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An introduction to Islamic finance instruments

Sultan Choudhury intro to islamic finance

Sultan Choudhury is chairman of Offa

 

One of the salient features of Islamic Finance is the prohibition of interest (riba) and any unjust premium. Interest is completely prohibited in the Islamic financial paradigm and as such, any cash-for-cash transaction must be free from interest.

Conventional financing products are largely interest-based lending and therefore are not compatible with Islamic finance. Islamic financial institutions do not engage in direct cash-for-cash financing, instead their products are composed of ‘cash-asset-cash’ structures, wherein there is an intervention of an asset between the cash flows. One of the most famous Islamic products which uses this concept is Murabaha (cost-plus margin).

A ‘Murabaha’ is a financing product whereby an asset is initially purchased by the financier and then sold to the end-customer on a deferred payment basis, with a margin. This results in the end-customer receiving the asset they were seeking, as well as the financier earning a margin through the sale of the asset.

For example, in home financing, an Islamic bank would buy the property from the owner for, say, £500,000 and then sell it to the buyer for an increased purchase price of, say, £550,000. The Islamic bank and the buyer would agree to a fixed-term instalment arrangement for the payment of the sale price.

The key difference between this and a conventional loan is that in the Murabaha, the financier gains ownership of the asset and thereafter sells the asset, whereas in the conventional product, the financier never gains title or ownership of the asset. Thus, the Murabaha results in profit from the sale of the asset, whilst the conventional product results in interest from a lending facility.

However, the above structure does not always work in terms of wider legal and tax considerations such as land registry and stamp duty laws. Therefore, an extended version of the Murabaha is used which is called ‘Commodity Murabaha’.

In a basic Murabaha transaction, the customer receives assets in return for a deferred payment obligation and then employs those assets in its business, or for personal use. In a Commodity Murabaha transaction, the customer takes the additional step of selling the assets to a third party for cash, which represents the working capital or the bridging finance required by the customer. This additional step grants liquidity to the end-customer to then acquire what they need with cash.

The Commodity Murabaha allows for faster transactions, less regulatory costs and reduced tax implications. In practice, Commodity Murabaha is executed on broker platforms through trading metals and commodities like platinum, nickel and copper.

The process incorporates the following steps:

1. The sale of the commodity from the market to the financier on cash basis.

2. The sale of the commodity by the financier to the customer with a margin on a deferred payment basis.

3. The sale of the commodity by the customer to the market for spot payment on cost price.

 

Whilst this may sound complicated, in practice the sequence of commodity transactions happens quite simply on the technology platforms of the commodity brokers offering the service.

Murabaha and Commodity Murabaha are common Shariah compliant debt-financing structures. Debt financing is not prohibited in Islam.  However, there are various controls for such sales to ensure there is no element of interest (riba) in such structures. Nevertheless, these products are commonly used in the Islamic Finance industry and provide a viable alternative to conventional financing products.

 

Read more in Offa’s series on Islamic finance

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