Learning Objective 3.

2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Murabahah (Mark-up)

• Murabahah: cost-plus financing contract where a sale

is made at a specified profit margin
o Establishes a form of mutual contract between two
parties where they agree to the mark-up
o Murabahah is derived from the root word ribh which means
profit, gain or a legal addition
 Originally, it was used for trading
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Figure 3.1: A Typical Murabahah Contract

 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Figure 3.2: An Overview of the Murabahah

Contract
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

The specific disclosure requirements for the validity of

murabahah :
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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Class case study

1. For which purpose (or commodity) are the Murabaha
mostly used ?
2. Using their 2024 financial reports compare the percentage
of financing based on Murabaha for mortgage (real-estate)
for 3 IB in Morocco
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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 should be fixed when settling the
contract
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Figure 3.3: The Structure of an Istisna’ Contract

 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Figure 3.4: Sukuk Transaction Using the Istisna’

Structure
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Salam or Bay al-salam (Forward Sale)

• A forward sale contract where advance payment is made

for (agricultural) commodity 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

Obj:
 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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance
Salam (Forward Sale)
 Conditions for the validity of a salam
1. Not necessary that the goods sold exist at the time of concluding the contract.
[Link] price must be paid in full by the buyer at the time of concluding
the contract.
3. Delivery date and the location for delivery should be specified in the
contract.
[Link], size, and description must be specified and agreed upon in
the contract.
5. Quantity of the goods (and the means of measurement) must be agreed upon
in absolute terms.
6. The right to demand surety from the seller is vested in the buyer in order to
guarantee delivery of the goods.
7. Ownership of the goods and all the accompanying rights can only be exercised
upon receipt of the goods.
8. The buyer may nullify the contract and exercise the performance bond if the
seller is unable to deliver the goods on the delivery date.
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Bay Dayn (Sale of Debt)

• Bay al-dayn (sale of debt) A sale and purchase transaction
involving a quality debt (i.e. not risky)

• Muslim jurists are not unanimous on the permissibility of

this form of sale (see p.90 e-Textbook)
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Bay al-Inah (Sale with immediate repurchase)

• Bay al-Inah: commodity is sold on a cash basis, then 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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance
Bay al-Inah (Sale with immediate repurchase)

• Only used in Malaysia

• Bank sells an underlying asset to a client on a credit basis
and subsequently repurchases the asset from the
customer immediately at a price lower than its earlier cost
price on cash basis.
An alternative example is:
1. A client approaches a bank and concludes a sale contract for
the sale of land worth US$5,000 in cash.
2. The bank immediately concludes a separate contract with the
client for the sale of the same land for payment of US$6,000 on a
deferred payment
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance
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
○ Perceived as move towards circumventing the mandatory
prohibition of Riba through a legal device (hilah).

 The majority of jurists prohibit bay al-inah justifying that

it is tainted with elements of interest
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Tawriq (Securitisation)

• Tawriq is a process of converting an asset into cash issued

as tradable certificates of investments (tradable in the
secondary market)

 equivalent term for securitization in Islamic commercial

jurisprudence.

Obj.
• issuance of certificate (sukuk or sanadat= Islamic
commercial papers) to be traded in secondary market by
investors
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Parties to Tawriq

The most important parties in securitization are:

1. Originator/Issuer of Sukuk: large corporations, governments

2. Special Purpose Vehicle (SPV)

3. Investment Banks: Islamic banks or Islamic windows of

multinational banks

4. Subscribers or Investors: individuals and corporate

entities
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

How it Works in the Secondary Market

An SPV is established to manage the underlying asset and
issue investment certificates (sukuk) to the investors (sukuk-
holders).
• Certificates represent ownership of an asset or entitlement to
a debt or a rental income in the case of usufruct.
• Agreement btw the originator and the SPV with regard to the
purchase of the underlying asset.
• Agreement btw the SPV and the investors, whether senior or
subordinate.
 initial cash flows are effected from the subscribers or
investors to the SPV and from SPV to originator.
Concept of Exchange-Based Contract
Figure 3.6: The Flow Chart of the Securitization Process
ex: Murabaha Sukuk

o PTC= Participation
Term Certificates

 Obligor pays the

cash flows that are
securitized to the
servicer who
monitors and
maintains the
asset.
 Servicer pays into
an account where
the participation
term certificates
(PTC) are issued to
the SPV for the
purpose of
monthly payments
to the investor
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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
Conditions:

– delivery of currencies has to be made in full on spot

– exchange must take place at the same sitting where

the contract is drawn up
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

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 ... ” (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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Tawarruq (Cash Financing or Reverse Murabahah)

• Hybrid sale contract where a customer purchase a
commodity (usually from bank) 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-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Figure 3.7:Permissible Reverse Murabahah (Tawarruq)

 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Class discussion

• After reading International Islamic Fiqh Academy resolutions

on Tawarruq (p. 98) list the arguments
 Learning Objective 3.3
Concept of Service-Based Contract Understand how service-
based contracts are used as
financial instruments in
Islamic finance
Ijarah (Leasing)

• Ijarah: Financing mechanism involving rental of an asset or

hire purchase where a form of rental fee is paid for a
stipulated period of time agreed by the parties
• In Islamic jurisprudence the term has been used in different
ways
Most common forms:
1. ijarah (leasing)
2. ijarah muntahia bi al-tamlik (ONE single financial lease contract
with ownership transfert)
3. ijarah thumma al-bay (TWO contracts = leasing and
subsequent purchase)
Payment modes:
• ujrah (fees)
• ju’alah (commission)
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

• Modern application of ijarah are:

- Al-ijarah thumma al-bay’ (a contract of lease ending
with sale contract)
- Ijarah muntahia bi al-tamlik (leasing including
ownership transfer)

Ijarah Muntahia Bi al-tamlik (Financial Lease)

A typical lease contract which concludes in a transfer

of legal title and confers ownership on the lessee
- Ijarah means lease
- Tamlik denotes ownership
 Learning Objective 3.3
Understand how service-
Concept of Service-Based based contracts are used as
financial instruments in
Contract Islamic finance

Ijarah thumma al-bay (Leasing and Subsequent

Purchase)

• Ijarah thumma al-bay: a contract of lease subsequently

followed by a sale contract
• Two separate contracts are concluded under this chain
transaction
- The ijarah contract
- The purchase contract
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance
Figure 3.8: Ijarah Thumma bay’ Contract
 Learning Objective 3.3

Concept of Service-Based Contract Understand how service-

based contracts are used as
financial instruments in
Islamic finance

Alternative form : Ijarah mausufah fi dhimmah (Forward

Lease)

=lease agreement on a asset not yet in existence

 "wasafa" (‫" = )ﻑﺻﻭ‬described" or "specified.“ + “dhimma”=obligation
• The lessor has to deliver the asset to the lessee
in accordance with agreed specifications

 The modern application of forward lease is diverse; it can be

used in:
- Customized asset
- Construction (ex: off-plan property leasing)
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

Ujrah (Fees)

• Ujrah: a payment for usufruct in the use of another

person’s property or payment for service in contract
of ijarah

• Most Islamic financial institutions charge service fees for

services rendered to customers. Services fees should be
paid for through the ujrah scheme

• Ujrah has been used by a number of banks for Sharī‘ah-

compliant credit card schemes
 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

Ju’alah (Commission or Reward)

• In the juristic sense, ju’alah is a one-sided contract where
reward/commission is given for accomplishment of a task

• The legality of the ju’alah contract is established in

the Qur’an and Sunnah

• There is an element of ju’alah in takaful contracts

• Ju’alah may be useful in the recovery of overdue

debts