Controversies / Issues in IBF

Bay Inah / Tawaruq
Is viewed by some observers and practitioners as a hilah (legal trick), as the objective of the transaction is to exchange of money in different quantities at different times.
The argument for legalising or forbidding Inah and Tawarruq is based on the intention (niyyah) of the parties, i.e. real vs. declared intention.

Bay Inah is a legal sale in the Shafie School, where the intention is not a significant element in determining the validity of the contract. This is the basis for the endorsement of Bay Inah by BNM’s and SC’s SAC.
Rayner (The Theory of Contract in Islamic Law, 1991) concludes that the Malikis and Hanafis give due effect to the real intention or niyyah of the parties, but that as regards illicit motives both schools are reluctant to make such an uncertain element as motive a dependent factor of a legal act. The Hanbali School however, always gives precedence to real intention over declared intention. According to him, the general tendency of Islamic law seems to be to give priority to the declared intention. However, in the Shafie School, this is not just a tendency but a doctrinal stance.

Debt - property or money?
The Malaysian (presumably based on the Shafie’s opinions) view is that debt is a property and hence can be traded freely. For example, a RM100 million debt can be exchanged for RM90 million in cash without any implications.

The middle eastern views debt as money and therefore can only be changed with money of equivalent value. The RM10 million difference in the above example is therefore riba.

Purchase undertaking in an Ijarah transaction - valuation issues?
A purchase undertaking is part of an Ijarah transaction for the sole purpose of returning the leased asset(s) back to the originator. The Purchase undertaking (PU) is present because it was never the intention of the originator to sell the assets in the first place. Another reason is to facilitate the redemption of the principal, similar to the mechanics of a conventional bond/loan which explains why the PU is undertaken at nominal value and not marked to the prevailing market values.

The issue with PU is not whether it is allowed by Shariah or not but it has more to do with the price transacted under the undertaking. If the price is based on the prevailing price at the time of executing the undertaking, I see no issues. It is about justice and fairness to the contracting parties. If the market price is below the PU exercise price, it would mean injustice to the purchaser and conversely, it would be unfair to the seller if the market price is more than the price transacted under the PU.

Purchase undertaking in a Musharakah/Mudharabah transaction – capital protection?
Like the PU in an Ijarah transaction, its presence in a Mudharabah/Musharakah transaction is to facilitate the principal redemption to mirror the mechanics of a conventional bond. A PU under this circumstance tantamount to guaranteeing capital. It is permissible for a third party to guarantee capital but it should be done on the basis of hibah (gift).

BBA, Justice Abdul Wahab and the Court of Appeal

In July 2008, High Court judge Datuk Abdul Wahab Patail had ruled that the application of the BBA contracts in Arab Malaysian Finance Berhad v Taman Ihsan Jaya & Others (2008) was contrary to the Islamic Banking Act 1983 (IBA).

On March 31, the Court of Appeal unanimously overturned Abdul Wahab's much-debated judgment in the Bank Islam Malaysia Bhd v Ghazali Shamsuddin & Two Others, and nine other cases.

Abdul Wahab Patail ruled that BBA is a loan transaction and not a trade based financing. This is because there is no transfer of title from the customer to the bank during the PPA and hence the bank has no legal or beneficial capacity/right to make a valid sale under the subsequent PSA. This was why there was a fear of default under BBA contracts because the contract itself is deemed not enforceable.

Therefore, the BBA is deemed a conventional loan with an Arabic name, the form changes but in substance it is still a plain conventional loan and the profits charged under a BBA transaction are therefore deemed to be interest.

On 31st March (the report in the Malaysian Reserve is 6 months late), the 3 member CoA ruled that Abdul Wahab had erred in making his judgement and reversed the ruling, re-establishing BBA as a bona fide sale transaction and upholding to sanctity of the BBA contracts. The 3 member bench rules that “civil courts should not decide whether a matter is in accordance with the religion of Islam”. Such issues need to be solved in consultation with Islamic scholars. And since BNM’s SAC has endorsed BBA as an approved product, civil court judges should not dispute it.

My opinion – the BBA was created in 1983 based on the conventional loan platform to enable Islamic finance to break into the market while operating on the existing platforms. It was true 26 years ago when awareness on Islamic finance was low and such products were necessary to avoid “cultural shocks”. But as knowledge on Islamic finance grew, such Inah based products are not necessary anymore; the market has more understanding of the Islamic financial system and is ready to accept the structural differences.

Abdul Wahab was arguing on valid grounds, he is merely exposing the “loan behind the façade of a trade” element of the BBA.

It is about time the market, the regulators and the judiciary accept the fact that BBA is a product designed to ease the entry of Islamic finance into the market. It has outlived its purpose and should be phased out completely.

Tendering for Short Term Papers

In the Malaysian debt market, a short term bond is called a Commercial Paper (CP). A CP is either issued via a tender or private placement. In a tender, the CPs will be issued to the highest bidder(s) making the tender process a platform for investors to demand a rate of return that matches their risk appetite and/or investment objective. The basis for the bids is on the credit worthiness of the issuer. Once the CPs is issued to the winning bidders, the issuer is compelled to pay the promised returns to the investors.

Surprisingly, the same tender process applies to the Islamic CPs (ICP). I can understand if the ICPs are issued based on the Ijarah or Murabahah contract, there should not any problem with individually setting the rental or mark-up. The problem is when Musharakah and Mudharabah based CPs are subjected to the same procedure. I just cannot comprehend how an investor can demand, upfront, a fixed profit from a Musharakah/Mudharabah venture. It is totally against Shariah principles and contravenes the “profit and loss sharing” (PLS) model. Although the transaction documents clearly states that the returns are merely “expected” profits but in all likelihood, the projection will be met, 100% of the time.

What’s worse, the ICP is (usually) issued at a discount to nominal value and the issue price is calculated in accordance with the formula specified in Part III, Section 5 of the FAST Rules, the same formula used to calculate the discount for the conventional CPs.

Shariah based instruments and transactions may not be compatible with conventional platform all the time, it must un on its own unique platform.

So much for being in the forefront of Islamic finance.

Liquidity Management

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, inflation also influences the price of money.

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

The money market 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 (I’m already sounding like a broken record), 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 3.2%, 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.

Islamic Structured Investment

An Islamic Structured Investment (or deposit) is an investment product which is linked to or benchmarked against a Shariah compliant underlying range of performance indicators such as equities, real estate or commodities. There are some Shariah compliant structured products in the market which is benchmarked against (Shariah compliant) indices, foreign exchange and even inter-bank offered rates. The returns from the structured investment are therefore dependant upon the performance of the underlying range of performance indicators.

A structured investment can either be principal protected or non-principal protected.

A Shariah compliant structured investment works the same way as their conventional counterpart, the only difference is in the nature of the underlying asset, it must not contravene Shariah principles.

The mechanics are as follows:
The promoter pool funds via the sales of the structured investment. The contract between the promoter and investor is usually that of a wakalah fi istithmar (investment agent).

For a principal protected structured investment, the promoter will split the funds into two, one portion will be invested in the Islamic money market or a fixed income instrument (zero coupon / discounted Sukuk) and a smaller portion will be utilised to purchase an option, applying the Urbun contract and referenced against the underlying.

The investment in the (Shariah compliant) fixed income instrument is for the purpose of reserving the principal investment and the option will provide the upside, if any.

The capital protection will only be enjoyed if the investment is held to maturity. Any premature withdrawal will result in the investment being valued at market and the investor will incur mark-to-market losses.

The maths is basically, allocate a portion based on the prevailing (profit?) rates that will ensure the capital is 100% preserved at the end of the investment tenure. The balance will be used to purchase an option. The participation rate (in the upside) of the option may not be 100% as it will depend on whether the balance after setting aside for the money market/fixed income Sukuk is sufficient. In some cases, the participation rate is less than 100% meaning the option holder is not entitled to all of the gains made from exercising the option.

Let’s dissect the structure.
Pooling of funds for investment purposes are perfectly fine and Shariah compliant.
Investing a portion to preserve capital – this would be done via the money market using Tawarruq. My stand on Tawarruq can be found here

Capital preservation is often a sticky issue with Shariah, if economic conditions go against the investment, what right does the investors have to demand full capital preservation? It becomes a zero sum game and there will be one party in the transaction who will lose out at the expense of the other. Shariah based finance is about justice and equity, sharing of profits and losses.

Buying an option using Urbun*, putting a deposit/downpayment to earn rights to purchase an asset – sounds compliant but are indices, foreign exchange and even inter-bank offered rates Shariah compliant assets? Does buying an intangible asset serve any economic purpose? I have no issues on Urbun for tangible assets like property or commodities.

My take on structured investment is it sort of looks and sounds like a mutual fund with a derivative (the option) and capital preservation elements. My views on derivatives can be found here and I’m of the opinion that capital should be positively correlated to the economy, preserving it would entail going against economic trends and causing some party somewhere to suffer more losses than necessary.


*Urbun is sometimes spelled Arboon

Islamic Profit Rate Swap (IPRS)

IPRS is the Shariah compliant version of the conventional Interest Rate Swap (IRS). The IPRS/IRS is a risk management tool whereby an institution which is contracted to pay fixed profit rates may hedge its risks by swapping the fixed rate payment obligation for another party’s floating rate obligations. IRS refers to a generic rate swap in which one party pays a fixed rate while receiving a floating rate. As in the IRS, the notional principal in an IPRS transaction is never exchanged, only the difference is settled.

The IRS is a derivative product and the widely accepted market standard is the International Swap & Derivatives Association, (ISDA).

As usual, I want to be the party pooper. My question is; is IPRS a Shariah based solution or a conventional product made Shariah compliant?

Azrulnizam Abdul Aziz of Standard Chartered Bank Malaysia (now Saadiq) describes the Islamic Profit Rate Swap as follows (Islamic Finance news (IFN) Guide 2007):
The Islamic Profit Rate Swap (IPRS) was introduced to assist in the management of profit rate risks, thus enhancing cash flows. Profit rate swap is a mechanism structured to allow bilateral exchange of profit streams using two parallel and back-to-back Islamic marked-up sale transactions (Murabahah).
It comprises of three possible structures, namely the IPRS, Islamic Cross-Currency Swap (ICCS) and Islamic Forward Rate Agreement (IFRA). In IPRS, a series of Murabahah sale and purchases are conducted, allowing parties to swap or exchange profit rates from fixed to floating rate or vice versa.

Therefore, in theory, an Islamic Profit Rate Swap would operate in the following manner:

Party A purchases assets on Murabahah (fixed mark-up/profit) terms. They know the exact amount of profit due throughout the repayment tenure.
Party B enters into a Musharakah venture. They can estimate the returns but would not know exactly how much profit is made until the accounts are finalised.
An IPRS would entail Party A paying Party B a fixed, known amount of profit while Party B pays A an amount which is only known at the end of the financial year. The two profit amounts will not be identical; being identical defeats the whole purpose of the transaction!

A Murabahah or Istisna transaction has a fixed profit rate. Ijarah transaction can have a fixed lease rate while Musharakah and Mudharabah have variable profit rates, even loss rate!

If profits are made by the Musharakah (or Mudharabah) venture, the swap works fine(-ish). What if the venture suffers a loss? What is swapped?

An IPRS utilises the controversial Tawarruq structure. If the two parties are merely paying each other the (cash) amount of profits, utilising Tawarruq clearly shows an attempt to circumvent Shariah prohibition of exchanging unequal amount of money (which results in riba).

I would conclude that the IPRS is not a solution based on Shariah principles. An IRS is created with the primary objective of capitalising on the movements of interest rates. It is a tool to make (or save) money from the movements in the price of money (interest). It does not entail any productive economic activity. It is merely a transfer of money from one party to another.

How then does an Islamic financier hedge against movements in profit rates? Profit rates, unlike conventional interest rates are dependent on the underlying transaction. There is no one universal profit rate across the board. A Murabahah profit rate for a risky aerospace venture for example, would not be equal to the profit rate of an identical Murabahah transaction involving the government’s (less risky) purchase of educational equipment. Similarly, the Ijarah rate for a residential property is not the same as that of a CBD commercial property. For equity based contract like Mudharabah and Musharakah, profits cannot be guaranteed; returns depend on actual performance of the venture.

My stand remains – continuing to develop solutions that mimic the conventional system will not develop Shariah based finance.