of money, IFIs embrace the principle of sharing profit and loss and reject interest as a cost for accepting and lending money. Within these constraints, IFIs offer various services, including: (a) Islamic commercial banking; (b) Islamic wealth and asset management; (c) Islamic insurance; and (d) social services, where the IFI makes loans. In practice, a firm will offer Islamic financial services either as a full IFI, whereby its entire business is dedicated to offering Shari’a-compliant services and products, or through an ‘Islamic Window’, whereby a part of the firm's business is dedicated to offering Shari’a-compliant services and products. In either case, the firm will appoint a Shari’a Supervisory Board (SSB) entrusted with the duty of directing, reviewing, and supervising the firm's activities to ensure compliance with the Shari’a.