Out-Law / Your Daily Need-To-Know

Islamic finance is one of the fastest growing segments of the global financial system, with an estimated compound annual growth rate of 17% since 2009.

As of 2015, the industry’s global assets have reached at least $1.9 trillion. The Islamic finance sector is of systemic significance in several Asian countries, such as Brunei, Bangladesh, Pakistan and Malaysia. In these nations, Islamic finance has garnered a significant market share of at least 15% of the domestic banking sectors.

Countries that do not have a predominantly Muslim population are also beginning to open their doors to Islamic finance. Luxembourg, Hong Kong, China, the UK and South Africa have debuted sovereign ‘sukuks’ – Islamic trust certificates, similar to conventional bonds – with all issuances generally being oversubscribed, demonstrating a strong demand for Islamic finance globally.

With massive procurements going on in markets such as the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE) and Egypt and the consequent capacity constraints on conventional banks and financial institutions, the importance of Islamic finance cannot be underestimated.

China and Islamic finance

With the continued growth of business and financing between China and the Middle East, both Chinese banks and borrowers will come into continued contact with Islamic financing. The integration of Chinese interests in Muslim countries comes with the added necessity of understanding how aspects of the banking system work.

Chinese business has undoubtedly been supercharged by a flurry of initiatives in the 21st century, from the ‘Belt and Road’ pivot to the Middle East, to the setting up of Asian Infrastructure Investment Bank’s offices in Abu Dhabi and this decade’s kick-off of the Arab-China Business Conference. However, to truly tap into the growth potential of the region, a first-mover needs to grasp the unique principles behind Islamic finance.

The principles of Islamic finance

Islamic finance is the body of financial activities and products carried out and provided by banks and financial institutions which comply with Islamic law – also known as ‘Sharia’ principles. The two main sources of Sharia are found in the religious texts of the Quran and the Hadith.

Sharia law is not codified and is therefore the subject of continuing development and interpretation. Islamic scholars, known as ‘mufti’, and Sharia advisors follow different Islamic jurisprudence depending on their geographical location and their sect or school. This sometimes results in differing interpretations of Sharia laws.

Key considerations of Islamic finance

When considering or dealing with Islamic financial products, it is important to bear a number of different considerations in mind.

Opinions and approaches differ

Each market has different approaches. There are notable differences across and within Islamic finance markets in North Africa, the Gulf Cooperation Council (GCC), South Asia and Southeast Asia. Furthermore, each bank or financial institution operating within a particular market will have its own set of policies and Islamic scholars or Sharia advisors for the purposes of confirming Sharia law compliance – an opinion known as ‘fatwa’.

When sourcing financing within a particular market or from a particular bank or financial institution, it is important to seek advice from advisors who have a close appreciation of the prevailing customs and practices within that market and of that bank or financial institution.

For example, although there will be many points of commonality, experience within Islamic finance markets in Egypt, Bahrain or the UAE does not necessarily translate into the experience necessary to effectively navigate and efficiently ‘close’ a financing in KSA with Saudi banks and financial institutions, and vice versa.

Always ask your advisors for their experience:

  • in the specific market;
  • with the specific banks or financial institutions; and
  • with the specific Islamic finance products or structures which are being proposed.
There is no standard template

Market participants will be aware that there are standard templates for general financing set up by the Loan Market Association (LMA) and used globally. However, there is no LMA equivalent when it comes to Islamic financing. While the Asian Pacific Loan Market Association (APLMA) does have some Islamic templates, the jurisdiction specific requirements of Islamic financing should be noted.

For example, Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Standard Number 59 Sharia standards are implemented on ‘Murabaha agreements’ – a form of credit sales that is acceptable under Islamic law. In the UAE, the implementation of this Sharia standard has helped to popularise the concept of long and short Murabaha structures within a larger contract, creating certainty. However, in markets where strict compliance with AAOIFI standards is not required, such as KSA, Murabaha agreements typically take a different format.

Understand the fatwa process and timing

Like ‘Know Your Customer’ (KYC) processes and compliance and credit teams within banks and financial institutions, the fatwa process is a separate function from the deal team. Analysis of compliance from a Sharia perspective is largely insulated from a deal team’s commercial needs such as timing.

At the start of any process, it is paramount to understand from the bank or financial institution, as well as your advisors, whether a proposed product, structure or approach to documentation has been “banked” – both in the specific market and with the specific bank or financial institution you are dealing with.

It is also critical to understand as early as practicable from the bank or financial institution how their fatwa process works and what accommodation needs to be made in terms of timing. Engage regularly with your commercial counterparts at the bank or financial institution as to the status of their fatwa process.

Striking an appropriate balance

Contemporary financial markets demand that all banks and financial institutions offer competitive and innovative products tailored to the specific needs of clients. The Islamic finance community is not immune to these pressures. Islamic finance market participants face inherent tensions when attempting to structure products which must strictly ensure Sharia compliance on one hand, while allowing for comparative analysis, competition, innovation, flexibility and interoperability with broader financial markets on the other.

Overarching principles to Islamic finance

There are several guiding principles that you should bear in mind when analysing Islamic finance products.

The prohibition on usury, interest or excess

Sharia-compliant financial products refrain from applying interest or premiums, which are referred to as ‘riba’. Great focus is given to the consideration or value provided by a bank or financial institution and its sharing of risk, profit and loss. The agent bank takes on an element of risk sharing to earn its profit. This is often compared by market participants to interest seen in conventional loan products.

The prohibition on speculation

Sharia-compliant products prohibit any concept of speculation, or ‘maysir’. This means that many derivatives transactions are unsuitable for Sharia-compliant investors. Of particular note, conventional insurance is often considered forbidden, or ‘haram’, as it involves the element of chance.

The prohibition on uncertainty

Parties should only engage on set terms – particularly as to fundamentals such as price – and not agreements to agree. Certain concepts would be in breach of this rule such as agreements to come to a further consensus at a later date.

The prohibition of haram goods, services and activities

Islamic financing prohibits a range of licentious or exploitative products that cannot be Sharia compliant even if the financing is in line with the above concepts. Such products would involve gambling, alcohol, pork and even cryptocurrency – depending on the jurisdiction – where scholars and interpretations of religious texts have prohibited them.

Sharia-compliant financial products and practices

Sharia-compliant financing takes riba concepts, such as interest payments, and gharar concepts, such as a forward-looking reference, and works them into various concepts of agency, from which the objective of profit is derived.


Tawarruq, also known as ‘commodity murabaha’, or ‘reverse murabaha’, is a specific financing technique used in Islamic finance. It involves the creation of a transaction based on the purchase and sale of a tangible asset. It is used as an alternative to traditional interest-based loans while still meeting the financial needs of individuals and businesses. The process of tawarruq financing typically involves the following steps:

  • a customer has a need for immediate funds, such as working capital for their business or personal expenses;
  • the customer approaches an Islamic financial institution, seeking a tawarruq-based financing arrangement;
  • the bank purchases a commodity, commonly copper, at a market price on behalf of the customer;
  • the bank then sells the commodity to the customer at a higher price, with the payment structured in deferred instalments;
  • as the payment price is deferred, the bank levies a profit or markup on the price of the commodities;
  • after the sale, the customer may choose to liquidate the commodity immediately in the market at the prevailing market price, which converts the commodity into cash whilst retaining a deferred payment obligation to the bank;
  • the customer then repays the bank over time for the initial purchase price plus profit, as agreed upon in the sale contract.

While murabaha and tawarruq structures continue to be popular in KSA, there has been a shift away from such structures in the UAE as Sharia law scholars have commented that the simple moving of commodities for a profit lays bare the risk of a usurious profit relationship. This view is also somewhat reflected in the AAOIFI rules which have been adopted in the UAE.


Under an ‘ijarah’ finance lease arrangement, the bank procures an asset, like property or equipment, and then leases it to the customer for a prearranged duration and rental cost. At the end of the lease term, the customer may be given the choice to buy the asset if they desire.

Istisna ijarah

‘Istisna’ is the application of ijarah financing towards different types of projects, such as housing, roads, or maritime and aerospace manufacturing. It can also be used for export financing as well as to meet working capital requirements in industries where sale orders are received in advance.

Banks may undertake financing based on istisna by getting the subject of istisna manufactured through another such contract. Accordingly, they can serve both as manufacturers and purchasers. However, istisna cannot be used for natural products that are not manufactured, such as animals or fruits and vegetables.

Mudarabah and musharakah

‘Mudarabah’ is the term for a profit-and-loss sharing partnership agreement where a financier, or ‘rab-ul mal’, provides the capital to a labour provider, or ‘mudarib’, who is responsible for the management and investment of the capital. The profits are shared between the parties according to a pre-agreed ratio.

‘Musharakah’, meanwhile, represents a joint venture arrangement where all partners contribute capital and proportionally share both profits and losses. There are two primary types of such joint ventures: a ‘diminishing partnership’ and a ‘permanent musharakah’.

A ‘diminishing partnership’, frequently employed in property acquisitions, allows the bank and investor jointly purchase a property, before the bank gradually transfers its equity portion in the property to the investor in exchange for payments. Meanwhile, a ‘permanent musharakah’ has no specific end date, and the partnership continues to operate as long as all participating parties mutually agree to continue. This type of musharakah structure is typically used for financing long-term projects.

The mudabarah and mushkarah structures will be of most interest to mixed Islamic and conventional loan structures. Parties wishing to co-finance in a conventional manner with Islamic financiers will be able to make the most use of them. Typically, a financing involving both conventional and Islamic financiers would involve a dual structure, such as a murabaha for the Islamic tranche alongside a conventional loan, so there is increasing consideration of the mudarabah and musharakah structures by conventional financiers.


In Islamic finance, traditional bonds that involve interest payments are prohibited due to Sharia guidelines. An alternative in the form of ‘Sharia-compliant bonds’, or ‘sukuk’, exist. These are certificates of ownership representing undivided shares in the ownership of tangible assets or of a special investment activity typically used to structure Islamic bond investments and can be based on various Islamic finance structures.

Comparing Islamic and conventional financing

Concept Conventional financing Islamic financing
Interest Interest charged according to reference rates such as SOFR. Profit earned by the financier or agent through agency concepts such as the sale or purchase of commodities (Murabaha) on lease rental payments (Istisna). Reference rates can be worked into the concept of profit rates and calculations.
Benchmark Interest rates are calculated with reference to SOFR, SAIBOR or similar principals, multiplied over the number of days on which the principal is outstanding. Pricing is typically based on a reference rate such as an IBOR or term SOFR. Due to requirements for certainty of pricing, pricing based on backwards-looking compounded reference rates can prove challenging although we have successfully closed transactions where the Islamic elements are also priced based on backwards-looking compounded RFRs.
Hedges Normally done by way of an ISDA, hedging against foreign exchange rate exposure or rising interest rates. While normally prohibited as a form of speculation, the International Islamic Financial Market (IIFM) has developed its own template for hedging, known as the IIFM ‘Ta’hawwut’.
Liability Subject to isolated examples in unique law, common law financing structures tend to allow the financing of any product. Islamic finance prohibits financing activities that are haram such as pork and gambling related initiatives.

Co-financing with Islamic financiers

Co-financing conventional debt alongside Islamic finance is becoming relatively common. This is gaining popularity due to capacity constraints that conventional banks may face. For example, a foreign borrower may wish to finance its activities via conventional structures but may need to avail itself of Islamic finance borrowings due to the lack of conventional debt available.

Conversely, conventional banks may not be able to allocate sufficient exposure to finance a project, and may have to co-finance alongside local Islamic financiers. There are two issues that can arise in this co-financing context.

Prohibition on interest

There is a risk of a ‘contamination issue’ over ownership of assets. For example, under an ijara structure in a project financing, the asset will be “owned” by the ijara financier and only leased to the obligor (SPV). Legal counsel is often retained to break down the specific terms and ensure that security can be adequately placed, and revenues flow according to the overall commercial agreement.

The role of ‘bridge documents’

Common syndication documents, such as common terms agreements, are likely to contain provisions which would be considered non-Sharia compliant, which Islamic financiers generally do not wish to be a party to. However, conventional financiers need to ensure that the Islamic financiers are broadly treated the same way as they are. This often necessitates an additional finance document allowing the Islamic financier to adhere to the majority of terms in the common terms agreement but with a number of carve outs where a sharia concern arises.

Co-written by Patrick Yeo of Pinsent Masons.

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