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Principles o Islamic fnancegif

32GlobalIslamic Finance April 2010

Financial Transactions in Islam:Rules of Financial Transactions

in Islamic Legal System

Financial Transactions in Islam:Rules of Financial Transactions

in Islamic Legal SystemAuthor: Abu Umar Faruq Ahmad, PhD

School of Law, University of Western Sydney

& Chairman, Shari`ah Supervisory Board Islamic Co-operative Finance Australia Limited Sydney, Australia

The Islamic nancial system is an integral part of Islamic law that can only be understood

in the context of Islamic attitudes towards ethics, wealth distribution, social and economic

justice, and the role of society or the state. Principles encouraging risk sharing, individual

rights and duties, property rights and the sanctity of contracts are all part of the Islamic

code underlying the banking system. Muslims believe that human beings are Gods repre-

sentatives on the earth who act accordingly as His trustees.


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Principles o Islamic fnancePrinciples o Islamic fnance

2010 April GlobalIslamic Finance33

The absolute ownership of Mans

property is not recognised in Islam.

Therefore, transactions in Islamic le-

gal nancial systems should be car-

ried out in both individual and cor-

porate levels in accordance with the

Shariàh. Individual interest is not

the sine qua non in this system ratherthe interest of the public is based on

bottom-line considerations.

Given the above attitude of Islam to-

wards mankind, the core principles

underlying Islamic nancial systems

revolve around the concept of equity

and fairness. Islamic nancing is char-

acterised with not just obtaining bene-

ts or maximisation of prots but also

seeking promotion of social justice

and moral economy. The philosophy

of transaction in Islamic Law stems

from a set of rules and laws referred

to as Shariàh, governing economic,

social, political, and cultural aspects

of Islamic societies. These rules and

regulations administer the rights and

obligations of those involved in the -

nancial markets. They also may form

the basis of regulation and legislation

pertaining to nancial markets.

The rules of transaction in the Islamic

legal system can be summarised as

follows.

Reba-Free TransactionsAs the riba is prohibited in Islam all

types of nancial contracts and trans-

actions are required to be free from

riba. The jurists base this banning on

arguments of social justice, equal-

ity, and property rights. Social justice

demands that borrowers and lenders

share both rewards and losses in an

equitable fashion and that the proc-

ess of wealth accumulation and distri-

bution in the economy be fair and rep-

resentative of true productivity. The

question of riba has been addressedin literature of Islamic nance with

much elaboration and there is a near

consensus about the meaning and

implications of riba.

Transactions Free From

GhararAll forms of contracts and transac-

tions must be free from gharar or

excessive uncertainty. This implies

that contracting under conditions of

excessive uncertainty is not permissi-

ble. Contracting under gharar is simi-lar to gambling. The Prophetic hadith,

in addition to prohibiting gambling or

games of chance, also prohibits trad-

ing in gharar. Islamic scholars have

identied the conditions and highlight-

ed situations that involve excessive

uncertainty and consequently, outlaw

a contract. Also, transactions should

be devoid of any ignorance from both

parties. Therefore, contracting par-

ties should have perfect knowledge

of the counter values intended to beexchanged as a result of their trans-

actions.

The Hana School of Islamic Jurispru-

dence denes gharar as that whose

consequences are hidden. While the

Shaì legal School denes gharar

as that which admits two possibili-

ties, with the less desirable one being

more likely. The Hanbali School de-

nes it as that whose consequences

are unknown or that which is unde-

liverable, whether it exists or not.

On the other hand, the Zahiri School

says that gharar is where the buyer

does not know what he has bought,

or the seller does not know what he

has sold. The contemporary Shariah

Scholar Mustafa Al-Zarqa states that

gharar is the sale of probable items

whose existence or characteristics

are not certain, due to the risky na-

ture that makes the trade similar to

gambling.

There are a number of hadith that for-

bid trading in gharar or transactionsthat are based on gharar. Jurists have

sought many complete denitions of

the term. They also came up with the

concept of gharar yasir or minor risk.

What gharar is, exactly, was never

fully decided upon by the Muslim ju-

rists. This was mainly due to the com-

plication of having to decide what is

and is not a minor risk. Derivatives

instruments such as stock options

have only become common relatively

recently. Some Islamic banks do pro-

vide brokerage services for stock trad-

ing and perhaps even for derivativestrading.

Contracts Void of Qimar and

MaysirThe Quran and the Sunnah explic-

itly forbid gains made from gambling

or games of chance (Qimar). An un-

informed speculation (Maysir) in its

worst form is also akin to gambling.

The term speculation always involves

an attempt to predict the future out-

come of an event. But the process may

or may not be backed by collection,

analysis and interpretation of relevant

information. The relevant experts in

nancial institutions will assume risk

after making a proper assessment of

risk using the required information.

All business decisions involve specu-

lation in this sense. It is only the gross

absence of value-relevant information

or conditions of excessive uncertainty

that makes speculation akin to a game

of chance and hence, forbidden.

Sanctity of ContractsIslam upholds contractual obligations

and the disclosure of information as a

sacred duty. This feature is intended

to reduce the risk of asymmetric infor-

mation and moral hazard. It also pro-

vides basic liberty to enter into trans-

actions. Involvement of an element of

compulsion for either of the parties

invalidates the contract. However,

this basic rule does not entail uncon-

trolled liberty to contract and may be

given up when there is a transaction

with other rules and regulations re-

quiring unequivocal rulings.

Non-Interference in Price Fix-

ationIslam envisages a free market where

prices are determined by forces of

demand and supply. There should be

no interference in the price formation

process even by the regulators. How-

ever, some scholars admit to its per-

missibility which is subject to the con-

dition that price xation is intended to

combat cases of market irregularitiescaused by impairing the conditions of

free competition. It is a requirement

that the forces of demand and sup-

ply should be genuine and free from

any articial element. Islam therefore,

condemns any attempts to inuence

prices through creating articial short-

age of supply. Similarly, any attempt

to bid up the prices by creating arti-

cial demand is considered unethical.

Such an action of bidding up the price

without an intention to take delivery is

not permissible.

Fair Prices of CommoditiesPrices that are an outcome of free

play of forces of demand and supply

without any intervention or manipula-

tion are believed to be fair. However,

in cases where pricing is based on a

valuation exercise the difference be-

tween the price at which a transaction

is executed and the fair price (which is

determined by the valuation experts)

will make the transaction null and

void.

Release of Adequate Informa-

tionRelease of inaccurate information

as well as hiding crucial information

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1. This is namely both the Majallah al-Ahkam al-`Adliyyah and Murshid al-Hayran (the 1891 Egyptian version of the Ottoman`s Majallah). The Majallah, for instance, describes contract as a little contracting

parties obligating themselves with regards a given matter and binding themselves together with the same as result of connecting an offer with an acceptance. Also according to the Majallah, contracting is the

connection of an offer with an acceptance in a lawful manner which marks its effect on the subject of the connection.

breaches the rules of Islamic business

ethics. As such, transactions must be

free from any falsication in order to be

considered Islamic. The institution of a

transparent market is therefore, rather

important and transactions should be

executed within the market after tak-

ing into account all relevant informa-tion. Given this, Islamic business ethics

require that all information relevant to

expected cash ows and asset valuation

should be equally accessible to all inves-

tors in the market.

Devoid of HarmThis refers to the possibility of a third

party being unfavourably affected by a

contract between two parties. If a con-

tract between two parties carried out

with their mutual consent is detrimental

to the interests of a third party, then it

may enjoy certain rights and obliga-

tions.

No one may question in this regard that

how to prioritise various rules of Islamic

nancial transactions mentioned above

should there be a conict. The Islamic le-

gal nancial system has a clear scheme

of priorities in legislation. Where there is

a clear injunction in the Quran, for ex-

ample, in the form of prohibition of in-

terest and games of chance, these must

be observed at all costs. Next in impor-

tance are the rules that follow from theSunnah and Ijma` or consensus, in that

order. Historical Evolution of Islamic Fi-

nancial Contracts.

The Position of Contract in Is-

lamIslamic law of contract, unlike other

legal systems, stems from the Quran

the rst and foremost source of Is-

lamic Shariah. The jurists in all Islamic

Schools of law later developed the prin-

ciples of contract. The whole idea of hav-

ing a contract is to satisfy the consent of

both parties to a contract and it seems,

not only in Islamic legal systems but also

in other legal system, a contract is the

best available means to reect the in-

tention and accordingly the consent of

the parties. In any case, until the 19th

century, no denition of contract is to be

found in the treaties of Islamic law. This

is because Islamic law never developed

a general theory of contract. Instead, the

overwhelming majority of Muslim jurists

have focused on the contract of sale

which they regarded as the model for all

sorts of contracts. However, the IslamicCivil Law Codication which took place

in the 19th century started to give a pre-

cise denition of a contract.1

Classication of ContractContract, from an Islamic legal perspec-

tive is conceptually divided into two main

categories: unilateral and bilateral con-

tract. While the former is gratuitous in

character and does not require the con-

sent of the recipient, the latter is more

bound to strict rulings and guidelinessince it requires the consent of both the

parties to a contract. Also what is nor-

mally tolerated in unilateral contract,

would not necessarily be the case in bi-

lateral contract. Unilateral contract com-

prises of transactions in favour of the

recipient such as a gift (hadiyya, hiba),

off-set of the debt (ibra), will (wasiyya)

endowment (waqf) and loan (qard).

The bilateral contract covers the remain-

ing transactions in Islamic law which can

be further divided into different classi-

cations according to the very purpose

and reason detre of the deal and agree-

ment. In this regard, these contracts can

be classied into to following six catego-

ries:

1. Contracts of exchange (uqud al-

muawadat)

2. Contracts of security (uqud al taw-

thiqat)

3. Contracts of partnership (shirka)

4. Contracts of safe custody (wadia)

5. Contracts pertaining to the utilisation

of usufruct (uqud al manfaa) and6. Contracts pertaining to do a work (e.g.

wakala and juala)

This classication is not meant to be ex-

haustive because in the future many new

contracts with different features would

possibly come to exist on the basis of

the doctrine of permissibility (ibaha), as

previously discussed, that would render

all commercial transactions permissible

in the absence of a clear prohibition.

Nevertheless, the above classication

seems to be quite comprehensive to

cover all existing contracts found in qhal-Muamalaat, the branch of Islamic

qh literature.

The above classication of contracts

consists of different transactions but

contribute to the same purpose and

reason detre of the underlying contract.

For example, contract of exchange, will

primarily concern trading as well as

selling and buying activities inclusive

of their subdivisions such as cash sale,

deferred payment sale, deferred delivery

sale, sale on order, sale on debt, sale on

currency, auction sale and so on and soforth. Similarly other types of contracts

also include many sub-divisions relevant

to respective classication. For example,

contract of security not only deals with

surety-ship (kafala), but also with pledge

(rahn) and transfer of debt (hiwala) be-

cause the very purpose of these sub-

contracts under contracts of security

was to protect the interest of the parties

to a contract particularly the interest ofthe party in whose favour the respective

contracts are concluded.

As far as contracts pertaining to the utili-

sation of usufruct are concerned, it also

covers a few sub-contracts such as ijara

(hire and lease) ariya (loan of tangible

asset), waqf (endowment), qard (loan of

money), etc. The contract of partnership

(shirka) also includes different types of

partnership such as mudaraba (prot

and loss sharing) musharaka (prot and

loss sharing), sharika al-abdan (part-

nership by contributing effort and skill),

sharika al-wujuh (partnership based on

credit and reliability), muzaraa (partner-

ship in farming), musaqa (partnership in

fruit trees), etc.

Major Innovations in Islamic Fi-

nancial Products and ServicesIslamic banks and other nancial serv-

ices providers have been responsible for

major innovations in the banking sector.

Following are the key Islamic banking

products and services offered world-

wide.

Car and Home FinancingInnovative products such as Ijara (leas-

ing), Ijara Thumma al-Bai (leasing end-

ing with purchase), Ijara al-Muntahiya bit

Tamleek (leasing ending with ownership),

Musharaka Mutanaqisa (diminshing

Musharakah) and Murabaha Lil Aamir

Bi-Shira` (three- party Murabaha).

Working Capital and Industrial

Financing

Purchasing machine, asset constructionincluding manufacturing plants, con-

struction of a building or house; Islamic

products such as Istisna (manufactur-

ing contract), Istisna-cum-Ijarah, Ijara

Muntahiya bit Tamleek (lease ending

with ownership), Musharaka Mutana-

qisa (diminishing partnership) can be

used. Murabaha Lil Amer Bi-Shira` is

also applicable.

Depository ProductThere are Mudaraba account, Wadia

account, Mudraba Muqayyada (restrict-

ed Mudaraba), commodity Murabaha,

Wadia multi-currency accounts and

Mudaraba multi-currency accounts.

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34GlobalIslamic Finance April 2010

Principles o Islamic fnance


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2010 April GlobalIslamic Finance35

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Medium- and Long-term Invest-

mentThis includes capital-adjusted invest-

ment (for example a ve-year principal

adjusted structure linked to a Global

Equity Builder index and structured with

CPPI with a locked- in feature of 80 per

cent or 90 per cent of highest net as-

set value level reached, etc). There are

also innovative products from Deutsche

Bank (Islamic), and many more world-

wide, which are very competitive.

Corporate and Project Financ-

ingThere are several Shariah-compliant

products and nancing structures for

corporate and project nancing.

The contract of Murabaha allows for

the nancing of inventory and xed as-sets. Likewise, Ijara allows the leasing

of business essentials such as factory

and warehouse space, and all manner

of equipment, to a certain degree intan-

gible assets such as intellectual proper-

ties, services, workmanship, etc.

Furthermore, specialised contracts such

as Salam, a sort of forward purchase of

relevance to commodities, and Istisna,

a contract for manufacturing, allows for

a wide range of possibilities when these

are structured creatively.

Islamic law has made every provision

in dealing with debt in an efcient and

responsible manner. Debt may be trans-

ferred or assigned through a contract

called hawala (debt transfer), or through

another contract known as Kafala (guar-

antees). Through Suftaja, debt may be

safely repaid at another location.

Concluding RemarksThe basic tenant of the Islamic value

proposition is a prohibition on paying

and receiving of interest, and a fun-damental belief is the sharing of prot

and risk in the conduct of business. In

other words, Islamic banking fulls the

same basic intention as conventional

banking. However, it operates in ac-

cordance with an overall set of guiding

principles based on common Islamic

concepts described in the Quaran and

the Sunnah. These concepts are not

new. For many centuries, Muslim socie-

ties living in nations in all parts of the

world have strived to develop ways to as-

similate their religious values within the

economic and banking activities of thenations in which they live. The process

of assimilation follows two distinct ap-

proaches: a liberal approach, whereby

Islamic values are seen as compatible

with modern secular institutions and

law within certain limits, or a conserva-

tive traditionalist approach, where the

expressed goal is to produce a true Is-

lamic society and subsequent monetary

system. In todays global economy, the

vast majority of Muslims fall within agradient of tolerance between these two

approaches.

In the last four decades, Muslim schol-

ars worked to fashion nancial products

as a means to conform to Islamic law.

Two key concepts acted as motivating

factors: Islamic revivalism with a desire

to promote the beliefs of an Islamic iden-

tity and a practical response to prob-

lems of debt. If one considers Islamic

banks in their historical context, one

can clearly see that they follow a simi-

lar progression to conventional banking

in that they were established like other

banks to provide a service that is valued

by the communities they serve.

Islamic banking today is at the centre

of media hype. Some of us have great

hopes for this system of fair, prot and

risk sharing banking, and we ponder

whether non-Muslims will be equally

as attracted to this form of banking. It

can be said that even if the world does

not change from an interest-based to

an equity-prot based economy for glo-bal commerce and nance, the future

of Islamic banking presents Muslims

with an opportunity to demonstrate the

power of their values. Islamic banks are

renowned for caring and investing on

the communities that they serve, prot

being an important but not the only de-

termining factor in choosing products

and services offered to the population.

As Islamic banks expand their pallet of

services to address the nancial needs

of all customers, one thing is clear: the

next ten years will be an exciting time for

Islamic banking.

To unleash the potential of emerging

markets, Islamic banks must become

the catalyst of economic change by de-

veloping new products and services that

best serve the ever-changing needs of

people and small businesses. The vision

for all banks in emerging markets is to go

beyond simply replicating conventional

banking products. The historical evolu-

tion of Islamic banking is not nished;

we are amidst an evolutionary process

in which Islamic banks will adapt to

meet the needs of a nation state, thecommunities that they serve, and the

people within these communitie.

Additional Reading

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Abu Sulayman, Abd al-Wahhab. 1978. An-Nazariyyah wal-Qawaid l-Fiqh al-Islami in Ma-

jallah Jamaiah al-Malik Abdal-Aziz, No.2, May.

Abu Zuhrah, Muhammad. 1958.Usul al-Fiqh, Bei-rut: Darul Fikr Al-Arabi.

Ahmad, Z., IqbaL, M., and Khan M. F. 1983.Money and Banking in Islam, Ziauddin Ahmad,Munawar Iqbal, and M. Fahim Khan (eds.). Inter-

national Centre for Research in Islamic Econom-ics, King Abdulaziz University, Jeddah, and Insti-tute of Policy Studies: Islamabad.

Al-Bugha, Mustafa and Muhyiddin Misto. 1998.

A Discussion on An-Nawawis 40 Hadith, KualaLumpur: Prospecta Printers Sdn. Bhd.Al-Majallah al-Ahkam al-Adaliyyah - An Uthmani

Hana Shariah-Court Text, 26 Shabaan, 1293AH, (the 1891 Egyptian version of the Ottomans

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As-Sabuni, Abd ar-Rahman. 1982. Al-Madkhalal-Fiqhi wa Tarik at-Tashri al-Islami, Cairo: Makta-

bah Wahbah.

Bakar, M. Daud. 2003. Contracts in Islamic Com-

mercial and Their Application in Modern IslamicFinancial System. Iqtisad Al-Islamy, Islamic-

World.Net, accessed March 18, 2007 at: http://islamic-world.net/economics/contract_01.htm.

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at: http://islamic-world.net/economics/nan-cial_system_01.htm#

Ibn Abidin. 1987. Radd al-Muhtar` ala al-Durral-mukhtar, Beirut: Dar Ihya al-Turath al-Arabi,

vol.6.

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Finance & Development, June, vol. 34, No. 2, theInternational Monetary Fund and the Internation-al Bank for Reconstruction and Development,

Washington DC.

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Khan, S. Mohsin and Mirakhor, Abbas. 1992.

Islam and the Economic System, Review of Is -lamic Economics, vol.2, No.1.

Mahmassani, Subhi. 1961. Falasafat at-Tashril-Islam: The Philosophy of Jurisprudence in Is-

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