What is Islamic Finance?

Key Takeaways:

1. Rooted in Shariah

Islamic finance is based on Islamic law (Shariah), which prohibits interest (riba), excessive uncertainty (gharar), and gambling (maysir).

2. No Interest, Shared Risk

Unlike conventional finance, Islamic finance avoids interest. Instead, it uses contracts like profit-sharing, mark-up sale and leasing, where real assets are involved and risk is shared.

3. Investments Must Align with Islamic Ethics

Investments are allowed only in sectors permitted by Islam, excluding those involving activities prohibited by Islamic law, such as alcohol, gambling, pork, pornography, and drugs.

Islamic finance, or the Islamic financial system, is a system of financial operations and instruments based on Islamic values, regulated by the rules, norms, and principles of Shariah. Shariah is the system of Islamic law and moral guidelines based on the Islamic religion.

Today, the Islamic financial industry encompasses various sectors, including banking, leasing, the capital market (with the issuance of Sukuk - Islamic bonds, and the equity market), investment funds, Takaful (insurance), microfinance, and with the advancement of information technology, Islamic fintech products.

How Islamic Finance differs from conventional finance? 

Islamic finance has several key differences compared to conventional finance. In conventional finance, borrowing and lending processes are associated with predetermined interest rates, and the focus is primarily on transaction while presence of an asset in transaction more plays the role of collateral security, with the asset not necessarily being a part of the credit transaction. Islamic financial products and instruments are developed in accordance with the religious principles and restrictions of Islam, which prohibit certain types of financial operations, products, and practices.

The fundamental principles of Islamic finance include:

1. Prohibition of Interest (Riba): Islam prohibits the charging and payment of interest on borrowed funds. In Islamic finance, both parties involved must mutually share the risks and benefits of a business transaction. Instead of interest, various contracts are used, such as profit-sharing, leasing, and profit-and-loss sharing. These contracts require the presence of an underlying asset, making Islamic finance fundamentally different from conventional finance. Riba encompasses several situations in transactions and contracts, including:

• Charging and payment of interest on borrowed funds.
• Imposing fines and penalties in favor of the lender for delayed repayment of debt or non-fulfillment of obligations, such as when selling goods with a deferred payment to a specific term.
• Non-equivalent exchange of commodities falling under the category of ribawi (such as gold, silver, wheat, barley, dates, salt). Modern scholars also include goods that can be quickly exchanged, like certain types of food products, for example, rice, which can serve as a medium of exchange and liquidity. Note: for goods falling into the category of ribawi, there is a rule that requires mutual equality in the exchange of the same kind of commodities and that the exchange must take place on the spot (spot exchange). For example, currency exchange at the prevailing rate (Read more on Riba and contract Sarf).

2. Prohibition of Uncertainty (Gharar): Islam forbids uncertainty, or gharar, in transactions. There are two types of gharar. The first is nominal gharar, which is inherent in all transactions and is associated with the risk related to the implementation of a transaction or contract as a whole. From the Sharia perspective, this risk is acceptable. The second type is excessive gharar, and associated with excessive risk and uncertainty which puts great ambiguity into the possibility of implementing a transaction or contract. Such gharar is impermissible from the Sharia perspective. The main criterion of excessive gharar is the form of the transaction, in which one of the components lacks specificity, such as the item being sold, the terms of payment, or delivery. Examples of transactions and contracts falling under the prohibition of gharar include those with uncertainty in specifications, characteristics, quantity, or quality of the item being sold, as well as uncertainty in pricing. Examples of transactions and contracts falling under the prohibition of gharar include:

• Deals and contracts with uncertainty in specifications, characteristics, quantity, or quality of the sold item. For instance, the sale of goods without specifying their characteristics or verifying their working condition, the auction of unknown items in warehouses without knowledge of their contents, or the sale of the offspring of an animal that has not yet been born.
• Deals and contracts where uncertainty pertains to the price.
• Deals and contracts that include additional conditions introducing uncertainty. For example, the sale of a product with conditions related to the possibility of rainfall or conditions tied to prices, similar to those found in derivatives markets, and so on.

3. Prohibition of Gambling (Maysir): This category of prohibited transactions includes gambling activities or bets on outcomes between participants who cannot control the result of the game and where the outcome depends not on the abilities or efforts of the players but on chance or luck. Maisir refers to the earnings derived from gambling, such as lotteries, card games, dice games, casinos, and other forms of gambling entertainment.

4. Prohibition of Investments in Forbidden Sectors: Islamic financial institutions and investors are not allowed to invest in activities that are directly prohibited by Sharia, such as alcohol, pork, and gambling, as well as other activities derived from Sharia, such as pornography and drugs. 

These principles distinguish Islamic Finance from conventional finance and form the basis for the development of Islamic financial products and services.