Emerging markets: the importance of Islamic finance to the UK economy

This article was originally published in the Journal of International Banking Law and Regulation.

Introduction

The significance of wealth from new markets has become even greater in today’s international political economies in order to create growth and opportunities. One of these markets is the Islamic financial market.

The Western financial system is much more sophisticated than the Islamic financial system. The Islamic system is little understood in the Western world due to its emphasis on ethical norms governing the lives of Muslims. One of the main ethical principles of Islamic finance is the prohibition of riba in an interest-free economy where usury is curtailed. An ethical system is not a distant unreality for the Western world as Christianity prohibits usury as well.

Primary Islamic financing methods

The two main services provided by Islamic banks are mudarabah and murabaha.

A mudarabah contract is likened to a joint venture.  The profits of the venture are shared between the two parties in proportions previously agreed in the contract.

Murabaha financing involves the sharing of risk. Arguably it is the most commonly used structure in modern Islamic banking with more than 80 per cent of trading taking place on the basis of murabaha. The simplicity and flexibility of its structure has made it a popular Islamic financing instrument. Murabaha financing is whereby a bank purchases a good on behalf of a client and resells it to the client usually with an agreed mark-up.

Longer time financing can be made through another popular method known as ijara or leasing. Ijara-wa-iqtina is another variant whereby the client has the automatic right to acquire ownership of the asset at the end of the contract on the pre-arranged terms with the bank.

Innovations in the Islamic financial market and English law

The United Kingdom is confident that London can become an important leader in Islamic finance. Opportunity for global growth has led to the announcement of innovative products by both Islamic and Western financial institutions so that products can be accommodated for in a conventional legal system like English law. Two key Islamic financial products are seen as the drivers for change for Islamic finance to smoothly transcend into the conventional system: Islamic derivatives and Islamic bonds.

Islamic derivatives

Mimicking conventional derivatives in Islamic finance is not permissible per se as they involve, inter alia, high levels of gharar (uncertainty) and maysir (speculation). Due to this inherent uncertainty even equivalents in Islamic finance such as salam and urbun’ contracts, which are characteristically not as complex as conventional derivatives, test the boundaries of Sharia compliance. Although the contracts are subject to special conditions designed to ensure Sharia principles are not transgressed.

A salam contract is simply a sale with advanced payment for future delivery. Is it the closest approximation to a conventional forward contract. The delivery of the fungible in a salam transaction must therefore be clearly stipulated and not relate to an indefinite occurrence or event in the future, as the resulting ambiguity would lead to both gharar and maysir.

The arbun’ contract is the closest counterpart to a conventional call option. In an arbun ’ contract the buyer makes an initial down payment which is less than the full amount of the purchase price of the good. The buyer then either chooses to pay the remaining balance at a specified future date or forfeit the down payment and revoke the contract. The Accounting and Auditing Organisation for Islamic Financial Institution (AAOIFI) confirmed the legality of urbun ’ contracts subject to the condition that the buyer is not allowed to revoke the contract.

Islamic finance has seen the adoption of the ISDA/IIFM Ta’Hawwut (Hedging) Master Agreement, which is similar to the ISDA 2002 Master Agreement, launching standardised documentation for the creation of derivatives.

Islamic bonds and securitisation

Sukuk are certificates representing shares in an ownership of tangible assets and representing title to payment. A sukuk structure must adhere to the core principles of Islamic finance, namely the prohibitions on gharar and maysir. They are commonly referred to as "Islamic Bonds" as they are tradable securities like bonds. However, both instruments are structurally different, whereby bonds are traded with a debt claim, sukuk represents an ownership interest in an underlying tangible asset. As such sukuk must be asset based, but not necessarily asset backed.

Importance of Islamic finance and investment

Islamic investment is already fundamental to our success. From London’s Shard building to the athletes’ village for the 2012 Olympic Games, all were made possible by Islamic finance. Islamic finance plays, and continues to play, a vital role in UK infrastructure. There is the £400m Malaysian investment in Battersea power station, regenerating the Nine Elms area of London; to the £1.5bn Dubai investment in the London Gateway. These are only a few of the investments which have been made.

In order to re-generate the economy and create future success, both locally and globally, new investments are needed. Attracting middle eastern and Gulf investment will not only fund infrastructure projects in the United Kingdom but will create jobs and enhance liquidity in the economy. In short foreign investment creates wealth, jobs and growth.