Contemporary financing techniques underpin development of Islamic finance

As economic uncertainty persists in certain parts of the world, it has created a unique opportunity for Islamic finance to continue to flourish and expand into new regions.

British prime minister David Cameron delivers a speech at the World Islamic Economic Forum in London last month. Andrew Cowie / AFP

As uncertainty persists in certain parts of the global economy, it has created an opportunity for Islamic finance to continue to flourish and expand into new economies.

This was clearly evident at this year's World Islamic Economic Forum (WIEF), held in London at the end of last month. At the forum, the British prime minister David Cameron announced Britain's intention to become the first non-Muslim state to issue sukuk (Islamic bonds).

The issue size is expected to be fairly modest – in the region of £200 million (Dh1.17 billion). But the announcement has been viewed as a symbolic backdrop to Britain’s clear ambition to capture more of the growing Islamic finance market.

Earlier this year, Dubai declared its own intention to become the capital of the global Islamic economy, estimated to have a total value of US$8 trillion, including the Islamic finance industry.

Sheikh Mohammed bin Rashid, Vice President of the UAE and Ruler of Dubai, set a three-year timetable for Dubai to achieve its goal. It has already been confirmed that the emirate will host next year’s WIEF, marking the 10th anniversary of the forum.

The growth of Islamic finance is attributable to many different factors, but that growth would not have been possible without the development of the contemporary financing techniques or structures that underpin the industry.

These techniques have developed in accordance with strict Islamic principles. They all tend to have a common reliance upon a trade or transaction involving underlying assets as a fundamental part of each Islamic contract. This structuring avoids some of the fundamental prohibitions that would otherwise be associated with these kinds of financing products.

What are the main characteristics of sukuk? They are a type of certificate or note that represent a proportionate interest (sometimes also described as a participatory interest) in an underlying asset or investment.

They are generally considered to be debt securities (akin to bonds) which, depending on the underlying asset or transaction, can also be traded in the secondary market.

The sukuk certificates are often “layered” on top of other underlying Islamic financing techniques, which themselves are intended to derive a return from an underlying asset or investment. For example, ijara (or leasing), mudaraba (or investment partnership), or wakala (or investment agency) are commonly used to generate the periodic distributions (in other words, amounts comparable to the “coupon” on a bond) which are payable to the investors.

However, for modern-day purposes, the vast majority of sukuk structures are best described as being “asset-based” because the primary credit risk remains that of the issuer/obligor who is obliged to pay the sukuk holder irrespective of the performance of the underlying asset or investment.

This is to be distinguished from less prevalent “asset-backed” sukuk (in other words, securitisation) where recourse to, and revenues from, the underlying asset or investment play a more critical role.

The Islamic finance industry has developed on the basis of the following strict principles of Sharia (or Islamic law:

1 No interest: under Sharia, money is regarded as having no intrinsic value and also no time value. Money is considered as a means of exchange to facilitate trade. As such, Sharia principles require that any returns on funds provided by an investor should be earned by way of profit derived from a commercial venture in which that investor is involved. The payment and receipt of interest (riba) is prohibited and any obligation to pay interest is considered to be void. This rule also prevents an investor from charging penalties.

2 No uncertainty: uncertainty (gharrar), especially any uncertainty as to one of the fundamental terms of an Islamic contract (such as subject matter, price or delivery), is also considered to be problematic under Sharia. This principle is fairly broad, as it requires certainty on all of the key terms of a contractual arrangement.

3 No speculation: contracts which involve any speculation are not permissible (haram). This does not, however, prevent a degree of commercial speculation, which is often a feature of commercial transactions. The prohibition obviously applies to forms of speculation which are regarded as gambling, and the general test is whether something has been gained by chance.

4 Unjust enrichment/exploitation: a contract in where one party is regarded as having unjustly gained (at the expense of another) is also considered void. This principle also extends to the enrichment of one party who has exercised undue influence or duress over the other party.

5 Investments: the proceeds in Islamic finance should not be used for the purposes of purchasing or investing in products or activities that are prohibited (haram). This covers the manufacture and/or the sale or distribution of alcohol, tobacco, pork products, pornographic productions, the operation of casinos or manufacturers of gambling equipment. Conventional banking and insurance activities are also prohibited.

Globally, Islamic financial assets are said to be growing twice as fast as conventional banking assets and are expected to reach $1.4tn by the end of this year.

Growing demand across a number of sectors, rational pricing and innovative products are trends that are shaping the future of Islamic finance.

In addition, a well-publicised shortage of liquidity in American and European markets has resulted in western companies and other organisations looking increasingly towards funding from sources in the Middle East and South East Asia.

There is also a move towards more deals being funded from Islamic investors through the debt capital markets in the form of sukuk.

However, the strategic importance of becoming an Islamic finance hub should not be overlooked.

Not only does Islamic finance provide an important source of liquidity, but it also is likely to play a significant role in the reshaping of global financial centres in the post-financial crisis era, alongside more stringent financial services regulation.

On this basis, the theme of the 9th WIEF seems very appropriate: “Changing world, new relationships”.

Paul McViety is a legal director at DLA Piper Middle East