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KembaraXtra – Islamic Banking – Linking Dual Payment Systems with Muqasah (Islamic) and Non-Muqasah (Conventional) Settlement
In a dual-banking system, Islamic and conventional banks operate side by side and share the same national payment and settlement infrastructure. The key distinction does not lie in the payment system itself, but in how settlement obligations are handled internally by Islamic banks versus conventional banks.
1. One payment system, two settlement approaches
Both Islamic and conventional banks:
- use the same clearing house,
- participate in the same cheque-clearing and settlement system, and
- settle through the same central bank.
However, the settlement method differs:
- Conventional banks use non-Muqasah (gross or interest-based settlement)
- Islamic banks apply Muqasah (set-off) and Shari’ah-compliant liquidity tools
2. Conventional payment system (Non-Muqasah settlement)
In a conventional payment system:
- Cheques are cleared through the clearing house.
- Gross interbank obligations are calculated.
- Each bank settles its full obligation separately.
- If a bank has insufficient funds:
- it may borrow overnight,
- interest may be charged.
- Bank A owes Bank B: $10,000
- Bank B owes Bank A: $8,000
👉 Both amounts are paid separately.
👉 Temporary balances may attract interest.
This is non-Muqasah settlement.
3. Islamic payment system (Muqasah settlement)
In an Islamic payment system:
- Cheques are cleared through the same clearing house.
- Interbank obligations are identified.
- Muqasah (set-off) is applied:
- mutual debts are cancelled,
- only the net amount is settled.
- No interest arises at any stage.
- Bank A owes Bank B: $10,000
- Bank B owes Bank A: $8,000
L
👉 $8,000 is set off.
👉 Bank A pays only $2,000.
This ensures Shari’ah-compliant settlement.
4. Linking Muqasah to Malaysia’s dual-banking system
In Malaysia:
- Islamic banks and Islamic windows maintain Wadiah current accounts with Bank Negara Malaysia.
- During cheque clearing, Muqasah is applied internally to settle interbank obligations.
- If a settlement deficit arises:
- BNM provides liquidity under Al-Wakalah using Islamic securities,
- through a Shari’ah-compliant repo-like mechanism
5. Why separate payment systems are NOT required
Shari’ah does not require:
- separate clearing houses, or
- separate settlement infrastructure.
What Shari’ah does require:
- internal segregation of Islamic funds,
- Shari’ah-compliant settlement methods (Muqasah),
- interest-free liquidity support
- Infrastructure is shared
- Settlement logic differs
In a dual-banking system, Islamic and conventional banks share the same payment system, but conventional banks settle using non-Muqasah methods that may involve interest, while Islamic banks apply Muqasah and Shari’ah-compliant liquidity mechanisms to ensure interest-free settlement.
Shari’ah does not require separate payment systems in a dual-banking environment. Islamic banks participate in the same clearing and settlement infrastructure as conventional banks but apply Muqasah (set-off) and Shari’ah-compliant liquidity arrangements, while conventional banks use non-Muqasah, interest-based settlement methods.
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KembaraXtra – Islamic Banking – Introduction
-Shari’ah-Compliant Stocks
Shari’ah-compliant equity investment is founded on the Islamic principle of equity participation, which closely resembles a partnership arrangement known as Musharakah. Under this principle, investors participate in the ownership of a company and share in its profits and risks. While this approach is similar in form to equity investment in conventional capital markets, Islamic equity investment is restricted to stocks that comply fully with Shari’ah principles.
A company’s shares may only be classified as Shari’ah-compliant if its core business activities are permissible under Islamic law. Companies involved in activities prohibited by Shari’ah are excluded from investment. These prohibited sectors include interest-based financial services, alcohol production and distribution, pork-related products, weapons manufacturing, gambling, and certain forms of entertainment deemed non-compliant with Islamic ethical standards.
In addition to business activity screening, Shari’ah-compliant companies must also satisfy financial ratio requirements. These ratios typically limit the level of interest-based debt, non-permissible income, and liquid assets relative to the company’s total assets or market value. Although the presence of a limited amount of interest-based borrowing may appear to conflict with Islamic finance principles, Shari’ah scholars permit such tolerance under specific thresholds due to prevailing market realities. The rationale and detailed justification for these tolerable limits are examined further in Study Guide Three.
To ensure continued compliance, listed stocks are subjected to periodic Shari’ah screening and review. This process verifies that companies continue to meet both qualitative (business activity) and quantitative (financial ratio) criteria. Screening standards are determined by Shari’ah boards associated with recognised screening agencies, and updated lists of compliant stocks are published regularly for investor reference.
Prominent examples of Shari’ah-compliant equity indices include the FTSE Bursa Malaysia Hijrah Shariah Index (which replaced the Kuala Lumpur Shari’ah Index), the Dow Jones Islamic Market Index, and screening methodologies issued by the Accounting and Auditing Organization for Islamic Financial Institutions. These indices and methodologies provide investors with reliable benchmarks and guidance for Shari’ah-compliant equity investment.
Key Takeaway
Shari’ah-compliant stocks represent equity participation in companies whose business activities and financial structures conform to Islamic principles, with compliance ensured through rigorous screening based on both qualitative and quantitative criteria.
-Shari’ah-Compliant Stocks
Shari’ah-compliant equity investment is founded on the Islamic principle of equity participation, which closely resembles a partnership arrangement known as Musharakah. Under this principle, investors participate in the ownership of a company and share in its profits and risks. While this approach is similar in form to equity investment in conventional capital markets, Islamic equity investment is restricted to stocks that comply fully with Shari’ah principles.
A company’s shares may only be classified as Shari’ah-compliant if its core business activities are permissible under Islamic law. Companies involved in activities prohibited by Shari’ah are excluded from investment. These prohibited sectors include interest-based financial services, alcohol production and distribution, pork-related products, weapons manufacturing, gambling, and certain forms of entertainment deemed non-compliant with Islamic ethical standards.
In addition to business activity screening, Shari’ah-compliant companies must also satisfy financial ratio requirements. These ratios typically limit the level of interest-based debt, non-permissible income, and liquid assets relative to the company’s total assets or market value. Although the presence of a limited amount of interest-based borrowing may appear to conflict with Islamic finance principles, Shari’ah scholars permit such tolerance under specific thresholds due to prevailing market realities. The rationale and detailed justification for these tolerable limits are examined further in Study Guide Three.
To ensure continued compliance, listed stocks are subjected to periodic Shari’ah screening and review. This process verifies that companies continue to meet both qualitative (business activity) and quantitative (financial ratio) criteria. Screening standards are determined by Shari’ah boards associated with recognised screening agencies, and updated lists of compliant stocks are published regularly for investor reference.
Prominent examples of Shari’ah-compliant equity indices include the FTSE Bursa Malaysia Hijrah Shariah Index (which replaced the Kuala Lumpur Shari’ah Index), the Dow Jones Islamic Market Index, and screening methodologies issued by the Accounting and Auditing Organization for Islamic Financial Institutions. These indices and methodologies provide investors with reliable benchmarks and guidance for Shari’ah-compliant equity investment.
Key Takeaway
Shari’ah-compliant stocks represent equity participation in companies whose business activities and financial structures conform to Islamic principles, with compliance ensured through rigorous screening based on both qualitative and quantitative criteria.
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KembaraXtra – Islamic Banking – Introduction- Islamic Financial System (IFS) in Operation
All financial systems perform two fundamental functions: mobilising surplus funds from economic agents and institutions, and allocating those funds to deficit units that require financing. Surplus units typically include individuals or institutions with excess funds, such as investors and savers, while deficit units include borrowers, entrepreneurs, and businesses seeking funds for consumption or productive activities. By channelling funds between these two groups, the financial system supports economic growth and overall financial stability.
The mobilisation of funds provides returns to surplus units, thereby enhancing their wealth and economic well-being. At the same time, access to financing enables deficit units to expand their productive capacity and purchasing power, which in turn stimulates production, consumption, and investment within the economy. In this way, the financial system plays a central role in improving the economic performance of society as a whole.
Within the Islamic Financial System, funds or deposits can be mobilised through either debt-based or equity-based arrangements, provided these comply with Shari’ah principles. Debt-based Islamic financing structures, such as trade-based contracts, create a series of payment obligations that are settled according to predetermined schedules. These obligations arise from genuine underlying transactions involving assets or services, rather than from interest-bearing loans.
In contrast, equity-based Islamic financing involves profit-and-loss sharing arrangements, where depositors or investors acquire partial ownership in a business or venture. The returns on such investments depend on the future profitability of the underlying business activities. As a result, investors share both the risks and rewards of the venture, reflecting the Islamic finance principle of risk sharing rather than risk transfer.
The financing process within the IFS allows potential users of funds to compete for available resources, thereby creating incentives for funds to be supplied efficiently. Funds are expected to be allocated to projects and activities that generate positive real economic value. In other words, financing is provided where the expected returns from the use of funds exceed the returns promised or shared with the suppliers of funds, ensuring sustainability and economic viability.
A critical requirement of this process is comprehensive disclosure of information. Investors and other providers of funds must be given sufficient and accurate information to evaluate the risks, expected returns, and Shari’ah compliance of proposed financing activities. Transparent disclosure supports informed decision-making, promotes fairness, and strengthens confidence in the Islamic financial system.
Key Takeaway
The Islamic Financial System operates by mobilising surplus funds and allocating them to deficit units through Shari’ah-compliant debt-based and equity-based financing, emphasising real economic value, risk sharing, and transparency.
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KembaraXtra – Islamic Banking – Introduction-Indirect Financing System
(a) Products Available
The indirect financing system, also referred to as the financial intermediation process, is a core component of the Islamic Financial System (IFS). In this system, Islamic Commercial Banks (ICBs) act as financial intermediaries by mobilising surplus funds from savers and allocating them to deficit units that require financing. Through this intermediation role, ICBs connect economic agents with excess funds to those with productive or consumption-based financing needs.
Surplus funds are mobilised by ICBs through a range of deposit and investment products. These include savings and current accounts structured on Wadi’ah (safe custody) or Qard Hasan (interest-free loan) contracts, as well as Mudarabah-based savings accounts and Mudarabah-based investment accounts. Each of these products differs in terms of risk exposure, return expectations, and contractual obligations, allowing depositors to choose arrangements that align with their financial objectives and risk preferences.
Once mobilised, funds are channelled through ICBs to users of finance via various equity-based and debt-based financing products. Equity-based financing instruments include profit-sharing partnerships such as Mudarabah, joint-venture partnerships such as Musharakah, and diminishing partnerships such as Musharakah Mutanaqisah. These contracts enable shared ownership and risk participation between the bank and its customers.
Debt-based financing products are structured around genuine trade or asset-backed transactions. Common examples include Murabahah (cost-plus sale), Ijarah (leasing), Salam (deferred delivery sale), and Istisna’ (manufacturing or construction contract). In addition, Islamic financial institutions provide service-based activities such as Wadi’ah (safe custody) and Wakalah (agency) arrangements. Through this diverse range of products, ICBs offer investment opportunities to surplus units and financing solutions to deficit units under clearly defined Shari’ah-compliant terms and conditions.
(b) Putting Islamic Finance to Work
Islamic financial intermediaries earn income from indirect financing primarily through the spread, which represents the difference between the cost of funds mobilised from depositors and the returns generated from financing activities. This spread compensates the institution for the various risks it assumes, particularly credit risk, which arises from the possibility that customers may fail to meet their payment obligations.
As intermediaries, Islamic financial institutions manage and pool risks on behalf of depositors by maintaining diversified portfolios of assets with varying levels of risk exposure. These portfolios reflect the differing risk appetites and investment horizons of depositors and investors, while ensuring that financing activities remain Shari’ah compliant and economically viable.
Traditionally, finance companies specialised in serving market segments not fully addressed by commercial banks, such as hire purchase, leasing, small consumer loans, personal financing, and factoring. Commercial banks typically focused on retail banking, while merchant or investment banks concentrated on wholesale and corporate banking activities. However, as Islamic Commercial Banks expanded their scope of operations, they increasingly assumed the functions previously performed by finance companies.
This integration was further encouraged by the introduction of more stringent capital adequacy requirements, particularly risk-weighted capital standards under international regulatory frameworks such as the Basel accords. Consolidating finance company activities within the banking structure proved to be more efficient and financially sound than maintaining them as separate entities. As a result, many finance companies were absorbed into ICB conglomerates, strengthening the overall stability and efficiency of the Islamic financial intermediation system.
Key Takeaway
The indirect financing system in Islamic finance operates through Islamic Commercial Banks that mobilise deposits and investments and channel them into Shari’ah-compliant equity-based, debt-based, and service-based financing products, earning income through spreads while managing and pooling financial risks.
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KembaraXtra – Islamic Banking – Introduction-Direct Financing
The development of capital markets provides an alternative mechanism for financial intermediation known as direct financing. Unlike indirect financing, where funds are channelled through financial institutions, direct financing allows corporations to raise funds directly from investors by issuing securities. These securities are financial instruments that can be traded in secondary markets, thereby enhancing liquidity and enabling investors to enter or exit their positions more easily.
Through the issuance of securities, corporations gain direct access to capital without relying solely on bank intermediation. At the same time, investors are provided with opportunities to earn returns through dividends or coupon payments, as well as capital gains arising from changes in the market value of the securities. In direct financing, returns are linked to the performance of the issuing entity and prevailing market conditions rather than being fixed in advance.
Risk compensation in direct financing is primarily achieved through the risk–return relationship. Since most investors are risk-averse, higher levels of risk must be matched with higher expected returns to attract investment. As a result, the mobilisation and allocation of funds in capital markets reflect varying degrees of risk tolerance among investors. Securities perceived to carry greater risk are typically required to offer higher potential returns.
A distinctive feature of direct financing is issuer risk, which refers to the risk that the issuing corporation may be unable to meet its financial obligations. Because investors bear this risk directly, capital markets place strong emphasis on transparency, disclosure, and accurate information. Issuers are therefore required to provide detailed financial and operational disclosures to allow investors to assess risks and expected returns effectively.
In many jurisdictions, including Malaysia, Hong Kong, Singapore, the European Union, and the United States, issuers of securities are also required to obtain independent credit ratings. These ratings are provided by specialised rating agencies and serve as third-party assessments of the issuer’s creditworthiness and the quality of the securities issued. Credit ratings function as a grading system that offers an objective measure of the issuer’s ability to meet its financial obligations at maturity, thereby enhancing investor confidence and supporting the efficient functioning of capital markets.
Key Takeaway
Direct financing allows corporations to raise funds directly from investors through the issuance of tradable securities, with returns determined by dividends, coupons, and capital gains, and risks managed through disclosure, transparency, and independent credit ratings.
The development of capital markets provides an alternative mechanism for financial intermediation known as direct financing. Unlike indirect financing, where funds are channelled through financial institutions, direct financing allows corporations to raise funds directly from investors by issuing securities. These securities are financial instruments that can be traded in secondary markets, thereby enhancing liquidity and enabling investors to enter or exit their positions more easily.
Through the issuance of securities, corporations gain direct access to capital without relying solely on bank intermediation. At the same time, investors are provided with opportunities to earn returns through dividends or coupon payments, as well as capital gains arising from changes in the market value of the securities. In direct financing, returns are linked to the performance of the issuing entity and prevailing market conditions rather than being fixed in advance.
Risk compensation in direct financing is primarily achieved through the risk–return relationship. Since most investors are risk-averse, higher levels of risk must be matched with higher expected returns to attract investment. As a result, the mobilisation and allocation of funds in capital markets reflect varying degrees of risk tolerance among investors. Securities perceived to carry greater risk are typically required to offer higher potential returns.
A distinctive feature of direct financing is issuer risk, which refers to the risk that the issuing corporation may be unable to meet its financial obligations. Because investors bear this risk directly, capital markets place strong emphasis on transparency, disclosure, and accurate information. Issuers are therefore required to provide detailed financial and operational disclosures to allow investors to assess risks and expected returns effectively.
In many jurisdictions, including Malaysia, Hong Kong, Singapore, the European Union, and the United States, issuers of securities are also required to obtain independent credit ratings. These ratings are provided by specialised rating agencies and serve as third-party assessments of the issuer’s creditworthiness and the quality of the securities issued. Credit ratings function as a grading system that offers an objective measure of the issuer’s ability to meet its financial obligations at maturity, thereby enhancing investor confidence and supporting the efficient functioning of capital markets.
Key Takeaway
Direct financing allows corporations to raise funds directly from investors through the issuance of tradable securities, with returns determined by dividends, coupons, and capital gains, and risks managed through disclosure, transparency, and independent credit ratings.
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KembaraXtra – Islamic Banking – Introduction-The Role of the Islamic Capital Market (ICM)
Simple definitions
The Islamic Capital Market (ICM)
The Islamic Capital Market (ICM) refers to capital market activities that are conducted in full compliance with Shari’ah principles. Participants in the market are free to engage in all business and investment activities, provided these activities do not involve elements prohibited by Shari’ah, such as interest (Riba), excessive uncertainty (Gharar), gambling (Maysir), or investment in non-permissible industries.
Like its conventional counterpart, the Islamic capital market comprises both primary and secondary markets. Together, these markets perform three vital functions within the financial system:
The development of a well-functioning Islamic capital market is therefore essential for the stability, efficiency, and sustainability of the Islamic Financial Services Industry (IFSI).
Key Requirements of a Well-Functioning Islamic Capital Market
For the Islamic capital market to operate effectively, several key prerequisites must be in place. These include a supportive legal, regulatory, accounting, and tax framework that recognises Shari’ah-compliant instruments and transactions. In addition, established standards are required to ensure consistency, transparency, and market confidence. Finally, sufficient market depth and liquidity are essential to allow investors to buy and sell instruments easily without causing excessive price fluctuations.
Economic Role of the ICM
The Islamic capital market plays a crucial role in attracting investment funds and channelling them into productive, Shari’ah-compliant economic activities. The primary market enables companies and institutions to raise funds directly from investors for business expansion and development. The secondary market, on the other hand, provides liquidity by allowing investors to trade existing securities, making investments more attractive and flexible.
The availability of liquid capital market instruments encourages wider participation by economic agents, both for investment and liquidity management purposes. This liquidity also accommodates investors with different risk preferences and investment horizons, ranging from short-term traders to long-term institutional investors.
Products and Services in the Islamic Capital Market
Over time, the Islamic capital market has expanded to offer a wide range of Shari’ah-compliant products and services. These include Shari’ah-compliant equities, Islamic mutual funds, private equity funds, Sukuk and asset-backed securities, and short-term Islamic money market instruments. In addition, structured Shari’ah-compliant products, sometimes referred to as Islamic derivatives, have been developed to meet specific investment and risk management needs.
The ICM is further supported by specialised financial services such as merchant and investment banking, stockbroking, and asset management companies, all of which operate within a Shari’ah-compliant framework to support capital formation and market efficiency.
Key Takeaway
The Islamic Capital Market plays a vital role in mobilising and allocating long-term funds through Shari’ah-compliant instruments, supporting asset pricing, liquidity, and risk management, and contributing to the development of a sound and efficient Islamic financial system.
Simple definitions
- Capital market:
A capital market is a financial market where long-term funds are raised and traded through instruments such as shares, Sukuk, and other securities. - Security:
A security is a tradable financial instrument that represents ownership (such as shares) or a financial claim (such as Sukuk) on an issuer.
The Islamic Capital Market (ICM)
The Islamic Capital Market (ICM) refers to capital market activities that are conducted in full compliance with Shari’ah principles. Participants in the market are free to engage in all business and investment activities, provided these activities do not involve elements prohibited by Shari’ah, such as interest (Riba), excessive uncertainty (Gharar), gambling (Maysir), or investment in non-permissible industries.
Like its conventional counterpart, the Islamic capital market comprises both primary and secondary markets. Together, these markets perform three vital functions within the financial system:
- Pricing of assets and management of risk,
- Liquidity management, and
- Mobilisation and allocation of financial resources through specialised market services.
The development of a well-functioning Islamic capital market is therefore essential for the stability, efficiency, and sustainability of the Islamic Financial Services Industry (IFSI).
Key Requirements of a Well-Functioning Islamic Capital Market
For the Islamic capital market to operate effectively, several key prerequisites must be in place. These include a supportive legal, regulatory, accounting, and tax framework that recognises Shari’ah-compliant instruments and transactions. In addition, established standards are required to ensure consistency, transparency, and market confidence. Finally, sufficient market depth and liquidity are essential to allow investors to buy and sell instruments easily without causing excessive price fluctuations.
Economic Role of the ICM
The Islamic capital market plays a crucial role in attracting investment funds and channelling them into productive, Shari’ah-compliant economic activities. The primary market enables companies and institutions to raise funds directly from investors for business expansion and development. The secondary market, on the other hand, provides liquidity by allowing investors to trade existing securities, making investments more attractive and flexible.
The availability of liquid capital market instruments encourages wider participation by economic agents, both for investment and liquidity management purposes. This liquidity also accommodates investors with different risk preferences and investment horizons, ranging from short-term traders to long-term institutional investors.
Products and Services in the Islamic Capital Market
Over time, the Islamic capital market has expanded to offer a wide range of Shari’ah-compliant products and services. These include Shari’ah-compliant equities, Islamic mutual funds, private equity funds, Sukuk and asset-backed securities, and short-term Islamic money market instruments. In addition, structured Shari’ah-compliant products, sometimes referred to as Islamic derivatives, have been developed to meet specific investment and risk management needs.
The ICM is further supported by specialised financial services such as merchant and investment banking, stockbroking, and asset management companies, all of which operate within a Shari’ah-compliant framework to support capital formation and market efficiency.
Key Takeaway
The Islamic Capital Market plays a vital role in mobilising and allocating long-term funds through Shari’ah-compliant instruments, supporting asset pricing, liquidity, and risk management, and contributing to the development of a sound and efficient Islamic financial system.
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KembaraXtra-Islamic Banking – Islamic Mutual Funds
Islamic mutual funds, also known as Islamic unit trust funds, are collective investment schemes that consist exclusively of Shari’ah-compliant securities and are managed in accordance with Islamic principles. To ensure continuous compliance, these funds typically appoint Shari’ah advisers who supervise investment activities and review portfolio holdings.
These funds invest only in listed Shari’ah-approved equities and Islamic fixed-income instruments, such as Sukuk. The composition and proportion of assets within the portfolio are largely determined by the fund’s investment strategy, which reflects its risk profile and investment objectives.
In addition to equity and Sukuk-based funds, the Islamic capital market also offers a range of specialised Islamic funds. These include leasing funds, Murabahah-based funds, and private equity funds, which generally invest in asset classes other than listed equities. Such specialised funds provide investors with diversified Shari’ah-compliant investment opportunities while maintaining adherence to Islamic banking and finance principles.
Islamic mutual funds, also known as Islamic unit trust funds, are collective investment schemes that consist exclusively of Shari’ah-compliant securities and are managed in accordance with Islamic principles. To ensure continuous compliance, these funds typically appoint Shari’ah advisers who supervise investment activities and review portfolio holdings.
These funds invest only in listed Shari’ah-approved equities and Islamic fixed-income instruments, such as Sukuk. The composition and proportion of assets within the portfolio are largely determined by the fund’s investment strategy, which reflects its risk profile and investment objectives.
In addition to equity and Sukuk-based funds, the Islamic capital market also offers a range of specialised Islamic funds. These include leasing funds, Murabahah-based funds, and private equity funds, which generally invest in asset classes other than listed equities. Such specialised funds provide investors with diversified Shari’ah-compliant investment opportunities while maintaining adherence to Islamic banking and finance principles.
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KembaraXtra – Islamic Banking – Islamic Sukuk and Asset-Backed Securities
The Islamic Capital Market (ICM) facilitates the issuance and trading of long-term Shari’ah-compliant securities that are linked to real assets and future income streams. One of the most important instruments in this market is Sukuk, which represent proportionate and undivided ownership interests in underlying assets that are expected to generate returns for investors.
Sukuk are monetary-denominated participation certificates of equal unit value issued to investors. Each Sukuk holder owns a proportional share of the underlying asset and is entitled to a corresponding share of the income generated by that asset. Unlike conventional bonds, Sukuk do not represent a debt obligation with interest payments. Instead, returns to investors are derived from profits, rentals, or other income generated by the underlying Shari’ah-compliant assets. As such, Sukuk serve as the functional equivalent of conventional government and corporate bonds within an Islamic financial framework.
Islamic asset-backed securities are structured using a pool of assets or receivables whose obligors are legally independent of the issuer. Under this structure, the originator sells the assets to a Special Purpose Vehicle (SPV), which is established as a bankruptcy-remote entity. The SPV holds these assets on behalf of investors, ensuring that if the originator becomes insolvent, creditors of the originator have no claim over the assets held by the SPV.
The assets transferred to the SPV may consist of receivables or physical assets, provided they are capable of generating predictable cash flows and future income. A critical requirement in Islamic asset-backed securitisation is that the transfer of assets must constitute a true sale, meaning ownership is fully transferred to the SPV with no recourse to the originator. This feature distinguishes asset-backed Sukuk from asset-based structures, where ownership transfer may be more limited.
Following the true sale, the assets are removed from the originator’s balance sheet and recorded under the SPV. The cash flows generated by these assets are then used to make periodic distributions—often referred to as coupon payments—to investors. These payments are not interest but represent income generated from the underlying assets.
Both asset-based and asset-backed Sukuk are structured through a securitisation process known in Arabic as Tawriq or Taskeek. Securitisation refers to the process of pooling assets and converting them into tradable securities that can be sold to investors in the capital market. In some jurisdictions, such as Malaysia, securitisation has also been applied to receivables or future debt obligations, leading to the use of terms such as Islamic bonds or Islamic notes, while still maintaining Shari’ah-compliant structuring principles.
Key Takeaway (Exam-Ready)
Sukuk and Islamic asset-backed securities are Shari’ah-compliant capital market instruments that provide investors with proportional ownership in underlying assets and income streams, structured through securitisation processes that emphasise asset backing, true sale, and bankruptcy protection.
The Islamic Capital Market (ICM) facilitates the issuance and trading of long-term Shari’ah-compliant securities that are linked to real assets and future income streams. One of the most important instruments in this market is Sukuk, which represent proportionate and undivided ownership interests in underlying assets that are expected to generate returns for investors.
Sukuk are monetary-denominated participation certificates of equal unit value issued to investors. Each Sukuk holder owns a proportional share of the underlying asset and is entitled to a corresponding share of the income generated by that asset. Unlike conventional bonds, Sukuk do not represent a debt obligation with interest payments. Instead, returns to investors are derived from profits, rentals, or other income generated by the underlying Shari’ah-compliant assets. As such, Sukuk serve as the functional equivalent of conventional government and corporate bonds within an Islamic financial framework.
Islamic asset-backed securities are structured using a pool of assets or receivables whose obligors are legally independent of the issuer. Under this structure, the originator sells the assets to a Special Purpose Vehicle (SPV), which is established as a bankruptcy-remote entity. The SPV holds these assets on behalf of investors, ensuring that if the originator becomes insolvent, creditors of the originator have no claim over the assets held by the SPV.
The assets transferred to the SPV may consist of receivables or physical assets, provided they are capable of generating predictable cash flows and future income. A critical requirement in Islamic asset-backed securitisation is that the transfer of assets must constitute a true sale, meaning ownership is fully transferred to the SPV with no recourse to the originator. This feature distinguishes asset-backed Sukuk from asset-based structures, where ownership transfer may be more limited.
Following the true sale, the assets are removed from the originator’s balance sheet and recorded under the SPV. The cash flows generated by these assets are then used to make periodic distributions—often referred to as coupon payments—to investors. These payments are not interest but represent income generated from the underlying assets.
Both asset-based and asset-backed Sukuk are structured through a securitisation process known in Arabic as Tawriq or Taskeek. Securitisation refers to the process of pooling assets and converting them into tradable securities that can be sold to investors in the capital market. In some jurisdictions, such as Malaysia, securitisation has also been applied to receivables or future debt obligations, leading to the use of terms such as Islamic bonds or Islamic notes, while still maintaining Shari’ah-compliant structuring principles.
Key Takeaway (Exam-Ready)
Sukuk and Islamic asset-backed securities are Shari’ah-compliant capital market instruments that provide investors with proportional ownership in underlying assets and income streams, structured through securitisation processes that emphasise asset backing, true sale, and bankruptcy protection.
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KembaraXtra – Islamic Banking – Islamic Money Market Short-Term Financial Products
Unlike the Islamic Capital Market (ICM), which focuses on long-term financing instruments, the Islamic Money Market (IMM) is designed for short-term financial instruments and liquidity management. The IMM facilitates short-term interbank financing among Islamic financial institutions through the issuance of Shari’ah-compliant instruments and through contractual arrangements such as repurchase agreements structured in accordance with Islamic principles. Its primary function is to provide short- to medium-term liquidity within the domestic financial system.
The underlying objective of the IMM is to strengthen the operational framework of Islamic banking by efficiently channelling surplus liquid funds into short-term investments while simultaneously meeting the liquidity needs of deficit institutions. By enabling the smooth transfer of short-term funds between market participants, the IMM supports financial stability and ensures the continuous functioning of Islamic financial institutions.
In addition to liquidity management, the IMM plays an important role in the transmission of monetary policy. Central banks influence money market conditions by determining the overnight call rate, which serves as a benchmark for short-term funding costs. Movements in money market rates subsequently affect pricing across other financial markets and influence the financing rates offered by financial institutions to businesses and individuals. Through this mechanism, monetary policy decisions are transmitted to the broader economy. The development and functioning of the IMM are therefore closely linked to monetary price adjustments based on the overnight call rate, which is particularly important for maintaining stability in a dual financial system where Islamic and conventional finance coexist.
Two prominent Islamic money markets are the Islamic Interbank Money Market (IIMM) in Malaysia and the Liquidity Management Centre (LMC) in Bahrain. The Malaysian IIMM primarily serves domestic liquidity management needs, while the Bahrain LMC plays a broader role by contributing to regional and international Islamic liquidity market requirements. In addition, some regulators offer specialised instruments to support short-term liquidity management. An example is Salam Sukuk, issued by the Central Bank of Bahrain, which provides Shari’ah-compliant short-term investment opportunities for Islamic financial institutions.
In jurisdictions where formal Islamic liquidity instruments are limited—particularly in parts of the Middle East—market participants have developed alternative arrangements based on Wakalah (agency) contracts. Under a Wakalah investment structure, a bank with surplus liquidity appoints another bank facing a liquidity shortfall as its agent to invest the surplus funds. The agent bank is permitted to invest only in Shari’ah-compliant assets capable of generating a return. The expected return is typically aligned with the rate that the deficit bank would normally achieve on its own investments.
This Wakalah-based arrangement benefits both parties: the surplus bank earns a return on otherwise idle funds, while the deficit bank gains access to short-term financing to manage its liquidity needs. As such, Wakalah investment products have become a practical solution for short-term liquidity management in markets where formal IMM instruments are still underdeveloped.
Key Takeaway
The Islamic Money Market provides Shari’ah-compliant short-term liquidity instruments that support interbank financing, monetary policy transmission, and financial stability, playing a crucial role in the effective operation of Islamic banking systems.
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KembaraXtra – Islamic Banking – Islamic Derivative Instruments
A derivative is a financial instrument whose value is derived from the value of an underlying asset, such as shares, commodities, currencies, or profit rates. Common examples include the right to buy an asset (call option) or the right to sell an asset (put option). These instruments involve agreements to exchange money, assets, or values at a future date, which means payment and delivery do not occur immediately. Because of this forward-looking nature, derivatives raise issues of uncertainty, requiring careful attention to Shari’ah compliance.
When standard financial instruments available in the market are unable to meet the specific needs of investors, synthetic investment instruments, commonly known as structured products, are developed. Structured products are typically pre-packaged investment strategies that may replicate direct investment, assist in asset allocation to reduce portfolio risk, or take advantage of prevailing market conditions. In conventional finance, these products are often based on derivatives such as options and, to a lesser extent, swaps, and may include features such as capital protection if held until maturity.
Islamic derivative instruments, usually referred to as Islamic structured products, are designed primarily for risk management related to genuine underlying business transactions. While they aim to achieve outcomes similar to conventional derivatives, Islamic derivatives must follow different contractual routes and methodologies to comply with Shari’ah principles. In conventional finance, derivatives often involve the payment of a premium to obtain protection, functioning in a manner similar to insurance. Islamic finance, however, avoids interest, excessive uncertainty, and speculation, and therefore structures such instruments using permissible contracts.
Conventional derivative instruments generally include forwards, futures, options, and swaps, each serving different purposes. For example, an option gives its holder the right—but not the obligation—to buy an underlying asset at a predetermined price in the future after paying a premium. If the asset’s market price rises above the agreed price, the holder benefits by exercising the option. If the price falls, the holder does not exercise the option, and the loss is limited to the premium paid.
In Islamic finance, derivative-like instruments are structured to achieve the legitimate objective of risk management while remaining Shari’ah-compliant. An Islamic option can be viewed as a down payment towards a future purchase. If the market price of the asset rises, the purchaser proceeds with the transaction. If the price falls, the purchase is not completed, the contract lapses, and the down payment—known as ‘Urbun—is forfeited in favour of the seller. If the purchase is completed, the Urbun amount is treated as part of the final purchase price rather than as a separate premium.
In addition to Islamic options, Islamic finance has developed other Shari’ah-compliant risk management tools, including forward currency exchange arrangements and profit rate swaps, to manage real business risks faced by Islamic financial institutions and their customers. These instruments are structured to support genuine economic activities rather than speculative trading.
Key Takeaway
Islamic derivative instruments are Shari’ah-compliant structured products designed to manage genuine business risks. Although they aim to achieve outcomes similar to conventional derivatives, they are structured using permissible Islamic contracts such as Urbun, Wakalah, and profit-sharing arrangements, rather than interest-based or speculative mechanisms.
