General rules to legitimate the tawarruq transaction:

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Joanna Carson
10 years ago
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1 CONTROVERSIAL DEBT-BASED FINANCING PRODUCTS The Islamic financial services industry has witnessed the introduction of some mechanisms recently that are either forbidden or at best controversial. These products have been the subject of intense debate. Some mechanisms permit riba through the back door. Others appear permissible in form only; and not in substance. In fiqh literature these are documented as cases of legal stratagems (legal tricks, hiyal). I. Tawarruq (Monetization, Tripartite Sale) Islamic financial institutions like conventional banks face challenges in order to satisfy the needs of their customers. Moreover, they have to develop and create products that are shari a compliant. Since interest is prohibited in Islam, so one of the solutions for personal financing this problem is tawarruq, which is a controversial issue among the majority of the scholars. Tawarruq is a financing product that is cited as a classical case of hiyal, or legal tricks, but has been permitted by mainstream scholars under certain conditions. The word tawarruq comes from the word al-wariq, which means silver, because originally dirhams were made from silver. It means also money. Tawarruq is a combination of two separate sale transactions whereby an individual in need of funds purchases a commodity from a seller on a deferred payment basis and then sells the same on spot basis in order to realize cash to a party other than the original seller. In modern Islamic banking practice, the bank usually performs all the transactions needed as it first buys the commodity under its own name, then sells it to the customer on credit, and finally sells it on behalf of the customer to a third party for its cash value. 1

In fiqh literature these are documented as cases of legal stratagems (legal tricks, hiyal). I.

2 The procedures of tawarruq as a financing product involves the following steps: 1. Client approaches Bank with a specific need for cash; 2. Bank purchases commodity X of value equivalent to the Client s need, (say P) from a Seller. 3. Bank sells X to Client on a deferred basis for P+I. 4. Bank as Agent of Client sells X in the open market or back to Seller for P* on cash basis 5. The three transactions occur within a short time period between each other 6. In practice, the bank often acts as an agent on behalf of the customer (in the customer s transaction with the commodities broker) Note that P* may be different from P if prices are fluctuating in the market and there is a time gap between the various activities. The client receives P* - an amount that closely matches its financing need. Although the 15 th meeting of "Majlis Majma al Fiqh al Islami" approved tawarruq in principle, in their 17 th meeting, tawarruq masrafi was deemed impermissible This tawarruq is considered a legal trick, since the individual concerned has no real intention of buying or selling the commodity. He engages in these purchase and sale transactions for realization of cash. Despite the general rejection, tawarruq has been one of the fastest growing forms of Islamic finance, because it enhances liquidity and enables people to meet their liabilities. General rules to legitimate the tawarruq transaction: Scholars have permitted tawarruq since it fulfills a genuine for funds. It is permitted as long as it does not violate the norms of Sharia a. Hence, all care should be taken to ensure that it does not involve riba. 2

Bank as Agent of Client sells X in the open market or back to Seller for P* on cash basis 5. The three transactions occur within a short time period between each other 6.

3 For the sale transaction to be acceptable, 1. The buyer should fully possess the goods before selling them for the second time, in order to expose the buyer to the risk associated with holding the commodity and storing it. 2. The second sale should be separate from the first sale to avoid complexity and not to fall in gharar. 3. The good should not be sold to the same person it was originally bought from., The client must sell the commodity in the market place to a third party. Otherwise, it would be a case of bay'-al-einah. 4. There must be a time gap between the first sale by the bank to client and sale by the client in the market. This is in addition to the time gap between the purchase by the bank and its sale to client as in case of all permissible murabaha. 5. Another condition of a valid and permissible tawarruq is the absence of any pre-arrangement between the three parties. In tawarruq, therefore, one needs to exercise extra care and subject the product to an additional investigation before accepting it as Shari a compatible II. Bay'-al-Einah (Buy-back sale, Repurchase) A very popular mechanism used by Islamic banks in South East Asian countries is based on repurchase or bay'-al-einah. A murabaha can change into bay'-al-einah if the identity of the seller is not different from its client. Bay Al-Einah represents the purchase of a commodity on deferred basis and the commodity is then sold for cash on a spot basis, at a price lower than the purchase price, back to the original seller. The rate of profit in this case is indistinguishable from prohibited riba on a conventional loan. 3

The second sale should be separate from the first sale to avoid complexity and not to fall in gharar. 3. The good should not be sold to the same person it was originally bought from.

4 You may note that bay al-einah involves a mere debt creation exercise; there is no sale in the real sense, as the commodity does not move from the client to the bank or vice versa. The market price of the commodity, under bay'-al-einah, need not bear any relationship with the amount effectively borrowed. There is no genuine trade and exchange in bay'-al-einah; and the cash sale in bay'-aleinah may be for the amount that the client needs to borrow. The deferred repurchase may be for the loan amount plus interest. There is a consensus among Muslim scholars that bay al-einah is not permissible. III. Bay'-al-Dayn (Sale of Debt Bill Discounting, Bill Factoring ) Much of today s business is conducted on credit. Businesses that sell commodities on credit tie up their financial resources in the form of IOUs. Thus, liquidity may become a business concern In conventional finance, this problem is addressed by way of selling these debts to surplus units. Discounting bills of exchange is quite common in conventional banking. Islamic Shari a allows selling on credit as in murabaha on deferred payment terms. The ongoing debate is whether Shari a allows the selling of debt! A bill of exchange originates with a sale or purchase. The seller draws a bill of exchange asking the buyer to pay a certain amount (value of purchase plus interest) after a certain time period called maturity. When the buyer accepts the bill of exchange, it becomes a valid financial instrument that can be traded in the market. The seller now has two options. 1. He may wait until maturity and realize the full maturity value - value of his sale plus interest for the maturity period. In this case 4

There is no genuine trade and exchange in bay'-al-einah; and the cash sale in bay'-aleinah may be for the amount that the client needs to borrow.

5 the seller finances the working capital requirement of the buyer; 2. He may go to the market (such as a commercial bank) and sell the instrument at a discount to the maturity value. The discount is determined by the rate of interest and the time between date of purchase of the instrument by the bank and the maturity date. When the bank buys the instrument, it effectively engages in lending at interest. Mainstream Islamic scholars have put a plug on the possibility of earning interest by insisting that any sale of debt (bay'-al-dayn) or transfer of debt (hawalat-al-dayn) must be at par. This means in the above case, when the bank buys the instrument of debt from the original buyer, it is not entitled to any discount. Riba is avoided by disallowing any difference between what it pays (purchase price of the instrument) and what it receives on maturity (its maturity value). Notwithstanding the clear verdict against such transaction, some Islamic banks have been offering Islamic bill discounting products. They essentially treat debt as any other physical asset that can be traded at a negotiated price. 1. Supplier draws a bill of exchange on Customer for a specific maturity value, say M, maturing after time period t; 2. The Customer accepts this bill of exchange 3. Supplier sells the bill to Bank now for a discounted value, say N 4. Bank presents the bill to Customer at time period t and receives M. (The bank may resell or rediscount the bill before maturity to another bank at a discounted price that is higher than N, but lower than M). 5. The amount M-N constitutes profit to the bank(s) that is in the nature of riba. 5

When the bank buys the instrument, it effectively engages in lending at interest.

6 Another similar financial product that involves bay'-al-dayn is factoring in which a company transfers its selected accounts receivables to a bank (factor). The bank is now assigned the accounts receivables and entrusted with the task of collecting the receivables. Against these receivables, the bank provides financing. While an Islamic bank may legitimately charge a fee for its collection activities, it cannot accept interest on the loan extended. 6

The bank is now assigned the accounts receivables and entrusted with the task of collecting the receivables.

TRADE-BASED FINANCING MURABAHA (COST-PLUS SALE)

TRADE-BASED FINANCING MURABAHA (COST-PLUS SALE) The early models of Islamic banks are based on partnership of mudharaba and musharaka (profit-loss sharing) structure. Such equitybased financing are perceived