Three. Payoff Structures and Sukuk Valuation

The Foundation and Principles of Islamic Finance

This chapter provides the general foundation and principles of Islamic finance. This discussion will place sukuk securities within the ambit of design features common to Islamic (participation) finance. The governing principles are profit and loss sharing, risk sharing, fee-based transactions (not discussed up to now), the prohibition of excessive uncertainty and ambiguity (gharar, maysir, and qimar), information symmetry, and the prohibition of riba (interest).

FOUNDATION

Shari'ah-based financial transactions have their roots in the Quran and the Sunnah, the body of practices of the Prophet Muhammad, refined over 1,400 years from the time his mission that began in 610 ce.1 The Quran contains commandments prohibiting interest (considered as usury in contemporary interpretation) or contracts with excessive uncertainties (gharar), with speculation (maysir), or chance bets (qimar), such as gambling.

These highly developed financial practices lapsed around 1850 ce, following the introduction and consolidation of Western colonialism, with its laws, practices, secular banking, and capital markets that had disconnected with religion. When political independence freed these colonies from Western financial practices after World War II, there was a collective urge to return to Islamic norms for financial transactions, which were considered more just and ethical.

Hence, Muslims started to avoid some, though not all, Western practices, and this movement developed into Islamic finance as interpreted by the newly evolving Islamic schools of thought in the second half of the 20th century. Existing modern financial practices were fine-tuned in accordance with the Quran and the Sunnah.

Contemporary Islamic finance is an attempt to revive some of the older practices while not rejecting modern financial instruments for modern times. It creates new products (sukuk as an example) or adapts existing ones to Islamic principles. Contemporary Islamic finance is only about 50 years old (participation banking started in 1963). It spread into many major areas of financial practices, and it borrows heavily from modern finance in order to serve modern needs.

Early attempts at Islamic finance attempted to revive the historical microfinance and community banking systems, but both of these failed to take root, though microfinance has been a fledgling part of finance in the last few years.2 Then Islamic banking introduced the two-tier mudarabah (a savings account modified to suit profit-sharing deposits) as a permissible product under Shari'ah principles. Later, Islamic banking adopted other services of conventional finance. In this short time, the number of Islamic financial institutions (mainly banks) has grown to more than 390 in 76 countries. Table 12.1 summarizes the expansion of Islamic finance in the last 40 years.

PRINCIPLES

As a product of Islamic debt finance, sukuk must comply with the principles of Islamic finance. These principles have been explained in more detail in the 2011 work Foundation of Islamic Banking: Theory, Practice, and Education by Mohamed Ariff and M. Iqbal.

Profit and Loss Sharing

Profit and loss are two sides of the same coin; therefore, one must accept both possibilities in any investment decisions, as has been the historical practice right up to the time of modern banking with fractional reserves.

TABLE 1Z.1 Expansion of the Islamic Financial Services Industry

1970s

1980s

1990s

2000-Present

Institution

Commercial

Commercial

Commercial Islamic

Commercial Islamic

Islamic

Islamic banks

banks

banks

banks

Takaful

Takaful

Takaful

Islamic

Islamic investment

Islamic investment

investment

companies

companies

companies

Asset management

Asset management

companies

companies

Brokers and dealers

Brokers and dealers;

e-commerce

Islamic investment

banks

Products

Commercial

Commercial

Commercial Islamic

Commercial Islamic

Islamic

Islamic banking

banking products

banking products

banking

products

Takaful

Takaful

products

Takaful; mutual

Mutual funds or unit

Mutual funds or unit

funds

trusts

trusts

Sukuk

Sukuk

Sbari'ab-compliant

Sbari'ab-compYiant

stocks

stocks

Islamic brokerage

Islamic brokerage

Area

Persian Gulf,

Persian Gulf,

Persian Gulf, Middle

Persian Gulf, Middle

Middle East

Middle East,

East, Asia Pacific

East, Asia Pacific,

Asia Pacific

Europe, United States,

global offshore

Source: Adapted and amended from N. Daryanani, A Deeper Understanding of the Prohibition o/Riba (Nottingham, UK: University of Nottingham, 2008).

A capital owner who invests in a venture under conventional borrowing is subject to either the profit or the loss of the investment and cannot claim a loss from the borrower. If the venture is prosperous under sukuk borrowing, the profit is distributed between the parties in a prenegotiated ratio. If the venture turns out to be a failure, the capital provider loses his or her capital unless negligence or fraud is proven in a court, whereas the entrepreneur loses his or her efforts.

Risk Sharing

Related to the above, all parties to a contract share the risk associated with the contract, proportionate to the amount of each party's share in the venture.

Fee-Based Transactions

Shari'ah accepts some forms of fee-based financial transactions for specific purposes. These fees are fixed and predetermined and should not be based on an interest rate. Murabahah and ijarah are contract forms based on this principle. Mortgage financing is done in this manner in which the financier lends money to buy a property and adds fee, while the borrower makes regular payments for property or machine in order to defray the total loan while owning the assets.

The Prohibition of Excessive Uncertainty and Ambiguity

Gharar, ambiguity or excessive uncertainty in a contract, is strongly prohibited in Shari'ah because it may be a way for one party to take an unfair advantage of the others as a result of the one-sided effect of the uncertainty. Hence, any type of transaction in which the subject matter, the price, or both are not determined and fixed in advance is considered to contribute to uncertainty.

The most extreme form of uncertainty, speculation, is called maysir and is also strongly condemned in Shari'ah. Uncertainty can ultimately turn into a chance-based game, or gambling (qimar). This, too, is prohibited as sinful activity in Islam. Although the Quran does not totally deny the fact that there are advantages in these activities, the disadvantages are greater. Thus, these speculative activities are forbidden.

Information Symmetry

Islamic principles require the disclosure of information and the removal of asymmetrical information in a contract by all parties. A contract that has not revealed how disputes are to be resolved in the absence of a clearly defined court system would be considered an asymmetric contract and would be technically void. Similarly, a contract that specifies a term introducing uncertainty at the time of liquidation of the contract would also be an asymmetric contract.

The Prohibition of Riba

Riba (interest or usury) is any return, reward, or compensation charged on a loan contract or in rescheduling debts. According to the currently accepted majority opinion in Islamic law, interest is not allowed in a contract. Islamic scholars believe that money is only a medium of exchange and does not have any intrinsic value as did Aristotle even before the advent of Islam.

As a result, charging interest on loans (starting with consumption loans, at least) is considered unjust; hence, all transactions should be interest-free and based on profit sharing, if there is risk involved. This is essentially aimed at preventing the exploitation of the weak by those who possess money and power. From the prohibition of riba, one may infer that a return from a loan contract, the compensation-based restructuring of debts, and trade in debt contracts at a discount are also prohibited. Even when a lender receives some kind of favor from the borrower, it is considered riba and hence forbidden. Scripture-based principles are aimed at lending to individuals, and the scholars have confused this with production loans, which had profit shares.

However, as described in Chapter 3, there is a difference of opinion despite the majority consensus. For example, would a rate of reward that is very close to the rate of inflation be considered usurious if given after an entrepreneur and the financier share the risk? Some scholars say no. It is the risk sharing and then profit sharing that is the issue.

CONCLUSION

To these six fundamentals, common to all Islamic financial instruments, one may add asset backing as a major component of sukuk industry practices. Asset backing, or its softer version, asset-based sukuk, provides a degree of joint financing between the financier and the entrepreneur so that the contract is evenhanded instead of being one-sided like the conventional banking practices of interest and no risk sharing.

Hence, the sukuk industry, as part of the wider Islamic financial industry, offers participation financing consistent with the ethical and fair principles central to the Quran's call for just and fair dealings among people.

 
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