When it comes to Islam, non-Muslims may have impressions of its headscarves, halal food, and rituals and pilgrimages. But what is less known to many is that in the global financial landscape, Islamic finance, with its growing participation and its unique ethical and religious foundations, is becoming a force that cannot be ignored.

Summary

• Prohibiting interest income is the primary legal and economic basis of Islamic finance. Islamic law stipulates that making money from money is unacceptable.
• The origin of modern Islamic finance can be traced back to the 1960s and 1970s, when some Islamic countries and organizations began to establish banks and financial institutions that comply with Islamic law. Since then, traditional retail and commercial banking activities (including trade finance) have gradually been conducted in accordance with Islamic law.
• The global market size of Islamic finance is expected to reach $4.2 trillion in 2023. The huge market has also attracted more investors’ attention and has become an important component of the global market.

Basic Principles

Islamic finance is based on the doctrines of Islamic law (Shariah), and investing in Islamic financial products must not violate Islamic law. The core of its law has the following key points:

• Strictly prohibit interest (riba): Prohibiting interest income is the primary legal and economic basis of Islamic finance. Islamic law stipulates that making money from money is unacceptable. Therefore, it is forbidden to lend money to others to earn interest income.
• Prohibit risky or uncertain transactions (gharar): For example, transactions where the parties do not know the characteristics of the traded goods are prohibited to avoid unfairness and disputes.
• Prohibit gambling (maisir): Traditional financial products, such as derivatives and insurance, as well as various speculative methods, are considered to contain elements of gambling, and Islamic finance prohibits transactions involving such financial products.
• Financial business must share profits and losses, and share risks: All parties involved in financial transactions must share the profits as well as the risks. As long as the commercial risks can be shared, investors and investees are allowed to earn profits or returns from assets.
• Asset-backed: All financial transactions must be based on identifiable and tangible relevant assets. For example, Islamic law allows loans to projects involving physical assets, but does not allow loans without physical asset support.
• Ethical investment: Prohibit any “non-halal” industries, such as tobacco, alcohol, gambling, pornography, pork-related products, or any other activities that Islamic law considers illegal.

Despite the prohibition of interest-related transactions, Islamic finance still has alternatives for investors to profit: the Islamic financial system allows banks to earn profits by investing. Under the compliance of Islamic doctrines, banks and customers both participate in actual economic activities, and obtain profits or bear losses based on actual performance and results, rather than through interest income.

In addition to restricting the industry category, Islamic investment also has three provisions:

• Prohibit investing in companies with a debt-to-asset ratio of more than 33%
• The interest income of the company to be invested must be less than 33% of the company’s total income
• The receivables of the company to be invested must not exceed 70% of the company’s total assets

Modern Islamic Finance

The origin of modern Islamic finance can be traced back to the 1960s and 1970s, when some Islamic countries and organizations began to establish banks and financial institutions that comply with Islamic law, such as the Islamic Development Bank in Saudi Arabia, Bank Islam in Pakistan, and Mit Ghamr in Egypt. Since then, Islamic banking and financial activities have spread to many countries that believe in Islam, including the Gulf Cooperation Council member states and Malaysia.

Islamic financial business grew steadily in the late 1970s, and traditional retail and commercial banking activities (including trade finance) gradually took place in accordance with Islamic law. Since then, Islamic financial products have expanded and increased in both scope and complexity, including insurance, capital markets, and fund management products.

To date, Islamic finance has become an important and active part of the global financial market, with its size and influence growing. According to statistics, the total value of Islamic financial assets is expected to exceed $4.2 trillion in 2023, covering more than 75 countries and regions around the world, with Malaysia, Indonesia, Qatar, Iran and Saudi Arabia as the main markets.

Islamic Financial Instruments

There are currently many types of financial instruments that comply with the Islamic law perspective. In daily Islamic financial transactions, these financial instruments can be used to package their financial products to meet customer needs.

Murabaha:

The Islamic bank purchases the tangible assets required by the customer on behalf of the customer, and then resells the assets to the customer at a price that includes the cost and profit. The customer can purchase the asset by deferred payment or installment payment within a specified period. For example, a customer wants to buy a property through a bank, then the bank will buy the property first and resell it to the customer at a price that includes the cost and profit, and the customer can pay by deferred or installment payment.

Mudaraba:

One party provides capital and the other party provides expertise and conducts investment and management. If the investment is profitable, the partners will share the profits according to the agreed ratio; but if there is a loss, the accumulated loss will be borne by the capital provider alone.

For example, a capital owner wants to invest in a restaurant, but he has no time or experience. Another partner, who has a background and skills in the catering industry, but does not have enough funds to open a restaurant. By signing a partnership financing (Mudaraba) contract, the capital owner provides the funds, and the partner is responsible for management and operation. It is agreed that if there is a profit, it will be distributed according to a certain proportion; if the restaurant has a loss, the capital owner will bear it, and the partner will not bear any responsibility, but will also not receive any remuneration.

Musharaka

The partners of equity participation must both contribute capital, unlike partnership financing where only one party contributes capital. The management rights can be exercised jointly or separately by the partners, or entrusted to a third party to operate the investment project. The profits and losses of the joint venture are distributed according to the proportion agreed by the partners in advance. Islamic banks actually invest in the real industry of financing customers through this financing method, rather than a direct loan.

Ijara

The bank purchases the goods needed by the customer on behalf of the customer, and then leases the goods to the customer for use, and charges the customer rent. The ownership of the relevant assets still belongs to the leasing bank.

Sukuk

Sukuk are financial products that comply with Islamic law rules. They are asset-backed securities that allow investors to share the income and risk of assets. Sukuk can be understood as Islamic bonds, but unlike traditional bonds, Sukuk are not based on debt, nor involve interest payments, but are based on asset ownership and income distribution. Sukuk holders are actually co-owners of the assets, not creditors.

Takaful

Islamic insurance is a mutual insurance method based on Islamic law, which is established by a group of individuals who agree to share the potential loss risk. The members of the insurance pool pay a certain amount of money (called Tabarru), which is used to compensate the claims of the members. The core concept is that insurance is based on a cooperative and mutual model, rather than a commercial and profit model.

Islamic insurance is managed and operated by Islamic insurance companies (Takaful Operators), but Islamic insurance companies are not insurance providers, but agents or managers of the participants. Islamic insurance companies are responsible for collecting and distributing the contributions of the participants, handling claims and investments, and charging a certain fee (Wakalah Fee) or profit (Mudarabah Profit) for their services.

Outlook and Opportunities

As an important financial hub in Asia and the world’s largest offshore RMB business hub, Hong Kong is conducive to trade and investment cooperation with Islamic economies such as the Middle East, and seize the increasingly close cooperation and opportunities between Asia and the Middle East.

As the demand for investment from Islamic economies increases, the Islamic financial system is gradually becoming more open, and the innovation and diversity of Islamic finance are constantly developing. In addition to traditional products such as Islamic banking, Islamic insurance (Takaful) and Islamic bonds (Sukuk), there are also emerging fields such as Islamic funds, Islamic microfinance, Islamic social responsibility investment, and Islamic fintech.

Moreover, in 2016, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) opened up gold investment for the first time, changing the long-standing situation of gold being a taboo for Islamic finance. Before that, although there was no explicit prohibition on Muslims investing in gold, Muslims stayed away from it because of its controversial nature, and only conducted physical gold spot transactions.

Hong Kong, as an important financial hub in Asia, issued Islamic financial bonds for the first time in 2014, attracting some investors from the Middle East and Southeast Asia. It then issued two more rounds of Islamic bonds, but there were no more initiatives afterwards. However, during this period, Islamic finance developed rapidly and the market size continued to expand.

Hong Kong’s Financial Secretary Paul Chan published a blog post on December 3 this year, in which he said: “Hong Kong’s ETF market has further grown this year, with an average daily turnover of HK$11.6 billion in the first 10 months, up 25% year-on-year. Last week, Asia’s first Saudi Arabian ETF was listed in Hong Kong, which is expected to further enhance the global connectivity of Hong Kong’s ETF market and consolidate Hong Kong’s position as a leading ETF market in Asia. The Middle East region is a strong source of development momentum. Hong Kong will strive to expand its relations with Asian and Middle Eastern partners and attract new funds.”

However, Hong Kong’s current tax arrangements for Islamic bonds are the same as those for traditional bonds, but other common Islamic financial instruments such as Murabaha, Musharaka, Takaful, etc., do not have corresponding laws and regulations and regulatory institutions to support them. In addition, the handling of Islamic bonds in bankruptcy is also not clear in terms of legal basis.

To develop Islamic finance, in addition to the gradual improvement of the law, it also requires the assistance of professionals who are familiar with Islamic finance and doctrine, especially Islamic law consultants, to audit and approve Islamic financial products, to achieve compliance at the doctrinal level. Gathering and cultivating professionals who can take into account civil law, common law and Islamic law, can achieve synergy and seize the opportunities of future capital from the Middle East and Southeast Asia.

Ideas and suggestions

Hong Kong, as an international financial center and the world’s largest offshore Renminbi business hub, is conducive to trade and investment cooperation with Islamic economies such as the Middle East, and to seize the increasingly close cooperation and opportunities between Asia and the Middle East. Saudi Aramco, the Saudi Arabian oil company, met with Hong Kong media in mid-November to talk about its business development in Asia and China, and Hong Kong also intends to promote and invite Middle Eastern companies to list in Hong Kong for the second time.

In addition to attracting Middle Eastern or Southeast Asian Islamic capital, there are also many opportunities for the development of many Middle Eastern countries: non-Muslims can still invest in Islamic financial products, such as Islamic funds, Sukuk bonds, stocks, etc.; Hong Kong Stock Exchange-listed global Islamic bonds, Islamic funds, international markets also have other Islamic funds such as Amana Funds, Wahed Invest, etc. Due to the doctrinal requirements of Islam, investors also need to pay attention when investing: purification - donate income that does not comply with Islamic law, or different interpretations of doctrine by experts in different regions, these will also affect the actual performance of investment.