UKFF3363 – Islamic Finance

Topic 1: Introduction & Development of Islamic Finance

 Why study Islamic Finance?

o Depends on the people’s level of exposure, understanding and objectives
o Appears to be far removed from politics and philanthropic endeavors
o Rapid growth of Islamic finance
 What is the meaning of Islamic finance?
o Finance: Deal with allocation of resources, management, acquisition and investment
o Islamic” Unique characteristics with number of distinctive
 How is the Islamic financial system (Islamic banking) different from conventional banking system?
o Islamic Banking is not based on the concept of lending money for interest. In Islamic Banking,
money is not lent. It provides finance to the clients who have a need for asset. Islamic Banking
does not consider money as commodity since it does not have any intrinsic value of its own
 When did the Islamic financial system come into existence? (Importance)
o To those especially who want to avoid prohibited elements especially interest. It provides them
an alternate system which is as competitive and comprehensive in product offerings as the
conventional system. It allows people and institutions who are looking to avoid interest to still
have access to financial services which do not have an element of interest
 What are the main components of this system?
o Free from Riba, Gharaar, Compliance with Shariah Principles
 Can you provide a list of Islamic banks operating in Malaysia?
o CIMB Islamic Bank, Public Islamic Bank, RHB Islamic Bank, Bank Muamalat, Bank Islam
 What is a Shariah Board
o Members: Islamic scholars who are experts in Islamic jurisprudence
o Task: Ensuring compliance to Islamic principles in products offered by Islamic Financial
Institutions (IFIs). All the products offered by IFIs have to be vetted by Shariah Board
o Their verdict and judgement is binding on the management and their presence and affiliation
with IFIs provide a level of comfort to the customers of IFIs
 Islamic Finance only for Muslim - No
 What is the difference between Islamic Finance and Islamic Banking
o Islamic Finance
 Covers broader term which includes Islamic Banking, Takaful and Islamic Asset
Management, REITs, ETFs, etc
 Uphold the Shari’ah principles and framework
o Islamic Banking
 It’s major component of Islamic Finance and significant since it comprises many
institutions, more client base and more assets based
 Operates business within Shariah principles and framework
 6 Principles of Islamic Finance
o Risk Sharing
o No Speculations
o Prohibition of Riba
o Sancity of Contract
o Shariah Compliant
o Medium of Exchange
 Shariah as the basis of the Islamic Financial System
o Shariah (Primary Sources)
 Quran and Sunnah Islamic Law / Legislations
o Fiqh (Secondary Souces) Refer to Shariah also
 Many, need human justification

 Fiqh Muamalat
o A branch of Islamic jurisprudence that deals with commercial and business activities in an
economy. Fiqh literally means understanding of rulings and precepts, whilst muamalat, in this
particular facet, refers to economic transactions and activities.
o Rule making process in IBF
 When faced by new and unprecedented issues, jurists will employ certain methodology
in deriving ruling of the Shari’ah on that issue.
 Regulatory & Supervisory Environment
o Key Stakeholders
 Financial System
o Banking System - Bank Negara Malaysia, Banking Institutions
o Non-Bank Financial Intermediaries
 Provident Fund (EPF), Insurance / Takaful
 Development Financial Institutions, Saving Institutions
o Money Market / Foreign Exchange - Foreign Exchange Money Changed
o Capital Market - Stock / Equity, Bond / Sukuk, Deriviatives
o Offshore
 Labuan Offshore
 Why we need financial intermediaries?
o Direct finance is normally less effective – involve information costs i.e.: search cost, screening
cost, monitoring cost, enforcement cost;
o Financial intermediaries enjoy informational economies of scope – provide low costs of funds;
o Asymmetric Information & Law of Large Numbers.
o Facilitators of risk transfer and risk consolidation/ transformation mechanism in complex
financial markets;
o Match the SFUs & DFUs when they have different liquidity preference.
 Requisites of IF
o Strong Risk Management
o Effective Regulation
o Sound Corporate & Shari’ah Governance
o Supportive Legal Framework
o Robust Accounting Disclosure & Taxation Regime
 Development of Islamic Finance in Malaysia
o 1969 - Pilgrims Management Fund and Board of Malaysia
o 1983 - First Islamic bank established (Bank Islam Malaysia Berhad)
o 1984 – First full-fledge takaful company established (Syarikat Takaful (M) Bhd )
 1. Islamic Banking Act 1983
 2. Government Investment Act 1983
o 1993 - Introduction of Interest-free banking Scheme or Skim Perbankan Tanpa Faedah (SPTF) -
‘Islamic window ’
o 1994 - Islamic Interbank Money Market
o 1996 - New Financial Disclosure (GP8)
 1. Income recognition for SPTF from cash basis to accrual basis
 2. SPTF allowed to set up full-fledged Islamic Banking branch
 3. Establishment of Syariah Advisory Council (SAC)
o 1999 - Bank Muamalat Malaysia Berhad started operation as second Islamic bank
o 2004 – Three licenses issued to foreign Islamic bank:
 1. Kuwait Finance House
 2. Al-Rajhi Banking & Investment Corp.
 3. A consortium of Islamic financial institutions (Qatar Islamic Bank, RUSD Investment
Bank Inc. and Global Investment House)
o 2006 International Centre for Education in Islamic Finance (INCEIF), Malaysia International
Islamic Financial Centre (MIFC)
o 2008 - Issuance International Islamic Banking licenses (IIB)
o 2010 Onwards
 NKEA - National Key Economic Areas – NKEA#5 Financial Services, EPP 10: Becoming
the Indisputable Global Hub for Islamic Finance
o 2011 Onwards - Financial Sector Blueprint 2011 - 2020
 Challenges in Islamic Finance
o Key challenges
 Adoption of a Robust Domestic Financial System
 Availability of a Wide Range of Instruments
 Human Resource Requirements
 Efficient & Active International Islamic Financial Markets
Topic 2: Shariah Principles for Islamic Finance

 How The Rulings of Shari’ah Are Formulated?

o When faced by new and unprecedented issues, jurists will employ certain methodologies in
deriving ruling of the Shari’ah on that issue.
o These processes can be summarized in steps:
o Reference to Primary Sources;
o Reference to Secondary Sources.
 Legal Ruling in Islamic Law

 Sources of Islamic Commercial Law

o Primary Sources
 The Holy Quran
 Prohibition of Intoxicants & Gambling (QURAN: SURAH AL MAIDAH [5:90-91])
“O you who believe, intoxicants, and gambling, and the altars of idols, and
the games of chance are abominations of the devil; you shall avoid them,
that you may succeed. The devil wants to provoke animosity and hatred
among you through intoxicants and gambling, and to distract you from
remembering GOD, and from observing the Contact Prayers (Salat). Will
you then refrain?”
 Prohibition of Riba’ (QURAN: SURAH AL BAQARAH [2:275-276])
Those who devour riba will not stand except as stands one the Satan has
driven to madness by his touch. That is because they have said: "Trade is
but like riba." but Allah has permitted trade and forbidden riba. So,
whosoever after receiving admonition from his Lord desists, he shall be
pardoned for the past, and his case is for Allah (to judge); but one who
reverts (to the offence), those are the companions of the fire. They will
abide therein (for ever). Allah destroys riba and gives increase for deeds of
charity, for Allah loves not any ungrateful/non-believing sinner.
SUNNAH: It is reported from Abu Sa‘eed al-Khudari, he said: the
Messenger of Allah said:
“[Exchange] gold with gold, silver with silver, wheat with wheat, barley
with barley, dates with dates, salt with salt in equal quantities and spot.
Anyone who increases the quantity or asks for increase indulges in riba.
The receiver and payer are equal in this.” [Muslim]
  Sunnah/ Hadith
 The speech of Allah (SWT), sent down to Prophet Muhammad p.b.u.h. in its
precise meaning & wording, transmitted by numerous persons.
 Provides general guidelines/ principles and it is dependent on the jurists to utilise
these principles to resolve the issues in fiqh muamalat.
 What is narrated from the Prophet p.b.u.h. including his actions, sayings &
whatever he has tacitly approved.
 Supports the rulings stated in the Quran, explains and further elaborates the
meaning stated in the Quran.
o Secondary Sources
 A well considered and balanced opinion of qualified jurists to to reach at a correct decision
for a particular case where no applicable text of the main sources of Shari’ah (Quran &
Sunnah) is available to rely upon (Ijtihad/ Legal Reasoning).
 These efforts and considered opinion are exerted within the framework of a methodology
 called Usul al-Fiqh and is binding in matters of law.
 A prime example of present day business transaction: Takaful.
1. Ijma’ (Consensus)
 Constitute unanimous agreement among most knowledgeable & highly qualified
scholars in terms of authoritativeness of sources after the Quran & Sunnah.
However, ijma’ is hard & difficult to proof.
 Requirements of Ijma’:
There are a number of qualified scholars available at the time the issue is
encountered;
All scholars must reach a consensus on a juridical opinion at the time an
issue arises;
The scholars’ agreement must be demonstrated by their expressed opinion
on a particular issue (verbal/ writing).
2. Qiyas (Analogical Reasoning)
 A method that is used by the jurists and scholars in determining the Shari’ah
practice if the subject/ case is not mentioned in the former sources – The extension
of a Shariah ruling from the original case
 Applying Qiyas in IF:
Original case (asl): A case in which its ruiling is given in the Quran or
Sunnah and analogy seeks to extend it to new case
 Prohibition of usury in exchange of gold & silver
New case: A case in which ruling is needed - Modern currencies
Effective cause: Although it’s and attributable of the original case, it is
found to be commonly shared between the original case and the new case
- Medium of exchange
Rule: The rule governing the original case is to be extended to the new
case - Prohibition of usury in exchange of modern currencies.
3. Istihsan (Juristic Preference)
 To depart from a precedent for a reason which is stronger and more appealing.
 Purpose: to avoid rigidity and unfairness which might result from the literal
enforcement of the existing law: Waaf, ijarah, Salam, cultivation of land by force
  Application of Istihsan in Islamic Finance

4. Istishab (Presumption of Continuity)

 Presumptions of existence or non-existence of facts.
 It can be used in the absence of other proofs.
 When a person is known to be indebted to another, he is presumed such until it
is proven that he has settled the debt, or was acquitted of it
5. Maslahah Mursalah(Public Interest)
 The consideration which secures a benefit or prevents harm but is, in the
meantime, harmonious with the aim and objective of the Shari’ah (Maqasidal-
Shari’ah).
 Generally, maslahah indicates not only social welfare but also the measures taken
to achieve it.
 Tax collection, agriculture production, warranty system, SST
6. Sadd al-Dhara’i (Blocking the Evil Means)
 Blocking the means to an expected end, which is likely to be materialized if such
a mean is not blocked.
 Applicable to activities which are originally lawful but leading to unlawful ends.
 Non granting credit cards for those whose credit worthiness is very low, which
lead to accumulation of debt that could harm the person
7. Urf (Business Customary Practices)
 Frequent and prevalent practices and usages which do not contradict any texts or
principles of Islamic law.
 Custom is authoritative in cases of dispute.
 Case Study: Company ABC decides to expand its business internationally and
would like to operate a Nostro account with a conventional bank abroad in order
to facilitate its business. Advise the company in this matter. What is the Shariah
ruling regarding the above issue? What is the Shariah source and justification for
this issue?
 The Application of the Maqasid Al-Shariah in Islamic Finance
o Maqasid Al-Shari’ah (Higher Objectives of Islamic Law)
 To govern human lives and to protect the interests and benefits (maslahah) of the people.
 Higher objectives of Islamic Law consist of two types:-
 Religious/ spiritual (din)pertaining to the Hereafter;
 Worldly objectives (dunyawi) pertaining to mundane affairs of this world.
 Maqasid al-Shari’ah & Islamic Finance: with reference to wealth & property management.
 Protect the property with proper management and distribution of wealth.
 Legal Maxims
o Legal maxims which provide for the general rules of fiqh indeed have a big role in modern
banking and finance.
o Modern issues in Islamic finance which have no precedent in classical texts arise from time to
time and need to be addressed according to Islamic rulings.
o Thus, the solution is found in the application of the legal maxims that works as the general
principles and the parameters of modern Islamic banking and finance practices.
o 5 Legal Maxims in Islamic Finance
1. Matters are Determined According to Intentions;
 Ta’widh is imposed to whom who are intentionally / negligently refuse to pay
their obligation towards the bank (default payment
2. Hardship Begets Facility;
 To deal with conventional due to necessity
3. Harm is to be Eliminated;
 BNM to raise income requirement for acquiring credit card – data showed there
is an increasing rate of customers’ default on personal financing
4. Certainty is not to be Overruled by Doubt;
 Customer claim that he has settled his debt / bank has waived it but denied by the
bank. Maxim only recognize the bank’s claim since it is known with certainty
(docs)
5. Custom is Authoritative.
 FXSpot trading (t+2) – to facilitate the cross border transfer of funds
 Variation of opinion among scholars - The Needs of Shari’ah Standard
o To serve the needs of the increasing number of Muslims customers who want to lead their lives
(including commercial activities) in accordance with the Shari’ah;
o To prevents supervisory authorities to tailor the legal, regulatory and Shari’ah framework in
their respective jurisdiction to suit market realities & the stage of development of Islamic
financial service industry;
o To establish the prerequisite of an Islamic financial system which are a sine quibus non (essential
action) for the development & stability of the system.
o There is a need for strong linkages, interdependencies & synergies among certain components
in Islamic financial system comprising the Islamic banking industry (e.g.: Takaful);
o To ensure no worse-off treatment when compared to conventional finance in terms of taxation,
laws and regulations.
 Fundamental Prohibitions in Islamic Finance
o Prohition of Riba’ (Usury)
 Riba’ in IF: is an unjustified increment in borrowing or lending money, paid in kind or in
money above the amount of loan, as a condition imposed by the lender or voluntarily by
the borrower.
 Applied rules in the prohibition of riba’:-
 It must be a spot transaction - If one commodity is delayed, riba’ al-buyu’ occurs.
 It must be of equacounter value-In a barter transaction, the must be equal in
transaction.
o Reasons for the Prohibition of Riba’
 General reasons: Riba’ corrupts society, implies improper appropriation of other’s property,
ultimate effect is negative growth, demeans and diminishes human personality and being
unjust.
 Quran permits sales but prohibits riba’ due to fairness in risk and return.
 Sale: assume risk taking, the seller deserves profit from it.
 Riba’: Profiting without taking/ sharing related risks.
o Prohibition of Gharar (Uncertainty)
 A sale in which the vendor is not in the position to hand over the subject matter to the
buyer, regardless if the subject matter is in existence or not.
 Prohibition of gharar is found on the rule of justice and fair dealings:
 Occurrence of gharar in sale transactions may result in oppression or injustice, and the lost
of properties to one party or both.
 Reasons
 Due to the non existence of the subject matter or not having control over it.
 Due to inadequacy/ inaccuracy of information.
 Due to complexity of the contract (combining 2 sales in 1 contract).
o Prohibition of Maysir (Gambling)
 Gambling that assumes below characteristics:-
 It takes place between two or more parties;
 Each participant bets his property/ wealth;
 Each party has an equal probability of gain/ loss;
 The winning party’s gain corresponds exactly with losing party’s loss.
 Types of Riba’
o Riba’ al-Duyyun (Modern form of interest in loan)
 Increment charged on debt principal in consideration of the repayment period (penalty to
late payment).
 Hadith: Any added benefit for the lender that is contractual derived from a loan transaction
is riba’ (Ibn Abi Shaybah)
o Riba’ al-Buyu’ (Usury or Surplus)
 Exchange of commodities in unequal amount/ deferred delivery of the commodity.
 E.g.: 1kg of wheat vs 2kg of wheat.
 Hadith: Gold for gold, silver or silver, ………..like for like, equall for equal, and hand to
hand, if the commodities differ, then you may sell as you wish provided that the exchange
is hand to hand (Muslim).
Topic 3 & 4: Shariah Contract

 Contract - Literally: A’qad (tying tightly, as in tying a rope)

o Technically: a form of agreement between contracting parties in legally accepted, impactful and
binding manner
 Elements of Shariah Contracts
o FORM OF A CONTRACT (Ijab & qabul)
 Forms: Verbal, Writing, Gestures/conduct
 Conditions:
 Clear indication/ motive – acknowledge and understand the contract
 Correspondence of acceptance to the offer
 Continuity of offer & acceptance; Made in one single session;
 No indication of objection to the contract from both parties;
 Offerer did not retract the offer before being accepted by the offeree.
o CONTRACTING PARTIES (Buyer & seller)
 Conditions:
 Capable of taking responsibility (puberty & prudence)
 Not prohibited from dealing with the SM - owner (or representative), not
bankrupt/ prodigals.
 No coercion is exerted on either of the contracting parties (mutual consent) except
insolvency state.
o SUBJECT MATTER (Goods & services)
 Conditions:
 Exist at the conclusion of the contract;
 Precisely determination/ certainty of the SM - to avoid dispute;
 Certain delivery at the conclusion of the contract;
 Permissibility (lawfulness)to trade – own the property/ has intrinsic value/ halal
 Classification of Shariah Contracts
o Exchanged-based (Sale) Contracts - Bay al-Murabahah, Bay al-Istisna’
 Bay as-Salam, Bay al-Dayn, Bay as-Sarf, Bay al-Inah, Bay al-Tawarruq, Ijarah
o Partnership Contracts - Musyarakah, Mudarabah
o Security Contracts - Kafalah, Ar-Rahn
o Other Contracts - Hiwalah, Muqasah, Wa’d, Ta’widh & Gharamah
o Agency Contracts - Wakalah, Jualah
o Gratitious Contracts - Wadi’ah, Ibra’, Hibah, Qard, Waqf
 Exchanged-Based Contracts - Nature & characteristics/ purpose: For sale, For financing, For leasing
o Murabahah
 Definition: Literally: An increase in capital/ profit trading.
 Technically: A sale in which the acquisition cost and the markup are disclosed to
the purchaser, either on cash basis/ deferred payment basis.
 # The seller should expressly tell the buyer/ purchaser how much cost has incurred &
how much profit he is going to charge in addition to the cost.
 Types:
 Ordinary murabahah
 A contract in which the seller (ordinary trader) buys a commodity without
relying on any prior promise to purchase/ to sell or without a purchase/
sale undertaking
  Financing murabahah
 Resale to the purchase seeker where 3 parties are involved namely
customer (seeker), financier (seller) and the supplier.
 Commodity murabahah
 The sale of a commodity through a murabahah contract to the purchase
orderer (MPO) for a pre-agreed selling price, which includes a pre-agreed
profit mark-up over its cost price.
 Ordinary Murabahah
 Source: Portland Business Journal “Nike veteran Steve Bence on Tuesday broke
down the costs of a $100 shoe in a workshop…”

 Terms & Conditions

 There is a transfer of ownership of the asset from the seller to the purchaser, since
murabahah is a trust based / fiduciary sale contract, knowing the prices (initial
price / costs) is a condition of validity
 The mark up price (profit) must be disclosed to the contracting parties;
 Subject matter must be fungible – measurable, weighable and countable
 The contract should not lead to Riba, if the SM is a ribawi item, the validity of the
murabahah requires that riba does not occur in relation to the original price (item
measured by weight / volume is initially traded for goods of the same genus /
amount, the purchase good cannot be sold in murabahah concept)
 The initial contract should be valid, an item sold through a murabahah contract
must be acquired by the seller through a valid contract (not fraud or voidable)
 Application of Murabahah in Islamic Finance
 Home/ vehicle/ personal financing; Letter of Credit; Banker’s Acceptance;
 Credit Card; Trust Receipt; Securitization; Working Capital Requirement.
 Issues
 Disclosure of cost price, Use of interest rate as a benchmark for mark-up price
 Determination of actual financial loss in the event of default
 Rebate in the event of default and early settlement of debt
 Contractual relationship established prior to the execution of a murabahah
contract.
 Murabahah for Home Financing
 Customer identifies the house
 Bank buys the house on cash basis & takes ownership of the house
 Bank sells the house to customer for an approved period
 Customer pays the Bank within the agreed terms of financing
o Istisna
 Definition: Literally: To request someone to manufacture an asset.
 Technically: A sale of commodity which is to be manufactured and delivered at a
future date with flexi payment.
 Types:
 Classical
 Involves 2 contracting parties namely buyer (Mustasni’) & manufacturer
(Sani) Financing murabahah.

 Parallel
 Consist of a 2 series of separate Istisna’ contracts whereby the 1st Istisna’
contract is between the ultimate purchaser (customer) & the seller (bank),
where the seller is responsible to deliver the asset to the purchaser.

 Terms and conditions

 Subject matter to be manufactured must be precisely determined (type, kind,
quantity & quality (risk mitigation mechanism); √
 Subject matter is something common & familiar, usually commissioned on the
basis of istisna’ contract; √
 The delivery place should be specified. If commodity needs loading /
transportation costs √
 Time of delivery is clearly specified to avoid gharar;
 Flexi payment; Materials should be supplied by the manufacturer not buyer, if not
is ijarah; √
 Application of Istisna’ in Islamic Finance
 Applicable to various types of industrial productions.
 Problem - Manufacturer/ seller fails to complete/ deliver the asset
 Solutions
 Terminate the contract, the seller to return the paid amount but ownership of
Istisna’ remains with the seller
 Allows purchaser to purchase and take ownership of the Istisna’ asset on an ‘as is
where is’ basis and pay the Istisna’ price
 To include punitive clause in the Istisna’ contract (lower the cost)
o Bai Salam
 Definition:
 A sale of commodity which is to be delivered in the future for an immediate
payment.
 Advantages:
 Financing aspect – advance payment; Buyer gets low price of the commodities;
 Fights against trade – cycles (ready buyer); Protects buyer from price fluctuations.
 Types:
 Ordinary
 Involves 2 contracting parties namely Buyer (Musallim) & Seller
(Musallam ilayh)
 Parallel
 Consist of a 2 series of separate/ independent contracts between the buyer
(bank) & the seller.
 Process
 Bank enters into a salam contract with the seller & pays cash in full for
commodities to be delivered at agreed time in future
 Bank enters into a parallel salam contract with the buyer & who will purchase the
commodities from the Bank when they are delivered.
 Commodities are delivered to the Bank
 Commodities are delivered to the purchaser who pays the agreed price to the Bank
 Terms & Conditions
 Conditions related to the price √
 Price is determined and paid in full (cash) at the condition of the contract
 Maliki: can delay but not stated in the contract as condition
 Conditions related to the purchased commodity √
 Quality & quantity (to avoid dispute)
 Freely available in the market except gold & silver
 Not valid on movable assets / transport
 Condition related to date & place of delivery √
 Application of Salam in Islamic Finance
 Typically used for ST/ LT financing;
 Effective financing tools in providing micro financing services for small and needy
farmers;
 Appropriate mode for seasonal agricultural productions in which lies the benefit
for both parties.
 Bank can safeguard itself from the buyer’s default risk as the payment is received
on a spot basis;
 Seller has funds to produce commodities according to the quantity and quality
specified by the buyer.
 Modern banks are not so much in favor of a salam contract due to below reasons:-
 Banks can only sell the commodities after being hand over to them
 Banks are only interested in monetary product not commodity
 Banks are not allowed to impose punitive condition
 Banks face ownership risk of the perisable commodity when it is in its possession
 Fail to deliver the commodity to other counter party on the agreed date
o Bai Al Dayn
 Definition: A sale of debt for money.
 The said debt (unlike loan) is a right arises out of transactions with the underlying
element of commodity/ services.
 Therefore, debt includes deferred payment in BBA and Murabahah, deferred
payment of dowry, rental payable at the end of the month, etc
 Note: while many scholars opposed bay al dayn, the modern scholars agree to it
on the basis of modern transactions
 The basis of modern bay al-dayn:
 Debt is different from loan since it’s traded on market value;
 Sale of debt is similar to ibra’;
 Important tool for liquidation purpose.
 Application of Bay al-Dayn in Islamic Finance
 Mainly used in Malaysia as one of the underlying Shari’ah contracts in structuring
various Islamic Finance facilities.
 Key Issues
 Produces the same economic effect as conventional bond if it’s sold at discount
using Bay al-Inah – put IF products in a bad light
 Legal status of the subject matter (certificate of debt) as to whether it is a
commodity or money. This paper is equal to property & supported with
underlying assets via Tawarruq (Malaysia case). Therefore it satisfies current
customers’ needs
o Sarf
 Definition: The exchange of 2 currencies
 Applicable to modern FX Spot which is based on the spot rate in which the deal
settlement is expected to be completed within 2 business days after the contract has been
executed - Meets all conditions and requirements of Bay al-Sarf laid down by the Prophet.
 Legality:
 Hadith: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates
for dates and salt for salt – to be exchanged like for like, hand to hand. If the
species differ, sell as you wish provided that the payment is made on the spot.”
 All Islamic scholars unanimously agree on the permissibility of Bay al-Sarf since
it has been long practiced during Prophets time without no objection.
 Basic Structure of Bay as-Sarf
 Terms and Conditions
 Taking possession before departing – Delivery of both currencies must be done at
the of the conclusion of the contract (completed in the same session); √
 Equal for equal transaction – when it involves the exchange of currencies of the
same genus; Eg: RM 360 = USD 100 √
 Freedom from khiyar al-shart – Refers to an option to reward a sale contract based
on certain condition stipulated in the contract; √
 Non-deferment of the currency(ies). √
 Application of Bay as – Sarf in Islamic Finance
 FX Spot
 Based on the spot rate (market rate) in which the deal settlement is
expected to be completed within 2 business days after the contract has
been executed. But does it meet the conditions and requirements of Bay al
Sarf laid down by the Prophet?
 FX SWAP
 2 different currencies with 2 different rates (2 legs)
 Non – Shariah since delivery is in future
 FX Forward
 There is no forward market in IF because of its future delivery
 Utilized the rule of sarf but employs wa’d principle
 Eg: Hedging – RM4.50 = USD 1 with future delivery
 Future Market - There is no future market in Islamic Finance
 Issue in Focus
 Legality of paper currency – Being a legal currency, it’s subject to the dictates of
Shariah principles of gold & silver;
 Legality of FX Forward contract for hedging- Does not met the very basic
requirements of bay al-sarf, exchange of currencies must be delivered
immediately without delay. Solution: Resorting to another Shariah tool (wa’d);
 In FX Forward-i, there is an imposition of charge based on a MTM gain/ loss, in
the case wa’d is extended, cancelled and rolled over.
 IFIs may not have in possession sufficient foreign currency on the deal date to
deliver to customer. Bank will not hold high volume of foreign currencies to avoid
risk of market rate fluctuations
o Tawarruq - Tawarruq (Monetization/ Cash Financing/ Cash Procurement)
 Definition:
 Scholars gave different opinions on the definition.
 Earlier generation: seeking silver money;
 Now: seeking paper money
 “Buying a commodity with deferred payment and selling it to another person other than
the buyer for a lower price with immediate payment.”
 Types:
 Individual tawarruq
 The purchase of commodity possessed/ owned by the seller for a delayed
payment. Then the buyer will resell the commodity for cash but not to the
1st seller.
  Organized tawarruq (3 conditions)
 Original seller acts as an intermediary by selling the commodity for cash
on behalf of the mutawarriq (monetization beneficiary).
 Mutawwariq receives cash from the original seller, to whom he owes the
delayed price.
 The original seller might agree beforehand with the final buyer that he
(the seller) will purchase the commodity.
 Banking Tawarruq
 IFI will represent the mutawarriq monetization beneficiary and sell it to
another buyer for cash.
 Jurists consider it as organized tawarruq preceded by murabahah (purchase
& resell with profit).
Structured are the same but different in terms of entity who
administers the procedures
 Legality of Individual & Banking Tawarruq
 Different opinions on its legality.
 Opposition: it’s a trick of riba’.
 Proposition: as long as it fulfills some conditions.

Structure of Bay al-Tawarruq

  Application of Bay al-Tawarruq in Islamic Finance
 Tawarruq or commodity murabahah is one of the popularly used principles to
structure Islamic financial products.
 Can the agent is allowed to conduct deals with himself?
 Yes, if not in favour and offer more than marketprice
o Ijarah
 Definition:
 Varies according to subject matter
 Good/assets: lease a property to someone for a rent in which the latter is
entitled to enjoy the usufruct of the lease property.
 Services: hire of someone’s services for some work in which the employee
is entitled for salary/ fees.
 Legality: Lawful and permissible
 Application of Ijarah in Islamic Finance

PURPOSE APPLICATION

Financing Simple Ijarah, AITAB, musyarakah mutanaqisah, ijarah based credit card
(restricted to leasable items)

Government & corporate sukuk Ijarah sukuk

Risk management & hedging Ijarah rental swaps

purpose
 Terms and conditions
 The lessor must be the absolute owner of the leased property/ the equivalent (e.g.:
agent, natural or real guardian); √
 The leased property and the rent should be made known; √
 The mode of usage should be agreed upon to avoid dispute; √
 The lessor is responsible to maintain the leased property to retain the benefit of
the profit; √ The leased property is a trust in the hands of the lessee. √
 Sub-let is permissible with the permission of the first lessor; √
  Issues
 Combination of Contracts
 Execution must be separated and clearly stated in the contract
 Linked Rentals in LT Leases with an interest rate benchmark
 Benchmarking against interest rate is subject to certain conditions – profit
not vary according to the changes in the interest rate
There is a difference between making the profit dependent on the
rate of LIBOR and benchmarking the profit against the LIBOR
 Tying the rental with an interest rate benchmarks is rendered akin to
interest based financing
The variations of the interest rate is also unknown, therefore the
rental tied to the interest rate will imply gharar or jahalah
 Sale & Lease Back
 Permissible upon
Maturity of the lease contract
Time lapse between contracts
 Partnership Contracts
o Musyarakah
 Definition:
 Literally: sharing or mixing shares of 2 or more parties to make them
interchangeable.
 Technically: A contract between partners on both capital and profit.
 Types

 Terms and Condition

 The ratio of profit & losses between partners to be determined at the conclusion
of the contract; √
 Profit sharing should be on agreed percentage on profit, not a sum of
money or percentage of capital. Losses upon discretion of partners (but
usually based on capital contribution)
 Capital contributed should be in monetary form; √
 Can be tangible assets (commodities) because it has monetary value
 Permissible business; √
 Musyarakah Mutanaqisah (Diminishing partnerhip)
 One of the partners promises (wa’d) to buy the equity share of the other partner
gradually until the title of the equity is completely transferred to him
 It starts from the formation of the partnership after buying and selling takes place
(but this should not be stipulated in the comtract.
 The buying partner is only allowed to give promise (wa’d) to buy
 Sale is independently in separate contract
 Application of Musyarakah in Islamic Finance
 Home financing; Project financing; Asset financing;
 Syndicated financing; Working capital financing; Trade financing; Sukuk.
 Musyarakah Mutanaqisah Home Financing

 The customer identifies the property and gets the price quotation from the seller/
house developer.
 The customer approaches the bank for financing. The customer & the bank enter
into a musyarakah mutanaqisah contract.
  The customer & the bank jointly purchase the house (10% & 90%).
 The bank leases its portion of the house to the customer.
 The customer pays the lease rental with an additional amount to gradually buy
the bank’s ownership in the house.
 At the end of lease term, the partnership will be terminated with the customer
owns 100% of the house.
 Issues
 Contracts of Musyarakah & Ijarah in one document? – SAC BNM
 Method for profit distribution?
 Gross profit? Net profit? Based on ratio?
 Negotiable? Negotiable upon conditions? – sleeping partner…
o Mudarabah
 Definition:
 Profit and loss sharing where 1 party provides capital and the another party
provides labor/ services.
 Types:
 Al-MudHarabah Al-Mutanakisah (Unrestricted)
 - No limitations on location, time, methods of payment imposed on
manager.
 Al-MudHarabah Al-Muqayyadah (Restricted) - opposite the above.
 Terms and Conditions
 Capital
 Must be present at the conclusion of the contract
 Must be in monetary forms only.
 Profit - Basis: Agreed % of the profit & not on the basis of % of capital
 Loss
 Monetary loss: Rabbul-maal except negligence case.
 Time & effort: Mudharib
 Business Operations - √ Mudarib, X Rabbul maal
 Sub mudarabah - X without Rabbul maal’s permission
 Management Expenses - √ others, X Syafie
 Termination of contract
 Notice of termination by party(ies); Insanity of contracting party(ies);
 Death of the Mudharib only; Contract has life limit;
 Mudharabah funds – exhausted/ suffered losses;
 When the entrepreneur goes beyond what he is permitted, the contract would be
terminated by virtue of the breach of trust.
 Application of Mudarabah in Islamic Finance
 Unrestricted and restricted mudarabah investment accounts ; Corporate financing;
 Working capital financing; Mudarabah sukuk
 Key Issues
 Profit equalisation reserve (per)
 Fluctuations in profit rate depending on the flux in income, provisioning
and deposit. This may affect the customer’s confidence retain the extra
profit for as future reserve, AAOIFI; profit should realize immediately
then later clause permissible
  Third party guarantee
 Investment manager not guarantee profit and capital but 3rd party
guarantee is allowed
 Administration cost in a mudarabah investment account
 Admin is under expenses not to claim for profit

Musyarakah Mudharabah

Investment All partners Rabbul-maal

Management All partners Mudharib

Ownership of All partners (equal rights & benefits) Rabbul-maal (including assets purchased
assets by the Mudharib)

Profit 1. According to ratio of capital Pre-agreed ratio (determined upfront)

contribution
2. Pre-agreed ratio
3. Percentage of profit

Monetary loss All partners Only Rabbul-maal (Mudharib borne the

effort and time loss)

Liability Normally is unlimited. Limited to Rabbul-maal investment.

- If the business goes in liquidation & all - Unless he has permitted the Mudharib
partners have agreed that none should be to incur debt on his behalf.
incur any debt during the course of
business, then the exceeding liabilities
should be borne by the partner(s) who
incurred the debt in violation to the
condition.
 Security Contract
o Kafalah
o Al-Rahn
 Definition: Literally: Collateralized borrowing
 Technically: An arrangement whereby a valuable asset is placed as a collateral for
a debt or pecuniary obligation so as to make it possible for the creditor to recover
the debt or some portions of the good or property.
 Elements:-
 Offer & Acceptance;
 Contracting Parties;
 Pledgee (creditor) & Pledgor (Debtor)
 Pledged property (Marhun); and Underlying debt (Marhun Bihi),
 Terms and Conditions
 1. Offer & Acceptance (Ijab & Qabul)
 Contract is binding – when the pledged property is delivered to the
pledgee;Phrase must be clear & free from ambiguity;
 Signified by words which show agreement between parties.
  2. Contracting Parties (Pledgee & Pledgor)
 Must have legal qualification/ eligibility to enter into sales contract.
 3. Pledged property (Marhun)
 Fulfill the conditions of the sale object – can be sold to pay off debt
 Thus it should be: valuable, permissible items, exist at the time of contract,
deliverable.
 4.Underlying debt ((Marhun Bihi)
 Must be an established, binding and enforceable;
 Must be known & defined by both contracting parties;
 Must be matured/ binding or about to be matured;
 The underlying debt must be liable to paid off – Hanafi & Maliki

 Termination
 Full repayment and return of pawn asset(s)
 Either creditor or debtor dies, Transferring of debtor’s liability to other creditor
 Creditor withdraws from contract
 Pawn property perished or destroy, Property given as gift or sell to 3rd party
 Liquidation
 If the pledgor fails to pay the debt, the property may be sold its price may be used
to satisfy his outstanding debt; If he refuses, the court will force him.
 In Malaysian practice, the customer who created a legal charge over the house
will sign an agreement with the bank allowing the bank to sell the house in case
of default. This agreement is known as Power of Attorney.
 Agency Contracts
o Jualah
o Wakalah
 Contract Termination
 Principal dismissed the agent;
 Principal performed the assigned task himself;
 Agent resigned - notice to principal;
 Agent completed the task;
 If any of the principal or agent were to lose legal capacity – e.g. due to death,
permanent insanity etc.
 Expiry of period of agency.
 Application of Wakalah in Islamic Finance
 Deposit taking based on wakalah
 Letter of credit (LC ) based on wakalah
 Private banking investment
 In murabahah financing
 In tawarruq financing
 Can we appoint the same FI as the wakil to sell the commodity to the market (3rd party) to
obtain cash?
 Can but with condition
 Gratituous Contract
o Wadi’ah
 Definition:
 A safe custody contract between the depositor (customer) & the custodian (Bank).
 Wadiah yad amanah (trust custodian)
 Wadiah yad dhamanah (guaranteed safe custody)
 Custodian is entitled to use the depository property for trading or other purposes;
 Custodian is liable for any damage or loss;
 Custodian has the right to any income from the utilization of the deposited item and
therefore under his discretion to give certain portion (as gift) to the depositor;
 Custodian must return the depository property to the owner (depositor) upon request.

 Application of Wadi’ah in Islamic Finance

 Savings & Current accounts;
 Wadiah based bonds/ notes.
 o Hibah
 Definition:
 A gift granted by the donor in favor of the recipient in terms of cash or any kind.
 Hibah in Wadiah deposit account
 Hibah is given based on Bank’s discretion
 Hibah should not be promised upfront (riba)
 Gifts to attract depositors – must be avoided
 Advertisement of contractual hibah prior/ at the time of the contract – disallowed
 Hibah rates – based on historical data for reference
o Ibra’
o Qard
o Waqf
 Other Contracts
o Hiwalah
o Muqassah
o Wa’d
 Definition:
 Literally: promise/ undertaking.
 Technically: A promise which connotes an expression of commitment given by a
promisor to another party to carry out specified actions in the future.
 Reasons for wa’d:
 To show commitments from parties;
 As an alternative to put & call option;
 As a risk mitigation technique.
o Ta’widh & Gharamah
 Ta’widh
 The amount that may be compensated to the Islamic banking institution, based
on the actual loss incurred due to default.
 Gharamah
 A penalty or fine imposed for late off the debt, without proof of the existence of
the actual loss.
 Imposition of ta`widh and gharamah in islamic financing facilities in conventional
financial system, the problems associated with default in loan repayment are controlled
by charging interests or riba on customers. Since the imposition of interests or riba is
prohibited by shariah, islamic financial institutions do not adopt this mechanism to
address cases on customers’ default in settling their financial obligations under islamic
contracts. The sac was referred to ascertain a shariah compliant mechanism to deal with
this issue.
 Resolution
 The sac, in its 4th meeting dated 14 february 1998, 95th meeting dated 28 january
2010 and 101st meeting dated 20 may 2010, has resolved that the late payment
charge imposed by an islamic financial institution encompassing both concepts
of gharamah (fine or penalty) and ta`widh(compensation) is permissible, subject
to the following conditions:
 Ta`widh may be charged on late payment of financial obligations resulted
from exchange contracts (such as sale and lease) and qard;
 Ta`widh may only be imposed after the settlement date of the financing
became due as agreed between both contracting parties;
 Islamic financial institution may recognise ta`widh as income on the basis
that it is charged as compensation for actual loss suffered by the institution;
and
 Gharamah shall not be recognised as income. Instead, it has to be
channeled to certain charitable bodies.