Islamic Finance and Its Impact on International Trade

Islamic finance refers to financial practices that are compliant with Shariah (Islamic law). Unlike conventional finance, it operates under a distinctive set of principles that emphasize ethical, asset-backed transactions and risk-sharing. Over the past few decades, Islamic finance has grown rapidly around the world, evolving from a niche serving Muslim-majority markets into a significant part of the global financial system (The IMF and Islamic Finance). Today, Shariah-compliant financial assets are measured in the trillions of dollars and continue to expand their reach internationally. By 2022, the industry’s assets had topped US$3 trillion (S&P Projects Strong Islamic Finance Assets Growth in Core Markets in 2023/24 and Good Prospects for Sustainability Sukuk Albeit from a Low Base as Market Size Tops US$3tr – DDCAP). Some forecasts project that total Islamic finance assets could exceed US$6.5 trillion by 2027 (Navigating Uncertainty: Global Islamic finance assets expected to exceed 6.7 trillion by 2027 | LSEG). This growth reflects rising demand not only from the world’s 1.8 billion Muslims (An introduction to Islamic Finance and its impact on trade), but also from investors and businesses across various regions seeking ethical and resilient financial solutions.

Islamic finance has become globally significant due to several key factors:

• Resilience and Stability: It showed stability during financial crises by avoiding speculative practices and excessive debt.
• Growth Potential: Strong growth rates and untapped markets (including large unbanked Muslim populations) drive its expansion.
• Real Economy Focus: Financing is closely tied to tangible assets and real economic activities, fostering sustainable development.
• Ethical Investment: Funds are channeled into halal (permissible) ventures, avoiding industries harmful to society (e.g., gambling, alcohol), which appeals to socially responsible investors.
• Diversity of Instruments: A variety of participation models (partnerships, profit-sharing, leasing, etc.) offer alternatives to interest-based lending, providing flexibility for modern financial needs.
• Structural Finance Fit: Its asset-backed, risk-sharing approach is a natural fit for structured finance and trade financing solutions.
• Wide Acceptance: An increasing number of non-Muslim majority countries and international financial institutions are integrating Islamic financial services, indicating broadening acceptance.

These characteristics have elevated Islamic finance from a religious niche into a globally relevant industry, now present in over 80 countries. It is particularly systemically important in parts of Asia and the Middle East (The IMF and Islamic Finance), but also has a growing footprint in Europe, Africa, and the Americas through Islamic banking windows, sukuk investments, and Shariah-compliant funds.

Foundations of Islamic Finance

Islamic finance is founded on principles derived from Islamic religious law. Its guiding sources and jurisprudential foundations include:

• The Holy Quran – The primary scripture of Islam, containing general economic and ethical injunctions.
• The Sunnah – The teachings and practices of the Prophet Muhammad (peace be upon him), which provide practical examples and guidance (including sayings hadith related to business and trade ethics).

In addition to these primary sources, Islamic jurists developed secondary interpretative tools to apply core principles to new situations over time:

• Ijma (Consensus) – Agreements of scholarly opinion, used to form a consensus on Islamic rulings for finance when clear texts are not available.
• Qiyas (Analogy) – Reasoning by analogy from existing Shariah rulings to new cases (for example, extending the prohibition on wine to other intoxicants by analogy).
• Ijtihad (Independent Reasoning) – Expert jurists’ independent reasoning to solve novel issues, allowing Islamic finance to evolve with changing economic contexts.

Using these sources and methods, Islamic scholars ensure that modern financial products comply with the spirit of Shariah. This means all financial contracts must adhere to Islamic ethics – promoting justice, transparency, and shared prosperity – while avoiding what Islamic law prohibits. The result is a distinctive framework of permitted and forbidden activities, as outlined below.

Historical Evolution and Growth of Islamic Finance

While finance principles based on Islam trace back centuries (early Islamic civilization conducted trade and credit under Shariah norms), modern Islamic finance as an organized industry began taking shape in the mid-20th century. Below are some key milestones in its evolution into the system we know today:

• 1950s: The first experimental Islamic financial institution was launched in rural Pakistan in the late 1950s. It functioned as a local bank that charged no interest on its loans, pioneering the concept of Shariah-compliant banking on a small scale.
• 1963: The first modern Islamic bank on record, Mit Ghamr Savings Bank, was established in rural Egypt by economist Ahmad Elnaggar. This institution operated on profit-sharing principles, aiming to serve people who lacked trust in the interest-based, state-run banks of the time (What is Islamic Banking? A Guide for Everyone – NylaBank). Mit Ghamr’s success demonstrated the viability of interest-free banking and is often cited as a foundation for the contemporary Islamic banking movement.
• 1973: The oil boom and influx of “petro-dollars” in the Middle East, coupled with a broader revival of Islamic identity, created momentum for Islamic finance. Following the 1973 oil crisis, there was a general re-Islamisation in financial thinking. Abundant liquidity in Muslim-majority countries and a desire for Shariah-based financial solutions encouraged the development of Islamic banks.
• 1975: The Islamic Development Bank (IsDB) was established as a multilateral development bank by OIC member countries. Headquartered in Saudi Arabia, the IsDB’s mission has been to fund socio-economic development projects in the Muslim world in a Shariah-compliant manner, marking a major step in formalizing Islamic finance on a global stage. Around the same time, Islamic banking began spreading internationally; for example, 1975 also saw the founding of Dubai Islamic Bank – the world’s first modern commercial Islamic bank – in the UAE.
• 1979: The first Islamic insurance (takaful) company – the Islamic Insurance Company of Sudan – was established, extending Shariah principles into the insurance sector. This year also saw the formal launch of Dubai Islamic Bank in full, proving the commercial viability of Islamic banking and setting a model soon emulated in other countries.
• 1980–1985: The early 1980s witnessed a rapid expansion of Islamic investment companies and banks across the Muslim world. These institutions attracted masses of depositors by offering the promise of “religiously permissible” returns. Scholarly fatwas (religious rulings) were issued during this period, openly denouncing conventional interest-based banks and encouraging Muslims to place their money with Islamic banks instead. This surge, however, also taught regulators important lessons about the need for oversight and genuine profit-and-loss sharing (to temper unrealistic return expectations).
• 1986: In the United States, the finance industry saw the introduction of Islamic principles with the creation of the Amana Income Fund in Indiana – the world’s first Islamic mutual fund. Managed in accordance with Islamic guidelines (investing only in Shariah-compliant equities), this demonstrated that Islamic finance had relevance beyond Muslim-majority countries, even within Western financial markets.
• 1990: The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was founded by a consortium of Islamic financial institutions (initially in Algiers, later headquartered in Bahrain). AAOIFI became a key international standard-setting body, issuing uniform accounting, auditing, governance, and Shariah standards for Islamic finance. The year 1990 also saw the emergence of the Islamic bond market with the issuance of the first tradable sukuk (Islamic bonds) by Shell MDS in Malaysia. This innovation provided Shariah-compliant capital market instruments for investors, analogous to conventional bonds but structured around asset ownership and lease returns instead of interest.
• 1995: By the mid-90s, Islamic finance had firmly taken root globally. A survey in 1995 counted 144 Islamic financial institutions operating worldwide – including 33 government-owned banks, 40 private Islamic banks, and 71 Islamic investment companies. This indicated not only growth in predominantly Muslim countries but also increasing interest in Islamic financial products in international markets.
• 1996: Even major global banks acknowledged Islamic finance’s potential. In 1996, Citibank established the Citi Islamic Investment Bank in Bahrain, becoming one of the first large Western banking institutions to offer Islamic banking services. This move by a Wall Street bank validated Islamic finance in the eyes of mainstream investors and opened the door for more conventional banks to launch “Islamic windows” and products for their clients.
• 1999: The year saw the introduction of the first comprehensive benchmark for Islamic investment performance – the Dow Jones Islamic Market Index (DJIMI). The DJIMI tracked a portfolio of Shariah-compliant stocks, giving investors a yardstick to compare Islamic funds’ performance globally. The creation of such indices helped further integrate Islamic finance into global capital markets by providing transparency and attracting non-Muslim investors interested in ethical investing.
• 2002: The Islamic Financial Services Board (IFSB) was launched in Malaysia as an international standard-setting body (akin to the Basel Committee but for Islamic finance). The IFSB issues regulatory and prudential standards to ensure the soundness and stability of Islamic banking, capital markets, and Takaful sectors worldwide, complementing AAOIFI’s work. This coordinated infrastructure supported the globalization of Islamic finance by promoting best practices and consistency across jurisdictions.

By the early 2000s, Islamic finance had transitioned from experiment to established industry. Total Shariah-compliant assets, which were negligible a few decades earlier, climbed to significant levels. For instance, by 2010 the industry was valued at about $1 trillion, and it kept accelerating. Two decades on from the 1980s boom, global Islamic finance assets reached an estimated $2.8 trillion in 2019, and were forecast (pre-pandemic) to approach $3.7 trillion by 2024 (An introduction to Islamic Finance and its impact on trade). This momentum has largely continued. Major financial centers such as Kuala Lumpur, Dubai, London, and Manama have developed as hubs for Islamic banking and sukuk issuance. Importantly, non-Muslim majority countries including the UK, Luxembourg, South Africa, and Hong Kong have issued sovereign sukuk or facilitated Islamic banks, underscoring the appeal of Islamic finance beyond its traditional base.

Core Principles and Prohibitions in Islamic Finance

Islamic finance differs fundamentally from conventional finance due to a set of core principles rooted in Shariah. Foremost among these are prohibitions meant to ensure fairness, transparency, and ethical behavior in all financial dealings. Key forbidden elements include:

• Riba (Usury/Interest): The charging or paying of any interest on loans is strictly prohibited. In Islamic doctrine, money itself should not generate more money simply by the passage of time. Riba literally means “increase” or “excess.” Any guaranteed or predetermined gain over the principal of a loan – whether a high usurious rate or a low interest rate – falls under riba and is forbidden (An introduction to Islamic Finance and its impact on trade). The underlying rationale is that earning profit from a loan without sharing the risk or effort is considered unjust. This is the most pivotal prohibition in Islamic finance and the feature that most starkly distinguishes it from conventional finance. (Notably, Islamic teachings encourage trade and investment, but condemn interest-based lending as exploitative; the Quran states “God has permitted trade and forbidden usury”.)
• Gharar (Excessive Uncertainty): Transactions involving extreme uncertainty or ambiguity in terms or subject matter are disallowed. Gharar often refers to undue risk or ignorance – for example, selling an item that the seller does not yet possess or whose qualities are unknown, or entering a contract with unclear or deceptive terms. While a normal level of business risk is acceptable (and even inevitable), excessive or avoidable uncertainties that could lead to one party being unfairly disadvantaged invalidate a contract under Shariah (The IMF and Islamic Finance). This principle promotes transparency and full disclosure between parties.
• Maysir/Qimar (Gambling/Speculation): Engaging in games of chance or speculative transactions akin to gambling is forbidden. Maysir refers broadly to acquiring wealth by chance instead of by effort (e.g., lottery-like contracts), and Qimar is a term for betting where one party’s gain is purely another’s loss. In finance, this translates to a ban on speculative investments and derivative contracts that have no underlying real asset or productive purpose and merely bet on price movements. Shariah-compliant finance avoids excessive speculation, preferring investments with identifiable assets or business activities behind them (The IMF and Islamic Finance). This reduces the risk of harmful volatility and encourages productive economic activity over pure profiteering.
• Unjust Enrichment & Exploitation: Any transaction that leads to unjust enrichment of one party at the expense of another, or that involves exploitative conditions, is considered haram (forbidden). Contracts must be fair to all parties, and the asymmetry of information or power should not result in oppression (zulm). For instance, excessively one-sided contracts, deception, or taking undue advantage of someone’s hardship (e.g., predatory lending) would violate the Islamic ethos of justice.
• Haram Goods and Unlawful Activities: The financing of industries or products deemed unethical or unlawful in Islam is prohibited. Islamic banks and funds cannot invest in businesses dealing with alcohol, pork, gambling, pornography, illicit drugs, or anything that is explicitly forbidden (haram). Similarly, transactions involving bribery, corruption, or harm to society are off-limits (The IMF and Islamic Finance). This aligns financial flows with Islamic moral values, ensuring that wealth is generated in socially responsible ways. Contracts themselves must also be lawful in object and purpose – for example, one cannot have a valid Islamic contract to sell something that it is not permissible to sell (like narcotics or stolen property).

Of all these, the ban on riba (interest) is often highlighted as the defining feature of Islamic finance. It is considered the most significant differentiator because much of conventional finance – from simple bank loans and bonds to complex debt instruments – relies on interest. To comply with Shariah, Islamic finance had to devise alternative mechanisms to intermediate funds between savers and users of capital without fixed interest. This gave rise to a set of permissible contracts based on profit-and-loss sharing, trading, and leasing as substitutes for interest-bearing loans.

Definition of Riba: Islamic scholars and courts have formally defined riba in financing as “any loan that attracts any kind of gain (monetary or non-monetary) to the lender.” (An introduction to Islamic Finance and its impact on trade) In other words, any guaranteed benefit tied to a loan contract – whether labeled interest, fee, or gift – is considered riba and prohibited. This forces financial transactions to be structured in ways where the financier’s return is not a sure increment on money lent, but rather comes from engaging in true commerce or partnership with its attendant risks.

Because interest-based lending is off the table, Islamic finance uses asset-based and equity-based contracts to encourage financing. The core idea is that money should be invested in real economic ventures and returns earned through shared business profits or rents, not simply by lending at interest. The main Shariah-compliant financing modes can be categorized into a few broad types, such as partnerships, sale contracts, leasing, agency, and guarantees. Each of these modes adheres to Islamic principles while fulfilling similar economic functions to conventional finance. We will explore each category in the next section.

Key Islamic Financing Methods (Shariah-Compliant Modes)

(An introduction to Islamic Finance and its impact on trade) Conceptual illustration of key Islamic finance instruments (e.g., Ijarah, Murabaha, Mudarabah, etc.) spread across global markets. Islamic finance transactions are underpinned by real assets and ethical principles instead of interest-based debt.

In today’s financial industry, Islamic banks and institutions utilize a variety of Shariah-compliant instruments to meet clients’ needs – ranging from business loans and trade finance to personal banking and investments. All these instruments avoid interest and excessive uncertainty, but they mimic the commercial objectives of conventional products through different contract structures. The major modes of Islamic finance include partnerships, sales, leases, agency arrangements, and guarantees. We outline the key ones below:

Partnership-Based Financing (Profit-and-Loss Sharing)

Musharakah: A musharakah is a joint partnership or joint venture where all partners contribute capital (and, in some cases, also expertise) to a project or business. Profits from the venture are shared among partners according to a pre-agreed ratio, which need not be the same as their capital contribution ratio. However, any loss must be shared strictly in proportion to each partner’s capital investment. In practice, one or more partners may be silent investors while others manage the business, but ownership and risk are mutual. Musharakah is often compared to equity participation – for example, two companies jointly financing a new project would share profits as per an agreed split, but if the project fails, each bears losses relative to how much each invested. This ensures risk-sharing in line with Shariah principles.

Mudarabah: A mudarabah is a special type of partnership where one party (the rab-ul-mal) contributes capital and the other party (the mudarib) contributes labor, expertise, and management. It is essentially an investor–entrepreneur arrangement, somewhat analogous to a silent partner (investor) and a working partner. The profit-sharing ratio is agreed upon at the outset of the partnership (e.g., 70% of profit to investor, 30% to manager, or vice versa). If the venture generates profit, it is split per the agreed ratio. Importantly, in case of a loss, the financial loss is borne entirely by the investor, while the working partner loses the time and effort they put in (and of course earns no profit). The mudarib does not owe the investor for lost capital, as long as the mudarib managed diligently and there was no misconduct. This arrangement incentivizes the entrepreneur to work hard (to earn profit share) and the investor to trust competent managers, while aligning with Islamic tenets that one cannot guarantee a return on capital without risk.

Both musharakah and mudarabah embody the principle of profit-and-loss sharing (PLS). Unlike a conventional lender, who expects interest regardless of the borrower’s outcome, an Islamic finance provider using these partnership modes shares the business risk. If the business succeeds, all parties profit; if it fails, both the financier and entrepreneur face losses. This encourages prudent investment and entrepreneurship and avoids over-leveraging. Many Islamic banks operate investment accounts on a mudarabah basis (the depositor funds are invested by the bank in Shariah-compliant ventures, and profits are shared).

(Note: In both types of partnerships, an absolute profit amount cannot be pre-fixed for any partner. Only a proportional profit ratio can be decided upfront. The actual profit realized will be distributed according to that ratio, maintaining uncertainty in outcome but fairness in distribution. This is in contrast to interest, which is a pre-fixed return on capital.)

Sale-Based Financing (Trade with Cost-Plus or Deferred Terms)

In Islamic finance, a number of instruments are structured as sales of assets, since trading is halal (permissible) as a source of profit. The seller’s profit in these contracts functions similarly to interest would in a loan, but crucially, it is earned as part of an actual trade of goods or assets (which involves risk and ownership), rather than as a charge on money lent. Key sale-based modes include:

Murabaha: Murabaha is a cost-plus sale contract. In a murabaha transaction, the seller (often a bank) explicitly discloses the cost at which it acquired the item to the buyer, then sells it to the buyer at that cost plus a stated profit margin. Thus, the buyer knows the original cost and the markup. For example, an Islamic bank might purchase a piece of equipment for $100,000 and then sell it to a client for $110,000 payable in installments – the $10,000 difference is the bank’s profit for facilitating the purchase. Both parties are aware of the cost and profit. Murabaha is widely used as a substitute for loans in working capital finance, home purchases, auto financing, etc. The bank takes ownership of the asset (hence assumes some risk) and then resells it; the client gets to pay over time. Because the profit rate can be benchmarked to market rates, murabaha offers a familiar financing cost structure without violating the riba prohibition (since it’s structured as a trade). It’s essentially trade credit with a markup.

Musawamah: Musawamah is a general sale contract where the seller is not obligated to disclose their cost. The bargaining is simply on the final selling price. In practice, this is just a normal sale – the buyer and seller negotiate a price for the goods, and the buyer need not know or care what the seller’s cost or profit margin is. Most retail and commercial sales in Islamic finance (and commerce in general) are musawamah by default unless a murabaha is specifically arranged. Musawamah is less commonly mentioned as a special financing mode since it’s essentially the standard way trade happens (with negotiation). However, it’s noted to contrast with murabaha – in murabaha the transparency of cost is required as part of the contract, whereas in musawamah it is not. Islamic banks may use musawamah for asset sales if disclosing cost is not practical or necessary.

Istisna: Istisna is a forward contract for manufacturing or construction. It is used when goods need to be manufactured or built to order (e.g., constructing a building, or manufacturing a specialized product). In an istisna contract, the buyer places an order with a manufacturer (or through a bank as an intermediary) to produce specified goods at an agreed price. Payment terms can be flexible: the buyer may pay in advance, in stages based on milestones, or upon completion (as agreed in the contract). The key is that delivery of the goods is deferred until they are completed in the future. Istisna allows Islamic banks to finance projects like housing construction or infrastructure – the bank effectively funds the manufacturer/contractor (sometimes taking staged payment from the ultimate buyer), and upon completion the asset is delivered to the buyer. This differs from a conventional construction loan primarily in form: the profit for the financier is built into the istisna sale price of the asset, rather than as interest on a loan. Importantly, istisna is an exception to the general Shariah rule that you cannot sell something not yet in existence; it is specifically allowed due to necessity of manufacturing contracts, provided the specifications, delivery timeline, and price are agreed clearly upfront. The flexibility in payment schedule makes istisna useful for long-term projects.

Salam: Salam is another form of forward sale, typically used in financing agriculture or other standardized commodities. In a salam contract, the buyer pays 100% of the purchase price upfront for goods that will be delivered later at a specified future date. The goods are often fungible commodities (e.g., a certain quantity of wheat, rice, or other crops, or metals) that are not yet harvested or produced at the time of contract. By paying in advance, the buyer effectively provides working capital to the seller (e.g., a farmer) who will supply the goods later. On the delivery date, the seller delivers the goods as promised, completing the sale. From the buyer’s perspective (if the buyer is a bank, for instance), salam can be used to finance producers and later either take delivery of the commodity or sell it to another party at maturity (often through a parallel salam contract). Salam, like istisna, is an approved exception to the rule against selling non-existent goods, with the rationale of facilitating agriculture and trade. Strict conditions govern salam to protect both parties: the quality, quantity, and delivery date of the commodity must be precisely specified (to avoid gharar uncertainty), and it’s usually restricted to standardizable, readily deliverable goods. Salam is useful because it provides liquidity to producers and allows financiers to earn a return embedded in the discounted purchase price of the goods (which is typically set lower than the expected market price at delivery, compensating the buyer for paying upfront).

Important Notes on Sales: In Islamic law, ownership risk is critical. A principle is that one cannot sell what one does not own or does not exist at the time of sale, as that would be speculative or void. Both istisna and salam are structured exceptions to this rule, crafted to meet practical needs (manufacturing and agriculture financing) in a Shariah-compliant way. Another important rule is that in any sale, once the price is agreed and the sale concluded, the price cannot be changed by either party (no variable or retrospective pricing). This is unlike some interest-based loans where rates can float, but more akin to a fixed-rate loan where the total repayment is fixed upfront. Murabaha and other Islamic sales thus fix the obligation once the contract is signed. If late payment or default occurs, Islamic finance doesn’t allow compounding additional interest; any penalties usually must go to charity rather than to the lender’s profit (to avoid riba). These mechanisms ensure the sale-based modes remain fair and Shariah-compliant.

Lease-Based Financing (Ijarah)

Ijarah: Ijarah is essentially leasing – an owner of an asset transfers the right to use that asset to a lessee for a specified period in exchange for rental payments. It is comparable to conventional operating leases or finance leases, with some Shariah-specific conditions. In an ijarah, the lessor (often an Islamic bank or finance company) retains ownership of the asset, and the lessee has the right to use it. The asset could be a physical property (house, vehicle, machinery) or even an intangible asset or service. For example, a bank may buy a piece of equipment and lease it to a client for a monthly rent. At the end of the lease term, depending on the contract, the asset might be returned to the lessor, or there may be an option for the lessee to purchase it (through a separate contract, since combining a lease and sale in one contract can be problematic under Shariah).

From a financing perspective, ijarah provides a way to finance assets without an interest-bearing loan – the bank earns rent instead of interest. A key flexibility in ijarah is that rent can be fixed or floating (e.g., pegged to a benchmark) over the lease term, with agreed adjustment periods. This means Islamic banks can manage changing financing costs by revising lease rentals as pre-agreed, somewhat analogous to a floating interest rate but structured as periodic renewal of the lease terms. Unlike a sale, where price is locked, a lease can accommodate variable payments. Ijarah contracts, however, must clearly separate rental charges from any interest concept and ensure the lessor truly bears ownership responsibilities. For instance, in a true ijarah, the lessor is responsible for major maintenance and asset risk (like insurance or loss of asset), because one cannot lease something and put all risk on the lessee without transferring ownership (that would effectively be a disguised loan).

Islamic banks use ijarah extensively for asset financing (homes, vehicles, equipment) – often in a form called ijarah wa iqtina (lease to own) or ijarah muntahia bi tamleek (lease ending with transfer of ownership), where the bank agrees to gift or sell the asset to the client at the lease end for a token amount, thereby transferring ownership after the lease period. This mimics a hire-purchase arrangement but ensures that until the final transfer, the bank as owner shares the asset risk. Ijarah provides clients use of an asset and the bank a halal return (rent) without any loan contract.

(Comparison: In conventional finance, a bank might give a loan to buy a car, and charge interest. In Islamic finance, the bank might buy the car and lease it to the customer for monthly rentals. The end result — the customer gets the car and pays extra over time — is economically similar, but the form (lease instead of loan) complies with Shariah.)

Agency-Based Financing (Wakalah)

Wakalah: Wakalah is an agency arrangement. Under wakalah, a principal hires an agent to perform a certain task or represent him in a transaction, usually for a fixed fee or commission. In finance, wakalah can be used to structure trade financing or investment management. For example, an Islamic bank’s customer might appoint the bank as their agent to purchase goods on their behalf from overseas (the bank uses its expertise and network to facilitate the import), for an agreed commission. The bank as agent does not take ownership of the goods (unlike in murabaha) and typically does not take on risk of the goods – it simply performs services as instructed and earns a fee, regardless of the outcome (as long as it fulfills its duty). However, if the agent is proven negligent or breaches the terms, they would be liable for losses caused.

Wakalah is a very flexible tool in Islamic finance: banks use wakalah to manage investment funds (the investor appoints the bank as agent to invest in Shariah-compliant instruments; the bank may charge a fee and possibly a performance incentive). In trade, a Wakalah Letter of Credit (LC) can be issued where the Islamic bank acts as an agent for the importer rather than a guarantor of payment, depending on structure. The use of wakalah keeps the bank’s role to a service provider for a fee, thus avoiding interest. It is considered a relatively low-risk mode for the bank since the bank isn’t putting its own money at risk (aside from operational risk and reputation).

Guarantee (Kafalah)

Kafalah: Kafalah is a guarantee or suretyship arrangement. It involves a third party (the guarantor) adding their assurance or guarantee to an obligation of an original party. In Islamic finance, kafalah is often used to provide bank guarantees, performance bonds, or to secure a debt without charging interest. The guarantor (for example, an Islamic bank) can issue a guarantee on behalf of a client to a beneficiary (e.g., guaranteeing an importer’s payment to an exporter, or a contractor’s performance to a project owner).

Charging a direct fee purely for guaranteeing (like a risk premium) can be controversial, as some scholars view a paid guarantee as similar to insurance or financial security for a fee, which can conflict with gharar or riba if not structured carefully. However, in practice Islamic banks do often charge fees under kafalah, justifying them as service fees for documentation, administrative costs, or related services rather than a fee on the guarantee risk itself. The key is that the fee should not be proportional to the amount or duration of the guarantee in a way that mimics interest; it should reflect actual expenses. Kafalah allows Islamic banks to engage in trade finance instruments like guaranteed letters of credit, bid bonds, and financial guarantees in a Shariah-acceptable way by separating fee for service from the act of guaranteeing. It provides assurance to parties in a transaction while aligning with Islamic rules (the guarantor, as a benevolent act, is expected not to benefit beyond covering costs).

Other Notable Instruments

In addition to the main modes above, Islamic finance has developed other products and hybrid structures to address various financing needs:

• Sukuk: Although not a mode of financing per se (sukuk are Islamic bonds or investment certificates), it’s worth noting that sukuk represent a Shariah-compliant way of raising capital in the markets. Sukuk are structured around one of the permissible contracts – for example, a sukuk might represent a share in an ijarah (lease) or a mudarabah (partnership) or a commodity murabaha, etc. Investors in sukuk receive profits or rental income from the underlying assets/projects rather than interest. Sukuk have become an important instrument for governments and companies to finance infrastructure and trade, forming a bridge between Islamic finance and global capital markets. (We define sukuk further in the glossary.)
• Tawarruq: Tawarruq, sometimes called “commodity murabaha”, is a controversial but commonly practiced structure to generate liquidity. It involves a series of sales: a person in need of cash buys a commodity from the bank on a deferred murabaha (cost-plus) basis, then immediately sells that commodity to a third party for cash at a slightly lower spot price. The result is the person gets cash now, and owes the bank a higher deferred payment later. This effectively produces cash financing but via commodity trades rather than a direct loan. Many Islamic banks use tawarruq to offer personal financing or liquidity to businesses when other modes are not feasible. Critics argue it can resemble a back-door to interest-based lending, so its use is under scrutiny by some Shariah boards.
• Takaful: Islamic insurance (takaful) is another pillar of Islamic finance, though it pertains to risk management rather than financing. In takaful, participants jointly contribute to a pool that indemnifies any member who suffers a loss, structured as cooperative risk-sharing rather than the insurer-insured transactional model. While we do not cover takaful in depth here, it complements Islamic banking by providing Shariah-compliant insurance for assets and trade activities.

The above instruments show that for virtually every conventional financial product, there is an Islamic analog that achieves a similar purpose but through Shariah-permissible means. From mortgages (often done via murabaha or ijarah) to working capital loans (murabaha or salam) to private equity (musharakah/mudarabah) to bonds (sukuk), Islamic finance has developed a comprehensive toolkit. All of these ensure that financing is tied to real assets or business performance, and that financiers and clients share risks and rewards, rather than one side bearing all risk and the other side getting a fixed return.

Role of Islamic Finance in International Trade

International trade is an area where Islamic finance has made significant contributions by providing Shariah-compliant trade financing, risk mitigation, and payment facilitation. Banks and financial institutions traditionally play a critical role in trade by bridging the trust gap between exporters and importers, offering instruments like letters of credit (LCs), guarantees, trade loans, and factoring solutions. Islamic banks likewise offer a full suite of trade finance products that mirror those in conventional trade finance – but with the structural twists needed to comply with Shariah.

Consider the typical trade finance instruments involved in cross-border commerce: letters of credit, documentary collections, import/export loans, bill discounting, guarantees, and structured solutions like supply chain finance. In a conventional setting, many of these involve interest or speculative elements (for example, an import loan charging interest, or discounting a bill of exchange for a fee that implies interest). Islamic banks have developed parallel products such as Murabaha letters of credit, Salam for pre-export finance, istisna for project-based trade, wakalah agency arrangements, and kafalah guarantees, which serve the same purpose of financing and securing trade transactions without interest.

One key difference is how risk and responsibility are allocated. In conventional trade finance, a bank’s role is often that of a creditor (lender) or a guarantor that earns a fee or interest but does not get involved in the actual goods. In Islamic trade finance, the bank often has to take a more active role – as a buyer, seller, lessor, or partner – to justify its income. This means Islamic banks inherently end up sharing in certain risks of the underlying trade.

For example, in a typical import Letter of Credit, a conventional bank will issue an LC on behalf of an importer, essentially promising the exporter that it will pay them upon presentation of shipping documents. The bank charges a commission or fee for this service and possibly interest if there’s a financing period. The bank isn’t concerned with the actual goods – its exposure is to the importer’s credit risk (and possibly the country risk). By contrast, an Islamic bank offering the equivalent service often needs to go a step further:

• If no financing is needed and the importer simply wants the security of an LC, the Islamic bank might use a Wakalah LC structure: the bank acts as the importer’s agent to pay the exporter. The bank could still issue an LC as a guarantor (under kafalah) but charge only a fee that represents administrative costs, which is permissible. Essentially, the bank provides the service of facilitating payment and document handling for a fee, without lending money.
• If the importer needs to pay the exporter but also wants financing (to pay later), a conventional bank would pay under the LC and then give the importer a loan (import loan) to be repaid with interest. The Islamic bank has a few options to achieve the same result:
• Murabaha LC: The Islamic bank could itself purchase the goods from the exporter (paying at sight under the LC as a buyer of the goods), then immediately sell those goods to the importer on a murabaha basis (cost plus markup) with deferred payment. In doing so, the bank takes title to the goods for a moment and hence the risk (if the goods are damaged or not as described, the bank as buyer has recourse to the exporter). The importer gets the goods as soon as they land, and now owes the bank the murabaha price at a later date. This gives the importer financing for the import, and the bank’s profit is the markup, which is Shariah-compliant since it’s part of a sale transaction (An introduction to Islamic Finance and its impact on trade). Alternatively, if the importer only needs very short-term credit (say 30 days) and will pay quickly, the bank can even do the murabaha on a spot basis (immediate resale) or arrange an ijarah (lease) of the goods if that suits the scenario.
• Musharakah LC: In some cases, the bank and importer can enter a partnership for owning the goods. For instance, the bank and importer could jointly purchase the goods (sharing cost and ownership). The bank’s share of the goods is then either sold to the importer on deferred payment or the bank rents its share to the importer until the importer buys it out (An introduction to Islamic Finance and its impact on trade). This musharakah or profit-sharing LC is useful if, say, the importer can pay part of the cost upfront but needs financing for the rest – effectively the bank partners for that portion. This is more complex but embodies risk-sharing.
• Wakalah (Agency) LC: As mentioned, if financing isn’t needed, the bank can simply facilitate as an agent. Or even if financing is needed, wakalah can be combined with murabaha – e.g., the bank acts as agent to purchase on behalf of itself (to then sell via murabaha).

Additionally, Islamic banks provide pre-shipment financing through salam or istisna. For example, to finance a farmer who will export cotton in six months, an Islamic bank could do a salam contract buying the cotton now for future delivery (giving the farmer working capital), and later sell the cotton (maybe via another contract) when it’s delivered. This achieves the effect of an export loan. For manufacturing goods, istisna can be used similarly, with staged payments helping the manufacturer.

Islamic banks also engage in trade-based financing like factoring or receivables finance through permissible means. One method is murabaha on receivables or wakalah where the bank acts as agent to collect and takes a fee or discount structured in a Shariah-compliant way (there is ongoing debate on how to do factoring Islamically because selling debt at a discount is generally not allowed under Shariah due to riba al-nasia concerns, but some solutions exist via structured fund or mudarabah on the receivables).

Example: To illustrate how Islamic trade finance works in practice, suppose a customer in Dubai wants to import machinery from China and needs their bank to facilitate and finance this transaction. Under a conventional arrangement, the importer’s bank would issue a letter of credit to the Chinese exporter, and once the documents are presented, the bank would pay the exporter and later collect the amount from the importer (possibly providing a short-term loan to the importer to pay over time, with interest). The bank’s role is largely as an intermediary and lender, earning fees and interest, but it does not take possession of the machinery at any point.

Now, with an Islamic bank, the transaction can be structured in three possible ways depending on the customer’s needs (An introduction to Islamic Finance and its impact on trade) (An introduction to Islamic Finance and its impact on trade):

• Wakalah (Agency) LC: If the importer has the funds and just needs the facilitation, the Islamic bank will act as an agent (wakil) on behalf of the importer. The bank issues an LC and ensures the machinery is shipped as per terms. Upon arrival, the importer pays the exporter (or reimburses the bank if the bank paid). The bank charges an agency fee for this service. The bank does not assume ownership or price risk of the goods – it simply uses its network and credibility to guarantee payment. This structure involves no interest, only a service fee, and is suitable when no extended payment terms are required.
• Murabaha (Cost-Plus) LC: If the importer needs credit to pay over time, the Islamic bank can purchase the machinery from the Chinese exporter itself (thus, the LC is effectively the bank buying as the applicant). Once the machinery ships, the bank takes ownership upon dispatch or arrival. Then the bank immediately sells the machinery to the importer on a murabaha agreement, i.e., at cost plus an agreed profit, with payment perhaps in 12 monthly installments (or a lump sum at a later date). During the period before it’s sold to the importer, the bank bears the risk (for instance, if the machinery is damaged in transit and not per contract, the bank would sort that out with the exporter under the LC terms). The importer, having received the machinery, now owes the bank the deferred murabaha price. Alternatively, instead of selling on installment, the bank could also lease the machinery to the importer under an ijarah contract, earning rent and eventually transferring ownership. Both approaches ensure the bank isn’t just lending money; it’s financing through trade or lease, which is Shariah-compliant.
• Musharakah (Partnership) LC: If the importer can cover a portion of the cost but not all, the bank and the importer might enter a partnership to import the machinery. For example, the importer pays 30% upfront; the Islamic bank provides 70%. They jointly own the machinery upon import in those ratios. The bank can then sell its 70% share to the importer on deferred terms (like a murabaha for that share), or rent out its share to the importer (ijarah) until the importer gradually buys it. In effect, the bank’s 70% is financed to the importer. Profit to the bank comes via the markup or rent on its share, rather than interest on a loan. The risk (ownership, etc.) for that share lies with the bank until fully transferred.

In all the above Islamic solutions, the end result (the exporter gets paid, the importer pays over time with an added cost) is achieved just like in conventional finance. However, the nature of the contractual relationship is different. The Islamic bank is not merely a lender charging interest; it is an active participant (as an agent, trader, or partner) in the transaction, and its earnings come from permissible trade profit or service fees. This means the bank also shares in certain responsibilities or risks: for instance, as a seller in murabaha the bank must ensure the goods are as described; as a lessor in ijarah the bank must maintain the asset; as a partner in musharakah it shares business risk.

Thus, Islamic trade finance ties financing to the underlying goods and performance. This has some broader implications for trade and the economy:

• Islamic banks, by taking ownership or partnership stakes, help ensure that transactions have real economic substance. There is no incentive to finance fictitious or highly speculative trades because the bank would have to assume real risk in them. This naturally discourages forms of “ghost trading” or purely paper transactions that might be used in money laundering or financial skullduggery. In fact, Islamic trade finance’s emphasis on documentation and asset-backing can mitigate trade-based money laundering risks, as funds are linked to actual goods movement.
• The risk-sharing element can lead to more careful due diligence and monitoring by banks. Since they cannot simply rely on collateral and interest, Islamic banks often take extra steps like inspecting goods (or appointing an agent to do so) before finalizing a murabaha or starting an ijarah. This improves the overall robustness of the transaction for all parties.
• On the flip side, Islamic trade products need more structural work and sometimes can be slower or slightly more expensive to execute (due to double transfers, additional contracts, etc.). However, many Islamic banks have refined their processes to be as smooth as conventional ones, often running both systems in parallel.

In summary, Islamic finance provides all the necessary instruments for international trade – from securing payments to financing shipments – in a manner that aligns with Shariah law. By doing so, it facilitates global commerce for businesses that prefer or require Shariah compliance, and it introduces a framework where financiers and traders share risks and rewards more equitably. Everything a conventional bank can do in trade finance (letters of credit, loans, guarantees, factoring), an Islamic bank can also do, but through contracts that promote risk-sharing, asset linkage, and ethical compliance. This not only broadens the inclusion of Muslim-owned enterprises in global trade (by giving them Shariah-compliant banking options), but also offers alternative financing paradigms that could appeal to a wider market interested in ethical finance.

The Future of Islamic Finance: Innovation and Technology

(An introduction to Islamic Finance and its impact on trade) The Islamic finance industry is increasingly leveraging digital technologies – from blockchain platforms for sukuk and trade finance to AI-driven Shariah compliance – to modernize and enhance its services in a post-pandemic world.

Islamic finance is a dynamic sector that continues to evolve in response to global economic changes, technological advancements, and the growing needs of its participants. As we move further into the 21st century, several trends and developments are shaping the future of Islamic finance:

• Digital Transformation: Like the broader financial industry, Islamic finance is undergoing rapid digitalization. FinTech innovations are being adopted to improve efficiency and customer experience while maintaining Shariah compliance. For instance, many Islamic banks have developed robust online and mobile banking platforms to offer instant sukuk investments, digital takaful policy management, and automated Shariah-compliant robo-advisory for investments. The COVID-19 pandemic accelerated this shift, as banks had to serve customers remotely and ensure operations continued with minimal physical contact. As a result, processes that used to be manual – such as Shariah board approvals, documentation of murabaha sales, or identification verification – are now often handled through secure digital channels.
• Smart Contracts and Blockchain: Islamic financial institutions are exploring blockchain technology to enhance transparency and trust. Blockchain’s ability to provide immutable, transparent transaction records resonates with the Islamic emphasis on clear contracts with no gharar. For example, blockchain can facilitate the issuance and management of sukuk by automatically distributing profit payments to investors and ensuring asset-linked compliance. It can also be used in trade finance – e.g., to create smart contracts for salam or istisna, where payment is released automatically upon delivery conditions being met, reducing reliance on paperwork and intermediaries. Some jurisdictions have piloted digital sukuk and Islamic fintech platforms that connect SMEs to investors through Shariah-compliant crowdfunding using blockchain.
• Process Automation and Efficiency: Traditional Islamic finance transactions sometimes involve extra steps (like multiple sale contracts, transfers of title, etc.). To remain competitive, Islamic institutions are streamlining these processes. The use of electronic documentation and e-signatures has become common. Importantly, there’s a push towards electronic trade documents – for example, electronic Bills of Lading in trade finance – which can integrate well with Islamic trade processes and cut down on delays and uncertainties (aligning with the principle to reduce gharar). Banks are coordinating with customs, ports, and logistics providers to accept digital documents, which could significantly speed up Islamic trade finance transactions that currently require physical verification (like the inspection Islamic banks need to do on goods for murabaha, which can now be done via digital photos, live video, or IoT sensor data).
• Adaptation of Shariah Oversight: As new financial technologies like cryptocurrencies, peer-to-peer lending, and artificial intelligence emerge, Islamic scholars and regulatory bodies are actively engaging to determine how these fit within Shariah guidelines. There are ongoing discussions on topics such as whether crypto assets can be halal investments (some utility tokens might be considered assets, others may be seen as speculative), how AI-driven decision-making can be reconciled with the need for human intention in contracts, and how to automate compliance checking. Going forward, expect to see clearer frameworks from bodies like AAOIFI and IFSB on these issues, enabling Islamic finance to participate in cutting-edge financial innovation responsibly.
• Sustainability and Social Impact: There’s a natural alignment between Islamic finance principles and the goals of sustainable and socially responsible finance. Going forward, Islamic finance is expected to play a bigger role in funding green projects and social initiatives. Already, we’ve seen issuance of green sukuk (for renewable energy projects) and social sukuk (for education, healthcare funding, etc.). These cater to both faith-based and ESG-conscious investors. The concept of WaQf (Islamic endowments) is being modernized to finance social infrastructure, and microfinance combined with zakat/charity is being deployed to alleviate poverty in a Shariah-compliant way. The future likely holds greater integration of Islamic finance with global sustainable finance efforts, showcasing how ethical finance can be both profitable and purpose-driven.
• Geographical Expansion and Regulation: More countries are creating legal frameworks to accommodate Islamic finance. Recently, markets like Russia, parts of East Africa, and Central Asia have initiated regulatory changes to allow Islamic banking, seeing it as an avenue to attract investment and foster inclusive growth. The entry of new markets could drive innovation and competition. However, one challenge remains standardization: different interpretations of Shariah can lead to slightly different practices by region (for example, how certain sukuk are structured in Malaysia vs the GCC). Efforts are underway to harmonize standards internationally, which will be aided by technology (as smart contracts require precise rules) and by collaboration among scholars. Greater standardization and clarity will lower costs and complexities, boosting cross-border Islamic transactions.

In conclusion, the future of Islamic finance appears bright, with robust growth prospects and innovation helping it adapt to modern needs. By embracing technology and staying true to its core values, Islamic finance can continue to widen its appeal. Its principles of ethical investing, risk-sharing, and asset-backing are increasingly relevant in a world seeking financial systems that are both inclusive and resilient. As Islamic finance integrates more with global markets, it could influence mainstream finance as well – encouraging a shift towards more equitable and socially conscious financial practices on a larger scale.

Glossary of Islamic Finance Terms

Below is a glossary of key terms and concepts used in Islamic finance, with brief definitions:

• Gharar (Uncertainty): Refers to excessive ambiguity or uncertainty in contracts. Gharar is present when the terms of a deal are not clear or the subject matter is undefined, potentially leading to dispute. Islamic law prohibits contracts with significant gharar to ensure transparency and fairness between parties. Minor or unavoidable uncertainties (e.g., not knowing exact yield of a farm crop due to weather) are tolerated, but major ones (selling something one doesn’t own or can’t describe) nullify the contract.
• Ijarah: An Islamic leasing agreement where one party (the owner/lessor) leases an asset (such as equipment, vehicle, or property) to another party (the lessee) in exchange for rent. The lessor retains ownership of the asset, while the lessee has the right to use it. Ijarah can be used as a mode of finance (analogous to asset financing), and the lease payments provide the financier’s return instead of interest. Variations include operational lease and lease-to-own structures.
• Islamic (Shariah-compliant): In the context of finance, “Islamic” refers to any activity, contract, or institution that follows the principles of Shariah jurisprudence. This means compliance with the Islamic legal code derived from the Quran and Sunnah, including prohibitions on riba (interest), gharar (excessive uncertainty), maysir (gambling), and haram (unlawful) activities. An Islamic bank, for example, is one that operates entirely under these principles and is overseen by a Shariah board to ensure compliance.
• Istisna: A forward contract for manufacture or construction. Under istisna, a buyer places an order with a seller (or manufacturer) to produce a specific item or project, according to agreed specifications, price, and delivery date. Payment can be made at intervals or at completion as agreed. It is commonly used for project finance, such as housing development or equipment building, where the Islamic financier funds the construction and delivers the finished asset to the customer. Istisna contracts allow deferred delivery of something that doesn’t yet exist (an exception in Shariah law), facilitating infrastructure and manufacturing finance.
• Kafalah: A guarantee in Islamic finance. Kafalah involves a guarantor who agrees to stand surety for the obligation of a debtor or the performance of a party, thereby assuring the beneficiary that the obligation will be fulfilled. It is often used in bank guarantees, letters of credit, and performance bonds. The guarantor may charge a fee to cover administrative costs. Kafalah helps in trade and project contexts by providing third-party assurances without involving riba (interest).
• Maysir: Gambling or speculative betting. In finance, maysir refers to transactions of purely speculative nature where gain/loss is due to chance, considered akin to gambling. Examples include very high-risk investments that are no better than bets, or games of chance in contracts. Maysir is strictly prohibited in Islam. Financial contracts should not be designed such that one party wins only because the other loses by chance. All participants should ideally have knowledge and control over the risk factors, as opposed to gambling where outcomes are completely uncertain and based on luck.
• Mudarabah: A profit-sharing partnership where one or more partners (investors, called rab-ul-mal) provide capital and another partner (the mudarib) provides expertise and management. Profits from the venture are split according to a pre-agreed ratio. In case of loss, the financial loss is borne by the investors in proportion to their capital (and the mudarib earns nothing and loses the effort/time). Mudarabah is frequently used by Islamic banks for deposit accounts and investment funds, where the bank manages the funds as mudarib and shares profits with depositors. It embodies the principle of sharing risk and reward between capital and labor.
• Murabaha: A cost-plus sale contract. In murabaha, a seller agrees to sell a commodity or asset to a buyer at a stated price that includes a known profit over the seller’s cost. The seller must disclose the actual cost incurred and the profit margin being added. Often used by Islamic banks to finance purchases, the bank buys the goods first (taking on ownership risk) and then sells to the client on deferred payment. The client gets the goods immediately and pays the marked-up price over time. The markup is the bank’s profit for providing the financing. Murabaha is not a loan but a sale, so it is Shariah-compliant, yet it provides a fixed predictable return akin to interest (but structured as trade profit).
• Musawamah: A general sale in which the price is negotiated between seller and buyer without any obligation to disclose the seller’s cost. It’s the regular form of bargaining sale. Most retail transactions are musawamah – the buyer and seller agree on a price, and that’s it. In Islamic finance context, musawamah is essentially the same as any normal sale and is permissible so long as it’s free of fraud, coercion, or forbidden goods. It is distinguished from murabaha only by the disclosure aspect; if no cost disclosure is required, a financing sale could be termed musawamah, but practically, murabaha is more commonly used as a financing mode for transparency and Shariah compliance reasons when a bank is involved.
• Musharakah: A joint partnership where all partners contribute capital (and optionally, also skills or labor) to a venture. Profits are shared in a mutually agreed ratio, while losses are shared strictly in proportion to each partner’s capital contribution. Musharakah can be used for business startups, joint investments, or asset purchases. For instance, several investors might fund a real estate project together under musharakah – splitting profits from sales or rent per agreed ratios. Diminishing Musharakah is a form used in home financing, where bank and client jointly buy a property, and the client gradually buys out the bank’s share while paying rent on the bank’s share in the interim. Musharakah aligns well with Islamic principles as all parties have “skin in the game” and no one gets a guaranteed return regardless of outcome.
• Riba: Commonly translated as usury or interest, riba is any guaranteed or fixed increase in capital without any risk or effort, simply by virtue of a loan or credit. It is categorically prohibited in Islam. There are two types historically defined: riba al-nasi’ah (interest on loans or debt) and riba al-fadl (excess in barter exchanges of certain commodities). In modern terms, any interest-bearing loan or bond involves riba. The prohibition of riba is intended to promote economic justice – ensuring that lenders do not exploit borrowers and that wealth is generated through legitimate trade and investment, not by charging rent on money. Eliminating riba leads to financing models based on profit-sharing, leasing, and sales as described in this article.
• Salam: A forward purchase contract in which the buyer fully prepays for goods that will be delivered in the future. It is typically used for commodities or agricultural products. For example, a bank might pay a farmer today for a certain quantity of crops to be delivered in six months. Upon delivery, the contract is fulfilled. Salam provides immediate funds to the seller (producer) and a guaranteed future supply for the buyer. The price in salam is usually set lower than the expected future market price, giving the buyer (often the financier) a profit margin for paying early. Salam is allowed as a special case (despite the goods not existing yet at time of sale) because it helps provide liquidity to producers and is common in agriculture. Conditions ensure specificity of quality, quantity, and delivery date to minimize uncertainty.
• Sale: In Islamic finance context, a sale (bay’) is the exchange of a thing of value for another thing of value with mutual consent. This encompasses trade transactions where goods or services are exchanged for money (or other goods). Sale is a permissible and encouraged activity in Islam (as opposed to riba which is forbidden). Many Islamic financing techniques are structured as sales – e.g., murabaha (sale with markup), salam (forward sale), istisna (made-to-order sale) – to derive profit through trade rather than through lending. A valid sale in Shariah requires mutual agreement, a legitimate and deliverable subject matter, known price, and immediate transfer of ownership (except in salam/istisna where an exception is made).
• Sukuk: Often referred to as Islamic bonds, sukuk are financial certificates that represent a share in the ownership of an asset, project, business, or investment pool. Unlike conventional bonds that are pure debt instruments paying interest, sukuk returns are linked to the performance of the underlying asset. For example, a sukuk might give holders a share of rental income from a property (ijarah sukuk), or profits from a business (musharakah sukuk). Sukuk have fixed maturity dates and can be structured to provide periodic profit distributions and a final redemption amount, analogous to coupon payments and principal of a bond, but all payments are derived from halal business income or asset yields, not interest. Sukuk are used by companies and governments to raise capital in a Shariah-compliant manner and have become popular globally, attracting both Islamic and conventional investors due to their asset-backed nature.
• Tawarruq: Also known as commodity murabaha, tawarruq is a mechanism to raise cash through a series of sales. In a tawarruq transaction, a person who needs cash buys a commodity from an Islamic financial institution on a deferred payment basis (with a markup) and then immediately sells that commodity to a third-party buyer for cash at a slightly lower spot price. The result: the person effectively gets cash now, and will pay back a larger amount later to the institution. The institution’s profit is embedded in the deferred price. Tawarruq is used by Islamic banks to offer personal financing, liquidity management, or interbank lending without violating the letter of Shariah (since it’s structured as commodity trades). However, because the commodity typically is just a means and not something the buyer actually needs, and it’s executed rapidly (often the commodity is on an exchange or through brokers), some scholars criticize this practice as it can resemble an interest-based loan in economic effect. Despite debates, tawarruq is widely practiced under approved guidelines, especially in regions like the GCC, to provide cash financing flexibility.
• Wakalah: An agency contract where one party (the principal) appoints another (the agent or wakil) to perform a certain task on their behalf. In finance, wakalah is employed when a customer needs a bank or agent to act in a transaction for convenience or expertise reasons. For instance, investment accounts under wakalah mean the investor appoints the bank as agent to invest funds in Shariah-compliant ventures; the bank may charge a fixed fee and any profit (after fee) belongs solely to the investor (unlike mudarabah where profit is shared). In trade, a customer can ask a bank to serve as their agent to source goods. Wakala is also used internally in Islamic banks for treasury placements between banks. Because the agent’s remuneration is a known fee and not contingent on outcome (unless a performance fee is agreed separately), wakalah contracts fit well for services. They must be transparent about the scope of agency and the fee. Wakalah emphasizes trust – the agent must act in the best interest of the principal within the mandate given, and the principal should honor the fee as long as the agent fulfills the terms.

This glossary covers the fundamental terms frequently encountered in Islamic finance discussions. Understanding these enables a clearer grasp of how Islamic financial products are structured and how they operate differently from (or similarly to) their conventional counterparts. Islamic finance has its unique vocabulary, but as we’ve seen, each concept addresses a specific need in financial transactions, all while adhering to a coherent ethical framework.