What is Islamic finance?

Islamic finance is a term used to describe a type of finance that complies with Sharia law, the religious law derived from the Quran and Hadith. Sharia law prohibits making money from money. It views money as a measuring tool, a medium of exchange, and not as an “asset” in itself, meaning that organizations that comply with Sharia law do not earn interest.

Since the mid-1970s, when modern banks began offering Sharia-compliant products, Islamic finance has become a global industry and continues to grow.

Examples of Islamic finance contracts

Islamic finance financial products are based on specific contract types. These include, but are not limited to, the following contracts

Safety and Security Contracts – used by Islamic banks to protect the funds of individuals and businesses.

Wadiah – the bank undertakes to keep the customer’s deposit safe and return it on request, but it is not obliged to pay profits or interest.
Rahn – when a valuable asset, such as real estate, is placed as collateral for an obligation in order to secure a financial liability.
Hiwala – contract used for debts. It involves the transfer of a debt from one party to another, releasing the first debtor from their obligation.

Partnership Agreement – a contract entered into between two or more parties to mutually develop wealth by sharing risk and return.

Murdaraba – money is given from one party to another to invest in a business or economic activity. Both parties share the risk and reward of the investment. However, if the investment fails, only the investor loses money.
Musharaka – money, skills and labor are contributed by both parties in a joint venture and both parties share the results of the investment, whether profit or loss.

How does Islamic finance work?

The interest

Islamic finance is a model based on risk sharing between financial institutions and individuals who use them. Instead of earning interest, wealth is generated through legitimate trade and investment in assets. However, it cannot be invested in assets prohibited by Islam, such as alcohol, pork, tobacco and gambling.

The operation of mortgages in Islamic finance is an example of Sharia compliance. Traditionally, the customer borrows money from the bank to purchase the house and then repays that loan with interest. In Islamic finance, there are two systems: ijara Or murabaha.

In the case of an ijara, there is no deposit, but the bank makes money by renting the property to the customer while the customer repays the mortgage.

In the case of a murabaha, the bank buys the good and then sells it to the customer at a slightly higher price. The latter is reimbursed in installments agreed in advance, but the property officially belongs to the client.

Sukuk, Sharia-compliant obligations, operate in the same way. The money is not loaned, but the investor owns a share of what the money is spent on. The investor receives income not in the form of interest, but in the form of profits generated by this asset or rents paid by the issuer. At the end of the period, the issuer buys back the share of the asset from the investor.

Uncertainty

Investments or contracts involving a high level of uncertainty or speculation, primarily gambling, are not permitted. In other words, Islamic finance does not allow trading in stocks, derivatives or short selling.

Conventional insurance is therefore also not permitted, as paying in advance for an event that may never occur introduces elements of gambling. It also creates a situation where one party gains an advantage at the expense of the other. There are, on the other hand, Sharia-compliant products, in which elements of agency and profit sharing are written into the contract.

Who is Islamic finance for?

Islamic finance is available to everyone and you do not need to be Muslim to use Islamic financial services. It is gaining popularity among non-Muslims, particularly because of its principles of ethics and transparency. The Islamic financial market is much more developed in countries like the United Arab Emirates and Malaysia, but Islamic banks and financial institutions are beginning to establish themselves in countries where Islam is not the predominant religion, and banks Conventional companies are starting to offer more Sharia-compliant products.