Islamic Financial Products Based on Sharia-Compliant Contracts
Part of the Islamic Finance For Dummies Cheat Sheet
In accordance with Islamic law (sharia), Islamic financial products are based on specific types of contracts. These Sharia-compliant contracts support productive economic activities without betraying key Islamic principles as some conventional financial products do. Sharia-compliant contracts cannot create debt, cannot involve the payment of interest, and must provide for a sharing of risk and responsibility between the involved parties.
To be valid, an Islamic contract must feature subject matter that is lawful, has value for a Muslim, and is specific enough to avoid uncertainties. The service or asset described in the contract generally must exist when the contract is being created, must be owned by the seller (hence prohibiting short sales of stock, for example), and must be deliverable.
Here are some of the most commonly used contracts in Islamic finance:
Contracts of partnership allow two or more parties to develop wealth by sharing both risk and return:
Mudaraba: One party gives money to another party, which invests it in a business or economic activity. Both parties share any profit made from the investment (based on a pre-agreed ratio), but only the investor loses money if the investment flops. The fund manager loses the value of the time and effort it dedicated to the investment. (However, the fund manager assumes financial responsibility if the loss results from its negligence.)
Musharaka: This contract creates a joint venture in which both parties provide investment capital, entrepreneurial skills, and labor; both share the profit and/or loss of the activity.
Contracts of exchange are sales contracts that allow for the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money:
Murabaha: In this cost plus contract, an Islamic financial institution sells a commodity to a buyer for its cost plus the profit margin, and both parties know the cost and the profit in advance. The buyer makes deferred payments.
Salam: In this forward contract, the buyer (or an Islamic financial institution on behalf of the buyer) pays for goods in full in advance, and the goods are delivered in the future.
Istisna: This second type of forward sale contract allows an Islamic financial institution to buy a project (on behalf of the buyer) that is under construction and will be completed and delivered on a future date.
Contracts of safety and security are often used by Islamic banks; these contracts help individual and business customers keep their funds safe:
Wadia: A property owner gives property to another party for the purpose of safeguarding. In Islamic banks, current (checking) accounts and savings accounts are based on the wadia contract.
Hiwala: Debt is transferred from one debtor to another. After the debt is transferred to the second debtor, the first debtor is free from her obligation. This contract is used by Islamic financial institutions to remit money between people.
Kafala: A third party accepts an existing obligation and becomes responsible for fulfilling someone’s liability. In conventional finance, this situation is called surety or guaranty.
Rahn: A property is pledged against an obligation. A customer can offer collateral or a pledge via a rahn contract in order to secure a financial liability.