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.

Tawarruq – a Tripartite Inah?

The OIC Fiqh Academy rules that organised Tawarruq is unacceptable (Resolution 179 (19/5) 26 – 30 April 2009). In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlying Shariah).

Tawarruq is widely used as a liquidity management tool and most scholars sanction the structure. However, some scholars argue it involves legal trickery and contains elements of interest based lending. Tawarruq does not create any economic activity but instead it creates debts.

Tawarruq is a tripartite arrangement between a bank and two commodity brokers. The bank will undertake a Tawarruq transaction whenever it gives out loans (or in a more Shariah compliant term – financing) or when the bank requires funds.  The modus operandi is as follows:

1. The bank will procure commodities or metals from a broker at price P, payment is spot.
2.  The bank will then sell the commodity to the customer (borrower) at price P plus profit, payment is deferred as per the financing agreement.
3. The customer then instructs the banks to sell the commodity/metal back to the market at price P, payment spot. The customer gets his cash from the “sale proceeds”.
4. The commodity is bought and sold within minutes and never leaves the warehouse. All this buying and selling action has no real economic value. Only the brokers make money.

•  The operations is reversed if the bank wishes to borrow from another institution.

To me, Tawarruq is basically an Inah with an additional contracting party. The whole process of buying and selling metals/commodities is merely a charade, a legal trick as the main purpose is to transfer cash from one party to another.

It has always been argued by some that niyah (intention) is secondary when undertaking such contracts. I do not agree. If we exclude niyah, everything will be permissible. A lot of observers have urged Islamic finance practitioners to look at the substance behind the form when structuring Shariah based solutions, the on going debate on substance over form of Islamic banking products and services.

Dr Nikan Firoozye (http://islamic-finance-resources.blogspot.com/) opines that we should categorize products by their Shariah-risk, with hiyal (legal trick) the most risky. I wish to add that if such measure is used, the higher the Shariah-risk is, the less compliant the product is.

Dr Mohammad Akram Laldin, a respected Malaysian religious scholar, disagreed with OIC's ruling, saying organised tawarruq does not violate Islamic law principles. “From the point of view of Islamic law, there is nothing wrong with the transaction itself.” (http://islamicfinanceupdates.wordpress.com/2009/06/04/islam-allows-organised-tawarruq-asset-sales-scholar/)

I do not see this declaration as a hindrance to the growth or development of Shariah based finance. I see it as moving out and away from the conventional norms and in the long run will bode well for Islamic banking and finance. BBA and Inah based products are being gradually phased out in Malaysia and with the latest declaration, expect to see more products being out of favour. I hope Commodity Murabahah will be next.

Eurozone Predicament – Could Shariah Based Finance Avert the Crisis?

The Eurozone crisis is caused by fractional reserve banking and interest based lending and borrowing. 

A very strong statement/accusation but I will stand by it and I am sure I’m not the only one with that view. In fact, any financial or economic crisis will have roots in the fiat monetary system and lending with interest.

The beginning of the 21^st century saw low interest rates and easy credit fuelling a borrowing binge. This spree caused prices of assets, real estate in particular, to soar. Rising prices ‘invited’ a new group of investors into the market – the speculators, and their presence made things even worse. Banks too made things worse by lending to people who were not really credit worthy or lending to people amounts beyond their ability to repay.

Similarly, in the Eurozone, countries which are not creditworthy were allowed to borrow beyond their means, often hiding behind the credit strength of stronger countries;, in this case, Germany. These governments took advantage of the opportunity and cashed in on the cheap funding to finance everything from infrastructure to social benefits.

Everyone seemed to forget that what goes up must come down; the economy is no exception.

In 2008, everything collapsed. The US housing bubble burst and the whole world followed suit. House prices crashed, banks went bust, stock markets crashed, pension funds lost money, unemployment rose and everything fell apart.

Now everyone is poorer.

Let’s try to imagine if things were done according to Shariah rules. Profit and loss sharing (PLS); a ban on speculative activities and prohibiting the creation and trading of ‘gharar’ and ‘maisir’ infested financial instruments would almost certainly prevent the bubble from appearing in the first place. If the bubble doesn’t exist, it cannot burst.

Imagine if businesses carried out investments on a PLS basis where returns on investment (i.e. cost of funds) matches the actual returns of the investment and not burdened by movements in the rate of interest. The problem with interest based bank lending is that it does not care how much the business is making (or losing); all it wants is their money back plus interest. PLS on the other hand is directly linked to demand and supply and the real economy; when times are good, partners have more to share but when times are bad all partners share the smaller pie (or absorbs the losses). It all boils down to the intention of the investor (lender, in conventional terms); adopting PLS means riding the waves of the economy, insisting on interest based lending could mean not getting anything if the economy crashes.

Imagine if properties are acquired on a (pure) diminishing partnership basis. The buyer (borrower, in conventional terms) and financier jointly purchase a property which the buyer rents at the market rental rate. Being a joint owner, part of the rental is attributable to the buyer him/herself which is then used to purchase equity in the property from the financier. If times are bad, the buyer can choose to only pay the portion of the rental owed to the financier and if times are good, he/she can choose to buy more equity in the property. The rental is market determined and not influenced by movements in interest rates.

Investment bankers are smart people. They are so smart they come up with all kinds of solutions to earn themselves a commission and bonus. However, some of these solutions may only be good for the banks and not for the customers. In most of the solutions, the element of gharar and maisir are clearly present. To make matters worse, some of the instruments can be used to speculate and gamble. These are the recipes for disaster and are exactly what mortgage-backed securities (MBS) and collateralized debt obligations (CDO) are.   The U.S. Senate's Levin–Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." Shariah based finance would not have allowed such instruments to flourish (although I personally know of some bankers who wanted to create a “Shariah compliant” CDO!).

Therefore, I conclude that the Eurozone crisis (and the global financial meltdown of 2008) was created by;

1. Fiat money;
2. Interest based lending;
3. Unjust and unethical business practices (lending to those who can’t afford, selling potentially worthless credit notes etc.)
4. Gharar; and
5. Masir.

Riba

The prohibition of riba is the foremost issue in Islamic banking and finance. The literal definition for riba is “excess”, “increase”, or “growth”.

In Islamic banking and finance context, riba is often equated with interest. It is not inaccurate to equate riba with the interest rate but the term riba has a broader definition.

The following are the definitions of riba given by some scholars;

Abu Bakar ibn al Arabi – riba is excess in return of which no reward is paid.

Abu al Ala al Maududi – a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specific period. Riba contain the following elements:

i) Excess over and above loan capital

ii) Determination of the excess in relation to time

iii) Stipulation of the excess in the loan document

http://hazariba.com/DefinitionRiba.shtml - a forced increase of value in the medium of exchange (money/commodity) that is loaned or swapped.

Engku Rabiah Adawiah – an increase or excess which accrues to the owner in exchange or sale of a commodity or by virtue of a loan arrangement, without giving in return equivalent counter value to the other party.

From the above definitions, we can see that any excess earned over the principal amount is considered riba if it is earned without putting in any effort and without assuming any economic risk. The difference between riba and profit is that profits are earned from a productive economic activity whilst riba is earned without doing anything.

Socio-economic justice is one of the main objectives of the Islamic faith. The definitions above show that riba guarantees that only one or some of the contracting parties benefits from the transaction at the expense of the other parties. Therefore, Islam prohibits riba to ensure that the principles of just and equity is preserved, enabling all contracting parties to share the benefits equitably.

Types of riba:

Riba al fadl – excess accruing in sale or barter transaction

Riba al nasiah – excess accruing from a loan transaction (similar ribawi items) in relation to time

Prohibition of Riba in Quran:

1st stage – Surah al Rum verse 39 (Makkah) – call to abolish interest bearing loans and give alms instead.

2nd stage – Surah al Nisaa verses 160-1 (Madinah) – riba was also prohibited to the Jews (reminder)

3rd stage – Surah Ali Imran verse 130 (Makkah) – stronger prohibition

4th stage – Surah al Baqarah verses 275-281 (Makkah) – Strict law prohibiting riba, establishes clear distinction between trade and riba and defines riba as any increment (however small, whatever the reason) added to the principal. Instructing to only receive principal and waive repayment if borrower is in hardship. Cites the consequences for indulging in usury.

Hadith on the prohibition of Riba

Sahih Muslim, Book 010, Number 3854: Abu Sa'id al-Khudri (r) reported Allah's Messenger (pbuh) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to hand. He who made an addition to it, or asked for an addition, in fact dealt in riba. The receiver and the giver are equally guilty.