This article is the first in a wider series of articles focused on basic Islamic finance concepts and structures. This article will focus on Murabaha transactions.
What is Murabaha?
In simple terms, Murabaha is a sale with a profit markup. It is a form of 'cost plus financing', involving a minimum of three parties. A financier – such as a bank – purchases an asset and offers to sell it to a customer on a grossed-up basis. The sale price of the asset will be fixed between the customer and financier prior to the sale and it will either be payable immediately or on a deferred payment basis.
What makes this different to a conventional loan?
Murabaha structured financing involves the actual purchase and sale of an asset by a financier to generate the economics of conventional debt. The profit margin is typically agreed between the parties in advance.
How is it structured?
There are two stages to a Murabaha transaction and two contracts.
Firstly, the customer will request a Murabaha from a financier, promising to buy a specified asset, if the financier acquires it. The financier will then purchase the asset from the supplier (1st contract).
On receipt of said asset, the financier will then sell this to the customer, either on a deferred payment basis with an agreed payment schedule, which is typically the most common form used in the market, or for immediate payment (2nd contract).
This is a traditional Murabaha. There are other forms of Murabaha, such as a commodity Murabaha, in which the financier does not acquire the underlying asset but instead purchases commodities which are then sold to a customer before being sold on a spot basis by the customer to a third party. Other Murabaha structures include parallel commodity Murabaha and equity Murabaha, both of which include two parallel finance structures, but which can incorporate conventional financing arrangements.
When is Murabaha most often used?
Murabaha is one of the more commonly used modes of financing in Islamic finance. The structure of Murabaha is particularly well suited to asset financing, trade financing and home financing (acting as the Islamic finance equivalent of the traditional mortgage).
On the other hand, a Murabaha structure may not be well suited for long term financing, or a structure for transactions with payment terms linked to a floating benchmark rate. This is because the profit margin is usually fixed on day one and the financier may lose money if its costs ultimately increase over time.
Security position
How is a Murabaha financing secured? Security structures tend to be like those found in conventional financing. Like a conventional loan, the customer will grant security over certain of its assets to the financier in order to support the payment liabilities owed to the financier.
For further advice on Islamic finance, please feel free to get in touch.
