Islamic Finance: Types of Contracts

Islamic finance for dummies

There are several types of financial contracts in the field of Islamic finance. Some of them serve as substitution to existing conventional finance contract, and some of them are special contracts only exist in Islamic finance. Below are just simple definitions of some of the transaction contracts in Islamic finance; note that these contracts are limited to transaction contracts for goods (physical products) and business, and excluding Islamic financial funds to be operated in capital market, such as Sukuk, Wakala, and Takaful:

1. Mudharaba

 Conventional equivalent: Trust fund agreement

In mudharaba (partnership), one party (rab al mal) gives money to another party (mudharib), which then invests the money into a business/economic activity. Both parties share any profit from the investment based on pre-agreed ratio, but if the investment goes bad, only the first party (who gives money) can lose money, while the other one loses his time & energy. The mudharib can also receive fixed fee for its service in managing rab al mal’s money. This contract is widely used by Islamic banks to accept deposits from its depositors, in which the depositors become the rab al mal, and the bank becomes mudharib. This contract is also used when Islamic banks make loans to its customers, in this case the bank becomes the rab al mal, and the customers become the mudharib (which then used the money for whatever business they might have).

2. Musyaraka

Conventional equivalent: Joint Venture

Unlike Mudharaba where a party acts only as provider of capital while the other acts only as fund manager, in Musyaraka all parties contribute both capital , skills, and labors needed in its venture. Any profit/loss made will be shared among all partners.

3. Murabaha

In Murabaha, an institution buys a commodity on behalf of another party (who is the one really needing the commodity), and then sells the commodity to the buyer party for the cost plus some profit margin. Both parties know and agree upon the cost and profit. The buyer can either pay in lump-sum or in installments. This contract has many applications in Islamic bank’s service to its customers. The bank can use this contract to provide personal financing, auto financing, mortgage / real estate financing, etc. If the buyer defaults on its payment, the bank can impose some penalty fee, but the fee received cannot be treated as income, instead it will be given to charity.

One derivation of this contract is Tawarruq (reverse Murabaha). In Tawarruq, a buyer buys a commodity from a seller on an installment (deferred payment) basis, and then he sells it right away to a third party which pays him lump sum. In substance, this is like the buyer “borrows” money from the third party and then “return” the money to the seller afterwards. Tawarruq transaction is actually still a controversial topic, in which Islamic scholars are still debating whether it is sharia-compliant or not.

4. Salam

Conventional equivalent: Forward contract

In Salam, a buyer pays for goods (or an Islamic bank does it on his behalf) upfront, and the goods is delivered in the future. Differentiating it to conventional forward contract, there are some requirements to Salam contract:

  • The product must be physically exist at the time of sale
  • The seller must have the ownership of the product
  • Full payment must be made in advance.
  • The products quality & quantity must be specified in the contract.

5. Bay al Muajil

Conventional equivalent: Deferred payment

Bay al Muajil is simply a deferred payment sale (an opposite to Salam contract), in which a buyer buys goods from a seller but defers its payment to some extended period, either installment or lump sum. Both parties must agree on the price at the time of trade.

6. Istisna

Conventional equivalent: Forward contract on a project

In Istisna, the Islamic bank agrees to buy a project on behalf of a buyer that is still under construction and will be completed and delivered in the future. Unlike Salam contract, Istisna contract does not require full payment to be made upfront, and the exact time for delivery is not specified either (although there is a clause for the maximum time needed to complete the project).

One derivation of Istisna is called “Parallel Istisna”, in which a customer enters into istisna agreement with the bank for a specific asset (say, a house for example). The bank then enters another istisna agreement with a real estate company, in which the company builds the house and then sells it to the bank when the house is complete. The bank then delivers the house to the first customer at cost plus some profit margin. In this case, the bank acts as some kind of intermediary between the customer & the real estate company. Parallel Istisna is widely used by Islamic banks to provide mortgage or home financing.

7. Ijara

Conventional equivalent: Lease / rental

In Ijara, one party use another party’s property and earn profits from it for a set of payments made to the owner for a specific period of time. If the owner lets other party uses his property free of charge, the contract becomes Ariyah contract. There are 3 types of Ijara available to Islamic banks:

  • Ijara wa Iqtina: basically the same as capital lease agreement, in which the ownership of the property transfers from the lessor to the lessee at the end of the contract.
  • Operating Ijara: basically the same as operating lease, in which there is no agreement to transfer ownership at the end of the contract.
  • Ijara mawsoofa bil thimma (Forward ijara): a combination of Istisna and redeemable lease agreement, in which a party buys out a project as a whole at its completion or by tranches. In conventional finance, this type of contract is almost the same as the BOT (Build, Operate, Transfer) or BTO (Build, Transfer, Operate) agreement in construction projects.

Ijara contract is also widely used by Islamic banks, and is often combined with other contracts.

8. Wadia

In Wadia, an owner of a property gives his property to another party for safeguarding. The owner then pays some fees to the safeguarding party.

9. Hiwala

In Hiwala, debt is transferred from one debtor to another. After the debt is transferred to the second debtor, the first one is free from his obligation. Islamic banks use this contract to remit money between depositors.

10. Kafala

Conventional equivalent: Bank Guarantee

In Kafala, a third party accepts an existing obligation and becomes responsible for the fulfillment of someone’s liability to another. The third party may receive some fees for upholding the responsibility. Islamic banks use Kafala contracts to issue bank guarantee on a project, or to issue Letter of Credit (LoC) needed in export/import transactions.

11. Rahn

Conventional equivalent: Collateral

In Rahn, a property is pledged against an obligation. Islamic banks use this Rahn contract when receiving collateral for loans made to its customers or when seeking loans from other banks.

References:

Jamaldeen, Faleel. Islamic Finance for Dummies. John Wiley & Sons. 2012.

Note: For more details about Islamic finance Industry, please visit https://ifinanceexpert.wordpress.com/, a website managed by Dr. Faleel Jamaldeen, an expert in Islamic finance from Effat University, Jeddah, Saudi Arabia.  

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One thought on “Islamic Finance: Types of Contracts

  1. Pingback: Islamic Finance: Banks in Islamic Financial System | rifqilazio

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