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Demystifing Islamic Finance

Publication: Demystifying Islamic Finance: What is Islamic finance? This short article explains the basics of Islamic finance, including a discussion of rules and common financial products.

A “useful” definition of “Islamic finance” is that “Islamic finance” is composed of institutions that are based, in their objectives and operations, on Koranic principles.[i] This definition is more tautological than useful, since the Koran is the basis of Islam, therefore “Islamic finance” would also be based on the principles expressed in the Koran.

Before going into detail about Islamic finance, why do people use it? In general, there are two sets of reasons why people use it: Islamic reasons and financial reasons.[ii] Islamic reasons include both investors who had used conventional finance, but have sufficient pride in their religion to structure transactions in an Islamic way as opposed to a conventional way, and investors who would not avail themselves of conventional interest-based financial services due to religious convictions.[iii] On the other hand, Islamic financial structures can be used to stimulate investment in multiple ways ignored by conventional finance. Certain partnership structures do not require capital on the part of one party, which would in theory allow all sorts of new entrepreneurs to enter the market. Additionally, Islamic finance can provide an alternative source of infrastructure financing, “a pre-requisite for sustained economic development.”[iv]

This article explains Islamic finance by looking at what cannot be done for finance to be “Islamic,” and what common Islamic finance structures look like.[v]

  1. Rules for Islamic Finance

Unlike conventional banks in developed countries, which are subject to rules such as Basel III, there is no central regulatory body for Islamic financial institutions. There are nonbinding standards bodies, such as AAOIFI (Accounting and Auditing Organization for Islamic Finance Institutions), a Bahrain-based organization that attempts to set accounting standards, and IFSB (Islamic Financial Services Board), which tries to set standards for liquidity and risk. In the absence of a central body, as with the definition of “Islamic finance” itself, there is no set list of principles that make certain forms of finance “Islamic.”

In the absence of a standard definition, Islamic finance can be explained by five basic principles:

1) Any predetermined payment over and above the actual amount of principal is prohibited, that is, no interest.

2) The lender must share in the profits and losses arising from the enterprise for which the money was lent, so that the borrower is not unjustly enriched at the expense of the financier.

3) Making money from money is not acceptable (this would seem to prohibit securitization of loans or the bundling of securities).

4) Gharar (uncertainty, risk, or speculation) is also prohibited.

5) Investments for which loans are extended should only support practices or products that are not forbidden (alcohol, the production of pork-based products, investment in real estate for a casino, and the like.[vi]

To explain the first two principles, referring to the ban on interest and the fear of unjust enrichment, it is necessary to introduce the Arabic term for “increase,” which is widely used as a substitute for “interest:” riba.[vii] With the lack of a central regulator for Islamic finance, there is a fair amount of controversy about the applicable meaning of riba. On one end of the debate, some scholars argue that riba means any sort of increase, which would ban any use of interest. On the other side, some argue that riba only refers to a pre-Islamic tribal custom in which lenders would allow debtors to delay repayment of amounts due in exchange for increasing the amount owed.[viii] This led to debtors becoming buried in debt, and only able to repay their debts by selling themselves into slavery. By banning riba, Muhammad ended this particularly cruel practice, but no one is quite sure how far this ban goes. Moving away from the letter to the spirit of the law, there is a strong distaste in Islam for unjust enrichment that originated in unequal distribution of resources.[ix]

An alternate way to phrase principle 3) is that there is a requirement that all financial instruments need to be based in real items. In addition to ostensibly banning securitized loans and the bundling of securities, this seems to prevent most derivatives, since derivatives are (by definition) “derived” from the value of other financial instruments.[x] This presents a challenge for practitioners since they are unable to establish a secondary market for Islamic finance, which limits liquidity.[xi]

Gharar (from principle 4) is another term, which deserves further explanation. Although Perry & Rehman define gharar as “uncertainty, risk or speculation,” this is too broad. Muhammad himself was a merchant who traveled widely through different places and cultures, an inherently risky endeavor. Unlike Christians who have long denigrated all business endeavors, Muslims have traditionally looked favorably at commerce, while being suspicious towards finance. One does not have to be an expert in Modern Portfolio Theory to understand that reward follows risk, therefore the search for commercial reward always will involve the risk of loss. However, risk must be equitably shared, and risk must be contained.

Practically, gharar refers to aleatory transactions, that is, transactions conditioned on uncertain events.[xii] This would limit the ability for Islamic finance practitioners to use certain derivatives such as options as credit default swaps, since both of these transactions depend on future market events. There is a fair amount of overlap between the concern of setting limits through gharar and attempts by American financial regulators since the Great Depression to limit speculation.[xiii] In America, this is seen most recently with the “Volcker Rule” from the Dodd-Frank Act. In Islamic finance, “Speculation in its worst form is gambling. The holy Quran and the traditions of the holy prophet explicitly prohibit gains made from games of chance which involve unearned income.”[xiv]

In response to the final principle, since Muslims are not supposed to trade in forbidden (haram) substances such as pork, alcohol, gambling, and pornography, it follows that they would not be able to invest in companies that provide these goods and services.[xv]

  1. Common Islamic Finance Structures

With this definition through prohibitions established, how does Islamic finance actually work? Historically, Muslims would use various stratagems to perform desired transactions without breaking the letter of the law.[xvi] These strategies were known as “hiyal al-sharia,” which literally translates into cleverness with the law.[xvii] Historically, market participants would tacitly admit, in the words of Michael Corleone in The Godfather Part II, that they were “all part of the same hypocrisy,” and business would continue unabated through the use of stratagems that met the letter of the law.

Modern Islamic financial institutions are monitored by a Sharia Supervisory Board (SSB), which is almost always composed of scholars of Islamic law. As with other areas of Islamic finance, there is no professional body specifically established to set a standard practice for an SSB as is the case for other professionals such as lawyers, accountants, medical practitioners, and engineers.[xviii] For a conventional financial analogy, one can view an SSB as an entity that combines the functions of independent directors (paid to rein in the worst proposals by the institution’s management) and credit rating agencies (paid by the institution to place their seal of approval on activities undertook by the institution). No financial transaction can be deemed Islamic without first receiving SSB approval. A modern SSB, since it is composed of experts in Islamic law, who are familiar with the development of sharia, would likely refuse a rather transparent stratagem such as the double sale.

Modern structures fall into three broad categories, which this article analogizes to sales, partnerships, and derivatives.

First, although the double sale between two parties is prohibited, cost-plus resale (known as murabaha) is permitted worldwide.[xix] Murabaha is the most widely used Islamic finance transaction. Murabaha is widely used with exchange of commodities, such as platinum and oil, since the expectation that the value of these commodities will increase over time alleviates concerns over gharar. If it is too difficult to assemble the required capital to finance a single sale of a given assets, leases (known as ijara) are also common. An ijara transaction can only occur when a tangible asset is being leased, so it is impossible to rent out an apartment under construction through an ijara structure. It is possible to use the ijara structure to lease an item for a set period of time, and permit later purchase of the leased item.

Second, there are two primary means of partnership: mudaraba and musharaka. In a mudaraba, there is a passive partner, who provides all of the capital, and an active partner, who undertakes the project.[xx] 9 The partners agree beforehand on how to distribute profits, and, if the enterprise makes profits, split the profits as agreed. A mudaraba is analogous to venture capital, in which an investor places money into a venture, and does not take further steps to manage that venture. However, a musharakah involves contributions of both time and effort by both parties.[xxi] In both cases, repayment comes from a share of future profits, rather than a guaranteed rate as seen in a conventional loan. Because repayment depends on future success, banks have been reluctant to finance mudaraba and musharaka operations.[xxii] One key difference between these two structures is that the active partner in a mudaraba does not contribute any capital, which means that this partner can exit the project without incurring financial damage. However, the quitter’s inevitably damaged reputation ought to be enough to keep the active partner within the mudaraba.

Third, “derivatives” is an imperfect categorization, because, as mentioned above, conventional derivatives are prohibited under Islamic law. However, there are a number of generally acceptable structures that accomplish many of the same results as conventional derivatives. Although options are prohibited, it is possible to replicate a call option through use of an arbun, which is a form of earnest money deposit.[xxiii] There is a general prohibition against buying and selling items before they fully exist, but there is an exception for specific items to be manufactured. This exception comes in the form of the istisna, which derives from the word for “to produce.”[xxiv]

In addition to the specific exceptional arrangements possible under arbun or istisna, there are three developing structures, which indicate either pragmatism on the part of SSBs, or repetition of conventional financial arrangements. Conventional insurance, in which participants pay a small sum in exchange for a large return in case of disaster, would violate the sharia prohibition against gharar. To avoid that prohibition yet still protect investors, takaful, which is a form of mutual benefit society, has increased rapidly in use.[xxv] Sukuk, commonly oversimplified to be an “Islamic bond,” involves equity interests in particular entities. Unlike partnership arrangements, it is markedly easier to buy and sell sukuk, which means that the “Sukuk market is of strategic importance for the global Islamic financial system and its stability, given the widespread use of the instruments as tools of sovereign and corporate financing.”[xxvi] In addition to sovereign and corporate financing, sukuk structures have been used for Islamic project financing.[xxvii]

Finally, although conventional conditional transactions such as credit default swaps are prohibited because of their speculative nature, it is possible to make promises through using the structure known as waad.[xxviii]  The inherent flexibility of the waad has led to some strong criticism,[xxix] but it is increasing in popularity nonetheless.


[ii] See id. at 159


[iv] Id.

[v] In explaining how to structure transactions, there are examples in the footnotes of transactions between Aziz (A), Bassem (B), and Colin (C). See generally M. Kabir Hassan & Mervyn K. Lewis eds., HANDBOOK OF ISLAMIC BANKING, 2007 [hereinafter Handbook].

[vi] Frederick V. Perry & Scheherazade S. Rehman, Globalization of Islamic Finance: Myth or Reality? in 1 INT’L J. HUMANITIES & SOC. SCI. 107,111 (2011).

[vii] WARDE, supra note 2, at 58.

[viii] In 2011, A loans B $100 with 10% interest to be repaid in one year. In 2012, A extends the loan for another year since B cannot repay him on time, but raises the amount due from $110 to $220. B’s debt would continue to grow with compound interest and geometrically increasing principal.

[ix] WARDE, supra note 2, at 58.

[x] “Derivative,” Commodity Futures Trading Commission, Glossary, available at http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm#D

[xi] WARDE, supra note 16 at 158. [That said, as Michael Lewis wrote about in FLASH BOYS, maximizing liquidity (in that case through use of high-frequency trading) may not be the healthiest thing for the financial sector.]

[xii] Id. A cannot promise to pay B $500 if Brazil wins the World Cup in 2018.

[xiii] For example, Bernard Baruch, one of FDR’s main advisers, expressed concerns about “taxi drivers, shoeshine boys, beggars, and cooks” investing in the stock market. LIAQUAT AHAMED, LORDS OF FINANCE  311 (2009).

[xiv] Mohammed Obaidullah, Financial Contracting in Currency Markets: an Islamic Evaluation, 3 INT’L J. OF ISLAMIC FIN. SERVS 1, 9 (2001).

[xv] A cannot purchase stock in Diageo (the world’s largest producer of liquor), or Harrah’s (owner of numerous casinos).

[xvi] See generally TIMUR KURAN, THE LONG DIVERGENCE (2011).

[xvii] A classic example of this is the “double sale,” in which, in 2011, A would sell B a pen (or any permitted item, as seen above they could not exchange a bottle of scotch) for $100. B would immediately sell this pen back to A in exchange for $110, payable in 2012. A keeps the pen, and the result is a loan of $100, payable over a single year, with a 10% interest rate. Since there are two sales, rather than one loan, this would be acceptable under the letter of Islamic law.


[xix] A sells B a bike for $100; 6 months later, B sells that bike to C for $110.

[xx] A provides $1,000 in seed capital for B to develop his iPhone app. B does all the active work, including engineering and sales, and profits are split 50/50.

[xxi] For the example seen above, A provides $600, B provides $400, A does engineering, B does sales and other tasks, and profits are split 70/30.

[xxii] WARDE, supra note 16, at 175.

[xxiii] In January 2011, A wants to buy $100 of gasoline from B in January 2012. However, A is concerned about the price of gasoline decreasing in the year between. A can use an arbun to give $10 to B in January 2011, and A can choose whether or not to pay the remaining $90 in January 2012.

[xxiv] A can pay for a custom-made bike from B using an istisna arrangement while B is still building the bike.

[xxv] At the most basic level, takaful works by A, B, and a few more of their friends contributing money voluntarily to a pool. If any member were to suffer a loss, the members would voluntarily give that person money from the pool. Unlike conventional insurance, takaful is supposed to be based on mutual charitable benefit, rather than financial return.

[xxvi] Stability Report, supra note 6, at 157.

[xxvii] GE Capital issued a sukuk on the London Stock Exchange in 2009. Islamic Finance Secretariat, Islamic Finance, THECITYUK, 8 (Oct. 2013).

[xxviii] Today, A could use a waad to promise B to sell a bike to him for $100 in six months time. B probably cannot make a complementary promise to buy a bike from A for $100 in six months time because this would be a transaction in the future, and therefore speculation. However, unilateral promises are generally acceptable.

[xxix] See e.g., YUSUF TALAL DELORENZO, THE TOTAL RETURN SWAP AND THE “SHARIAH CONVERSION TECHNOLOGY” STRATEGEM,” available at http://uaelaws.files.wordpress.com/2012/06/delorenzo-copy.pdf.