A Breif Overview of Islamic Finance

Islamic finance principles

Islamic, or shariah-compliant, finance is concerned with the conduct of commercial and financial
activities in accordance with shariah, or Islamic law. Islamic finance emphasises productive economic
activity over pure speculation, and encourages transaction counterparties to share profits and losses
in order to promote collaborative efforts. The main shariah principle relating to Islamic finance is the
prohibition of riba, which essentially represents unearned excess or profit charged in connection
with a transaction, and derived by the mere passage of time. This is generally thought to include a
prohibition against charging interest in connection with the use of money. Other
relevant shariah principles are the prohibition of: (i) gharar (undue uncertainty in a contract);
(ii) maysir (impermissible speculation); (iii) qimar (transactions tantamount to gambling); (iv)
investing in, or being involved with, haram products and activities (such as alcohol and gambling
establishments); and (v) becoming unjustly enriched.

Islamic finance structures

Profit and loss sharing forms the bedrock of Islamic finance since Islam perceives that the ideal
relationship between contract parties should be that of equals where profit and losses are
shared. Shariah by no means prohibits the making of profit, but it does scrutinise the basis upon
which profit is made as, for example, charging interest could exploit the client in a time of hardship
whilst the financier's wealth is increased by no effort of its own. Islam instead empowers the
financier to derive a profit by investing its money or other consideration directly (or indirectly
through a joint venture arrangement, for example) in real assets using one or more of the Islamic
finance structures discussed below. The financier will then generate a profit and recoup the principal
sum invested in the asset by exercising its rights as an owner; using, leasing, or selling the asset.
Here, unlike conventional finance, the money itself has not yielded the profit; instead the
assumption of the risks and responsibilities as owner of the asset, or as a partner in the venture, has
yielded the profit made by the financier. This highlights the preference of Islamic finance for equity
over debt and seeking to deal in tangible assets. This also explains why Islamic finance can be used
as a form of both asset backed financing and asset based financing.

The principal Islamic finance structures applied in a commercial context (either singularly or in
combination) are:

 Ijarah (lease): a form of lease financing pursuant to which the usage (usufruct) of an asset or
the services of a person are leased by the lessor to the lessee for rental consideration;

 Istisnah (procurement): a contract for the manufacture or development of an asset. Under

this structure, one party engages a counterparty to construct an asset in accordance with
agreed specifications, and agrees to purchase or lease the asset upon completion;

 Murabahah (cost-plus financing): an asset purchase transaction, in which a party purchases

an asset from a third party upon the request of its counterparty, and then resells the asset
to that counterparty. The sale price payable by the counterparty equals the original
acquisition price paid by the first party plus an agreed return (i.e., cost-plus), and is payable
on a deferred basis;
  Mudarabah (investment fund arrangement): an investment fund arrangement, under which
one party (the rab al maal) provides capital to an enterprise while a second party
(the mudarib) contributes work. The mudarib manages the enterprise's capital for a fee, and
the mudarabah parties also share profits of the enterprise according to agreed percentages.
However, only the rab al maal bears the risk of losing money on the enterprise;

 Musharakah (partnership arrangement): a partnership arrangement in which transaction

parties contribute cash or property, or both, to a collective enterprise. The parties share
profits according to agreed percentages (as with the mudarabah), but also share losses in
proportion to their capital investments; and

 Sukuk (Islamic trust certificates): often referred to as 'Islamic bonds', sukuk are more akin to
Islamic trust certificates representing an undivided beneficial ownership interest in an
underlying asset where the return is based on the performance of that underlying asset.
A sukuk issuer pays an agreed amount of the revenue produced by the sukuk assets to
the sukuk holders.

Challenges

Principal challenges

Despite the significant growth of Islamic finance in recent years, 2017 continues to prove to be
another difficult year for Islamic finance, primarily due a shifting global economic and political
landscape, unresolved geopolitical conflicts, and the continued low oil price environment, which has
led to major changes to spending policies in oil-exporting GCC countries (who, together with
Malaysia and Iran, account for more than 80% of the Islamic finance industry's assets), and in-turn a
significant reduction in economic growth in those countries. Other contributing factors are that:
(i) sukuk have not been used by GCC governments and corporates as significantly as anticipated as
an alternative source to close funding gaps and maintain spending, with those entities instead opting
for conventional sources of finance given the low prevailing interest rates, and the perception that
the process for issuance of sukuk is longer and more complex than conventional debt issuances; (ii)
the lack of standardisation in the Islamic finance industry which compounds the perception of delay
and complexity associated with issuing sukuk; and (iii) ambiguity over what is shariah-compliant
which has been thrown into the spot-light by the events surrounding the ongoing Dana Gas case
(discussed further below), which is proving to be one of the greatest challenges that the Islamic
finance industry has faced in recent times.

Dana Gas

Dana Gas' (an issuer based in the UAE) ongoing attempts in 2017 to render its US$700m mudarabah
sukuk unenforceable on a number of grounds, one of which was that the sukuk were not shariah-
compliant, have been the cause of great concern in the Islamic finance industry. Whilst Dana Gas has
sought to bring proceedings to adjudicate on this matter in the Sharjah Federal Court of First
Instance, a number of the sukuk documents are governed by English law, and so Dana Gas has also
sought and obtained an interim injunction in the English courts preventing the sukuk holders from
declaring an event of default or dissolution event in relation to the sukuk. At the time of publication,
it was not clear whether there will be a full hearing of this matter before the English courts, but it
was clear that a judgment in favour of Dana Gas could have wide ranging implications for
the sukuk market, in terms of how such transactions are structured, and increase the likelihood of
investors and rating agencies coming to the view that certain types of sukuk present a higher risk
relative to corresponding conventional instruments, and offer issuers another ground to seek to
declare their sukuk instrument as being not shariah-compliant.

Opportunities

Despite these challenges, Islamic finance has shown a willingness to be versatile and ready to
overcome these challenges.

Islamic finance in Africa

Diversifying and increasing the customer base of Islamic finance is important to ensure that the
market is not overly dependent on the economic outlook of a particular region or a particular
commodity. To this end, Islamic finance provides major opportunities in Africa, where Islamic
finance development has been growing steadily, with more countries in Africa offering shariah-
compliant banking and issuing sukuk. With almost 60% of the world's uncultivated land and vast
natural resources such as oil, gas and mineral deposits, Africa, dubbed Islamic finance's "new
frontier", has proven itself to be an area of vast opportunity. Despite some high barriers to entry,
such as regulatory setbacks, the issue of double taxation, and a lack of assets, there is clear demand
for Islamic financing in Africa. In June 2017, the Africa Finance Corporation, a pan-African
multilateral lender, was the first African government-backed entity to issue a three-year
$150m sukuk. Islamic financing has also featured significantly as part of Egypt's landmark solar Feed-
in-Tariff programme. Given the ethical foundations of Islamic finance, this ties in well with the
United Nations' Sustainable Development Goals, in the context of Africa.

Standardisation

Islamic finance stakeholders are focussed again on standardisation by working on standard Islamic
finance legal structures to be used to shorten and facilitate the sukuk issuance process. In particular,
the Accounting and Auditing Organization for Islamic Financial Institutions, a non-profit industry-
sponsored organisation, issues non-binding shariah standards developed in consultation with
industry practitioners. Other influential bodies include the Fiqh Academy of the Organization of the
Islamic Conference, the Shari'ah Supervisory Board of the Islamic Development Bank, and the Islamic
Financial Services Board in Kuala Lumpur. These bodies, and individual shariah scholars, provide the
context for Islamic finance generally, and play an important role on standardisation.

This is now perceived by investors as a key area to address given the ongoing Dana Gas case referred
to above.

The end of LIBOR

In the UK, the Financial Conduct Authority announced in July 2017 that it would no longer sustain
LIBOR, the primary reference rate used in floating rate commercial financing arrangements (and
many other financial transactions including Islamic finance transaction), as a benchmark beyond
2021. This announcement has generated uncertainty in affected markets about existing transactions
and the structuring of future floating rate transactions, or where LIBOR is used as a benchmark to
calculate rent under an ijarah, for example. While there have been suggestions made by numerous
market participants in the UK and US about new rates to replace LIBOR, it is too early for the
financial industry to coalesce around one or more replacement rates. For Islamic finance, this
presents an opportunity for it move away from LIBOR as a benchmark, which has been a constant
criticism from shariah scholars and investors seeking no affiliation with a benchmark that is also
used as part of calculating prohibited interest, but has had to be accepted (under the principle of
necessity) given the lack of alternative benchmarks. It remains to be seen, however, whether a
uniform shariah-compliant benchmark for Islamic finance products can be established and accepted

Conclusion

Despite slow growth, and that this year has done much to highlight the shortcomings with regard to
standardisation and vulnerability to global shocks, there are many promising signs for the future of
Islamic finance. Islamic finance is growing more worldwide as an ethical form of financing projects,
which is supported by the report jointly published by the Islamic Development Bank (IDB) Group and
the World Bank Group, "Islamic Finance: A Catalyst for Shared Prosperity?", and the synergies with
United Nations' Sustainable Development Goals, particularly of relevance in Africa. Islamic finance
would greatly benefit from more integration, in particular in relation to the types of sukuk issued,
and the standardisation of the documents and processes used for such sukuk issuances.