Types of Islamic Financial Products - dummies

By Consumer Dummies

Islamic financial companies have developed many different products to meet customer needs and provide sharia-compliant alternatives to widely available conventional options. In this article, you discover some common categories of Islamic financial products.

In practice, a product can be developed to serve many purposes — not only to satisfy social justice demands. However, no matter the motivation for creating a product (such as to meet market demand), every Islamic financial product must exist under the framework of sharia law.

Products based on profit and loss sharing

To establish social justice, Islam requires that both investors and entrepreneurs share involvement in economic activities that result in profit and loss. Here are two broad categories of well-known, widely used equity products that support the sharing of profit and loss:

  • Mudaraba products: In a mudaraba contract, a financier provides capital to an entrepreneur who manages an economic activity such as property construction, a business, or a joint venture. When this economic activity returns a profit, both parties share the proceeds; when a loss occurs, only the financier bears the financial loss. (The entrepreneur loses his effort and time.) However, if the loss is due to the misconduct of the entrepreneur, then he must suffer the financial loss as well.

  • Musharaka products: In a musharaka contract, both parties become involved in a joint venture project or property by investing capital and entrepreneurship. Both parties share any profit or bear any loss generated by the activity.

Products based on investment financing (sale and lease contracts)

In Islamic economics, debt-based transactions (interest-based lending and borrowing) are prohibited. If you’ve grown up in a society where every home, car, and other major purchase is financed by debt, you may wonder how people and businesses can function without it. But doing so is, indeed, possible! As part of the Islamic finance system, contract products are available to facilitate the sale or lease of a property (a home or car, for example).

Islamic law is clear: Only real assets can be transacted with Islamic sale and lease contracts, and such assets must be owned by the lessee or seller — not by a third party. These conditions make it impossible to sell debt in a capital market and create imaginary assets, which enable transactions of a speculative nature.

For example, if an Islamic bank purchases a home and sells it on an installment basis to a buyer, the bank is the owner of the home until the final payment is made. The bank earns a fee from the buyer but may also be responsible for repairs on the home for the duration of its ownership period if stated in the agreement.

Islamic funds

Islamic funds are investment products (such as mutual funds and unit trusts) that are based on equities that are screened, or filtered, to ensure sharia compliance.

Screening refers to the process of checking the sharia compliance of every entity included in an equity fund. The first step in the screening process is to filter out any company whose business involves industries or types of transactions that are prohibited by Islamic law. The second step in the process involves looking closely at each company’s financial ratios; a company must meet certain financial benchmarks to assure Islamic investors that it isn’t engaged in prohibited speculative transactions (involving uncertainty or gambling), which are likely leveraged with debt.

An alternative to bonds: Asset-based securities (sukuk)

Sukuk are often referred to as “Islamic bonds,” but they’re very different from conventional bonds, which benefit one party more than another and, therefore, can’t promote social justice.

Sukuk are asset-based securities; they’re certificates (sold to investors) that represent ownership in a tangible asset, service, project, business, or joint venture. Every asset that supports a sukuk must be sharia-compliant.