12.4 The concept of interest (riba) and how returns are made by Islamic financial securities

In Islamic finance, the concept of interest, known as riba, is strictly prohibited. Riba refers to the unjust or exploitative increase in the value of a loan or debt. It is considered unethical because it generates income without any productive economic activity or sharing of risk.

Instead of interest-based transactions, Islamic financial securities are structured based on profit-sharing arrangements or asset-based transactions. Here are some common types of Islamic financial securities and how returns are generated:

1. Mudarabah: Mudarabah is a profit-sharing partnership where one party provides the capital (rab al-mal) and the other party provides the expertise and management (mudarib). The profits generated from the investment are shared between the two parties based on a pre-agreed ratio, while losses are borne by the capital provider.
2. Musharakah: Musharakah is a partnership where multiple parties contribute capital to a venture. The profits and losses are shared based on the agreed-upon ratio of capital contributions. This partnership allows for shared ownership and shared risk.
3. Sukuk: Sukuk are Islamic bonds that represent ownership in underlying assets. Sukuk holders receive returns based on the income generated by the underlying assets, such as rental income or profits from a project. The returns are distributed to investors in proportion to their ownership in the assets.
4. Murabaha: Murabaha is a cost-plus financing arrangement where a seller sells an asset to a buyer at an agreed-upon cost plus an agreed-upon profit margin. The buyer pays for the asset in installments, including the profit margin, over an agreed-upon period.