Applied Shariah in Financial Transactions

1
Applied Shariah in Financial Transactions

• Assoc. Prof. Dr. Mohamad Akram Laldin
• Executive Director, ISRA

2
Presentation Outline
1
Essential Shariah Guidelines
2
Islamic Contracts and Products
3
Islamic Investment Products
3
Details

• Essential Shariah Guidelines
• Islamic Contracts and Products
• Deposit taking Contracts
• Sale based Contracts
• Lease based Contracts
• Equity based Hybrid Contracts
• Fee based Contracts
• Other Supporting Contracts
• Takaful
• Investments Products

4
Transaction in Islam
Any transfer of wealth or property has to be made
through a valid contract or aqad
Divine Sources (Quran Sunnah)
Mutual Consent

• Contracts in Islam is the linking of offer and
  acceptance, resulting in legal effects on the
  subject matter of the contract.
• In Islamic law, contracts includes both
  bilateral as well as unilateral

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Essentials of Valid Contract
CONTRACTING PARTIES
CONTRACTUAL EXPRESSION
SUBJECT MATTER
Goods/ asset
Price/ consideration
Offeree
Acceptance
Offeror
Offer

• Clear
• Corresponding of offer acceptance

• Of full contractual capacity
• Legal authority to contract
• As owner in possession of asset
• legal representative (agent, guardian etc.)

• Something of value
• Ascertainable
• Legal

6
General Principles in Transaction
CONTRACT AS BASIS OF TRANSACTIONS
AVOID
Mutual consent
Lawful Contractual Objective
Interest
Gambling
Uncertainties
Other prohibitions Eg liquor, pork
7
Freedom of Contract
8
Promote Maslahah
Entitlement to Equal, Adequate, Accurate Info.
Freedom from Riba
Promote Brotherhood
Freedom from Gharar
A system grounded on moral and ethics
Freedom from Dharar
Characteristics of Shariah-compliant Banking
and Financial System
Entitlement to Transaction at Fair Price
Freedom to Contract
Freedom from Qimar Maysir
Freedom from Price control Manipulation
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Various Forms of Islamic Contracts Used in
Banking
Wadiah Yad Amanah Wadiah Yad Dhamanah,
Mudarabah al-Qard
Deposit-taking Contracts
BBA deferred sale Murabahah cost-plus sale
Bai al-Inah, Bai al-Tawarruq
Sales-based Contracts
Ijarah Wa Iqtina Ijarah Thumma Al-Bai, Ijarah
Muntahia Bitamleek
Lease-based Contracts
Equity-based Contracts
Mudarabah, Musyarakah
Kafalah/Dhaman (Guarantee) Wakalah (agency)
Fee-based Contracts
Promise/Undertaking Waad
Musyarakah Mutanaqisah (Dimishing Partnership),
AITAB etc.
Hybrid Contracts
9
10
Conceptual Balance Sheet of an IFI
Assets
Liabilities
Trade Finance (Mudarabah/ BBA)
Custodial Services (Amanah/Wadiah)
Deposits/Investments (Mudarabah/ Wakalah)
Asset-backed Securities (Ijarah/Salam/Istisna)
Fund Management/ Private Equity
Venture Capital (Special Mudarabah/ Musyarakah)
Fund Management (Mudarabah/ Special
Mudarabah/Musyarakah)
Fee-based Services/ Advisory (Wakalah/Jualah/Kafal
ah)
Capital Owners Equity (Musyarakah)
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Deposit-taking Contracts
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DEPOSIT SERVICES PRODUCTS
Saving/ Current Account
Investment Account
Negotiable Islamic Deposit Certificate (NIDC)
Sale Buy Back Arrangement (SBBA)
Qard or Wadiah Yad Dhamanah
Mudarabah
Bay al-inah
Bay al-Dayn
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Qardh (Loan)
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WADIAH

• Types
• Wadiah Yad Amahah
• Wadiah Yad Dhamanah

15
How Bank Can Benefit From Wadiah Contract?
The Wadiah Contract is combined with Guarantee
contract (Dhaman or Kafalah)
Wadiah Yad Dhamanah (Guaranteed Safe Custody)
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DHAMAN / KAFALAH
Wadiaah Dhaman it converts the whole concept
of wadiah to guaranteed safe custody
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Wadiah Yad Dhamanah

• The custodian is a trustee and guarantor to
  safeguard the deposited asset.
• The deposited asset/property need not be
  separated/segregated
• The deposited asset/property can be used for
  trading etc.
• The custodian has a right to any income derived
  from the utilisation of the deposited asset
• Depositor can take back the deposited asset at
  any time
• Wadiah Yad Dhamanah is like Qard (loan)
  therefore all principle of loan would be
  applicable
• Thus as a loan WYD cannot generate any pre-agreed
  benefit/income to the depositor, over and above
  the principal amount of deposit, otherwise
  tantamount to riba

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Shariah Issues
Current Account
Saving Account
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Mudarabah
Mudarib is only liable for negligence or
transgression or violation of contract terms
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Issues To Be Considered

• Investment from certain individuals and
  companies
• Investment of a minor
• Advertisement of gift prior to the contract
• Guaranteeing profit/capital?
• Variation of the ratio of profit and loss sharing
  
• Pre-mature withdrawal of capital-mudarabah
  investment

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Other Deposit Products / Structures

• Commodity Murabahah Deposit-i
• Structured based on Tawarruq
• Structured Deposit Products
• Pure Al-Qard Structures
• Absolutely no returns or benefits provided to
  depositors
• E.g., Al-Rajhi Malaysias savings and current
  accounts
• Combination Structures
• Each deposit split into stipulated portions
  (Mudarabah Qard)
• E.g., KFH Malaysias savings and current accounts

22
Sales-based Contract (Al-Bay)
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Murabahah Bay Bithaman Ajil
Bay Inah
Bay Tawarruq
Common Types of Sale-based contract
Bay Istisna
Bay Salam
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Murabahah
A sale all sale conditions apply
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Basic Shariah Rules on Sales

1. Subject of sale must be existing at time of sale
2. Subject of sale must be owned by seller at time
   of sale
3. Subject of sale must be in physical or
   constructive possession of seller at time of sale
4. Sale must be instant and absolute
5. Subject of sale must be of value
6. Subject of sale cannot be for haram use
7. Subject of sale must be specifically known and
   identified
8. Certainty of delivery
9. Certainty of price
10. Sale must be unconditional

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Application of Murabahah in Finance(Murabahah To
The Purchase Orderer )

• It is a sale in which two parties or more
  negotiate and promise each other to execute an
  agreement according to which the orderer asks the
  purchaser to purchase an asset of which the
  latter will take legal possession.
• The orderer promises the purchaser to purchase
  the asset from him and give the ordered a profit
  thereon. The two parties would conclude a sale
  after the possession of the ordered to the asset.

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Murabahah Trade Financing
Customer buys commodity via murabahah on
deferred payment terms
Trader transfers Commodity to Bank
Customer identify the commodity
Bank buys commodity on cash basis
Customer approaches bank and promises to buy
commodity from bank
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Bay al-Inah?
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Bay al-Inah Personal financing
How can I borrow RM100,000 to get married?
Bank sells asset
RM 150,000
Customer pays on deferred
Banks Pays on cash basis
RM 100,000
Customer sells back asset
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Bay Al Inah
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Tawarruq
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Tawarruq Model of Home Financing
Customer
Property Owner/Developer
Electrical Appliances Wholesaler
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Commodity Murabahah Deposit-i
US 1 Million Cash
US 1.1 Million deferred
Broker B
US 1 Million Cash
Broker A
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Ruling on Tawarruq
35
Bai Bithaman Ajil (BBA)
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BBA HOME FINANCING MODUS OPERANDI
Developer/Vendor
5. Bank pay developer the 90 balance
Sales Purchase Agreement (SP)
1. Beneficial ownership
1. 10 down payment
Property Sale Agreement (PSA)
3. BBA price (deferred payment)
3. House
2. House
2. Cash price (90 balance)
BANK
Property Purchase Agreement (PPA)
Customer
37
Financing Facility Islamic Banking vs.
Conventional Banking

• Fin. Amount RM100K
• Tenure 25 yrs
• (1981-2005)
• Single Rate BFR-0
• Ceiling Rate 9.90
• Tawidh 1
• Total Selling Price

Islamic Home Financing
Convensional Home Loan

Loan Amount RM100K Tenure 25 yrs
(1981-2005) Single Rate BLR-0 Ceiling Rate
-no- Penalty 8 compounded Total Repayment
RM240,996.96
RM245,982.72
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MOVEMENT OF BASED LENDING RATE (BFR)
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Lease-based Contract (al-Ijarah)
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Ijarah (Leasing)

• Ijarah contract is a form of exchange contract
  (aqd al muawadah) usufruct vs. rent.
• Ijarah (Operating Lease) means leasing of asset
  pursuant to a contract under which a specified
  permissible benefit in the form of a usufruct is
  obtained for a specified period in return for a
  specified permissible consideration.
• It is a manfaah (usufruct) type of contract
  whereby a lessor (owner) leases out an asset to
  its customer at an agreed rental fee and
  pre-determined lease period upon the aqad
  (contract). The ownership of the leased equipment
  remains in the hands of the lessor.

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Ijarah Muntahiah Bi Tamlik (Financial Lease)  

• Ijarah Muntahiah Bi Tamlik has similar rules to
  the ordinary Ijarah except that it is associated
  with a promise by the lessor to transfer
  ownership at the end of the Ijarah period via a
  separate sale agreement or gift.

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DIRECT LEASING
3. Bank pays airplane manufacturer
5. Bank lease airplane to airline
4. Airplane manufacturer delivers airplane to bank
7. At the end of lease term airline take ownership
6. Airline pays rental
2. Airline approaches bank to seek financing
1. Airline places order with airplane manufacturer
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Ijarah Mausufah Fi Zimmah (Forward Lease)

• Ijarah Mausufah Fi Zimmah means an ijarah
  contract which is executed for an asset
  undertaken by the lessor to be delivered to the
  lessee according to accurate specifications, even
  if the asset is not owned by the lessor. 
• During the period that the leased asset/property
  is under construction, the lessor may ask the
  lessee to pay a certain portion of pre agreed
  lease rental as a forward lease.
• The forward lease rental payment will be
  considered as a debt to the lessor until the
  delivery of the leased asset to the lessee.
• Ijarah Mausufah Fi Zimmah can be in a form of
  Ijarah or Ijarah Muntahiyah Bi Tamlik.

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Salient feature of Ijarah
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Contd

• The purpose and mode of usage should be agreed
  upfront
• The lessor could be the legal owner or the
  equivalent (agent, natural or legal
  guardian)
• The leased asset is a trust in the hands of the
  lessee.
• The rental payment commences after the delivery
  of the leased asset, actually or constructively.
• The lease contract terminates upon the loss /
  non-existence of the usufruct
• Lease contract is a bilateral contract. Any
  termination, in normal cases, must be mutually
  agreed.

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Equity-based Hybrid Contract
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Musharakah
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Musharakah (Profit Loss Sharing)
Venture

• Application
• Home Financing
• Diminishing
• Musharakah
• Sukuk
• Equity Shares
• Project Financing
• Letter of Credit

Profit or Loss
Capital
Partners
Profit n Loss Sharing
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Musyarakah Mutanaqisah(Diminishing Partnership)

• Musyarakah mutanaqisah is a form of Musyarakah
  (partnership) in which one of the partner
  promises to purchase the equity share of other
  partner gradually until the title of the equity
  is completely transferred to him.
• This transaction starts with the formation of
  partnership, after which buying and selling of
  the equity take place between the two partners.
• One partner may lease his share of the asset to
  the other partner on Ijarah (lease) basis.
• The partnership will come to an end with one
  partner being the sole owner of the asset or
  business venture.

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Musyarakah Mutanaqisah (Modus Operandi)
90
10
100
0
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ILLUSTRATION of Musharakah Mutanaqisah
Banks Share
Customers Share
MM
100
90
80
70
60
50
40
30
20
10
Customer now owns 100 of the Assets
The asset is now mine. Thanks to Islamic Bank
90
80
70
60
50
40
30
20
Banks share 0
10
10
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Differences Between Murabahah MM?
No BBA Musharakah Mutanaqisah
1 Involves a Sale Contract Involves Partnership, Leasing and Sale contracts
2 Contract Buyer Seller Contract Partnership
3 Require underlying assets to complete Aqad (APA ASA) Underlying assets not required
4 With Selling Price Fixed No Selling Price Flexible
5 Security documents Asset Purchase Agreement Asset Sale Agreement Charge/Deed of Assignment Security documents MM Co-Ownership Agreement Charge/Deed of Assignment
6 Property belongs to the customer Property belongs to both the customer and the bank according to the percentage of ownership
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Fee-Based Contract
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Delegation (al-Wakalah)

• Wakalah is a contract of agency which gives the
  power to a person to nominate another person to
  act on his behalf as long as he is alive based on
  the agreed terms and conditions.
• Wakalah is commonly used in Letter of Credit-i
• Delegation Al-Wakalah has four pillars
• The Delegator Al-Muwakkil
• The Delegatee Al-Wakeel
• The wording of the Delegation
• The subject of the Delegation

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Letter of Credit (LC)- Wakalah
Need to produce Required documents Eg.
commercial invoice BL (Bill of landing), etc
Seller (Beneficiary)
Buyer (Applicant)
Advice LC
Apply LC
Issue LC
Advising Bank
Issuing Bank
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Other Supporting Contract (Waad)
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Waad (Promise)
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1st Group (Hanafis, Shafiis, Hambalis and some
Maliki jurists)
2nd Group (Samurah b. Jundub, Umar
Abdul Aziz,Hasan al-Basri, a-Ashwa, Ishaq
Rahwaih, Al-Bukhari some Malikis)
Fulfilling a promise is noble but it is neither
mandatory nor enforceable through a court of law
Fulfilling a promise is mandatory the promisor
is under a moral and legal obligation to honor
his promise.
WAAD (PROMISE)
4th Group (Islamic Fiqh
Academy Generally accepted view)
3rd Group (Some Maliki Jurists)
Promise is not binding under normal circumstances
but becomes binding where the promisor has caused
promisee to incur certain expenses or undertake
work or any form of liability
Fulfilling a promise is allowed subject to
certain conditions as enumerated in the next
slides
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Islamic Fiqh Academy Position on Promise

• Promise in commercial dealings are binding
  subject to the following conditions
• It should be one-sided promise
• The promise must have caused the promisee to
  incur certain liabilities for the promisee to
  seek enforcement on the promisor
• If the promise is to purchase something the
  actual sale must take place at the appointed time
  by the exchange of offer and acceptance. A mere
  promise itself should not be taken as a concluded
  sale
• If the promisor bakes out of his promise, the
  court may force him either to purchase the
  commodity or pay actual damages to the seller.
  The actual damages include the monetary loss
  suffered by the promisee, but shall not include
  the opportunity cost.

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Takaful
61
BASIC MECHANISM OF INSURANCE
Profit
No Claim
Premium
Policy holder
Insurance Company
Peace of mind
Calamity
Compensation
62
Conventional Insurance Not Shariah-compliant

• Element of uncertainty (gharar)
• There is uncertainty of what the insurance
  policy-holder is buying or paying for
• If no loss occurs ? Policy-holder receives
  nothing
• If loss occurs ? Policy-holder gets compensation
  in varying amounts

• Element of gambling (maysir)
• The insurance company is gambling that total
  premiums collected will exceed total claims and
  thus producing underwriting surplus (profit)
• Total claims is predominantly affected by chance
  (will of God)
• Element of riba
• Insurance fund commonly invested in
  interest-bearing securities

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ISLAMIC ALTERNATIVE TO INSURANCE
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SHARIAH LEGITIMACY OF TAKAFUL

• ??????????????? ????? ??????? ???????????? ?????
  ???????????? ????? ???????? ?????????????
• and help ye one another in righteousness and
  piety, but help ye not one another in sin and
  rancour (52).
• Hadith
• tie the camel, then submit (tawakkal) to the
  will of God.
• Importance of risk mitigation
• Islamic Legal Maxim
• ????? ????

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BASIC DESCRIPTION OF TAKAFUL INSDUSTRY

• Takaful participants contribute to a takaful fund
  based on the concept of mutual assistance
• The contribution is done via reciprocal/mutual
  donation (tabarruat) and does not represent a
  commercial sale of coverage
• Takaful entails a unilateral, charitable contract
  (tabarruat) in contrast with the conventional
  insurance contract which is a bilateral exchange
  contract (muawadat)
• Gharar is tolerated in a charitable unilateral
  contract

66
Takaful Wakalah Model
Takaful Participants
1st contract Tabarru
Wakalah fee
Contribute
-retakaful -reserves -claims -investment
income -stabilization reserves
2nd Contract Wakalah
Risk Fund
Manage
Takaful Operator
Surplus
67
Takaful Mudarabah Model
Takaful Participants
1st contract Tabarru
Contribute
2nd Contract Mudarabah

1. Unilateral contract
2. Valid though no acceptance and consideration from
   the recipient

Takaful Funds
Manage
Invest
Takaful Operator
Pay Claims
Profit, if any, is shared between the two based
on certain ratio or percentage loss, if any,
will be borne by the capital provider alone
68
Takaful vs. Insurance
Basis Conventional Insurance Takaful
Principles Non compliance with Shariah principles In compliance with Shariah principles
Contract Buying Selling Tabarru , Wakalah Mudarabah
Obligation of Company Guarantor to insured Fund Manager
Guarantee Given By Company Participants Mutually guarantee each other
69
Islamic Investment
70
Technical Meaning Sukuk refers to securities,
notes, papers or certificates, with features of
liquidity and tradability (except for salam and
murabahah sukuk)

• Literal Meaning
• Sukuk is the plural of sak which means
  certificates. Other similar terms
• Taskik process of dividing assets into papers
  (sukuk)
• Tawriq to render something into cash

SUKUK
AAOIFI Investment sukuk are certificates of
equal value representing undivided shares in
ownership of tangible assets, usufructs and
services (in the ownership of) the assets of
particular projects or special investment
activity

• Malaysian Securities Commission
• A document or certificate which represents the
  value of an asset
• Asset may include financial asset such as
  receivables and debts, as well as non financial
  assets like tangible assets, usufructs and
  services.

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Obligor/Project Developer
Issuer/Trustee
BASIC STRUCTURE OF SUKUK
Proceeds from Sukuk Sales
Sukuk
Issue Proceeds
Income from project
Income Generating Project
Sukuk Investors
72
Comparing SUKUK to BONDS
Sukuk Bonds
1. Holder owns assets 1. Holder owns cash flow only
2. Use a variety of contracts to create financial obligations between issuer and investors e.g. Sale, lease, equity partnership, joint-venture etc. 2. Simply use a loan contract to create indebtedness
3. Return linked to profit elements in-built in the sale, lease or partnership 3. Return linked to interest charged out of the loan contract
4. Instrument may be equity or debt depending on underlying contract 4. It is a Debt instrument
5. Tradability of the sukuk depends on the nature of the underlying asset 5. No restriction on the tradability
6. Investment in Shariah-compliant activities 6. Proceeds are invested in any business without restrictions
73
Bases for Sukuk Classification
The Nature and Type of Asset represented by the
Sukuk
The Underlying Contracts in the Sukuk Structures
Debt-based
The Technical and Commercial Features of the Sukuk
Tangible assets
Sales-based
Usufructs
Lease-based
Rights in investment projects
Partnership-based
Asset-based (normal)
Agency-based
Asset-Backed (ABS)
Special investment activities
Hybrid Structure (convertible exchangeble )
74
Types of Sukuk
Asset-Based
Asset-Backed
Hybrid
Convertible
Sales-Based
Lease-Based
Partnership-Based
Agency-Based
Exchangeable
Mudarabah
BBA
Ijarah
Wakalah bil Istithmar
Musharakah
Ijarah Muntahiya bi Tamlik
Murabahah
Salam
Ijarah Mawsufah fi Zimmah
Istisna
75
MUNIF Basic Structure
3. Subscriber cum tender panel member provide
proceeds
2. Sell the asset on tendered basis
TPM/Underwriters
1. Issuer identified asset
4 Disburse the purchase price
5. Subscriber resale the asset at selling price
(mark-up, i.e. Murabahah)
Primary Subscriber
Issuer
MUNIF
Debt (Selling price) is evidenced by issuance of
MUNIFs
May sell MUNIF in Secondary Market (Bay al-Dayn)
76
BASIC STRUCTURE IJARAH SUKUK
1. Sale of assets to the primary subscribers
2. Lease back assets to issues in return for
ijarah rental (periodic distribution)
Primary Subscriber
Sukuk Issuer
3. Issue Sukuk Ijarah as evidenced of undivided
proportionate ownership of leased asset right
to ijarah rental stream
Secondary Market Trading
Investors
77
STRUCTURE OF MUDHARABAH SUKUK
Issues Mudarabah Sukuk
Contract of Mudarabah
1
Investors (Rabb al-Mal)
Issuer (Mudarib)
Profit shared in accordance to pre-agreed
proportions (X,Y)
Y to rabb al mal
CAPITAL
X to Mudarib
3
Outcome Of Project
Loss? borne totally by rabb al-mal
2
Invests in project
78
Rental from halal activities
Islamic REITs
Return from Islamic REITs
Rental from mixed activities (halal haram)
Method to calculate rental From non halal
activities
Instruments used in deposit, investment and
financing i-REIT
Fund Management
Takaful Protection
Risk management issue
79
Islamic REITs
Shariah advisors
Unit Holder
Advise on Shariah issues
Investment
Returns
Safeguard unit holders interest
Management services
REITs
Management fees
Trustee fees
Ownership Of Property
Trustee
Manager
Net Property Income
Maintenance and Management Services
Rent
Maintenance and management fees
Rental Payment
Property Manager
Properties
Tenant
80
Shariah Issues involving Rental from Lessee who
conduct Mixed Activities
The core activity is halal but small portion of
the whole activity is not- halal
Principle
Method of calculation
The non halal ration must not exceed 20 of the
total rental from Islamic REITS
In calculating the ratio of non-halal activity
usage of the space, length of service and others
are applied
If the width of the supermarket is 10,000
sqf, and the designated area for sale of liquor
is 1000 sqft, namely 10. It is still within the
acceptable ratio
Umum Balwa
Maslahah
Benchmarking
81
Islamic Structured Products
Fund-Mobilization Stage
Investment Activities Stage

• Fixed Income
• Investments
• Commodity murabahah
• Sukuk, Islamic ABS
• (Asset-Backed Securities)

Wakalah bi al-istithmar-based structured
investment
Invest 90
BANK
Client
Bank acts as agent (wakalah contract) in
investing depositors money charges a fee for
the service

• Higher Return
• Investments
• equity, derivatives e.g.
• Options, swaps, futures
• forward

Invest 10
Expected Return x
Expected Return 10
Principal Protection (90 investment 10
return)
82
Shariah Issues
Structuring

• Identifying contract and principle
• Fund raising stage Wakalah/Mudarabah
• Investment activities Tawarruq, purchasing
  basket of shares, embedded Islamic Option (wad
  or urbun etc)
• Wad, Wadan or Muwaadah?
• Underlying aset and investment activities

Implementation

• Each contract has to be executed separately
  follow the right order
• Capital protection objectives
• Efficient fund management
• Third party guarantee (subsidiary to
  principal/other branch of an international IFI)

Usage

1. Replacement of securities (Shariah compliance
   status changes)
2. Wad to sell and buy equity based on benchmark
   Iqnorance of price
3. Early settlement Justification?

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