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.

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.

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.