Islamic Finance
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Key structures in Islamic finance

A brief introduction to commodity murabaha, diminishing musharakah, sukuk, Islamic mortgages, and Shariah-compliant current accounts and savings accounts

Commodity murabaha

In a commodity murabaha transaction, two parties trade assets. Most commonly, those assets are metals that are publicly tradable on a commodities exchange.

A financier (usually a financial institution) acquires the commodities and then immediately sells them to its client for a higher price. This profit margin is often agreed by referring to a publicly available benchmark or index.

The payment to the financier is deferred, and usually paid in instalments. The client therefore has a lump sum, which can be used as credit might be, for example as working capital or to fund the acquisition of real estate or other assets.

Diminishing musharakah

Diminishing musharakah is an arrangement under which a financier and its client co-own an asset in a decreasing partnership. Again, the financier is usually a financial institution. It is often used to finance the acquisition of real estate.

At the start of the arrangement, the financier and its client co-own the underlying asset in proportion to their respective financial contributions. (Typically, the client either pays their share in cash or by contributing an asset in kind.) Over the lifetime of the arrangement, the client makes a series of payments, each of which increases its share and decreases the financier’s share. At the end of the process, the asset is 100% owned by the client.

If the client wants to have full use of the asset from Day One, this can be achieved by the financier leasing its share to the client.

Sukuk

A sukuk issuance can be used to finance income-generating assets such a real estate portfolio or a pool of Islamic mortgages.

Investors subscribe for trust certificates issued by a special purpose vehicle acting as their trustee.  The trustee uses the proceeds of the issuance to purchase the assets being financed. The trust certificates issued to the investors represent a share in the beneficial ownership of those assets.  The investors generally benefit from security created by the trustee over all its assets.

The returns generated by the assets held by the trustee are distributed to the investors periodically as profit. On the maturity of the trust certificates, the assets are often repurchased from the trustee, and the proceeds of that repurchase are applied to pay the principal amount of the certificates to the investors.

The trust certificates may be rated by a rating agency, and traded on an investment exchange.

Islamic mortgages

Islamic mortgages (also known as Shariah mortgages) for retail banking customers may be structured in several different ways. Murabaha and diminishing musharakah arrangements are commonly used, as described above. Another option is ijara, where the property is purchased by the financier and leased to the mortgage customer.

If the mortgage customer, or a relative, wants to live in the property, the transaction will often be classed as a regulated home purchase plan, in which case the financial institution providing the mortgage must be authorised under the Financial Services and Markets Act 2000. Islamic mortgages for buy-to-let properties, however, are typically unregulated.

Shariah-compliant current accounts and savings accounts

Shariah-compliant current accounts often take the form of a contract of qard (or “loan”), under which the customer or client lends a sum of money to a bank. In return, the bank undertakes to repay the principal amount of the loan without any interest or profit margin.

With savings accounts, the customer will usually want a return on their investment, so two other structures can be used. Either Mudaraba, a limited partnership arrangement in which the customer provides the capital and the bank manages that capital with a view to producing an investment return. Or Wakala, in which the customer appoints the bank as their agent to invest a sum of money with a view to providing a Shariah-compliant return.

The regulation of deposit-taking in the UK generally requires the bank to guarantee the repayment of the capital amount of any deposits that it accepts. Shariah-compliant savings accounts must be carefully structured to ensure that they receive the appropriate regulatory treatment.

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