Unfortunately many people are at a loss to explain the difference between Islamic finance and conventional finance. This article should make it easy to understand and explain.
Islamic law forbids two practices which form the foundation of conventional finance. The first of these is usury. The second is gambling. In both of these areas a lot of money can be made by keeping the issues confused, so it is not surprising that it has happened. This is my attempt to define exactly what Islamic law requires.
(Firstly I should give a caveat about this and any other article I write on this website: The conclusions are only my opinions. You are responsible to do your own investigations and take the opinions that your conscience is not in conflict with. I do not wish to be blamed on Judgement Day for having misled anyone. I do my best according to my resources and may Allah forgive all my errors.)
What is Usury?
When I make any contract of trade where a debt is defined, that debt can be in many forms. It could be to provide a service, some set of goods to be delivered, or some commodity which could be money. Islamic law on debts in contracts primarily is concerned with the duty to be as specific as possible so as to avoid ambiguities that may result in dispute. This includes specifying the due dates and times of the debt(s) as these do matter a great deal. Timing matters. If there is a more distant due date for a debt then it is a different contract and may have completely different value to all parties. This is all part of trade and trade is specifically allowed in Islam.
Usury is termed “riba” in Arabic and literally means “increase”. While trade is allowed, usury is forbidden. Usury only comes into play if there is a contract violation. If the person due to fulfill his contractual liability fails to do so.
In contracts, if someone fails to deliver what is promised, then the injured party may complain to the authorities of an injustice done to him and seek damages. Normally in such cases two things must be proved. Firstly the injured party must prove damage has in fact been done. Secondly, the injured party must prove that the injury was the fault of the accused party. Usury breaks this rule and is unjust for that reason alone.
Usury is any demand for damages without proving damage and without proving fault.
When someone fails to pay a debt, it may very well not be their fault. Being unable to pay is often a valid excuse. People in poverty and in debt may well deserve charity rather than punishment.
Usury has taken many forms over the years, it used to be that if your debt was not paid on time it could be doubled or worse.
Interest on loans is a mild form of usury in so far as it stipulates that the automatic damages that can be claimed must be proportional to both the delay in payment of a debt and proportional to the size of the unpaid debt.
Interest that a bank gives an investor may also be contractually required of the bank. If it is, then it is also a form of usury.
Usury demands are usefully captured by the claim “A Dollar today is worth more than a Dollar tomorrow”. While in some circumstances this may be true, it would only demonstrate damage done but not fault. The claim moreover is not true. A Dollar today may be worth more or less than a dollar tomorrow and is worth different things to different people at different times and circumstances. I may pay you to keep my dollar safe for a while. In this case a dollar is worth more to me in the future than it is now.
So Islamic finance, while it does recognise time value, or “paying for time” can be part of what matters in a contract, does not accept that any late payment should be higher than the amount in the contract. Damages may be sought for late payments, but then proof must be provided of damage and fault.
What is Gambling?
Gambling is a well understood concept of paying for a chance to win something, or if you are on the receiving side being paid for the chance of losing something. Key to whether something would be considered a gamble rather than just a risky venture is the question of control. If you are a party who may incur a liability or the party that may be receiving something and if you have no control over the outcome, then it is a gamble. If you have some control then it is not a gamble. This however hinges on the meaning of “some control”. There are many contests and races which require effort and which are high risk and high reward. To be part of a horse race, is not a gamble. The horse owner has some control, the rider has some control. But does the viewer who shouts out encouragement? The line must be drawn somewhere and as this is not defined specifically in the Qur’an, this is up to decisions made by the relevant legitimate authorities.
Many hedge fund operations and insurance operations are widely considered as nothing but gambling and so are avoided in Islamic finance.
Although the prohibitions of gambling and usury are a key part of Islamic finance another dimension is important to understanding what makes Islamic finance distinct and that is the overriding principle of avoiding doubts. Contracts must be clear and specific and avoid ambiguity that can give rise to doubts about what liabilities are and hence disputes. Much of insurance also has problems arrising out of the disputability of claims that can be made. The debts that would arise and the conditions under which claims can be made must be very clear and specific. Islamic contracts should avoid “the fine print” and be clear to all concerned.
A big part of the current financial turmoil has been the ambiguity of securitiesed rights which is now being wrestled with and all sorts of “toxic assets” which are nothing but contracts where the liabilities were loaded with ambiguous rights and were thus open to fraudulent abuses.