In Islamic trade, a letter of credit is a bank's payment undertaking to a foreign seller, backed by a compliant contract, Wakala, Murabaha or Musharaka, which determines who owns the goods during the transaction and how the bank is paid for its role.
What a letter of credit brings to cross-border trade
A foreign seller may not know the buyer and fears shipping without being paid; the buyer fears paying without receiving goods. The bank steps in by promising payment against compliant documents, replacing personal trust with a bank undertaking.
Three structures, three ways to allocate risk
An Islamic bank cannot simply lend money to pay the supplier. It therefore chooses a contract: a plain agency if the importer pays, a purchase and resale if the bank finances, or a partnership if both share the cost of the goods.
Wakala when the importer has the funds
The importer deposits the full amount and appoints the bank as agent to open the letter of credit, examine documents and pay the seller. The bank earns a fixed agency fee that has nothing to do with the length of any credit period.
Why the fee must pay for a real service
The AAOIFI standard allows the bank to charge for opening, document checking and advising, because these are services. It forbids linking the fee to the time during which the bank advances money, since that would amount to interest.
Murabaha when the bank finances the purchase
If the importer wants to pay later, the bank itself buys the goods from the foreign seller through the letter of credit. Once title documents are received, it resells the goods to its customer at a disclosed margin payable on a set date.
At what point does the bank become the owner?
The resale is valid only after the bank has acquired the goods and bears their risk, usually when the bill of lading is endorsed to it. If the customer signs the Murabaha before that step, the transaction loses its compliance.
Musharaka to share the import transaction
The importer contributes part of the price and the bank the rest, so both co-own the cargo. When the goods are sold, profit is split by an agreed ratio, while any loss is borne according to each party's capital contribution.
Variant: gradual buyout of the bank's share
In some import Musharaka deals, the customer buys out the bank's share step by step as it sells the stock. This suits distributors whose goods are sold in batches over several months rather than in a single resale.
On the exporter's side: being paid by an Islamic bank
An exporter receiving a letter of credit from an Islamic bank enjoys the same payment undertaking as with a conventional bank. It simply has to present compliant documents; the internal Sharia structure between the bank and the importer does not directly affect it.
Prefinancing exports without discounting
Instead of discounting the letter of credit it has received, an exporter can obtain Salam or Istisna'a from its bank to produce the goods, or a Murabaha on raw materials. Selling a receivable for a reduced price is generally still refused.
Prohibited goods and checks on the underlying trade
The bank must make sure the cargo includes no alcohol, pork, illicit weapons or goods destined for a prohibited activity. This check on the subject matter comes on top of the usual international sanctions and anti-money-laundering screening.
Choosing the right structure for your business
A company with cash on hand will prefer Wakala, the cheapest option. An importer that resells quickly will choose Murabaha for a fixed payment date. One that wants to share commercial risk will opt for Musharaka, after consulting the Sharia board.
Specialist external source
The AAOIFI Shariah standard on documentary credit sets out the permitted underlying contracts and the types of fees a bank may charge.