For the past few years, controversies have arisen over the use of several working capital products, which aims to provide one party with cash and another with debt. As with all Islamic transactions in the market, an underlying asset is a key requirement to ensure the transaction is valid in the Islamic Banking world. The main challenge for a customer requiring cash for their use but without any collateral or asset to enable the economic transaction to take effect, Banks have obtained alternative structures to provide the customers with the much-needed cash.
The structures of Bai-Inah and Commodity Murabaha are introduced as possible solutions.The word Tawarruq is also greatly been used to reflect transactions involving Commodity Murabaha.
Although the Bai-Inah structure is generally rejected by international scholars except for in Malaysia, the remaining Tawarruq arrangement with Commodity Murabaha are still accepted throughout the Islamic Banking world. Lately however, even this contract is put under pressure by scholars as something nearing its shelf life. Recent pronouncements by some scholars that the Tawarruq arrangement is not permissible only highlights the challenges in Islamic Banking. The main argument against Tawarruq arrangement with Commodity Murabaha is the same one; that the structure is “arranged” and therefore is not a genuine economic transaction.
But for proponents of both Tawarruq arrangements (even for Bai Inah), the question is that, unless a structure exists that provides cash while in the absence of valuable assets, should Islamic bankers continue to offer these structures in the meanwhile? Or divert the customer to conventional banking product which is clearly involved in Riba’? There are no easy answers to this as it depends on which side of the fence you are standing.
What is Commodity Murabaha / Tawarruq?
There has been on-going questions on the validity of the contract and the rationale for doing so. The Legal Maxim used is that Tawarruq satisfies people needs and meets their requirements i.e. removing difficulty as well as meeting the Maqasid of Shariah for protection of property. This structure is required in the face of today’s difficulty in addressing liquidity requirements. In order to overcome the option of reverting to a riba’ based facility to meet Customer’s need, Tawarruq is provided as a solution for their problems.
Before moving further, is there a difference between Commodity Murabaha and Tawarruq? Not many scholars made this distinction between these two terms, but in the early days, Bai Inah was a transaction done by 2-parties, and Commodity Murabaha transactions was either a transaction among 3-parties (Bank-Customer-Broker) or 4-parties (Bank-Customer-Broker A-Broker B). But over time, most of the 3-parties transactions Commodity Murabaha are enhanced to 4-parties transactions as per request by many scholars, and both 3-parties or 4-parties structures are generally now known as Tawarruq arrangement (which contains 3 Islamic contracts i.e. Wakalah, Murabahah and Musawamah). This is consistent with the Tawarruq Policy Document issued by BNM in 2015
Generally, the Tawarruq terms are commonly used in the Middle-East and Commodity Murabaha more popular in Malaysia. Between scholars and practitioners, these terms are now used interchangeably. But in my humble opinion, I subscribe with BNM view that Tawarruq is the over-arching arrangement where multiple contract work together; Wakalah, Murabahah and Musawamah to complete the Tawarruq arrangement.
We have to first ask this question, Is there anything fundamentally wrong with the contract of Tawarruq? Why is it being put to question? In the olden days, this structure would be a normal trading scenario, where there is real sale transactions involving goods or commodities. All the tenets of a valid sale can be met (Buyer, Seller, Price, Asset, Offer & Acceptance) and there should not be any issues of interconditionality.
Perhaps the notion that obtaining Cash from a transaction looks too much like a “loan” from the conventional banking space. But this Cash is derived from real trading. While the argument is that the “intention” of Tawarruq is not real trade, I tend to disagree as the customer do have a need to obtain Cash, via a real trade. Consider this scenario:
- A person needs Cash to run his business. Lets say he has an immediate business opportunity to earn 40%-50% returns for the year, but he needs $100,000 to do it.
- He looks around the market for a liquid commodity that can be sold quickly for Cash. Let’s say he identified there is need for Cocoa Beans by a few buyers.
- He approach a Cocoa Bean supplier (maybe direct from the plantation) and negotiates a deal for the beans. He offered to buy the beans (worth around $95,000 to $100,000) for a price of $120,000 to be settled in 12 months time. This is a Murabaha for purchase of Commodity transaction (in other words, Commodity Murabaha i.e. Profit Sale using Commodities). Murabaha is an accepted Sharia compliant sale-contract.
- Once the supplier agrees to this deal, he takes ownership of the Cocoa Beans (worth around $95,000 to $100,000).
- Now, it is not his intention to just “own” the Cocoa Beans (as he needed Cash for his business) so he will use the Cocoa Beans as Commodity goods to sell in order to obtain Cash. Is there any thing wrong with that? He plans to use the proceeds for his business to generate economic benefit for him. This is his main intention.
- As he already identified the buyers of Cocoa Beans in the market, he approaches them to sell the Cocoa Beans under contract of Musawama (simple sale). He may eventually sell all the beans for $100,000, but he may even get more than that, depending on his negotiation skills. All he needed was to obtain Cash of $100,000 for him to proceed to do his business which may earn him up to $150,000 for the year.
- He makes the sale at the market price on Cash-basis and managed to collect $102,000 which is sufficient for his requirements (with additional estimated up-front profit of $102,000 less $95,000 = $7,000). Again, nothing wrong for this profit deriving from a sale transaction, as he has taken some ownership & valuation risks by buying the beans.
- With that Cash, he funds his business and finally earns a profit of $147,000 (about 44% profit per annum) from the capital of $102,000.
- On the 12th month, he pays off the debt with the Cocoa Bean supplier for $120,000. His net profit will therefore be $147,000 less $120,000 = $27,000.
- All the underlying transactions are based on valuable, real and deliverable assets which meets the requirements of the Sharia.
Now, from the above scenario, not everyone is skilled to obtain Cash by way of going into the physical market, finding buyers and negotiating price with suppliers. Customers seeking Cash, for whatever reasons it may be, will approach people who are skilled to conduct such endeavour. Banks, seeing the need for such services or facility, have built a stable infrastructure to support the process. The infrastructure includes:
- Having dedicated personnel skilled in the booking of commodities that is able to identify “highly liquid” commodities that is in demand and easily sold (disposed) in the market. Crude Palm Oil (Malaysia) and Non-Precious Metals (International – London) are the commonly used commodity due to its stable and continuous demand for the commodities.
- Having developed internal systems that is able to track and monitor the evidence, ownership and movement of the commodities used.
- Having established relationships with commodity brokers and commodity bourse in where the trade transaction will happen.
- Having clear processes that is controlled and monitored to ensure proper sequencing and transfers in accordance to Sharia rules and regulations.
- Having Sharia-approved documentations to capture the debt obligations created from the Murabaha sale of commodities.
With the above infrastructure, Sharia is able to monitor and regulate the implementation of the Tawarruq transaction, ensuring its validity. The Bank is also able to manage the various risks accordingly as the “arranged” processes will be designed to minimise risks such as valuation risks, ownership risks and even market risks. A Tawarruq transaction (or arrangement) will then involve a series of sale contracts whereby:
- A Principal (Bank) purchases an Asset or Commodity from a Supplier for the purpose of entering into a Commodity Murabahah transaction
- A buyer (Customer) buys an asset from a Seller (Bank) for a deferred payment (either periodic instalments or lump sum settlements).
- The buyer (Customer) subsequently sells the asset (via an appointed Agent) to a third party (on-sell as Musawamah) for cash at a price less than the deferred price (usually equivalent to the original purchase price), with the objective of obtaining cash.
- The terms of the transaction is agreed up-front by both parties, including the type and price of commodities to be transacted, and the settlement details.
- The above transactions must be executed based on the sequence and in a timely manner.
The purpose of the above arrangement is to obtain immediate cash and not for the purpose of acquiring the Asset or benefiting from the commodity. The commodity transaction is a means to facilitate the attainment of cash and liquidity, and while the beneficial commodity ownership must changes hands during the transaction, it is rarely the case that the Customer actually takes physical ownership of the commodity (as this is not the main intention of the Customer). However, the option to take physical delivery of the commodity must always be present to the Customer should they choose to take the physical delivery.
Another key consideration is that the contract must stand-alone and not be conditional on the completion of the other contract. The arrangement of Tawarruq is a combination of 2 separate contracts that are complete and therefore legally binding on its own.
Based on the above structure, the Tawarruq arrangement must clearly consist of 2 separate standalone contracts. The legal documentation, as far as possible, must also reflect the same.
Why choose Commodity Murabahah?
The preference of using Commodity Murabaha instead of Bai Inah is the issue of interconditionality. Under Bai-Inah, the underlying Asset used is the Bank’s Asset i.e. Bank sells its Asset to Customer to create a debt and “buy-back” the Asset from the Customer for immediate Cash settlement. It puts the structure under extreme criticism as it is argued that this is a pre-arranged transaction of no economic value just for the purpose of creating a debt, without the ability to separate the sale and the buy-back contract. The interconditionality clauses built into the transactional documents to ensure the buy-back makes the contract now “un-preferred” by scholars in general.
Under a Tawarruq arrangement, it is deemed that the interconditionality aspect of the contracts are immaterial. This is because the Bank has no use of the commodity being traded, since it is a non-Bank Asset (not used by Bank) being traded by third parties in the open commodities market. The Bank simply has no interest to “buy-back” or even keep the commodities in their books, therefore it enters into an actual economic transaction done between 2 brokers. While the transaction itself doesn’t value-add to the commodity, the trading of the commodity allows for the creation of debt necessary for the customer.
The common criticisms revolves around the issue of ownership (constructive ownership vs physical ownership) as the commodities are usual located off-site and the ability to actually verify the commodities being traded is in existence and as per the description or not. It is because these criticisms that some countries (like Oman) still stay away from these “working-capital” product structures. However, most of the established commodity brokers have started to make available nearby commodities warehouse locations, nearer to many business locations. For example, a commodity broker may set up a warehouse in Singapore to cater for the commodities requirements from Malaysia, Indonesia and Brunei. This helps address Shariah Committee concerns as these commodities become more accessible for inspection, and ownership verification.
Criticisms in the Operationalisation of Commodity Murabahah
- Interconditionality in Tawarruq arrangements. As mentioned above, one of the major criticism of Tawarruq’s predecessor i.e. Bai Inah structure is that the interconditionality of the 2 contracts. Under Bai Inah, the legal requirements imposes that the Customer must execute Contract #2 for the compulsory buy-back of the Asset by the Bank, failing which Contract #1 becomes invalid. This issue is however mitigated under Tawarruq as the Bank, using third party commodities, has no interest to impose a buy-back of the commodity from customer thus removing the need to impose controversial interconditionality clauses.
- Commodities used for transactions. Another concern is that the commodities used for the transaction has little value, obsolete or defective, requiring scholars to emphasis the evidence, valuation and good order of commodities must be ascertained before a transaction starts. There has also been concerns whether the commodity really exists in its current form in the stated commodities location. Efforts have been made to verify and authenticate the existence of those commodities.
- Physical delivery of Commodities. The concern on the inability to deliver commodities to the Customer, should a delivery request be made, will render the arrangement of Tawarruq defective and is not in the right spirit of the contract. It may be construed as an economic trick. The condition, availability and location of the commodity are important factors to be addressed adequately by the Bank to ensure deliverability.
- Agency issues, including dual agency arrangements. There are opinions that the arrangement of dual agency (where customer appoints the Bank to conduct all transactions on their behalf by way of multiple agency appointments, thus removing any Customer interaction during the transaction) deems the arrangement as Organised Tawarruq (Tawarruq Masrafi) instead of Real Tawarruq (Tawarruq Haqiqi). Some prominent scholars, including Mufti Taqi Usmani and some countries (such as Oman) had criticized and/or rejected the use of Organised Tawarruq. Additionally, there are also contrasting opinions on the practice in a dual agency where a single person in the Bank acts as the agent to 1) purchase commodity (as customer’s Purchasing Agent) and 2) sells commodity (as customer’s Selling Agent) to himself (as Principal of the Bank). This allowance has been captured in BNM’s Tawarruq Policy Document but is still a talking point amongst practitioners.
- Sequencing and Ownership. Under Tawarruq, I believe the sequencing of the transfer of commodities are so critical that a break of sequencing have a domino effect for transactional defect. Many failed to see how important the sequencing are, because of commodities usually requires quick change in hands and ownership. Many cases we have come across showed breakage in sequencing and therefore rightful ownership to proceed with the transaction. Some cases we can rectify (for example in cases of Bay Fuduli i.e. Purchase made by unauthorised agent due to sequencing breakage), but some may require some drastic ratification, even resulting in loss or charity payments.
There have been efforts to introduce a more acceptable mode for commodity trade such as the introduction of Bursa Malaysi’a Bursa Suq Al Sila to make it more transparent the process for the ownership and transaction of a commodity, but the question still remain on how long will this structure be acceptable to the scholars. At the end of the day, this is still Tawarruq which is pre-arranged Commodity Murabaha; none of the parties intend to purchase or hold commodities. Unfortunately, the reality of it is that there is still a huge portion of the market embedded in debt rather than equity trading. Equity is simply not enough to support some transaction, and for an industry that pushes double-digit growth, Tawarruq arrangement and Commodity Murabaha will remain among the key growth enablers to Islamic funding.
Tawarruq is generally classified as a Debt-Based Structure.
Expanding Tawarruq into Deposit products
Moving forward, Tawarruq arrangement is already playing an even bigger role, as even depository and investment products are developed using these structures. The Malaysian market, for example, now shows heavy reliance on Tawarruq on Fixed Deposit-i which has replaced the previous favourite, Mudharabah Fixed Deposits-i. There are also Banks in Malaysia already offering Current Account and Savings Account based on Tawarruq, and moving forward, a lot more is expected to emerge in 2017-2018. The fore-runner of Tawarruq deposits is Hong Leong Islamic Bank (Malaysia), where a huge majority of its deposit and financing products are offered under the contract of Tawarruq.
Practitioners have to be even more vigilant in ensuring compliance to the rules of Commodity Murabaha transaction in a Tawarruq arrangement.
Bai Inah and Tawarruq were never intended to be the solution to Islamic funding. It is merely providing customers with an Islamic alternative while developers figure out a way to meet customer’s liquidity requirements. Or, the processes governing these structures may be further improved to become more acceptable to more scholars. Islamic Banking structures are always meant to be evolving as new discussions are undertaken, new regulations imposed and new solutions found. Until then, Islamic Banks will continue to utilise these structure to avoid customers going into Riba-based loans as their financial solution. Wa’ Allahu Alam.
- Analysis: Tawarruq declared impermissible by the OIC Fiqh Academy
- OIC Fiqh Academy Ruled Organised Tawarruq Impermissible in 2009
- Research : Suq Al Sila and Tawarruq Controversy (PDF)