Concept of Exchange-Based Contract
Exchange-based contracts in Islamic law have been transformed
into viable (debt financing) instruments:
- Murabahah (Mark-up) -
Istisna’ (Manufacture Sale) - Salam
(Forward Sale) - Bay Dayn (Sale of
Debt) - Tawriq (Securitisation)
- Sarf (Sale of Currency)
- Tawarruq (Cash Financing)
- Bay Inah (Sale with immediate purchase)
Debt-based financing instruments: Financial instruments that create debt-like
relationships between parties
Concept of Exchange-Based Contract
Murabahah (Mark-up)
• Murabahah: cost-plus financing contract where
a sale is made at a specified profit margin
• Establishes a form of mutual contract between
two parties where they agree to the mark-up
• Murabahah is derived from the root word ribh
which means profit, gain or a legal addition
Concept of Exchange-Based Contract
Figure 3.1: A Typical Murabahah Contract
Concept of Exchange-Based Contract
Figure 3.2: An Overview of the Murabahah Contract
Concept of Exchange-Based Contract
The specific conditions for a valid murabahah
transaction:
1. Goods subject to murabahah
2. Original Cost Price of the Goods and any Addition
Procurement Costs
3. Margin of Profit
Margin of profit (also net margin): Ratio determining the
degree at which profit is realised, calculated by dividing
net profits by sales
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Istisna’ (Manufacturing Contract)
• Istisna’: A manufacturing contract of a made-to-order asset
based on a deferred delivery basis. It is a transaction on a
commodity before the commodity is produced
• The manufacturer is morally obliged to produce items:
- at the agreed time
- in accordance with specifications (price, quality,
description)
• The price, specification, description and quality of the
commodity to be manufactured should be fixed with the
consent of the parties to the contract
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Figure 3.3: The Structure of an Istisna’ Contract
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
The Suitability of Istisna’
The istisna’ structure is most suited for
• Project finance
• Construction
• Manufacture and design of machinery for
specific purposes, and
• Trade finance
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Figure 3.4: Sukuk Transaction Using the Istisna’
Structure
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Salam or Bay al-salam (Forward Sale)
• A forward sale contract where advance payment is made
for goods to be delivered later
- does not require the commodity to exist at the time of
concluding the contract
- the delivery of the commodity is deferred
• Facilitates the commercial activities of farmers before crops
are harvested - farmers get paid in advance before a
harvest
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Salam (Forward Sale)
There are 10 conditions for the validity of a salam contract
as generally agreed upon by Muslim jurists – see page x
Bay Dayn (Sale of Debt)
• Bay al-dayn (sale of debt) A sale and purchase transaction
involving a quality debt
• Muslim jurists are not unanimous on the permissibility of
this form of sale
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Figure 3.5: An Application of Bay al-Salam as a
Sharī‘ah Financial Instrument in Modern
Financial Transactions
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Bay Dayn Position of the Four Major Muslim Schools
• Shafi’i School: Sale of debt is allowed to a third party only if the
debt was initially guaranteed and was sold in exchange for goods
to be delivered immediately
• Hanafi School: Sale of debt not allowed in Islamic commercial
transactions
• Maliki School: Sale of debt allowed subject to conditions
• Hanbali School: divides the sale of debt into two:
- confirmed debts can be sold on the spot
- unconfirmed debts are not tradable
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Bay al-Inah (Sale with immediate repurchase)
• Bay al-Inah: Where a commodity is sold on a cash basis;
the seller immediately repurchases the same commodity
on a deferred payment basis at a price higher than the
initial cash price
• Used in different real estate and house financing situations
• Bay al-inah is controversial in the global Islamic finance
industry
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Bay al-Inah (Sale with Immediate Repurchase)
Views on the Validity of Bay al-Inah
• The Shafi’i School: Bay al-inah contracts are permissible in
Islamic law
• The Maliki, Hanafi and Hanbali Schools: Bay al-inah is not
permissible in Islamic law because the motive of the parties in
such a contract is illegal
• The majority of jurists prohibit bay al-inah in Islamic
commercial activities because they believe it is tainted with
elements of interest
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Tawriq (Securitisation)
• Tawriq is a process of converting an asset into
cash issued as tradable certificates of investments
(tradable in the secondary market)
• Is the equivalent term for securitization in Islamic
commercial jurisprudence.
• The end product of tawriq is the issuance of sukuk
or sanadat to a large number of investors
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Parties to Tawriq
The most important parties in securitization are:
• Originator/Issuer of Sukuk: large corporations, governments
• Special Purpose Vehicle
• Investment Banks: Islamic banks or Islamic windows of
multinational banks
• Subscribers or Investors: individuals and corporate entities
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Figure 3.6: The Flow Chart of the Securitization
Process
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Sarf (Sale of Currency)
Definition and Nature
• bay’ al-sarf: a foreign exchange contract involving exchange
of currencies either of the same or of different kinds
• The delivery of both currencies has to be made in full at the
time of concluding the contract
• The contract of exchange must take place at the same sitting
where the contract is drawn up
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Sarf (Sale of Currency)
Validity of Foreign Exchange Contract in Islamic Law
• Trade in currency is permissible in Islamic law. “Gold for gold,
silver for silver, wheat for wheat, barley for barley, dates for
dates ... hand to hand ... ” (The Hadith)
• Limitation: the exchange must be done hand-to-hand in one
sitting if it involves different currencies
• If the currencies are the same, the currencies being
exchanged must be of equal amounts, and the exchange
must take place at the same sitting
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Tawarruq (Cash Financing or Reverse Murabahah)
• Hybrid sale contract where a customer approaches a financial
institution to purchase a commodity with payment arranged in
instalments and in turn sells the commodity to a third party for
cash
• Permissibility of Tawarruq is based on:
- The general principles of a typical contract of sale
- The absence of any bit of interest in this transaction (it does
not amount to riba)
• Permissibility of Tawarruq is subject to:
- The person must be in real need of money
- No other permissible alternative available
- The contract being free of any modicum of riba
- The customer having full possession of the commodity
Learning Objective 3.2
Understand how exchange-based
contracts are used as financial
instruments in Islamic finance
Concept of Exchange-Based Contract
Figure 3.7:Permissible Reverse Murabahah
(Tawarruq)
