Money Market – a Shariah Anomaly

Conventional wisdom states that money must generate returns all the time, even when it is idle. Hence the creation of the money market, a place for trading idle money. When there is a trade, there will be a price; and the price of money is the interest rate. What determines the interest rate? Other than the forces of demand and supply; monetary policy, expectation of changes in the base rate and inflation also influences the price of money.

The money market is also a place where mismatches in banks’ assets and liabilities are rectified. Banks with excess funds (liabilities > assets) will sell (lend) the excess cash in the money market and banks facing a shortage of funds (assets > liability) will buy (borrow) money from the market.

The money market ensures liquidity is managed and is therefore crucial to ensure the banking system and the economy works smoothly.

Why then do I say that the money market is an anomaly in Shariah based finance?

Firstly, my understanding is Shariah prohibits the trading of money because money is not a commodity; it is merely a tool to facilitate trade. Money is potential capital, useful only when put into productive economic use.

Secondly, money is a ribawi item, one which cannot be exchanged unless it is equal in value and transacted spot. The following hadith is the basis of this ruling.

The Prophet s.a.w. said “gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt should be exchanged like for like, equal for equal and hand to hand [on the spot]. If the types of the exchanged commodities are different, then sell them as you wish, if they are exchanged on the basis of a hand-to-hand transaction. (Sahih Muslim)

Therefore, the act of lending overnight money at 3%, contravenes the above hadith because (1) the exchanged value differs and (2) it is not exchanged on spot basis.

Then Tawarruq came along. Liquidity management in a Shariah compliant manner is now possible via the buying and selling of commodities (which does not leave the warehouse and is reused again and again for subsequent transactions). The route is longer but the objective is met nonetheless, money is exchanged in different amounts at different times, made “permissible” due to the presence of the trade. It sounds like a hilah to me because the whole transaction is undertaken merely to circumvent Shariah ruling on riba. It also does not entail any direct economic activity. The biggest beneficiary is the commodity brokers, getting paid for facilitating a seemingly pointless transaction.

No doubt, there will be times of excess liquidity and it does not make economic sense to keep the potential capital idle without generating any income.

This excess liquidity can be channelled towards financing short term projects or providing short term funding. Trade financing would be a good place to start. Retailers/traders usually buy from suppliers or wholesalers or manufacturers on credit terms. Banks could offer a short term murabahah facility to finance this type of transactions in the form of a 3 day, 1 week, 2 week or 30 day murabahah financing. This would channel the excess liquidity towards funding real economic activity.

Another way to absorb the excess liquidity is by way of a short term lease. A clearing house needs to be set up. The clearing house shall own a pool of tenanted properties. When a bank (or anyone for that matter) has excess liquidity, they will purchase property from the clearing house and the rental will be paid to them. When they need the cash, the property will be sold back to the clearing house at market value. In most cases, the purchase and sale price would be the same as it is quite unlikely for real estate values to fluctuate very much in the span of a few weeks.

Both methods entails actual economic activity and the returns from the investment are generated from actual economic activity.

There is always a Shariah based solution to every financial need. If there isn’t, the financial transaction is probably not in tandem with Shariah in the first place.

Will There be a New World Financial Order? by Pankaj Kumar (The Star, Business section, 21 January 2009)

Copy of the email I sent to the Editor of The Star, commenting on the need for an alternative financial model.

Dear Editor,

Quoted from Pankaj Kumar's article in The Star 21 January 2009:

"The simple argument is that asset managers or hedge fund managers do not need crude oil or other commodities for that matter or even currencies in their books.They have no business to be in these markets if they are purely speculating on price movements.They should stick to basic investment in asset classes, that is, genuine companies that use these commodities for real markets, real products and real profits. And yes, we do need a new world financial order to get rid of speculative activities which have time and again created asset bubbles and financial manias."

I cannot agree more with Pankaj's observation and would like to point out that an alternative financial order is already in place – Shariah (Islamic) based Finance.

The principles of Shariah disapprove of uncertain contract terms, prohibit gambling and abhor speculative practices. Unfortunately, these elements are prevalent in most financial instruments of late which ultimately caused the fallout in the financial markets that we are experiencing now. If undertaken in its true form, Shariah based financing can eliminate most of the problems associated with conventional financing as laid out by Pankaj in his article.

The key is however, to practice Shariah based financing as it should be, according to the principles of Shariah and not as a conventional product with an Arabic name. Shariah based finance is totally different in all respects from the conventional finance and banking the world has seen and grown to love for the past 100 years. It would be disastrous and detrimental to the development and growth of Shariah based finance if practitioners (and regulators) continue to develop so-called Shariah products based on the conventional platforms and norms.

What is needed is a paradigm shift in the way we approach and view Shariah based finance. We need to accept that although the objectives of Shariah based financing are similar to that of conventional finance, the means of achieving it is drastically different. Different here does not mean changing the product name or adding a few clauses in the transaction documents. The difference is in the mechanics, determination of profits (pricing), contractual obligations and relationship of all parties, the risk analysis and management, recovery methods, source of funds, utilisation of proceeds and remedies in the event of default.

In order for Shariah based finance to prosper, practitioners must not only be well versed in the laws of Shariah but more importantly understand the objectives of Shariah. The market also needs to be made aware of the uniqueness of Shariah based finance. Only then can we see the emergence of the true form of Shariah (Islamic) finance.

Regards,

Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws (Shariah) and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower relationship, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank; it is only concerned with the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met on time and in full by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally according to the invested capital. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Risk management in Islamic finance concerns the viability and potential profitability of a given project and has nothing to do with the investors’ personal ability to repay the capital.

Islamic financial transactions cannot involve anything prohibited by Shariah. The prohibitions include dealing in riba, alcoholic beverages, gambling (maisir), pork related industries, unethical practices such as prostitution and environmental damaging industries.

Uncertainty (gharar) is another major prohibition in Islamic finance. Uncertainty refers to events that are beyond the normal control of man such as profitability of a certain venture. It is therefore unlawful from the Islamic perspective to guarantee a predetermined amount of profit before the venture or project is concluded as the amount of profit generated is beyond the control of man. Of course effort and controls can be undertaken to ensure profitability but the actual amount cannot be determined at the onset.  

Being just and equitable does not mean at the expense of profits. Viability and profitability should be the main determinant in deciding to enter into a business transaction. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid.

Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions when the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not expected to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity and therefore has no price and cannot be traded. They are merely an intermediary to facilitate a transaction and therefore have no value on its own. The value of money is how much goods and services it can obtain.  Any exchange of money must involve not merely a trade but a productive economic activity. Any exchange of money with money must be of equal value and on spot basis, otherwise it will result in riba. Islamic economic prohibits hoarding of money. Zakat ensures that money is not kept idle and unproductive. Hoarding money will curtail economic activity and will result in economic hardship.

Islamic finance is all about financial transactions in a just and equitable manner. All parties involved in the transaction are expected to share the gains and bear the risks equitably. Islamic finance is not only for Muslims, it is for everyone who wishes to enter into an equitable financial transaction.