Understanding corporate finance: raising finance: alternative finance: types of contract
Alternative/Islamic finance: types of contract
A murabaha transaction is for the purchase and sale of assets and enables a business to acquire a fixed asset or raise capital. A finance provider will buy an asset and re-sell it immediately to the business at a pre-agreed higher price, payable either in instalments or in one lump sum at a later date. There may be other contracts forming part of the overall transaction, for example the business will identify the asset to be purchased and will promise to purchase the asset from the finance provider. Title to the asset passes from the original seller to the finance provider and on to the business.
Where a murabaha contract is used to raise finance the asset involved will usually be a commodity such as metal. Once purchased from the finance provider the commodity will be re-sold on the open market or back to a commodity dealer to provide the capital required by the business.
Murabaha contracts are also used to provide a return on customer bank deposits (known as a reverse murabaha).
A musharaka transaction is a form of partnership. A ‘diminishing musharaka’ contract may be used to purchase a property or some other asset. A bank and a customer may both acquire beneficial interests in the asset. The business may pay rent or some other type of fee for the use of the asset, while also making payments in stages as part of an agreement under which the customer progressively acquires an increasing share in, and ultimately all, the beneficial ownership of the asset.
A mudaraba contract is essentially one of profit sharing, and is often used by banks as a way of providing a return on customer deposits. The finance provider (depositor) allows the mudarib (manager, usually the bank) to use the finance provider’s money in exchange for a share of the profits arising from the use of the money. The finance provider bears any loss of the capital unless the mudarib is negligent. The mudarib is paid a fee for their services.
A wakala contract is another form of profit sharing, and is similar to a savings account. A customer deposits money with a financial institution, and appoints it as his agent, to invest the funds and provide an share of any profits as an agreed return to the depositor.
Sukuk are certificates issued to a person who provides money to a business which uses the funds to acquire assets which it will hold and manage on behalf of the certificate holders. The holder of the certificate has a share in the ownership of the assets. In legal form it is similar to a collective investment scheme, but the share of any profits from the investment going to the investor will usually be limited to an agreed percentage. In effect, sukuk are similar to corporate bonds, and are sometimes referred to as Islamic bonds.