Some common financial instruments currently being utilised in Islamic finance in various forms are as follows.
A. For financing working capital and liquidity management
1. Murabaha: This is effectively cost-plus financing, as used for trade and asset finance, allowing deferred payment by customers rather than lending money as in conventional loan. The bank purchases the requested commodity (thereby taking it on risk) and sells it to the customer at the agreed mark-up price. In recent times, Murabaha contracts have been the instrument of choice for many financial products, be it trade and asset finance or the provision of working capital facilities.
2. Istisna’a: Along with Murabaha products, it is one of two types of finance which allows the sale of a Commodity prior to production. Istisna’a contracts are clearly aimed at long-term projects, and are frequently used to finance the construction of real estate developments and large assets such as ships.
B. For asset finance
1. Ijara: This is a quasi-debt instrument, essentially equivalent to leasing. Often used in the context of home purchasing, most aspects of an Ijara are the same as those of conventional leasing, whereby the investor (lessor) purchases and leases the underlying asset to the prospective borrower (lessee) for a specified rent and term. Ijara are frequently used to finance the acquisition of real estate and equipment, although they have also been utilised to affect leveraged buy-outs in private equity transactions.
2. Diminishing Musharaka: Recent times have witnessed a shift in emphasis away from Ijara towards diminishing Musharaka (DM) as a mode of financing Islamic mortgages. Many of the major Islamic Mortgage providers have either already switched to DM (HSBC Amanah uses DM) or are planning to do so imminently. DM is a hybrid financing technique involving both Ijara and Musharaka. It appeals to Islamic investors because it is based on the fundamental principle of sharing risk. The attraction for financiers is twofold, in that it can incorporate a variable rate of return and has a credit profile that would be acceptable to most conventional institutions.
C. Equity based instruments
1. Musharaka: This is akin to a joint venture arrangement, through an equity participation contract. Ownership is distributed according to each partner’s share in the financing, and profit and loss is shared by the partners. Such contracts are often used in connection with large project finance and private equity funds. Despite it being a preferred option by many Islamic scholars, Musharaka captures only a tiny portion of all Islamic finance.
2. Mudarabah: This is essentially an investment fund where one party provides the entire capital, and the other party provides the management (usually the bank, but can be the reverse). Profit sharing is agreed up-front, although the loss is borne by the provider of the funds alone.
D. Fixed income investment
1. Sukuk: This is an investment certificate (bond) that represents a proportionate interest in a well defined pool of assets that yield income and capital returns. Usually setup through the conventional Securitisation process, with a special purpose vehicle acquiring the assets, the returns from the assets is passed to sukuk holders (investors). Nowadays popular asset classes have included real estate. This method has been a popular way for many governments to raise funds for infrastructure, and accounts for the largest portion of Islamic finance.
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