Understanding Islamic finance

Administrators do not need to have their own Sharia supervisory boards – but they do need to know how to work with them

Last October, London hosted the World Islamic Economic Forum. It was the first time the event had been held outside the Muslim world, and it was strongly backed by the UK government, with George Osborne, the UK’s Chancellor of the Exchequer, saying that he wants the City of London to become “the unrivalled western centre for Islamic finance”.

The Middle East may seem the natural home of Islamic finance, and Asian centres have the potential to grow, but the recent turmoil in emerging economies has helped London to strengthen its position.

Islamic Finance is a banking system based on the principles of Islamic law (or Sharia) and guided by Islamic economics. It emerged in the early 1960s in the Muslim world in order to provide financial contracts in conformity with the principles of Islam. Its main principles are the sharing of profit and loss and the prohibition of the collection and payment of interest (riba); as such it could be seen as a cultural form of ethical finance.

Speculation is prohibited

Islamic Finance requires that deals be based on tangible assets and that funds cannot be invested in ventures that involve prohibited activities (such as gambling, alcohol and pork production). Uncertainty (gharar) is prohibited by Islam, and hence Islamic finance also avoids derivative transactions (forwards, futures and options) and short selling, which Islamic scholars consider speculation.

Despite these prohibitions, the list of traditional contracts that Islamic finance can access is still long and varied. It includes: murabaha (loan), ijarah (leasing), mudaraba and musharaka (both are forms of participatory financing), istisna (advance purchase of goods and buildings), salam (advance purchase) and sukuk (asset based Islamic bonds). Islamic banks and financial institutions have developed other hybrid financial contracts based on these traditional modes.

The most widely known Islamic financial product is the sukuk, a bond that has been formatted in order to be compliant with religious principles.

Islamic financial institutions set up Sharia supervisory boards or Sharia committees in order to advise and certify that all Islamic products and services they offer are fully compliant with the principles of Sharia law. These boards are a key element of the structure, as they give a stamp of approval and conformity to straightforward equity, bond and bank assets, as well as more complex products.

This formal confirmation, although giving credibility to the institutions, carries nevertheless the prospect of potential inconsistencies, since Sharia law is subject to interpretation, particularly when it comes to the very technical financial services industry.

Expanding across the globe

Recently, the market for Islamic finance has expanded rapidly in the Middle East (mainly in the Gulf Cooperation Countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE), with asset volumes in the region doubling every year for the past five years.

Today, Islamic finance is also growing rapidly in international financial centres across Asia, Europe, and Africa. Total Islamic investments are projected to reach $2 trillion by 2014; a 150 per cent increase from their 2006 value, according to an estimate by Ernst & Young.

For an administrator, being Sharia compliant and servicing Sharia compliant funds is a matter of experience and sophistication. It requires the proper tools and the right people in order to cater for the specific needs and rules of Islamic finance.

An administrator does not need to have a Sharia board, as it does not make investment decisions. However, administrators must work closely with clients’ Sharia boards, and that requires them to have a range of skills and expertise in Islamic finance. Citco, for example, has been serving Sharia compliant funds for more than 10 years, and, as a result, has built up a wealth of knowledge in this rapidly growing area.

By Manmeet Thethi, Managing Director, Risk & Valuation and Nabil Abou-Charaf, Senior Manager, MENA

27th February 2014