{"id":6334,"date":"2023-05-23T16:49:41","date_gmt":"2023-05-23T16:49:41","guid":{"rendered":"https:\/\/ifg.local\/articles\/how-a-truly-islamic-financial-system-would-work\/"},"modified":"2023-10-05T13:13:06","modified_gmt":"2023-10-05T13:13:06","slug":"how-a-truly-islamic-financial-system-would-work","status":"publish","type":"post","link":"https:\/\/www.islamicfinanceguru.com\/articles\/how-a-truly-islamic-financial-system-would-work","title":{"rendered":"Whitepaper: How a Truly Islamic Financial System Would Work – IslamicFinanceGuru"},"content":{"rendered":"
\n\n\n\n
\n
1. Preface: Why write this piece in the first place?\u00a0<\/a><\/span>
\n<\/span><\/span>\u00a0 \u00a0 a. What is the nature of this solution?<\/a><\/span>
\n2. How does the modern financial system work<\/a>
\n\u00a0 \u00a0 a. Payments<\/a><\/span>
\n\u00a0 \u00a0 b. Financing\/Investment<\/a><\/span>
\n\u00a0 \u00a0 c. Insurance<\/a><\/span>
\n\u00a0 \u00a0 d. Clearing & Exchange<\/a><\/span>
\n3. Issues with modern finance<\/a>
\n\u00a0 a. Money creation method<\/a> <\/span>
\n\u00a0 \u00a0 b. Interest-based finance<\/a>\u00a0<\/span>
\n\u00a0 \u00a0 c. Derivatives and uncertainty in transactions<\/a>\u00a0<\/span>
\n\u00a0 \u00a0 d. No incentive to move to another system<\/a>\u00a0<\/span>
\n4. Issues with Islamic finance today<\/a>
\n\u00a0 \u00a0 a. Sharia wrappers<\/a>\u00a0<\/span>
\n\u00a0 \u00a0 b. Commodity Murabaha<\/a>
\n<\/span>\u00a0 \u00a0 c. Modern Islamic banking<\/a>
\n<\/span>\u00a0 \u00a0 d. 30 percent public equities rule <\/a>
\n<\/span>\u00a0 \u00a0 e. No incentive to move to another system<\/a>\u00a0<\/span>
\n5. A new way of doing things<\/a>
\n\u00a0 \u00a0 a. New mechanics of money creation<\/a><\/span>
\n<\/span>\u00a0 \u00a0 b. Scaleable alternative to debt-based finance<\/a>\u00a0<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 i. Change accounting and tax treatments of equity<\/a>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 ii. Reduced use of Sharia wrappers and commodity Murabaha<\/a>\u00a0<\/span>\u00a0<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 iii. Focus on real value rather than rental economics<\/a>
\niv. Equity and rental financing<\/span><\/span><\/a>\u00a0<\/span><\/span>
\n6. The roadmap<\/a>
\n\u00a0 \u00a0 \u00a0a. Show alternative structures that work<\/a>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 i. The bread and butter of finance<\/a><\/span>
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 ii. Investments<\/a> <\/span>\u00a0<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 iii. Insurance<\/a>
\n<\/span>b.Institutional Muslim AUM<\/a>
\n<\/span>\u00a0 \u00a0 \u00a0c.<\/span>Muslim retail pressure on Islamic banks<\/a>
\n<\/span>\u00a0 \u00a0 \u00a0d<\/span>. <\/span>Pressure on Islamic central banks to adopt new money creation mechanisms<\/a>
\n\u00a0 \u00a0 \u00a0e. Prove model and incentivise RoW to adopt it too<\/a><\/span>
\n7. Concluding Thoughts<\/a>
\n8. References and notes<\/a><\/span><\/span><\/h6>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n

<\/p>\n

<\/h3>\n

Why write this piece in the first place?<\/h3>\n

We want to sort out money and finances for Muslims once and for all.\u00a0<\/span>\u00a0<\/span><\/p>\n

We are tired of the endless debates at dinner tables on Islamic finance and if it is truly Islamic. We are deeply concerned by the sense of compromise felt by those who do end up using Islamic finance as well as the guilt felt by those who don\u2019t.<\/span>\u00a0<\/span><\/p>\n

The way to resolve this issue once and for all is to fix Islamic finance. We can\u2019t do this alone, and are self-aware enough to know we don\u2019t have all the answers. But this whitepaper is a start.<\/span>\u00a0<\/span><\/p>\n

The issues with the modern Islamic finance system arise primarily out of the following:<\/span>\u00a0<\/span><\/p>\n

    \n
  1. The entire financial edifice they operate within is unislamic \u2013 and so any products the Islamic finance industry do come up with are blighted by inadequacies. (the \u201cEdifice\u201d<\/strong> issue)<\/span>
    \n<\/span>
    \n<\/span><\/li>\n
  2. The Islamic finance industry has never really faced serious pushback from the constituency that matters most to them \u2013 their customers. (the \u201cNo Pushback\u201d<\/strong> issue)\u00a0<\/span><\/span><\/li>\n
  3. There is a received wisdom within the Islamic finance industry that a \u201ctruly\u201d Islamic product is just a mirage and the best way to structure an Islamic product is to start with a conventional product, and look to \u201cIslamify\u201d it. (the \u201cConventional First\u201d<\/strong><\/span> issue\u00a0<\/span>
    \n<\/span><\/li>\n<\/ol>\n

    To solve (1) we need to propose a genuine alternative financial edifice and we will need strong support from Muslim-majority countries and their central banks.\u00a0<\/span>\u00a0<\/span><\/p>\n

    To solve (2) we need to mobilise Muslims and educate them on what they need to kick up a fuss about.\u00a0<\/span>\u00a0<\/span><\/p>\n

    And to solve (3) we need to show that genuine alternative products are possible and encourage a new way of thinking within the Islamic finance industry by using (2).\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

    Solving the Edifice issue is at the heart of the entire solution. Absent a solution to this, any product coming out of Islamic finance will likely be a compromise. Also, absent a viable alternative to the current financial system, any criticism of modern Islamic finance will be (correctly) met with a \u201cright, so you come up with something then.\u201d<\/span>\u00a0<\/span><\/p>\n

    This is the divine pursuit too. In Surah Furqan the disbelievers expressed their surprise at a messenger that \u201cwalks in the markets\u201d:<\/span>\u00a0<\/span><\/p>\n

    \u201cAnd they say, “What is this messenger that eats food and walks in the markets? Why was there not sent down to him an angel so he would be with him a warner?\u201d<\/span><\/i>\u00a0<\/span>\u00a0<\/span><\/p>\n

    In the minds of these disbelievers the sacred is not to be linked with something as base as our appetites and commerce. But this thought process is faulty.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

    God is not a curiosity; a pastime to make us feel warm and fuzzy inside on an evening in our leisure time. Rather, he\u2019s the north star that we seek at even as we eat and transact. Doing \u201cGod\u201d is an all-encompassing pursuit. Islam is the colour of the spectacles through which we see all of life \u2013 it is not the resplendent garb we put on for a wedding.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

    The summary of our core proposal is: <\/strong>modern finance is an important industry that should do a few simple jobs for us in the economy. Modern finance has vastly overreached its remit and is dangerously broken. we believe a truly Islamic financial system is practically possible today. Such a system solves the knottiest issues around injustice and stagnant growth facing modern finance.
    \n<\/span><\/p>\n

    This system will:\u00a0\u00a0<\/span><\/p>\n

      \n
    1. be built upon a fairer way to create money; and \u00a0<\/span><\/li>\n
    2. materially change incentive structures and promote more productive economic activity. <\/span>
      \n<\/span><\/li>\n<\/ol>\n

      To get there we need to:\u00a0<\/span><\/p>\n

      a. show robust proofs of concept;
      \n<\/span>b. kick up a fuss with central banks and government; and
      \n<\/span>c. proactively present Islamic finance as a solution to global problems rather than a niche adaptation of conventional finance.<\/span><\/span><\/p>\n

      Now, when Islamic finance practitioners go about their work with a renewed vigour in their stem and the end clearly in mind, they do so with greater purpose and work on things that are pointed and focused rather than directionless. Collectively we will have dealt with the Edifice, No Pushback and Conventional First issues.\u00a0<\/span><\/p>\n

      In this whitepaper we will:<\/span>\u00a0<\/span><\/p>\n

        \n
      1. Outline the issues with the modern financial system and argue that a new financial system is possible \u2013 and sketch it out;\u00a0<\/span><\/li>\n
      2. Outline the issues with modern Islamic finance industry and sketch out alternative \u201ctruly\u201d[1]<\/a><\/span> Islamic financial products;\u00a0<\/span><\/li>\n
      3. Set out a viable roadmap to go from where we are today to a \u201ctruly\u201d\u00a0Islamic finance industry\u00a0<\/span><\/li>\n
      4. Set out a viable roadmap to getting an Islamic financial system adopted across an entire economy and, ultimately, the global economy. <\/span>\u00a0<\/span><\/li>\n<\/ol>\n

        A quick note: <\/span>we primarily use \u201cfinance\u201d to mean debt finance in this essay. Islamic equity finance does not face most of the issues associated with Islamic debt finance.\u00a0<\/em><\/p>\n

        A quick caveat: <\/span>this is a working document and we will adjust and tweak it over time. This is not intended as a definitive piece on this subject; rather it is intended as a way to organise our own thoughts and to stimulate further work by us and others.<\/em><\/p>\n

        What is the nature of this solution and where is it going to come from?<\/span>\u00a0<\/span><\/h4>\n

        \u00a0<\/span>Discussions within the Muslim community around finance and Islamic finance centre around three broad camps:<\/span>\u00a0<\/span><\/p>\n

          \n
        1. Conservative:<\/strong> This group broadly argue that the sharia rules around money are to be applied broadly to capture most things and are to be interpreted in a strict way. This usually results in the conclusion that most conventional finance products are not permissible and most Islamic finance products are unsatisfactory. Usually, proponents of this view will end up sitting on the side lines of finance waiting for something truly Islamic to come along.\u00a0\u00a0<\/span>
          \n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0a.\u00a0 \u00a0There is a subset of this group who hold the same fiqhi views, but\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0actually veer off in the complete opposite direction and conclude that,\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0as finance is a day-to-day need, and as Islamic finance is \u201cjust the\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0same as conventional finance but more expensive\u201d, one can just go\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0ahead and use conventional finance.
          \n<\/span><\/li>\n
        2. Practitioners<\/strong>: This group are typically in the Islamic finance industry. They are usually entrepreneurs or bankers. They are driven by two motives usually \u2013 desire to deliver something to the Muslim community that meets needs and desire to make profit. Their approach is characterised by a degree of pragmatism, commerciality, and \u201cthe path of least resistance\u201d.
          \n<\/span><\/li>\n
        3. Permissive:<\/strong> This group broadly argue that sharia rules should be interpreted narrowly when it comes to finance and effectively do not capture most of modern finance. They conclude that it is permissible to use modern finance and that there is no need for Islamic finance. <\/span>\u00a0<\/span><\/li>\n<\/ol>\n

          This is not the essay to be digging into the Permissive approach. Suffice to say that we hold two statements to be obviously true:<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            \n
          1. The sharia has a lot to say about financial matters and the conduct of transactions
            \n<\/span><\/li>\n
          2. The modern financial system is broken\u00a0<\/span><\/li>\n<\/ol>\n

            If those two statements are true, then we\u2019re going to have to reimagine our financial system anyway, and it would be very odd for a practising Muslim to not base our reimagining work on the sharia financial teachings. It is not acceptable to just shrug our shoulders and carry on using the current financial system.<\/span>\u00a0<\/span><\/p>\n

            We can\u2019t read a verse like this and but stop in our tracks and really think about what it means for our world today:<\/span>\u00a0<\/span><\/p>\n

            \u201cAnd whatever you give for interest to increase within the wealth of people will not increase with Allah. But what you give in Zakat, desiring the countenance of Allah \u2013 those are the multipliers.\u201d (30:39)<\/span><\/i>\u00a0<\/span><\/p>\n

            And\u00a0<\/span>\u00a0<\/span><\/p>\n

            \u201cO you who believe, fear Allah and give up what remains of your demand for riba if you are indeed believers. If you do it not, take notice of war from Allah and His Messenger.\u201d(2:278-279)<\/span><\/i>\u00a0<\/span><\/p>\n

            The Conservative group, on the other hand, agree there is a problem. Putting it crudely, some of them respond by saying \u201cit\u2019s all haram, just carry on renting your entire life\u201d, while others respond with \u201cif you can\u2019t beat them, join them (under necessity)\u201d.\u00a0<\/span>\u00a0<\/span><\/p>\n

            The reason both Conservative approaches fail is because they\u2019re defeatist by nature. They are opining on modern Islamic finance in isolation whilst shrugging their shoulders at the global Edifice problem. But that\u2019s not a solution-oriented approach \u2013 that\u2019s being a critic without anything viable to propose as an alternative. The long-term solution cannot be \u201ccarry on renting\u201d or \u201clet\u2019s just use conventional finance\u201d.<\/span>\u00a0<\/span><\/p>\n

            Our parents did not come to this country without any Masajid and halal meat and just shrug their shoulders and say \u201cah well, let\u2019s just be vegetarians and pray at home\u201d. We can\u2019t do that either with our generation\u2019s problem.<\/span>\u00a0<\/span><\/p>\n

            The Practitioners are actually doing something \u2013 which is commendable. However, there is a healthy dose of mercenaryism running through this group, and many in this group are not Muslim. That alone is not a reason to write someone\u2019s contributions off, but it is fair to say that a non-Muslim is unlikely to have ambitions to pave the way to a global financial system underpinned by Islamic teachings as an end. The Practitioners are simply there to a solve a problem and make some money whilst doing it.<\/span>\u00a0<\/span><\/p>\n

            We believe that a solution needs to come by breaking out of these three paradigms. Muslims need to come up with a roadmap, situate ourselves on that roadmap, and then drive ourselves in the direction of a better future. The solution is not a point of view, it is a <\/span>mindset<\/span><\/i> of dynamicity, movement, and progress. The solution is the conviction that we\u2019re not settling for anything less than the ideal, and we have a clear path to get there.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            We need the Practitioner to embrace the mindset, and come up with new Islamic finance products that get us down our roadmap quickly. We need Conservatives to educate their community with a critique of what currently is, but now also a realistic sketch of what could be. We will need the Permissive group to get inspired by a better, Islamic way of doing finance rather than settling for the broken conventional financial system.<\/span>\u00a0<\/span><\/p>\n

            The important of situating ourselves on a roadmap and stating an end goal that is appetising cannot be understated. Without doing that, Islamic finance today will always look unsatisfactory. But, when understood as an interim stage on a compelling roadmap, modern Islamic finance suddenly has the chance to be inspiring.\u00a0<\/span>\u00a0<\/span><\/p>\n

            Proposing a vision and redirecting critical energies of Conservative and Permissive groups on the development and critique of this desired goal is far more productive than a defeatist critique of the modern day.<\/span>\u00a0<\/span><\/p>\n

            Proposing a vision and striving towards it is also a Prophetic and Islamic methodology.\u00a0<\/span>\u00a0<\/span><\/p>\n

            Remember Our servants Abraham, Isaac, and Jacob, all men of strength and<\/span><\/i> vision<\/span><\/i><\/strong>.(38:45)<\/span><\/i>\u00a0<\/span><\/p>\n

            Yusuf asked to be put in charge because he had a gameplan:<\/span>\u00a0<\/span><\/p>\n

            Joseph said, \u2018Put me in charge of the nation\u2019s storehouses: I shall manage them prudently and carefully.\u2019 (12:55)<\/span><\/i>\u00a0<\/span><\/p>\n

            Similarly, Sulaiman asked for incredible power because he had a gameplan:<\/span>\u00a0<\/span><\/p>\n

            He turned to Us and prayed: \u2018Lord forgive me! Grant me such power as no one after me will have- You are the Most Generous Provider.\u2019 (38:35)<\/span><\/i>\u00a0<\/span><\/p>\n

            Similarly, the wife Imran (the mother of Mary) had pledged what was in her womb for God, expecting a male. But when she got a girl, she was really surprised (perhaps dismayed?). However she still stuck to her plan and followed through. Jesus (as) was the result.<\/span>\u00a0<\/span><\/p>\n

            We should now be clear on what the nature of the solution we need is, the importance of fighting for such a solution, and where it is going to come from.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            How does the modern financial system work?<\/span>\u00a0<\/span><\/h2>\n


            \n<\/span>Let\u2019s first sketch out how the modern financial system works \u2013 and then we\u2019ll turn to what\u2019s wrong with it from a sharia lens and how to fix it.<\/span>\u00a0<\/span><\/p>\n

            Today the financial system has become a huge part of our global economy \u2013 around 24% of global GDP is attributable to the financial sector[2]<\/span><\/a><\/span>.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            But it wasn\u2019t always that way. The financial sector has gone on a crazy, artificial, growth trajectory.<\/span>\u00a0<\/span><\/p>\n

            \"Chart,<\/span>[3]<\/a><\/span>
            \nThe graph above shows how we have been deregulating aggressively since the late 1970s \u2013 particularly in the USA and UK \u2013 and that has led to a massive expansion of the financial sector from little over 3% of the total GDP to over 8% today. <\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            If you add in insurance, real estate, and professional services \u2013 highly interconnected industries to finance \u2013 the total GDP share jumps to a remarkable 34%[4]<\/a><\/span><\/span>.\u00a0<\/span>\u00a0<\/span><\/p>\n

            In the UK, the story was similar, with the financial sector expanding to about 8.3% of the total GDP today, and if you add in professional services, over 12%.<\/span>\u00a0<\/span><\/p>\n

            This sounds very fishy, but perhaps, you might say, the financial sector just grew. Sure, it\u2019s large but it\u2019s not at crazy proportions.<\/span>\u00a0<\/span><\/p>\n

            The issue is the financial sector is not like any other sector. They are the sector entrusted to hold the money of the entire economy and so any turbulence or risk-taking materially affects us all.<\/span>\u00a0<\/span><\/p>\n

            And things materially changed in this period. The riskiest part of the financial sector \u2013 investment banks – quietly traded pieces of paper among themselves with increasingly inflated prices.\u00a0<\/span>\u00a0<\/span><\/p>\n

            To give context, investment banks held $33 billion in assets in 1978 (1.3% of the GDP), but by 2007 that had expanded out to $3.1 trillion (22% of GDP). Specifically, the instruments that caused the global financial crisis of 2007\/2008, collateralised debt obligations (CDOs) constituted $4.5 trillion in assets in 2007 \u2013 32% of the US GDP[5]<\/a><\/span><\/span>.<\/em>\u00a0<\/span><\/p>\n

            Another way to see how far these weapons of mass destruction \u2013 as Warren Buffett allegedly referred to them as \u2013 had expanded is by looking at the futures market. Futures are the bulk of derivatives transactions and they were originally used for practical, useful things for specific industries that needed to smooth over prices and build in certainty.<\/span>\u00a0<\/span><\/p>\n

            However, over the decades the entire industry has been subsumed by futures based on financial instruments used for trading between bankers in the City:
            \n<\/span>
            \n\"Chart,<\/span><\/span>            [6]<\/span><\/a>\u00a0<\/span><\/p>\n

            Yes, the whole thing is slightly absurd. The value of the assets underlying derivative contracts is three times the value of all the physical assets in the world[<\/span><\/a><\/span>7]<\/span><\/a>.<\/span>\u00a0<\/span><\/p>\n

            In the UK the picture is the same. John Kay eloquently explains this.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            The assets of British banks are five times the liabilities of the British government. But the assets of these banks mostly consist of claims on other banks. Their liabilities are mainly obligations to other financial institutions. Lending to firms and individuals engaged in the production of goods and services \u2013 which most people would imagine was the principal business of a bank \u2013 amounts to about 3 per cent of that total<\/span><\/i>. [8]<\/a><\/span><\/span>\u00a0<\/span><\/p>\n

            Financialisation has also caused a major increase in the volume of debt in the USA too. From 1973 to 2005, total debt rose from 140% to 328.6% of GDP. Over this time the financial sector debt grew particularly fast \u2013 from 9.7% of total debt to 31.5%[9]<\/span><\/a>.<\/span><\/p>\n

            Clearly something is amiss. But the financial system wasn\u2019t always like this. At heart the financial sector has 4 important jobs to do \u2013 and we need it to do those well for the whole economy to function like clockwork. Let\u2019s sketch those out.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            Breaking down the jobs the financial system does for us
            \n<\/span>\u00a0<\/span>\u00a0<\/span><\/h2>\n

            Payments<\/span><\/i>\u00a0<\/span><\/h3>\n

            The first, and probably most important job the financial sector does for us is provide the rails and infrastructure for us to be able to make payments to one another. This is a surprisingly complicated affair, involving multiple parties playing different functions using different technologies.<\/span>\u00a0<\/span><\/p>\n

            This article<\/span><\/a> is a great summary of how it all works, and summarises it nicely into this diagram:<\/span>\u00a0<\/span><\/p>\n

            \"How<\/span>
            \nThere are multiple modes of making a payment and getting it from one person\/entity to another. Layer in cross-border transactions, regulation, and different infrastructure in different countries, and this actually starts becoming a very complex problem.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            Banks and financial institutions can and do solve that for us today \u2013 although anyone who has recently tried to undertake a financial transaction involving a bank will attest that the system is still a way off perfect. The cynic would suggest that, perhaps, if more bright minds were focused on this rather than trading pieces of paper with each other, we might have progressed further.<\/span>\u00a0<\/span><\/p>\n

            Financing\/Investment<\/span><\/i>\u00a0<\/span><\/h3>\n

            The second key role the bank plays is connecting up those with money and want to park it somewhere to those who need it to do productive things with.\u00a0<\/span>\u00a0<\/span><\/p>\n

            The below diagram summarises the flows:<\/span>\u00a0<\/span><\/p>\n

            <\/span>\u00a0<\/span>
            \n<\/span>People with money (on the left side) have two potential intermediaries whom they trust with their money and whom ultimately will deploy that money into various investments\/loans (to the \u201cpeople who need money\u201d on the right).<\/span>\u00a0<\/span><\/p>\n

            The first route is funds and insurers who \u201cinvest\u201d the money into various endeavours. The second route is to deposit the money at banks, who will then lend it to others.\u00a0<\/span>\u00a0<\/span><\/p>\n

            The crucial difference between the two routes is that the banking route is almost entirely debt-based, while the funds route is usually equity-based. Additionally, banks can create money due to the regulatory powers they are given to operate fractional reserve banks (don\u2019t worry, we will explain these concepts shortly), while the funds\/insurers cannot do this. If funds\/insurers are given \u00a3100, they invest \u00a3100, while if a bank is given just \u00a38.50, it can loan out \u00a3100.<\/span>\u00a0<\/span><\/p>\n

            Insurance<\/span><\/i>\u00a0<\/span><\/h3>\n

            We featured insurance companies in the above diagram, and model it in the same bucket as a fund. This is not strictly true.<\/span>\u00a0<\/span><\/p>\n

            When we buy insurance, we are selling the risk we are exposed to, and the insurance company is buying it. This money is then sat with the insurance company and it is up to them to ensure that they have enough money to meet claims as they arise, whilst at the same time make certain investments with the money in order to make some profit.<\/span>\u00a0<\/span><\/p>\n

            There are certain catastrophic outcomes that are highly unlikely (but do happen) for which insurance is perfectly suited, and it helps us in our lives if we have a function that allows us to accommodate for those instances where we have a car crash or a house fire.<\/span>\u00a0<\/span><\/p>\n

            We have previously written our views on mainstream insurance <\/span>here<\/span><\/a>, but even if you consider insurance to be generally impermissible, you will be fine with takaful insurance (a variant of cooperative insurance). The point here is not to get into the debate of how to deliver an insurance financial product, more that there is a need for such a product, and it plays a function in our modern economy.<\/span>\u00a0<\/span><\/p>\n

            Clearing & Exchange<\/span><\/i>\u00a0<\/span><\/h3>\n

            Finally, the financial system is a great lubricant of trade and a venue for transactions to take place. If we revisit the below diagram again, we can see the central role \u201cmarkets\u201d play in the entire system:<\/span>\u00a0<\/span><\/p>\n

            \"A<\/span><\/p>\n

            \u00a0<\/span>The intermediaries (funds, insurers, banks etc) who hold financial instruments (debt or shares) often need to sell them to others to release capital. This is where the investment markets (also known as the stock exchange) comes in. For debts, there are the money markets.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            Currencies are also exchanged at an enormous level daily and there is a separate interbank market that facilitates these transactions.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            This central market system is vital to the seamless functioning of the financial system. If there is no central market, then counterparties need to find each other, do due diligence on each other, and come up with a deal that works for both. This makes each deal highly costly and time-consuming.\u00a0<\/span>\u00a0<\/span><\/p>\n

            Now, a central market allows transactions to be handled in a much quicker, more reliable and seamless way \u2013 often allowing transacting parties to avoid counterparty risk too (the exchange will say \u201cwe\u2019ll honour things if the other party defaults\u201d or \u201cwe are holding both the asset and the money in escrow and will facilitate this deal for you\u201d.)<\/span>\u00a0<\/span><\/p>\n

            Issues with the conventional financial system<\/span>\u00a0<\/span><\/h2>\n

            So far we have trailered that something is clearly very broken in our modern financial system, it has ballooned beyond all comprehension and control, and leads to materially harmful economic cycles in our economies for which ordinary folk end up picking up the tab.<\/span>\u00a0<\/span><\/p>\n

            We have also sketched out the primary purposes of a financial system \u2013 these functions are useful and should continue to be performed.\u00a0<\/span>\u00a0<\/span><\/p>\n

            So how did we end up from blamelessly providing just the primary functions of a financial system to the mess we are in today? The answer lies with three phenomena that underpin modern finance.<\/span>\u00a0<\/span><\/p>\n

            1. The Privatisation of Money Creation<\/span>\u00a0<\/span><\/h3>\n

            Up to 97% of our money today is not created by the central banks or governments \u2013 it is created by private banks. Organisations like <\/span>Positive Money<\/span><\/a> have done excellent work in detailing this exact point and you can also read about the mechanics of how money is created straight from (one of) the horses\u2019 mouths \u2013 the <\/span>European Central bank<\/span><\/a>.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

            We have explained how banks create money in videos like <\/span>this<\/span><\/a>, but in brief this is how the story goes:<\/span>\u00a0<\/span><\/p>\n

              \n
            1. I lend the bank \u00a3100 of notes
              \n<\/span><\/li>\n
            2. The bank now creates \u00a3100 of deposit liabilities that it owes to me. I can see these in my account with the bank.
              \n<\/span><\/li>\n
            3. The bank can then use that \u00a3100 to give out \u2013 not just that \u00a3100 \u2013 but more<\/i> than that \u00a3100. Here\u2019s how it works:\u00a0<\/span>
              \n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0a.\u00a0 \u00a0Initially, many countries have rules in place around how much of\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0that \u00a3100 a bank can lend out. Let\u2019s say this is 90% – so \u00a390.\u00a0<\/span>
              \n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0b.\u00a0 \u00a0However, that \u00a390 ultimately ends up back in someone else\u2019s bank\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0account and now the banking system can issue a further \u00a318 on\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0that too (20% of \u00a390). And the effect continues.\u00a0<\/span><\/li>\n<\/ol>\n

              A few clarifying points are important:<\/span>\u00a0<\/span><\/p>\n

                \n
              1. This is a simplified analysis. Technically banks don\u2019t directly take my money and lend that out. The activity of lending out money is separate to the activity of deposit-taking and paying out on those deposits. There is a loose connection between the two in that banks need to maintain reserve cash balances and the proportion of money they can therefore use as loans is indirectly affected by what is happening on the deposit-taking side.
                \n<\/span><\/li>\n
              2. What enables step (3) above is that bank money (or electronic money) is widely accepted today as money by everyone. Dogecoin isn\u2019t, and neither is bread, but electronic money is. What is electronic money? Money that banks have created in your account with them when they issue a loan to you. Think of it like when American Express reward you for spending through them with additional airmiles. There is no hidden reserve of airmiles that have been deposited with American Express to dish out, they can dish out as many as is appropriate given their ongoing and evolving (a) marketing budget; and (b) relationship with large airlines.
                \n<\/span><\/li>\n
              3. Let\u2019s put (3) another way \u2013 imagine instead of a bank you just loaned me money instead. Now, in order for me to lend that money out, I need to do it using only the \u00a3100 \u2013 unlike a bank. Why? Because when you send me that \u00a3100 \u2013 you are using electronic money. You\u2019ll have sent it via your bank to my bank.
                \n<\/span><\/li>\n
              4. In order for me to be able to create more money than I receive, I need to create my own money. Crypto tokens (or loyalty schemes like Amex, Tesco etc) are an example of this. Instead of lending out that \u00a3100, I change that \u00a3100 to 100 Ibrahim tokens and agree with you to return my loan in Ibrahim tokens. In your account with me you can see 100 Ibrahim tokens. Now I have a liability in a currency I control the issuance of. I owe you 100 Ibrahim tokens and I also do the same with 100 other people and so I owe them a number of Ibrahim tokens too. While I am waiting for everyone to redeem their Ibrahim tokens in their accounts, I can issue loans of Ibrahim tokens and start earning some interest on them. All this is only possible because my currency \u2013 Ibrahim tokens \u2013 is accepted as money by others \u2013 and, crucially, the Ibrahim tokens I give out as loans \u2013 ultimately still end up back on my balance sheet as an account with the debtor.\u00a0\u00a0<\/span><\/li>\n<\/ol>\n

                Banks\u2019 ability to create money was and continues to be restricted by government laws and regulations, however these have been systematically eroded over the years. PositiveMoney captures this nicely for the UK (the story is similar for the USA):<\/span>\u00a0<\/span><\/p>\n

                In 1866 there was a banking crisis, and the Bank of England then took on the role of \u2018lender of last resort\u2019, committing to lend to banks if they ran out of money to make their payments. Once this safety net was in place, banks reduced their liquid reserves to around 30%. In 1947, when the Bank of England was nationalised, they imposed a formal liquidity reserve ratio of 32%. This reserve ratio required banks to hold \u00a332 of cash, central bank reserves and government bonds for every \u00a3100 balance in customers\u2019 accounts. Of course, because government bonds would earn the bank some interest, unlike reserves and cash, the banks would try to hold as much of this 32% as possible in the form of bonds. In 1963 this liquidity ratio was dropped to 28%. Then, in the words of the Bank of England, \u201cBefore 1971, the clearing banks had been required to hold liquid assets equivalent to 28% of deposits. From 1971, this was relaxed and extended, requiring all banks to hold reserve assets equivalent to 12.5% of eligible liabilities\u2026. This combination of regulatory and economic factors coincided with one of the most rapid periods of credit growth in the 20th century (Chart 10). It also contributed to an ongoing decline in banks\u2019 liquidity holdings, ultimately to below 5% of total assets by the end of the 1970\u2019s.\u201d In this phrase, \u2018credit growth\u2019 really means a massive expansion in the amount of bank-created money, and consequently a massive rise in debt. Finally, in 1981, the liquidity reserve ratios were abolished all together.<\/span><\/i>\u00a0<\/span><\/p>\n

                Today banks can issue electronic money at scale, and, as governments (1) provide guarantees on bank deposits and (2) have consistently looked to bail out failing banks, banks are <\/span>the<\/span><\/i> go-to place to park your money safely.<\/span>\u00a0<\/span><\/p>\n

                The upshot of (a) our money creation being in the hands of private banks, (2) for that means of money creation to be interest-bearing debt issuance, and (3) these banks being government-guaranteed, results in an economy that deploys capital in the wrong places, increases the debt burden with every passing year, deepens inequality, and increases the potential of a boom\/bust cycle and bank crises\/collapses.<\/span>\u00a0<\/span><\/p>\n

                2. Interest-based financing<\/span>\u00a0<\/span><\/h3>\n

                Let me preface this section by saying that this is the \u201cproblem\u201d with the conventional financial system that we have the least clarity on today. Part of that stems from not having as clear a solution to it as I would propose for the other three problems. Another part of it is that I do not consider that I have spent enough time with the classical sources properly understanding the nature and definition of \u201criba\u201d.<\/span>\u00a0<\/span><\/p>\n

                And part of that also stems from difficulty in being able to calculate implications so far into the future: We know interest is haram, and that a society with it cannot be conducive for the flourishing of the human condition. However, we also know that modern banking has been a significant driving force behind much of the modern growth we have seen starting from the industrial revolution[<\/span><\/a><\/span>10]<\/span><\/a>. But we must believe \u2013 and model out \u2013 that in an alternative economic system where money creation methods are different and where debt finance is not as incentivised \u2013 that the better ways to do financing would emerge as the non-interest-based ones.<\/span>\u00a0<\/span><\/p>\n

                Let\u2019s revisit the diagram we looked at earlier:<\/span>\u00a0<\/span><\/p>\n


                \n<\/span>\u00a0<\/span>The core function that the banks and the funds\/insurers play is \u201cfinancing\u201d. Getting money from those who have it to those who don\u2019t and want to use it \u2013 and taking a broker cut in the middle.\u00a0<\/span>\u00a0<\/span><\/p>\n

                There are two routes to doing that \u2013 debt-based finance and equity-based finance. The former happens via banks and the latter via funds and insurers.<\/span>\u00a0<\/span><\/p>\n

                \u00a0<\/span>In today\u2019s world, debt-based finance is usually the more appealing \u201ccheaper\u201d option for most companies. Taking debt means you don\u2019t lose your shares in the business and it also means that anything you owe of that debt, including interest, is deductible as expenses and therefore reduces your tax bill. Equity on the other hand is \u201cexpensive\u201d. You can\u2019t deduct that as an expense, and you\u2019re going to be stuck with it permanently (unlike debt, which you can pay off). And if you want to sell equity you\u2019ll normally have to deal with additional taxes such as stamp duty that don\u2019t arise with debt.<\/span>\u00a0<\/span><\/p>\n

                Debt is also appealing to bankers (rather than using equity) because they can keep a meatier cut. If you raise money to provide home finance from investors \u2013 they\u2019ll want a decent cut themselves. This reduces the banker\u2019s margin. However, if you raise money from bank accounts, or savings accounts, the account holders are much happier to settle for far less returns (or in the current account \u2013 no return at all) safe in the guarantee that their account is FSCS protected (or equivalent protections across the world such as FDIC in the USA).<\/span>\u00a0<\/span><\/p>\n

                Practically this is how it plays out:<\/span>\u00a0<\/span><\/p>\n\n\n\n\n\n\n\n
                \n

                Type of capital source<\/p>\n<\/td>\n

                		\n

                Cost of capital<\/p>\n<\/td>\n

                		\n

                Rate of mortgage offered<\/p>\n<\/td>\n<\/tr>\n

                Savings account<\/span>\u00a0<\/span><\/td>\n3%<\/span>\u00a0<\/span><\/td>\n6%<\/span>\u00a0<\/span><\/td>\n<\/tr>\n
                Current account<\/span>\u00a0<\/span><\/td>\n0%<\/span>\u00a0<\/span><\/td>\n5%<\/span>\u00a0<\/span><\/td>\n<\/tr>\n
                Interbank market<\/span>\u00a0<\/span><\/td>\n4%<\/span>\u00a0<\/span><\/td>\n5.5%<\/span>\u00a0<\/span><\/td>\n<\/tr>\n
                Investors\u00a0<\/span>\u00a0<\/span><\/td>\n6%<\/span>\u00a0<\/span><\/td>\n7%<\/span>\u00a0<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

                As can be seen above, the cost of capital will determine the ultimate rates offered and banks always win as their cost of capital is the lowest (current accounts and savings accounts).<\/span>\u00a0<\/span><\/p>\n

                Additionally, because we are dealing with \u201celectronic money\u201d we\u2019re now playing the favourite game bankers like to play in any case. Being able to lend out their newly-minted money is much better than having to take in \u00a3100 and then lend out exactly \u00a3100.\u00a0<\/span>\u00a0<\/span><\/p>\n

                So the first issue with modern finance today is that both borrowers and financiers are very incentivised to opt for debt rather than equity.\u00a0<\/span>\u00a0<\/span><\/p>\n

                The second issue is that interest is inequitable and creates perverse long-term inequality. We run a few arguments against riba in our article <\/span>here<\/span><\/a> and won\u2019t replicate them here.<\/span>\u00a0<\/span><\/p>\n

                The third issue with interest-based financing is that you incentivise two lending behaviours which can lead to serious turmoil:<\/span>\u00a0<\/span><\/p>\n

                \u00a0 \u00a0 \u00a0 \u00a0 \u00a0a.\u00a0 \u00a0Banks are not as incentivised to diligence a deal as they might if their\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0returns were directly linked to the deal succeeding. Instead, bankers are\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0keen to finance a lot, for as much fees as they can get away with, and\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0then to package up these loans and sell them to someone else.\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Effectively, because the bank is not directly exposed to any downturn in\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0an asset or a transaction, the only thing they care about is the quality of\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0the security. This leads us nicely onto the second issue.\u00a0<\/span>
                \n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0b.\u00a0 \u00a0Because banks really like loans to be backed by a security, they\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0particularly like backing those industries where there are sizeable and\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0valuable assets that can act as a security. Houses are a classic example,\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0and over the years the property market has dramatically spiked up in\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0price disproportionate to the rise in salaries or even the wider economy.\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0This then creates the effect of pricing people out of their own home \u2013\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0particularly in major conurbations like London:\u00a0<\/span><\/p>\n

                \"Real<\/span>[11]<\/span><\/a>\u00a0<\/span>
                \n<\/span>
                \nThere are probably more arguments to run here, but we think we\u2019ve made the point: Interest-based financing clearly poses some significant challenges practically and ethically for society.\u00a0<\/span>\u00a0<\/span><\/p>\n

                3. Derivative and uncertainty in transactions<\/span>\u00a0<\/span><\/h3>\n

                We defined derivatives to include future, forward, options, swaps, CFDs, most forms of structured products and most forms of fixed income products.\u00a0<\/span>\u00a0<\/span><\/p>\n

                We have already shared this diagram above:<\/span>\u00a0<\/span><\/p>\n

                \"Chart,<\/span> [<\/span><\/a><\/span>12]<\/span><\/a>\u00a0<\/span><\/p>\n

                Today, the value of the assets underlying derivative contracts is three times the value of all the physical assets in the world[<\/span><\/a><\/span>13<\/span><\/a>]<\/span> and, banks carry \u201cassets\u201d on their books which consist mainly of claims on other banks, while their liabilities are mainly comprised of obligations to other banks and financial institutions.<\/span>\u00a0<\/span><\/p>\n

                We have divorced the real from the financial and increasingly it is unclear what the purpose of certain markets is other than as an enormous casino that give people a chance to become wildly rich if they learn the system.\u00a0<\/span>\u00a0<\/span><\/p>\n

                This point is also closely linked with the issue with interest \u2013 derivatives need an underlying to bring them to life \u2013 and the two underlying assets of choice are debt and stocks.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                We have already covered the wild spike in house prices since the deregulation. Here is the equivalent graph for the stock market. It follows a very similar story.\u00a0<\/span>\u00a0<\/span><\/p>\n

                \"S&P<\/span>[14]<\/span><\/a><\/p>\n

                It is no great surprise that the two asset classes most underpinning the explosion of derivatives have themselves exploded in price.\u00a0<\/span>\u00a0<\/span><\/p>\n

                So in our modern world, you become rich through holding assets that are popular with speculators, or you speculate yourself (work in finance), or, as a distant third, you do something entrepreneurial and add value to the world.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                Let\u2019s be clear, having assets has always helped throughout human civilisation. However, today having assets helps far more. In a recent report, Oxfam shared that the richest 1% pocketed $26 trillion in new wealth \u2013 nearly twice as much as the other 99% of the world\u2019s population.\u00a0<\/span>\u00a0<\/span><\/p>\n

                This creates a world where if you\u2019re rich you\u2019ll do just fine and probably get richer. But if you\u2019re poor, you\u2019re going to need a lucky break <\/span>and<\/span><\/i> incredible effort to break out.<\/span>\u00a0<\/span><\/p>\n

                But if you take away the massive speculation through derivatives you take away some of the unnatural juiced advantage that comes today from owning assets, you reduce financial speculation as a route to wealth, and you incentivise much more the route to wealth that we really should incentivise \u2013 good old-fashioned entrepreneurship.\u00a0<\/span>\u00a0<\/span><\/p>\n

                4. No incentive to move to another system<\/span>\u00a0<\/span><\/h3>\n

                Combining the three phenomena that we have sketched out \u2013 the privatisation of money creation, the prevalence of interest-based financing, and the rise of derivatives and financialization \u2013 and we have a situation where the world acknowledges something is very broken (Nicolas Sarkozy was calling for a total rethink of the financial system back in 2008[<\/span><\/a><\/span>15]<\/span><\/a>, while Yanis Varoufakis has been calling for it more recently[<\/span><\/a><\/span>16]<\/span><\/a>\u00a0but at the same time it is still completely rational for each individual country to stick with the current system.<\/span>\u00a0<\/span><\/p>\n

                Global finance is hugely interconnected, controlled by major financial institutions who owe no allegiance to a particular country. Global trade too is enormously interconnected and interdependent.<\/span>\u00a0<\/span><\/p>\n

                If any individual country decided to ban or reduce (i) the privatisation of money creation, (ii) the prevalence of interest-based financing, and (iii) the rise of derivatives and financialization, it would not be easy.\u00a0<\/span>\u00a0<\/span><\/p>\n

                Any such move would take serious political capital to make it happen, it would cause short term pain, and, if it was not handled extremely carefully, it would potentially set that country back economically.<\/span>\u00a0<\/span><\/p>\n

                It is far, far easier to go along with the status quo. <\/span>\u00a0<\/span><\/p>\n

                This apathy, therefore, is the fourth issue we must tackle if we are to move from today\u2019s financial system to a better one.<\/span>\u00a0<\/span><\/p>\n

                Issues with Islamic finance today<\/span>\u00a0<\/span><\/h2>\n

                We have critiqued the modern financial system but we must now also turn a critical eye to modern Islamic finance.\u00a0<\/span>\u00a0<\/span><\/p>\n

                We owe a lot to the pioneers of modern Islamic finance globally and it is on their shoulders that we build.\u00a0<\/span>\u00a0<\/span><\/p>\n

                There are certain compromises and leniencies allowed by Islamic scholars during the early period which got the industry up and running. But Islamic finance developed in a different time and place and today is a completely different world.<\/span>\u00a0<\/span><\/p>\n

                What has unfortunately happened is that those early leniencies and compromises have crystallised and cemented such that today \u201cmarket standards\u201d and \u201cmarket practice\u201d has established around measures that were only ever designed to be stop-gap.<\/span>\u00a0<\/span><\/p>\n

                As we stated right at the start of this whitepaper, we believe the issues with the modern Islamic finance system arise primarily out of the following:<\/span>\u00a0<\/span><\/p>\n

                  \n
                1. The entire financial edifice they operate within is unislamic \u2013 and so any products the Islamic finance industry do come up with are blighted by inadequacies. (the \u201cEdifice\u201d<\/strong> issue)\u00a0<\/span><\/li>\n
                2. The Islamic finance industry has never really faced serious pushback from the constituency that matters most to them \u2013 their customers. (the \u201cNo Pushback\u201d<\/strong> issue)\u00a0<\/span><\/li>\n
                3. There is a received wisdom within the Islamic finance industry that a \u201ctruly\u201d Islamic product is just a mirage and the best way to structure an Islamic product is to start with a conventional product, and look to \u201cIslamify\u201d it (the \u201cConventional First\u201d<\/strong> issue) <\/span>\u00a0<\/span><\/li>\n<\/ol>\n

                  If we boil all three issues into one macro-issue, it is that there is no great vision and impetus to a better future. Modern Islamic finance is happy where it is.<\/span>\u00a0<\/span><\/p>\n

                  We will of course sketch this \u201cbetter future\u201d out in the next section, however for this section I want to shed light on four manifestations of the Conventional First, Edifice and No Pushback issues within the Islamic finance industry. These should help clarify the challenge.<\/span>\u00a0<\/span><\/p>\n

                  Sharia wrappers<\/span>
                  \n<\/span><\/h3>\n

                  First some background. Sometimes Muslims want to buy something that is not technically sharia-compliant. This might be a larger group of companies for example, where a few of the companies are not sharia-compliant. It might be that these non-compliant companies have too much leverage or have haram income that is more than just nominal amounts. It might be that a company is being bought by a Muslim shareholder majority company, but the target company needs to go on a transition journey from non-compliant to compliant.<\/span>\u00a0<\/span><\/p>\n

                  Enter the \u201csharia wrapper\u201d, a legal solution constructed by some practitioners and Islamic scholars over the last couple of decades. Effectively what this structure does is allow sharia-compliant investors to invest in something that is haram but at some level be able to consider what they are investing in to be halal.<\/span>\u00a0<\/span><\/p>\n

                  The way this structure works is through back-to-back special purpose vehicle companies where your investment goes into Company A, which in turn passes it to Company B (through commodity brokers) and Company B is the entity that the haram investment is made from.\u202f<\/span>\u00a0<\/span><\/p>\n

                  Through a series of complicated transactions, the overall effect is that of an investor investing <\/span>x<\/span><\/i> into a transaction with Company A, Company A entering into a transaction worth <\/span>x <\/span><\/i>with Company B and Company B investing an amount worth <\/span>x <\/span><\/i>into a haram investment. Once the haram investment makes a profit and wants to pass the profits back to the investor, the same process starts again until the investor receives the profit back from Company A.<\/span>\u00a0<\/span><\/p>\n

                  The entire set-up is contrived and not liked by scholars. They will allow institutional funds to avail of these structures from time to time due to specific circumstances, however scholars and the AAOIFI – the global sharia standards authority – really limit the use of such a structure.\u202f<\/span>\u00a0<\/span><\/p>\n

                  There are other \u201clighter\u201d forms of sharia wrapper. When larger investors are investing into the USA or Europe (where there are fewer Islamic financial solutions) they will invest through master lease\/sublease structures.\u00a0<\/span>\u00a0<\/span><\/p>\n

                  The idea here is that an Islamic investor is only buying the freehold (or master lease) and then they will sublease the asset to someone else entirely and charge a rent for it. The sublessee will then be allowed to get conventional finance for their sublease.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                  However, there\u2019s a crucial move: the rent the sublessee pays the Islamic investor is actually just an economic arrangement to allow the Islamic investor to get the economic effect as if they had taken out the conventional loan themselves.<\/span>\u00a0<\/span><\/p>\n

                  The fiqh argument is that the Islamic investor only holds the master lease and so is insulated from any direct involvement with the interest-based financing.This structure is of course less contrived, but still, in our humble view, problematic if relied upon as a permanent solution.\u00a0<\/span>\u00a0<\/span><\/p>\n

                  We understand that there are a few lines of analysis that some will use to justify such sharia wrappers:<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                    \n
                  1. That if Muslims are to be able to invest in a globally diversified way, they need to be able to avail of conventional debt for certain investments that don\u2019t really work without it, in countries where no Islamic debt alternative is found.
                    \n<\/span><\/li>\n
                  2. That strictly structurally speaking, there is nothing impermissible taking place.
                    \n<\/span><\/li>\n
                  3. That for larger institutions in particular there is a need to invest globally into those markets that can easily absorb their capital. The size of their capital would mean that Muslim countries are not appropriate as the sole recipients of their investments. And to participate in these wider markets, conventional debt is necessary.
                    \n<\/span><\/li>\n
                  4. That Islamic debt finance is just not available and at the level of sophistication as mainstream finance, and so for many assets and investment strategies, the only option is conventional finance.\u00a0<\/span><\/li>\n<\/ol>\n

                    Argument (1) is not strictly true. Muslims can invest in real estate and companies across the world, but they won\u2019t make as much return from their investments as if they leveraged them with debt. And there are enough Muslim countries where there is sharia-compliant debt available as alternative venues for investment.<\/span>\u00a0<\/span><\/p>\n

                    Argument (2) is arguably true, but to our mind it seems to a very odd result of sharia rules to enable an investor to invest in a \u201chalal\u201d way into something that they couldn\u2019t directly invest in. This should only ever be allowed as a one-off.<\/span>\u00a0<\/span><\/p>\n

                    The reasons for allowing the transaction must necessarily derive from arguments (1), (3) and (4) otherwise we could \u201ctechnically\u201d justify anything.\u00a0<\/span>\u00a0<\/span><\/p>\n

                    Argument (3) is somewhat compelling, but it is somewhat undermined by two facts:<\/span>\u00a0<\/span><\/p>\n

                      \n
                    1. If you\u2019re an institution that is large enough, you can dictate terms to conventional banks and ensure you are provided with Islamic debt financing even in non-Muslim countries.\u00a0<\/span><\/li>\n
                    2. If you\u2019re not an institution large enough to dictate terms to conventional banks, then you\u2019re probably not an institution large enough to argue that you must<\/i> go abroad to deploy your capital. There are plenty of places to invest across the Muslim world and internationally in halal investments that don\u2019t require conventional debt.\u00a0<\/span><\/li>\n<\/ol>\n

                      Argument (4) is also initially compelling. It is true that complex types of finance such as fund finance may not properly exist in the Islamic debt markets. However, we remain unconvinced that the world of investments is so narrow as to <\/span>require<\/span><\/i> an investment house to use such conventional finance products. Take the case of fund finance. It is used by private equity funds to boost their returns as it limits the amount of time that they use investor capital in an investment. This in turn means a higher internal rate of return (or <\/span>\u201cIRR\u201d<\/span><\/strong>), which is the metric they are judged on. IRRs are linked to the time period an investment is held for, so PE funds want to reduce the time period by using an alternative source of finance. Bear in mind, that PE funds will be leveraging the actual investment itself heavily anyway – and that\u2019s separate.\u00a0<\/span>\u00a0<\/span><\/p>\n

                      Additionally, having conversed regularly with people in the finance world, our understanding is, for the right price and with the right scale, one can get pretty much any type of financing in a sharia-compliant structure. This is increasingly so as well, as undeployed capital pools switch from the West to the Middle East and Asia.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      Finally, is it a burning need for an institution to have to use niche forms of finance anyway? We\u2019re not convinced they are core to most investment strategies \u2013 just additive.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      Having said all of that, we could certainly see situations and reasons where scholars would allow sharia wrappers to be used for reasons (3) and (4).\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      So what\u2019s the issue?<\/span>\u00a0<\/span><\/h4>\n

                      The issue is that in most conversations where a practitioner says to an Islamic scholar \u201cplease can we use a sharia wrapper because we really want to do this deal,\u201d they are saying that because they come from a conventional finance background and are seeking to copy the mainstream system with an Islamic sign-off. They are not thinking from first principles \u201cokay, I know Goldman Sachs do these transactions in this way \u2013 but how about I do it differently?\u201d This is the <\/span>Conventional First<\/span><\/strong> issue writ large. This then leads to unsatisfactory products (the Edifice issue).\u00a0<\/span>\u00a0<\/span><\/p>\n

                      Commodity Murabaha<\/span>\u00a0<\/span><\/h3>\n

                      The next major issue in Islamic finance today is the widespread use of the commodity Murabaha structure. This product is approved by the vast majority of Islamic scholars and it is one of the most-used Islamic product today. However, we note that a number of scholars also advise that, where possible, if another product structure is possible, it is better to use that.<\/span>\u00a0<\/span><\/p>\n

                      The reasoning behind this is that commodity murabaha can, from some perspective, seem too synthetic a way of transforming a loan contract into a sale contract. The \u201ccommodity\u201d at the heart of the commodity Murabaha is not really the economic aim of the transaction, it does not even move during the entire transaction, and the same commodity could be used hundreds of times for multiple different Murabahas with no issues. From a risk perspective too, the way that the entire transaction is organised, a financier takes on very little to no ownership risk over that commodity.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      For a detailed analysis of how the classic commodity Murabaha structure works, see <\/span>here<\/span><\/a>.<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      We think that there are certainly situations where the use of commodity Murabaha makes sense \u2013 for example when operating in the UK or a non-Muslim country where tax and regulatory laws are such that they make the use of ijarah structures prohibitively expensive[<\/span><\/a><\/span>17]<\/span><\/a>.\u00a0<\/span>\u00a0<\/span><\/p>\n

                      However, in Muslim countries too, commodity Murabaha usage is prevalent.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      All too often, unless there is governmental intervention, it is very easy to just default to the commodity Murabaha product as a fix-all for everything. This is because the commodity Murabaha structure is malleable and versatile and can be combined and used to effectively solve any financial issue.\u00a0<\/span>\u00a0<\/span><\/p>\n

                      But when there is governmental intervention \u2013 such as when the Omani government <\/span>banned commodity Murabaha<\/span><\/a> –\u00a0 the industry figured out ways to manage their needs and started using alternative products instead. We understand and acknowledge that some may quibble about the execution of such changes, but these are logistical points, and we are talking right now on the conceptual level.\u00a0<\/span>\u00a0<\/span><\/p>\n

                      The overuse of commodity Murabaha and the sloth around innovating better products is in our humble view a key challenge for modern Islamic finance today. It is caused by a full house of the Edifice, No Pushback, and Conventional First issues.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                      Islamic banking<\/span>\u00a0<\/span><\/h3>\n

                      Modern Islamic banking is the third manifestation of the Conventional First, Edifice and No Pushback issues.\u00a0<\/span>\u00a0<\/span><\/p>\n

                      Modern Islamic banking today is structurally identical to conventional banking. The system is lubricated throughout by the use of commodity Murabaha to mimic the conventional banking system\u2019s core planks:\u00a0<\/span>\u00a0<\/span><\/p>\n

                        \n
                      1. Fractional reserve banking (or, as the financially savvy would articulate it, a careful management and balancing of long-term assets and short-term liabilities.)\u00a0<\/span><\/li>\n
                      2. The creation of private money\u00a0<\/span><\/li>\n
                      3. An overemphasis on savings account, cash management, and treasury solutions rather than an emphasis on productive investment activity:<\/span><\/li>\n<\/ol>\n

                        \"A<\/p>\n

                        [18]<\/span><\/a><\/p>\n

                        In contrast, if we add up overall global data we get:<\/span>
                        \n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0a.\u00a0 \u00a0Banking Assets: $183 trillion                        [19]<\/span><\/a>\u00a0<\/span>
                        \n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0b.\u00a0 \u00a0Bond market: $119 trillion                        [20]<\/a><\/span>\u00a0<\/span>
                        \n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0c.\u00a0 \u00a0Funds: $135 trillion                        [21]<\/span><\/a> <\/span>\u00a0<\/span><\/p>\n

                        As we can see, the spread is much more even in the mainstream than the Islamic industry, with a much heavier weighting towards public market investing (around 8.5x more in fact)[<\/span><\/a><\/span>22]<\/span><\/a>.<\/span>\u00a0<\/span><\/p>\n

                        As long as we stay stuck in a \u201crent-seeking\u201d mindset rather than a \u201cvalue-creation\u201d mindset the global Islamic economy will not grow as fast as it could and the velocity of money circulating through the economy will remain lower than it should. Islamic banks are only partly to blame for this \u2013 this is also a matter of consumer tastes and investment appetites. Those too need changing.<\/span><\/p>\n

                        A higher velocity of money circulation is a Qur\u2019anic mindset too. God says:<\/span><\/p>\n

                        As for gains granted by Allah to His Messenger from the people of other lands, they are for Allah and the Messenger, his close relatives, orphans, the poor, and needy travellers <\/span><\/i>so that wealth may not merely circulate among your rich<\/span><\/i><\/strong>. (59:7)<\/span><\/i>\u00a0<\/span><\/p>\n

                        30% debt ratio in public markets<\/span><\/h3>\n

                        It has become a very established norm in the public markets that Islamic funds are allowed to invest in companies so long as their income is less than 5% from haram sources, and so long as their debt is less than 30% debt\/market cap.\u00a0<\/span><\/p>\n

                        There are a few different variants of this rule, but all basically meander around the same point: leniency to allow for a certain percentage of conventional leverage in the companies invested in. The origins of the rule make for interesting reading as covered by Mufti Faraz Adam here<\/a>.<\/span><\/p>\n

                        We have previously analysed totally debt free stocks here<\/a>, and we found that it is possible to create a rather aggressive tech-leaning portfolio that is debt-free but not a particularly well-balanced one.<\/p>\n

                        What has resulted is the rather odd situation where any Islamic fund out there has a sizeable number of its investments in companies that benefit from conventional leverage. Muslim pensions are being grown using conventional leverage but with the veneer of investing through an Islamic fund.<\/p>\n

                        No incentive to move to another system<\/span>\u00a0<\/span>\u00a0<\/span><\/h3>\n

                        Like their conventional counterparts, Islamic financial institutions are all rational commercial organisations. Unless there is a clear reason to change, it is irrational and risky for them to change. Rather, it is better to keep one\u2019s head below the parapet and align with the status quo.<\/span>\u00a0<\/span><\/p>\n

                        The only realistic reasons a rational operator would have to change are:<\/span>\u00a0<\/span><\/p>\n

                          \n
                        1. Customer demands\u00a0<\/span><\/li>\n
                        2. Regulatory requirements\u00a0<\/span><\/li>\n
                        3. Competitive environment <\/span>\u00a0<\/span><\/li>\n<\/ol>\n

                          These rational reasons will play an important part in the practical roadmap we share towards the end of this whitepaper.<\/span>\u00a0<\/span><\/p>\n

                          A new way of doing things<\/span>\u00a0<\/span><\/h2>\n

                          We now turn to setting out a sketch of what a (modern) Islamic finance alternative economy could look like instead.<\/span>\u00a0<\/span><\/p>\n

                          This is not perfect, it is not deeply detailed, and it is not rigorously academic. But it is a starting point and coherently (we hope) sets out a practical roadmap to a reasonably well-articulated future world that we should all aim for.<\/span>\u00a0<\/span><\/p>\n

                          There will be some things we have omitted either intentionally (for brevity) or because we are not wise or experienced enough to even think about it. There are other things we may well have just got wrong.\u00a0<\/span>\u00a0<\/span><\/p>\n

                          If you spot these, dear reader, then know that there is an open invitation to you to contribute in your extensions on this whitepaper and even corrections of it.\u00a0<\/span>\u00a0<\/span>\u00a0<\/span><\/p>\n

                          With that, let\u2019s begin. We have two groups of interlinking solutions to propose:<\/span>\u00a0<\/span><\/p>\n

                            \n
                          1. A new mechanics of money creation\u00a0<\/span><\/li>\n
                          2. A scaleable alternative to debt finance\u00a0<\/span><\/li>\n<\/ol>\n

                            Ultimately, both solutions aim at doing the same things:\u00a0<\/span>\u00a0<\/span><\/p>\n