The Economist explains

Why Islamic financial products are catching on outside the Muslim world

By J.F. | SINGAPORE

IN JUNE Britain became the first non-Muslim country to issue sukuk, the Islamic equivalent of a bond (the word itself is the plural of sakk, which means contract or deed). The Hong Kong Monetary Authority made an issuance in September, and the governments of Luxembourg and South Africa will follow suit later this year. Nor has sukuk fever been limited to sovereigns: last month Goldman Sachs issued an Islamic bond, and before the end of the year, Bank of Tokyo-Mitsubishi and Société Générale, a French bank, are expected to do the same. All of these entities want in on the $2 trillion Islamic finance market. But what is Islamic finance, and why has it piqued the interest of non-Muslim countries and companies?

Broadly, Islamic financial products comply with the system of Muslim laws and norms known as sharia. Muslims consider pork, alcohol, gambling and pornography haram, for instance, so Islamic investment vehicles must steer clear of them. The Koran vehemently forbids usury. The debate over what, precisely, this includes is longstanding (and has led to the growth of a cottage industry of sharia-compliance advisors: religious scholars who rule on the acceptability of financial products and innovations and often charge sizable fees for doing so). But in practice it has led most Islamic financial products to eschew the payment or charging of interest, so sukuk and Islamic mortgages must be structured differently from traditional bonds and mortgages. Instead of receiving interest payments on lent money, as in a standard bond, a sukuk generally entitles its possessor to (nominal) part-ownership of an asset; he then receives income either from profits generated by that asset or from rental payments made by the issuer. In an Islamic mortgage, rather than lending a customer money to buy a house, the bank will buy the house itself. The customer can then either buy the house back from the bank at an agreed-upon, above-market value paid in instalments (this is called murabahah) or he can make monthly payments comprising a rental fee and a piece of the purchase price until he owns the home outright (ijara).

Islamic finance also treats risk differently: speculation, or maysir (the same word used for gambling) and uncertainty (gharar) are considered haram. These prohibitions tend to rule out derivatives, options and futures, all of which have been deemed to require excessive speculation about future events (those aversions meant that Islamic banks mostly came through the financial crisis in better shape than others, though their heavy exposure to the property sector meant that in the end they also felt the pinch). More broadly, Islamic finance takes a dim view of transactions not based on tangible assets. Islamic principles of risk-sharing rule out conventional insurance, because it tends to be offered by companies for the benefit of shareholders rather than the insured. In takaful, or Islamic insurance, rather than paying premiums to a company, the insured contribute to a pooled fund overseen by a manager, and they receive any profits from the fund's investments.

These vehicles may sound abstruse, but they are also increasingly popular. Britain's £200m ($323m) sukuk sale attracted more than £2.3 billion in orders. Hong Kong's $1 billion issuing attracted $4.7 billion in orders, nearly two-thirds of which came from outside the Muslim world. Nor did these investors sink their money into sukuk for the sake of feel-good multiculturalism: they did it because Hong Kong's product was a five-year dollar-denominated asset at 2.005%, or 23 basis points above five-year US treasuries. The secondary market may be small—generally, investors buy and hold Islamic financial products more than they trade them—and, at the risk of mixing Abrahamic metaphors, their payment structures can be somewhat jesuitical. But their appeal is down to two main factors. First, Islamic financial products—particularly sukuk, issuance of which grew at an average annual rate of 35% from 2002 to 2012—have begun appealing not just to religious customers, but to all investors as a pure value proposition. And second, they let sovereigns and institutions tap into a large liquidity pool in search of certifiably halal outlets.

Dig deeper:
The market for Islamic finance is growing fast (Sept 2014)
Malaysia leads the charge on Islamic finance (Jan 2013)
Why science is making a comeback in the Islamic world (Jan 2013)

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