Islamic finance rests on the fundamental principle that business should be carried out in an ethical manner, says Ken Eglinton, UK Islamic Financial Services Director, EY
Islamic finance rests on the fundamental principle that business should be carried out in an ethical manner. This includes the prohibition of charging interest or providing finance to businesses involved in products deemed as anti-social, such as the arms trade, gambling, drugs or alcohol. It is the role of recognised Shariah scholars to clarify what the fundamental principle, and other Shariah requirements, mean in practice. Over time, these scholars have endorsed a wide range of product structures, although they continue to be refined.
An important feature of Islamic finance concerns transparency and the sharing of information. The belief is that one party should not profit from asymmetric information, or as a result of having more knowledge than the other. In this respect, Islamic finance resembles ‘ethical investing’. The traditional ‘caveat emptor’ approach, once associated with western finance, is not really consistent with Islamic finance. Consequently, Islamic finance is aligned well with the agenda of the PRA and FCA of ‘Treating Customers Fairly’.
The prohibition of charging interest is based on the principle of ‘togetherness’ between the finance provider and the borrower. The provider cannot simply stand at arm’s length and make money for providing finance. Instead, the finance provider and the borrower must work together for a particular business goal, and will share the profit. A common form of Islamic finance is the ‘sukuk’ structure. Unlike bonds, whose values are typically driven by an interest rate or yield, sukuks typically offer investors the right to an income stream that is based on the money-making feature of the underlying asset – it works somewhat like a securitisation. Suppose that the underlying asset is an office building: it can be sold into a special purpose vehicle, and the investors– the buyers of sukuks – will have an equity right on the asset. The office will generate income in the form of rentals, which will form an income stream for the sukuk holders.
The prohibition on gambling generally extends to derivatives, however, scholars are increasingly agreeing that derivatives can be used for hedging, but not for speculation. For instance, foreign exchange derivatives, used to insulate against the unpredictability of currency fluctuations, are now deemed acceptable in many cases. Profit-rate swaps are also available to reduce the risk of sukuk income streams under-performing. Take-up of these, however, has been patchy to date.
The future of Islamic finance, from a global perspective, is certainly interesting. The hydrocarbon wealth in the Middle East is set to generate huge pools of liquidity for investment for decades to come. Furthermore, a growing demographic will mean there is a greater need for Shariah-compliant products.
It is, however, costly to design Shariah-compliant products that refer to assets in member countries of the Organisation for Economic Co-operation and Development. Luckily for the UK, this issue presents an opportunity, and London, as a world-leader in this arena excels at product structuring and in building secondary markets for such products.