What is Islamic finance?

Islamic finance is seen as an alternative approach to lending that is based strongly around morals and religious belief. Islamic trade finance is simply trade finance performed in a way that complies with the laws from the Islamic holy book, the Qu’ran. The idea of a set of rules for Islamic finance was introduced around 1950-70 as a solution and a response to the increasing influence of western economies.

In Islamic trade finance, trade transactions can be financed either on credit or on a participatory basis. Credit involves the delay of the price or delivery of the purchased commodities. Participatory finance involves the participation of the financier in the profits and losses brought in to resell the financed goods or put them into an income-generating production process.

There are a few significant differences when engaging in Islamic finance, a large one is Shari’a. Shari’a is a set of laws that have been derived from the Qu’ran and which forbid the payment of ‘riba’; which translates to interest. This can make trade transactions difficult between different countries as each individual deal has to be approved by a board of scholars and the interest gained from financing a deal can be the main incentive for the financier.

To help standardise international trade with an Islamic economy, different credit techniques have been developed to conform within shari’a. Murabaha is one way to incentivise banks whilst within the laws of shari’a. Murabaha is the mark-up or the bank’s return when an asset is sold to a customer for payment at a later date. By the buyer and seller agreeing on a certain profit margin to be added to the cost, this is not seen as interest; this is called a PLS technique (profit and loss sharing).

Below we have listed a few more relevant terms from Islamic finance:

  • Sukuk – a form of bond of which is based on the ownership of an approved asset                   
  • Salam – sale with advance payment for future delivery. It may be used as an indirect financing of the purchase of raw materials
  • Ijara-wa-iqtina – the lease of equipment over a certain period of time and the transfer of ownership to the lessee at the end of the period
  • Istijrar- a sale in which an asset is supplied on a continuous basis at a set price to be paid at a future date
  • Mudaraba contract – a trustee financing contract. The financier entrusts funds to the entrepreneur for undertaking an activity
  • Musharaka – capital contributed by the trader and bank
  • Ju’alah – the price for performing any service