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August 26, 2024

Islamic Financing Instruments and Their Applications in Türkiye – Series 1

INTRODUCTION

Islamic finance is a financing model based on the principles of prohibition of interest (riba) and profit, loss and risk sharing, which are not applicable in conventional financings. Accordingly, the development and widespread of Islamic financing instruments are material for diversifying both the financing and investment models as well as investor profile in Türkiye. Considering the importance of this issue, we detailed certain commonly used local Islamic financing instruments as well as their similarities with conventional financing instruments in this article.

A. The Legal Infrastructure of Islamic Financing Instruments in Türkiye

    In Türkiye Islamic financing instruments are implemented within the framework of the local banking and capital markets laws. These products are regulated and supervised by the Banking Regulation and Supervision Agency (“BRSA”) or the Capital Markets Board (“CMB”), depending on whether the instrument is a banking or capital markets instrument.

    Various Islamic financing instruments exist in Türkiye, and depending on the nature of the instrument, they can be provided by participation banks and/or development and investment banks (both will be referred to as “Islamic Bank”) or asset leasing companies. Certain Islamic financing instruments commonly used in Türkiye as well as their similarities with conventional financing instruments are detailed below.

    B. Major Islamic Financing Instruments in Türkiye

    1. Investment Proxy (Wakala)

      Investment proxy, or Wakala, is an investment and financing model under Islamic finance based on a proxy relationship. In this model, the proxy carries out the agreed activities on behalf of the proxy provider, and the profit gained through these activities is shared between the proxy and the proxy provider at a predetermined ratio. The proxy may also be entitled to a fee for its services. Such fee can be determined as a fixed fee, and/or the proxy can be entitled to a surplus profit in cases where it makes a higher profit than expected from the activities carried out. In conventional finance, investment proxy is similar to investment advisory, fund management, and portfolio management services. Additionally, investment proxies are commonly utilised by local Islamic Banks, similar to loans under conventional finance. In current practice, the bank, as the proxy giver, funds its customer’s certain operational and/or investment activities, while the customer, acting as the proxy, pays the profit gained from those activities to the bank, in accordance with a predetermined ratio. The most significant difference setting this model apart from conventional credit relationships is that the bank assumes the risk of loss in addition to the profit gained from the funded activity in certain cases. 

      2. Murabaha

        Murabaha is a transaction where the financial institution purchases a commodity requested by its customer and then sells it to the customer on a deferred payment basis with a predetermined profit margin. This product functions similarly to acquisition financings in conventional financings and is particularly used where sales by instalments is preferred over sales by lumpsum payment. In Murabaha transactions, typically a triparty deferred sales contract is signed between the Islamic Bank, the customer, and the supplier. The customer pays the price of the commodity along with the profit margin on an instalment basis to the bank, where the funds raised by the bank are utilised to pay the commodity purchase price on a lumpsum basis. Murabaha, similar to other Islamic financing instruments, is based on earning profit from the deferred sale of the commodity in question, without involving any interest component.  

        3. Musharaka

          Musharaka is a financing model where two or more parties invest jointly to a specific project by contributing capital and expertise, and the profit or loss derived from the project is shared among the parties. This model is also utilised in project financing transactions, which are generally considered as permissible under Sharia. Similar to conventional project financings, project financing based Musharaka agreements include, among others, the equity ratios to be contributed by the parties, terms applicable during the investment and operational periods, and the principles for profit distribution. Unlike the conventional project financings, Musharaka transactions do not involve interest, and the Islamic finance provider is required to bear the project loss as well in certain circumstances.

          4. Ijarah and Leasing

            Ijarah, while generally referring to traditional lease transactions, is widely utilised for financial leasing purposes under Islamic finance. Under this model, similar to conventional financial leasing transactions, the Islamic Bank transfers the rights to use and benefit from the leased asset to its customer for a specified term in exchange for periodic lease payments. The customer is granted with the right to purchase the leased asset at the end of the maturity by paying a predetermined purchase price, typically being a symbolic amount.

            5. Tawarruq

              Tawarruq is a transaction where Islamic Banks purchase commodities from liquid markets upon their customer’s request and then sell such commodities to the customers on a deferred payment basis. Tawarruq is similar to repos under conventional financings. In Tawarruq transactions, as in repo transactions, customers sell the commodities, they purchased from the bank on deferred terms, in liquid markets for a cash price, thereby generating immediate funds. As a result, the customer meets its liquidity requirements by incurring a debt on a deferred basis. Similar to repo transactions, a reverse Tawarruq is also available. In reverse Tawarruq, the customer sells the commodities, it already holds or acquires from the liquid markets, to the bank on deferred terms, thereby entitled to periodical payments from the bank, while the bank sells the commodities purchased on deferred terms in liquid markets to generate a return on funds.

              6. Sukuk (Lease Certificate)

              Sukuk, known as lease certificates in Türkiye, represent securities that offer a structure similar to bonds and provide investors with periodic returns derived from the income generated by the underlying assets or rights of the Sukuk. While they resemble to conventional bonds, the key difference between lease certificates and conventional bonds is that lease certificates are backed by an underlying asset or right, and holders of lease certificates have a beneficial interest in these underlying assets or rights. Additionally, as with other Islamic financing instruments, holders of lease certificates assume the transactional risk and bear the losses.

              In Türkiye, there are five main Sukuk models: asset-based, management-based, purchase-and-sale-based, partnership-based, and construction contract-based. These models are commonly used in hybrid forms under specific issuances. It must also be noted that the most widely used model under the Turkish capital market is management-based Sukuk. In this model, the entity holding the ownership the underlying assets or rights of the Sukuk and the entity that uses the funds raised from the Sukuk issuance are the same. The entity, holding the underlying assets or rights and using the funds raised, signs a management agreement with an asset leasing company authorized to issue Sukuk. Under such management agreement, the underlying assets and rights of the Sukuk are managed by the fund user on behalf of the asset leasing company, and the derived income is paid periodically to Sukuk investors (lease certificate holders). The fund user, on the other hand, is entitled to the funds raised from the Sukuk issuance as well as a management fee under the management agreement.

              CONCLUSION

              Islamic finance, with its interest-free structure based on profit, loss and risk sharing, provides a foundation for creation of new and diverse financing products. Additionally, it has the potence to an accelerated growth considering its alternative investor profile. Therefore, it is crucial for real and financial sector actors to become familiar with the available and widely used Islamic financing instruments in Türkiye and to incorporate these products into their portfolios, by evaluating their cost advantages in collaboration with Islamic banks and financial institutions. In this article, we aimed to draw attention to this topic by detailing the Islamic financing instruments commonly used in the Turkish market and their similarities with conventional financing instruments.

              This article is the first article of our series addressing the principles and instruments of Islamic finance. You may follow our upcoming articles to gain more insight on Islamic financing principles and instruments.

              Authors

              Bengü Çoşkun

              Bengü Çoşkun

              Senior Associate

              Çağla Yargıç

              Çağla Yargıç

              Lawyer