ISSN: 1204-5357
Shabbir MS1*, Ghazi MS1and Akhtar T2 |
*Corresponding Author: Shabbir MS, International Islamic University Islamabad, Pakistan, Tel: +92 51 9019100; E-mail; Mshahzad786.pk11@gmail.com |
Received January 20, 2015; Accepted February 25, 2016; Published February 28, 2016 |
Citation: Shabbir MS, Ghazi MS, Akhtar T (2016) The Relationship between Traditional as well as Modern Modes of Financial Instruments for International Market through Islamic Finance. J Internet Bank Commer 21:159. |
Copyright: © 2016 Shabbir MS, et al. This is an open-access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited. |
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Islamic financial system compared to western conventional system is related to the religion of Islam. The principles of Islamic finance are based on three main factors which are mentioned in the Quran and are an important part of Islamic jurisprudence, such as Riba, Gharar and Maysir. Islamic commercial law is based on three modes which serve as the basic blocks for complex financial products. These three modes are partnership based, trade based and rental based modes of financing. These three traditional modes of financing are dependent upon the size and limitations of entire market and desires of their target customers. The modern modes of financing consist upon Islamic Insurance (Takaful), Islamic financial derivatives, Islamic bonds (Sukuk) and Istisna. Furthermore, there should not be pure economical interest in transactions; it must contribute to the social harmony. It shows balanced between equity and debt and the trade of debt must be avoided which is explicitly expressed in the pillars of Islamic banking.
Keywords |
Islamic jurisprudence; Social harmony; Traditional; Modern financial instruments |
INTRODUCTION |
The principles of Islamic finance are based on three main factors which are mentioned in the Quran and are an important part of Shariah1 and Islamic jurisprudence, such as Riba, Gharar and Maysir. The concept of Islamic finance has existed since the emergence of Islam. However, it was not as developed and systematic as today before late 1970s. The main idea of Islamic finance is perhaps best described by Iqbal et al. [1]. They state that under Islamic jurisprudence there are two kinds of rulings, the worship ruling which governs the relationship between man and Allah, and the second being mutual dealing rulings which governs the relationship among mankind. The general principle of mutual dealing rulings is that, everything is permitted unless clearly prohibited, which includes the principle of Halal and Haram discussed earlier [2]. They call it the “Doctrine of Universal permissibility”. Iqbal et al. [1] further state that; “In addition to the Doctrine of Universal Permissibility, Islam permits the contracting parties to agree on any conditions as long as they do not violate any Sharijah ruling. …We call this the ‘Golden Principle of Free Choice’. As may be seen, this principle gives a very wide scope for designing contracts”. They argue that; “the purposes of such prohibitions are to provide a level playing field to protect the interests of weaker parties, to ensure justice and fairness and in general to ensure mutual benefit for the parties as well as society at large, and to promote social harmony”. |
Interest (Riba) |
In Islam it is not allowed to either receive or pay any interest on transactions involving money. This prohibition essentially implies that the fixing in advance of a positive return on a loan, as a reward for waiting, is not permitted by Shariah. This prohibition has not been confined to Islam. According to Visser [3], based on passages from the Bible, the Christian Church at various times took a strong stand against demanding and paying interest. Also in the Old Testament, Jews were forbidden to demand interest on loans from their own but they could charge interest on loans given to foreigners. Perhaps, best definition of Riba is given by Iqbal et al. [4]. |
In its basic meaning, Riba can be defined as anything (big or small), pecuniary or non-pecuniary, in excess of the principal in a loan that must be paid by the borrower to the lender along with the principal as a condition, (stipulated or by custom), of the loan or for an extension in its maturity. According to a consensus of Islamic jurists it has the same meaning and import as the contemporary concept of interest [1]. |
Gharar |
Translated directly from Arabic it simply means uncertainty or risk. Gharar is as important in Islamic finance as Riba. Compared to Riba, Gharar is more difficult to define clearly in financial transactions. It is one of the most difficult tasks for the experts in Shariah boards in many IFIs to agree upon when there are new products available on the markets. In this relation, Iqbal et al. [1] state that, “jurists make a distinction between two kinds of Gharar: Gharar ahish (substantial) and Gharar yasir (trivial). The first kind is prohibited while the second is tolerated since this may be unavoidable without causing considerable damage to one of the parties. In many cases, it is simply not possible to reveal all information (not because the seller wants to hide anything, but because it is in the nature of the product). The buyer has to trust the seller”. It is Gharar yasir (trivial) that sometimes causes problems for Shariah boards to agree upon. To prevent Gharar in a transaction, the full implications of this transaction must be clearly known to contracting parties. In other words there must not be “asymmetric information” between parties because it breaches the principle of Islamic law. Elgamal [5] states that, Gharar translated conceptually by professor Mustafa Al-Zarqaa means “trading in risk, which cannot be defined”. He further gives us examples of naked options, financial futures, and derivatives that are not backed by tangible and verifiable assets. |
Maysir |
Maysir is closely related to Gharar. In some papers about Islamic banking these two principles are used interchangeably even though there is a difference between these two principles. Where in Gharar the main focus is on uncertainty, Maysir, translated from Arabic “gambling”, focuses on and prohibits transactions that are based on one side’s gain at the cost of the other. According to Shabbir [6-9] describes that conventional banking products such as life insurance are prohibited in Islamic finance as it comes under Maysir. When gambling, the player pays a certain amount of money in the hope that he will gain much larger amount, similarly the conventional life insurance policy where the assured hopes for a chance to make a gain El-Gamal [5]. |
The three principles mentioned above are the main principles of Islamic finance. However, there are some general rules under which financial transactions become void in Islamic finance. This could be a contract which involves immorality, which involves illegality against public policy, its foundation or substance is unlawful or illegal, or any other contract or agreement which directly or indirectly is contrary to the divine principles of Shariah. |
Literature Review |
Islamic finance products |
A large number of products are available in Islamic finance and the number is growing as demand for more Islamic compliant products grow throughout the world. Broadly speaking, Islamic commercial law is based on three modes which serve as the basic building blocks for other more complex financial products. These three modes are partnership based, trade based, and rental based modes of financing. Nearly all Islamic finance products come under these three modes. The use of each mode is dependent on the purpose and size of transactions, but all of them are based on principle of Riba prohibition. One thing to remember is that, as mentioned earlier, as a result of the difference in interpretation not all of new products are universally acceptable. The three mentioned modes are covered in details below. |
Partnership based mode of financing |
Partnership based or Profit-and-Loss-Sharing (PLS) mode suggests an equitable sharing of risks and profits between the parties involved in a financial transaction, and include Mudarabah, Musharakah and other hybrid products. Theoretically, Mudarabah and Musharakah are the most desirable forms of Islamic financing. |
Mudarabah: Mudarabah is an agreement between a lender (bank), who acts as an investor, and a borrower, whereby the borrower can mobilize the borrowed amount for his business activity. If profits are made they will be shared between the lender and borrower according to the mutually agreed ratios. In the case of loss the lender shares the losses in proportion to his contribution. Hussein [10] gives a good example; “an Islamic bank lends money to a client to finance a factory, in return for which the bank will get a specified percentage of the factory’s net profits every year for a designated period. This share of the profits provides for repayment of the principal and a profit for the bank to pass on to its depositors. Should the factory lose money, the bank, its depositors and the borrowers all jointly absorb the losses”.2 |
Musharakah |
Musharakah is in its basic a business partnership or joint venture between two parties where one party could be a bank and the other party its customer. It is affected for a particular period like a few months, year or more than a year. Both parties agree on a certain percentage of the profit to be given to each party. The profit of the bank must not exceed the percentage of its investment in the Musharakah. The losses, if incurred, will be divided based on strict proportion to the equity participation ratio, i.e. to the capital contributed by each party. For example, if the bank invests 65 % and the customer 35 %, they must share the loss in the same ratio. “All parties, including the bank, have the right to participate in the management of the project, but equally, all parties have the option to waive such right. All parties agree through negotiation on the ratio of distribution of the profits generated from the project, if any. This ratio need not coincide with the ratio of participation in the financing of the project” [11]. Musharakah is used by financial institutions for asset and/or real estate financing, working capital financing, and etc. |
Both Mudarabah and Musharakah are closely related products. Mudarabah differs from Musharakah in the way that only bank is the investor here, whereas in Musharakah all parties invest in the project. In Mudarabah management is the prerogative of the investor, whereas in Musharakah all partners can manage the project based on a prespecified agreement. And finally, in Mudarabah the customer does not bear losses if incurred, whereas in Musharakah profits and losses are shared based on the percentage of the investment. |
Trade based modes of financing |
Trade based modes of financing became available in the market much later than partnership based mode, but its products gained dominance among other products very quickly. Because it targeted a much larger group of investors, both private and business customers, and it also is safer for both parties to invest in this mode of financing, compared to partnership based mode. |
Murabaha finance: Murabaha is an agreement between a bank and its customer. The customer requests the bank to purchase or import commodities on his/her behalf, with a promise to buy them from the bank at purchase price plus profit margin of the bank, and to be paid on deferred installments. One of the most used forms of Murabaha by Islamic banking customers is home financing. Murabaha could be named as the locomotive of Islamic finance because it was after the introduction of Murabaha that Islamic banking assets grew at double digits. But there are numbers of critics among prominent scholars criticizing Murabaha’s compliance with Shariah. As Usmani states, “It should never be overlooked that originally, Murabaha is not a mode of financing. It is only a device to escape from ‘interest’ and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of Islamization of the economy. And its use should be restricted only to those cases where Mudarabah and Musharakah are not practicable [12].” |
This statement can be confirmed by looking at a problem that Murabaha contains. The problem is that the customer’s promise to buy commodities from bank once the bank has bought it, cannot be binding since this would be a contract in which neither side is obligated immediately to perform. The solution to this problem, that Shariah boards has come with, is allowing banks to take collateral against losses incurred from a customer’s breach of promise Mansoor [13]. |
Salam finance: As mentioned before, Shariah does not permit selling what you do not own but Salam is exempt from this condition. In Salam, as long as the commodity is specified by both quality and quantity and at full payment at spot, it is allowed to sell it in a given future date. The seller is obliged to have the commodity by the end of contract. If the seller does not have the commodity in hand at the time of execution of the contract, he/she must buy it in the market. Salam is similar to forward contracts in conventional financial system with the difference that in Salam the entire amount must be paid when signing contract. Salam is used by IFIs in agricultural financing, pre-shipment export finance, and project financing. Iqbal et al. [1] have stated four basic rules that govern Salam: |
1. The price should be paid in full at the time of the contract. |
2. Goods whose quality or quantity cannot be determined by specification cannot be sold through the contract of Salam. An example is precious stones. |
3. Goods can be sold only by specifying the attributes. They cannot be particularized to a given farm, factory or area. |
4. The exact date and place of delivery must also be specified. |
There are also three major risks connected with the use of Salam, as mentioned by Venardos [11] which according to him reduces the Salam’s value as a financing vehicle. |
1. The risk of default by seller which could just partially resolved by obtaining some form of security from the seller. |
2. The bank’s need to liquidate the goods after delivery, an inconvenience made more serious by the Islamic legal rule that a Salam buyer cannot sell the expected goods before actually taking possession of them. But this is also resolved by Shariah boards, who allows banks to sell the goods with conditions that the new contract is unconnected to the first one (buying goods from seller), and that the goods are of exactly the same description, quantitatively and qualitatively, and with the same due date. |
3. Requirement of Shariah that if at the time of delivery the seller can neither produce the goods nor obtain them elsewhere, the buyer has only two choices: either withdraw his offer, or wait for the goods to become available later, with no compensation permitted for the delay. In either case, the buyer loses all or much of the profit from the use of his money. |
Rental based modes of financing |
Rental based modes of financing have existed since the beginning of Islam. It was used mostly in relation with agricultural products. Ijarah have been the only type used in this mode, but with time and the development of new products financial institutions have added other more complicated products under this mode. The main idea of this mode is that the financial institution purchases an asset for its customer and then hands it over to him/her on rental basis Hassan [14]. This can be an operational asset, where IFI act as warrantor of the asset or financial asset, and where the customer deals directly with the supplier so the ownership titles remains with the IFI until it is transferred to the customer. The two most used products in rental based mode of financing are Ijarah and Diminishing Musharakah. |
Ijarah finance |
Ijarah is much equivalent to leasing agreement in conventional financial system, but with a difference that Ijarah does not involve interest bearing contracts and they should be Shariah-compliant. When translated from Arabic, Ijarah means to provide something on rent. Venardos [11] define Ijarah as; “a contract under which the bank leases equipment to a customer for a rental fee. It is pre-agreed that at the end of the lease period the customer will buy the equipment at an agreed price from the bank, with the rental fees already paid being part of the price”. |
Ijarah is the most used type of product, not only among rental based mode products but also among all products provided by IFIs, when it is concerned the acquisition of assets for businesses. Ijarah have generally been used by private customers for financing consumer goods like homes and automobiles. But recently it has gained popularity among business customers in relation with project and transportation financing. Ijarah is used for almost everything that could be leased, but some certain items that is prohibited in Sharia and a few others like fuel, food and etc. are not included in Ijarah. |
Diminishing musharakah finance: As with Musharakah, diminishing Musharakah is a business partnership with the difference that in diminishing Musharakah, at the end of partnership, one part becomes the full owner of the asset in a predetermined mechanism agreed upon, when the contract is signed. The transfer of the ownership is determined by a leasing agreement where the lessee purchases the ownership on a pro-rata basis through periodical lease payments. Iqbal et al. [1] describe diminishing Musharakah as a contract between a financier (the bank) and a beneficiary in which the two agree to enter into a partnership to own an asset, but on condition that the financier will gradually sell his share to the beneficiary at an agreed price, and in accordance with an agreed schedule. Diminishing Musharakah is increasingly used in sectors like housing and real estate, project finance, and construction. Diminishing Musharakah takes different shapes according to the shape of the transaction. A general rule is that when a customer wants to buy a commodity he/she approaches the IFI which agrees to join into partnership. The customer has to pay at least 10-20 percent of the price, according to IFIs requirements, and the rest is paid by the IFI. The share of IFI is then divided into units which the customer has promised to purchase one after another in a predefined schedule. During this process the IFI gains on rent claimed according to its proportion of share. |
Modern Modes of Financing |
Insurance |
Insurance is one of the much discussed products in Islamic finance. Some hardliners in Islam condemn any kind of insurance arguing that insurer-insured relationship involves Gharar and Maysir and is not allowed in Islam. “Conventional life insurance was already declared unacceptable in 1903 by some prominent Islamic scholars in the Arab countries. This was followed in 1978 by a resolution of the Fiqh3 Council of the World Muslim League and in 1985 by one from the Fiqh Council of the Organization of the Islamic Conference declaring that conventional insurance as presently practiced is Haram (O.C. Fisher 2001) [3]”. Moderate Muslim scholars, on the other hand, argue that as long as Gharar and Maysir are separated from insurance product it is in compliance with Shariah. They state that in particular business activities such as construction, transport and investment services, the professional liability insurance is not involving Gharar and Maysir. Takaful is such an insurance product that does not involve Gharar and Maysir. |
Takaful |
Translated directly from Arabic, Takaful means cooperative or mutual insurance. Takaful is developed by Muslim scholars and economists because the conventional insurance contains Gharar which is forbidden in Islam. The main idea behind Takaful is that both insurer and insured are viewed as contributors to the pool of money which they voluntarily have agreed to share in case of loss incurred to one of them. “Islamic insurance, or Takaful, differs from commercial insurance in that it is a cooperative form of insurance, though the actual business operations may be left to commercial firms, who act as managers, or agents, with the policy holders as their principal [3]” . |
There are three major Takaful models and they are as follows: |
1. Mudarabah – derived from the Mudarabah contract, the Takaful company acts as the operator and share in the returns from the investments of the Takaful fund according to a predetermined profitsharing arrangement. If there is no profit, the operator will receive no compensation for management services. |
2. Wakalah – insurers appoint the Takaful Company as their agent or manger to handle all the activities of the Takaful fund in accordance with established guidelines. A predetermined fee compensates the agent or manager. |
3. Mixed model – under this model the Takaful Company will be assured compensation under the Wakalah contract and will receive a share of profit under a Mudarabah contract as well. |
Derivatives |
CFI derivatives include call and put options, futures, forwards, and swaps and are used for hedging, arbitrage, and speculation. From the Shariah point of view most of the derivatives provided by CFIs are deemed to be Haram i.e. prohibited for IFIs because these kinds of transactions refer to the commodities that might not be in seller’s possession. According to Khan [15] IFIs seemingly allow derivatives for the purposes of hedging and arbitrage, but prohibit their use for speculation or gambling. As mentioned before, Islam prohibits Gharar and Maysir (gambling and speculation). However, the need for a mechanism that could help IFIs customers to manage unnecessary risk has prompted Islamic jurists and scholars to come up with some standardized liquidity and risk management products, directly based on the generally accepted Islamic financing modes. A number of products are similar to conventional financial products, Forward or futures contracts (a combination of Salam and Murabaha), call (Arbun) and put options, total return or currency swaps and etc., but completely within an Islamic framework. Jobst [16] States that; “Shariah scholars take issue with the fact that futures and options are valued mostly by reference to the sale of a non-existent asset or an asset not in the possession of the seller, which negates the Shariah. Shariah principles, however, requires creditors (or protection sellers) to actually own the reference asset at the inception of a transaction.” Anybody who is familiar with the rules of Shariah can see that the idea behind these derivatives goes against the very pillars of Islam. Therefore the creation and development of such products are one of the most challenging tasks for Islamic finance practitioners. The size of the Islamic derivative market is not known but is quite small and derivatives are much less widely available to IFIs than to CFIs [3]. |
Sukuk |
Due to its similarity to conventional interest-based bonds’ characteristics Sukuk are often referred to as Islamic bonds. Like bonds, the holders of Sukuk are entitled to a regular stream of coupons and a final payment at maturity. However, in principle it is wrong to refer to Sukuk as Islamic bonds because the conventional bonds are debt transactions while Sukuk are asset-based and/or asset-backed. The difference in asset-based and asset-backed is risk associated with them. The asset-backed is much less riskier than asset based. The asset-backed Sukuk resemble the equity position in conventional system because they own a part of the underlying asset, while asset-based Sukuk are closer to debt position because the holders of asset-based Sukuk do not own the underlying asset and have recourse to the originator in case of default. AAOIFI define Sukuk as certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity [17]. |
Sukuk are used mostly to finance large investment projects. After the introduction of Sukuk they are increasingly used by IFIs in order to manage their liquidity because these securities are typically short term in nature, ranging from three months to one year and which can be liquidated easily in the secondary market. As mentioned before, IFIs are not allowed to use the available conventional instruments for liquidity management as they are interest based and therefore not in compliance with Shariah. The Gulf Cooperation Council (GCC) countries have prohibited trading of Sukuk in the secondary market arguing it involves Riba. Therefore, Salam-based Sukuk and the likes are typically held to maturity in this region while in other regions leading by Malaysia the secondary market for Sukuk is growing. Although Sukuk is in its infancy stage, first issued in the late 1990s, the increasing use of it as a liquidity management instrument has contributed to the fast growth of Sukuk market. Most of Sukuk offering have been asset-based or Ijarah Pepinsky [18]. |
Whereas, Ijarah-based Sukuk have medium- to long-term maturities, carry a put option, and can be traded in the secondary market. In a typical Ijara Sukuk structure, the originator sells assets to the Sukuk issuer, a bankruptcy-remote special purpose vehicle (SPV) created to act as a trustee for investors acquiring the assets [4]. Sukuk returns are tied to the cash streams generated by underlying assets held in SPVs. This cash stream can be in the form of profit from a sale, profit from a rental (Ijara), or a combination of the two. The conventional asset securitization process is used in structuring Sukuk. The Sukuk is a nascent product as well as the whole Islamic capital market is very young, therefore new Sukuk products are evolving around the world. In this relation AAOIFI issued a statement in 2008 stating that IFIs must avoid involvement of Sukuk in debt-related operations. |
Istisna |
Istisna is used in financing goods that are not yet ready for sale and will have to be manufactured according to certain agreed criteria and requirements, with payment on agreed terms. IFSB [19] defines it as an agreement to sell to a customer a non-existent asset, which is to be manufactured or built according to the buyer’s specifications and is to be delivered on a specified future date at a predetermined selling price. The IFI agrees to construct and to sell the project to be constructed at the bank’s selling price to the customer and thereafter it requests a third party to construct the project; Upon completion, the contractor will hand over the project to the IFI or the IFI will authorize the contractor to deliver the project directly to customer. |
Istisna is used in services such as tailoring, architect and construction projects, industrial equipment, plants and machinery, ships and aircraft, contract or asset financing, in pre-shipment exports financing and usable in all other situations where goods have to be manufactured before sale. Under these transactions the payment can be flexible depending on the agreement between the bank and the client; the price can be paid up front, according to manufacturing process, at completion or installments after completion [20]. Istisna is perhaps one of the most flexible products available by IFIs. Istisna offers greater future structuring possibilities for trading and financing. The contract can be cancelled at any time by any party given a prior notification time before starting the manufacturing process, but not later than that. |
Conclusion |
As mentioned before, theoretically that Islamic finance is based primarily on the avoidance of Riba (interest), Gharar (speculation), and Maysir (uncertainty) and exercising profit and loss sharing, which is touted as the foundation upon which all IFIs are based. Furthermore, there should not be pure economical interest in transactions. They must contribute to the social harmony. They must be balanced between equity and debt and the trade of debt must be avoided which is explicitly. The first Takaful Company is organized by IFIs, then both insurers make a periodic payment to the Takaful Company which it maintains in individual accounts for each member and these amounts can be invested in other Shariah compliant products during the contract period. As the numbers of different derivatives grow in Islamic finance, the criticism is also growing from different parts of the world by Islamic jurists and scholars arguing, that these kinds of products are not in full compliance with Shariah. |
Although Sukuk is in its infancy stage, first issued in the late 1990s, the increasing use of it as a liquidity management instrument has contributed to the fast growth of Sukuk market. Most of Sukuk offering have been asset-based or Ijarah. Ijarah-based Sukuk have mediumto long-term maturities, carry a put option, and can be traded in the secondary market. Istisna is perhaps one of the most flexible products available by IFIs. Istisna offers greater future structuring possibilities for trading and financing. The contract can be cancelled at any time by any party given a prior notification time before starting the manufacturing process, but not later than that. |
1 Islamic law – the fundamental religious concept of Islam, namely its law, systemized during the 2nd and 3rd centuries of the Muslim era equal to 8th-9th centuries AD. (Encyclopedia Britannica). |
2 Elasrag, Hussein, Global Financial Crisis and Islamic Finance (April 17, 2010). http://ssrn.com/abstract=1591563. |
3 Islamic Jurisprudence |
References |
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