Differences Between Islamic and Conventional Financial Instruments

Euro-Zahnrad

 

This article defines financial instruments and highlights some of the prohibited elements in conventional financial instruments.  Thereafter, the major differences between Islamic and conventional financial instruments are compared. 

A ‘financial instrument’ is defined by IAS 32.11 as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.” (Grant Thornton 2009)  Conventional financial instruments deal in intangible assets.  Intangible assets represent legal claims to some future benefit.  The typical benefit is a claim to future cash. (Fabozzi F.J. 2002)  Thus, money is treated as a commodity and traded as such in conventional financial instruments.  Islam on the other hand does not consider money as a subject matter of trade.  Money has no intrinsic value; it is only a medium of exchange.  Any profit earned through dealing with money (of the same currency) or the papers representing them is interest, hence prohibited.  Thus, Islamic financial instruments are asset backed and deal with tangibles.  (Mufti Taqi Uthmani 1998)

Another difference between conventional and Islamic financial instruments is the relationship between the investors and issuers.  In conventional financial instruments, there is generally a relationship of borrower/lender.  For example, in conventional bonds, the issuers are regarded as the borrowers and the bond purchasers are in reality lenders.  In Islamic financial instruments, the relationship is commonly some form of partnership, agency, lessor/lessee or buyer/seller.  For example, in a Diminishing Musharakah, the financier and client have a partnership relationship as well as a lessor/lessee.  In a Murabahah, the financier is a seller and the client is a purchaser. 

Risk taking is also a major distinction between conventional and Islamic financial instruments.  In conventional instruments, the financiers do not share the risk.  Risk is transferred to the client.  In Islamic financial instruments, the financiers must bear some risk in order to profit.

Conventional instruments are not regulated by any divine law or ethical guidelines.  Profit can be gained despite lying, excessive profiteering and other unethical practices.  Islamic financial instruments are governed by divine law and ethical principles.  Lying, cheating, excessive profiteering, hoarding, monopolising are all prohibited.

Conventional instruments do not have many contractual rulings and principles to make them valid.  Islamic financial instruments are governed by many contractual rulings.  For example, Islamic financial instruments must be free from Gharar (uncertainty).  Hence, contracts cannot be pegged upon uncertain events or forwarded to future dates.  Jahalah fahishah (excessive ambiguity) is another prohibited element in contracts.  Any ambiguity which has the potential to lead to argumentation and dispute will make a contract voidable.  Thus, a sale of a mobile phone without stating the specifications and model will be a voidable contract.

In conclusion, Islamic financial instruments must be asset backed, involve risk sharing and must work within the framework of Islamic law.  In contrast, conventional financial instruments are bereft of the former guidelines and principles. 

Bibliography

Fabozzi F. J. (2002), “Overview of Financial Instruments” in The Handbook of Financial Instruments, (Fabozzi, Editor), New Jersey: Wiley & Sons, Inc.

Usmani M.T. (2000), An Introduction to Islamic Finance, Karachi: Idaaratil Ma’arif

Usmani, M. I. (2002), Meezanbank‟s Guide to Islamic Banking, Karachi, Darul-Ishaat.

Al-Zuhayli, W. (2003), Financial Transaction in Islamic Jurisprudence, (Translated by El-Gemal), Damascus: Dasr al-Fikr.

Grant Thornton (2009), Financial Instruments – A Chief Financial Officer’s guide to avoiding the traps

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