APPLIED SHARI`AH IN FINANCIAL TRANSACTIONS

Associate Professor Dr Engku Rabiah Adawiah Ahmad Ibrahim Kulliyyah of Laws International Islamic University Malaysia rabiah@iiu.edu.my eradawiah@yahoo.com

INTRODUCTION
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Shari`ah law works in financial transactions (mu`amalat) by way of interpretative efforts (ijtihad) of the primary sources (Quran & Sunnah); & using various secondary sources & techniques of arriving at legal rules Shari`ah law declares that the original status of each and every contract is permissibility unless proven otherwise (al-asl fi al `uqud al-ibahah) This doctrine of permissibility gives flexibility and opens up opportunities for innovation and creativity in Islamic financial engineering and product development

CONTEMPORARY ISLAMIC FINANCIAL SERVICES

Islamic Banking

Islamic Capital Market

Takaful

Financing Financing Deposit Deposit & & Investment Investment

Bank Negara IBA 1983 - Islamic Bank BAFIA 1989 Islamic Windows

Equity Equity Market Market

Takaful Takaful

Bond Bond Market Market

Securities Commission SCA 1993 CA 1965

Retakaful Retakaful
Bank Negara Takaful Act 1984

KEY ISLAMIC COMMERCIAL CONTRACTS

Gratuitous Gratuitous Contracts Contracts

Trading Trading Contracts Contracts

Investment Investment Contracts Contracts

Supporting Supporting Contracts Contracts

Gift Gift Waqf Waqf Loan Loan Ibra Ibra

Leasing Leasing

Sale Sale

Mudarabah Mudarabah Musharakah Musharakah

Kafalah Kafalah Rahn Rahn Hiwalah Hiwalah Wadiah Wadiah

Operational Operational Lease Lease Financial Financial Lease Lease

Bay` Bay` Bithaman Bithaman Ajil Ajil (BBA) (BBA) Murabahah Murabahah

Wakalah Wakalah Salam Salam Istisna Istisna etc. etc. Jualah Jualah Muqasah Muqasah4

SALE CONTRACTS & SOME APPLICATIONS IN ISLAMIC FINANCIAL SERVICES

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Murabahah & Bay` bithaman Ajil (BBA) z Application in Asset Financing z Application in Sukuk issuance

MURABAHAH & BAY` BITHAMAN AJIL (BBA)

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Both contracts are contracts of sale and purchase (bay`) Sale and purchase is a contract of exchange (`aqd al mu`awadah) The exchange is between the two counter values, i.e., goods and price Sale and purchase presupposes the transfer of ownership between the parties (regardless of any formal registration of transfer)

SPECIAL FEATURES FOR MURABAHAH & BAY` BITHAMAN AJIL (BBA)

Murabahah
It is a sale and purchase contract based on trust (bay` al amanah) Full disclosure and transparency between the parties Cost and amount of mark-up are disclosed Payment of price can be spot or deferred, depending on the agreement between the parties (if deferred also a BBA)

BBA
Sale where payment of price is deferred Final price should be contractually agreed and known to both parties Time and mode of payment should be ascertained No need to state the cost price and amount of mark-up (if disclosed also a murabahah)

MURABAHAH & BBA (Modus Operandi for Asset Financing)

Property Purchase Financier Purchase Price Asset Owner

Asset

STEP ONE

MURABAHAH & BBA (Modus Operandi for Asset Financing)

Property Sale Financier Sale Price (Purchase Price + Mark-up) Customer

Asset

STEP TWO

OBSERVATIONS
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The Islamic banking practice in Malaysia tends to confine BBA to long term asset financing and Murabahah to short & medium term financing. This has nothing to do with any Islamic law requirement. BBA in Islamic law is simply a method of payment, i.e., deferred payment and thus, it applies to all kinds of sales where the payment is deferred whether on the basis of instalments or lump sum payment at the end of the tenor.

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APPLICATION OF MURABAHAH/BBA IN SUKUK (BASIC STRUCTURE MALAYSIA)

3 3

Primary Subscriber pays the Purchase Price

Issuer Issuer

Primary Primary Subscriber Subscriber

1 1

2 2

Issuer identified Assets

Issuers Assets

Purchase of Assets by the Primary Subscriber at Purchase Price 11

APPLICATION OF MURABAHAH/BBA IN SUKUK (BASIC STRUCTURE MALAYSIA) Contd

Creation of the Debt Resale of the assets at the Selling Price Murabahah/BBA

Issuer Issuer

1 1

Primary Primary Subscriber Subscriber

3 3

2 2

Murabahah/BBA Murabahah/BBA IDS/Bonds IDS/Bonds

Trading

Secondary Secondary Market Market

The issuer issues the sukuk evidencing the debt (sale price) arising from the second leg of the sale of assets (which is a Murabahah/BBA)

The Securitization process

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COMMENTS
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Murabahah/BBA sukuk are just tradable in Malaysian domestic market or perhaps some regional markets that adopt the Malaysian fatwa on bay` al `inah and bay` al dayn Not suitable for global / GCC market

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IJARAH CONTRACT & SOME APPLICATIONS IN ISLAMIC FINANCIAL SERVICES

Ijarah Islamic lease z Application of Ijarah as Operating Lease z Application of Ijarah as Lease followed by Purchase (AITAB) z Application of Ijarah in Sukuk Issuance
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IJARAH ISLAMIC LEASE

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Ijarah contract is a form of exchange contract (`aqd al mu`awadah) usufruct vs rent. Ijarah is a contract that results in the transfer of the right to use (usufruct). The ownership of the asset remains with the owner cum lessor. In practice, ijarah can be used as operating lease or lease contract with an option to purchase al ijarah thumma al bay` (AITAB).

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OPERATING LEASE (Modus Operandi)

Purchase Agreement

Financier
Purchase Price

Supplier

STEP 1

Asset
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OPERATING LEASE (Modus Operandi)

Lease Agreement

Financier
Rental Payment

Customer

STEP 2

Asset
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AL IJARAH THUMMA AL BAY - AITAB (Modus Operandi)

Purchase Agreement

Financier
Purchase Price

Supplier

STEP 1

Asset
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AL IJARAH THUMMA AL BAY - AITAB (Modus Operandi)

Lease Agreement / 2nd Schedule HPA 1967

Financier
Rental Payment

Customer

STEP 2

Asset
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AL IJARAH THUMMA AL BAY - AITAB (Modus Operandi)

Sale Agreement

Financier
Sale Price

Customer

STEP 3

Asset
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APPLICATION OF LEASE TO SUKUK (ISLAMIC SECURITIES)

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Nature of Sukuk al Ijarah:

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represents a share in a leased asset (pro-rata ownership by the sukuk holders of the leased asset) share entitles to economic benefits under the lease (enables the sukuk holders to enjoy rental income & capital gain from disposal of the leased asset, if any) subject to the obligations / liabilities (to bear the risk of loss and damage of the leased asset)

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MALAYSIAN GLOBAL SOVEREIGN SUKUK: TRANSACTION SUMMARY

Issuer Rating Size Format Type Tenor Yield & Coupon Listing Launch/Pricing Date Investor Distribution
z z z z z z z z z z

Malaysian Global Sukuk Inc. Baa2 (Moodys) and BBB (S&P) USD 600 million Reg-S Sukuk al Ijarah (floating rate) 5 year bullet USD LIBOR + 95 bps Bahrain, Luxembourg & Labuan (LFX) June 2002 51% Mid-East; 30% Asia; 15% Europe; 4% US

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USD600m MALAYSIAN GLOBAL SOVEREIGN SUKUK: TRANSACTION STRUCTURE

Government Government of of Malaysia Malaysia
6. Payment of rentals 2. Lease of land parcels 8. Sale at dissolution 9. Exercise price at dissolution 10.Dissolution Amount 1. Sale & Transfer of Beneficial Title for USD600m 7. Periodic rental payments 3. Sukuk issuance

Federal Federal Lands Lands Commissioner Commissioner

5. Proceeds

SPV: SPV: Malaysian Malaysian Global Global Sukuk Sukuk Inc. Inc.

Sukuk Sukuk Holders Holders (Investors) (Investors)

4. Payment of Proceeds from sale of sukuk

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PARTNERSHIP CONTRACTS & SOME APPLICATIONS IN ISLAMIC FINANCIAL SERVICES

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Musharakah Application of Musharakah in Project Financing z Mudarabah Application of Mudarabah in Project Financing z Application of Musharakah & Mudarabah in Sukuk Issuance
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MUSHARAKAH
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Meaning of musharakah:
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an arrangement whereby two or more persons contribute to the capital with their property for the purpose of trading with the joint capital, the profit of which, shall be shared among the partners

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MUSHARAKAH PROJECT FINANCING

Contract of Musharakah Capital contribution X:Y

Financier Financier // Bank Bank

Profit: shared according to agreed ratio or according to ratio of capital contribution Loss shared according to ratio of capital contribution

Company Company

X%

Capital

Y%

Project Project Revenue Revenue

Invests Invests in in project project

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MUDARABAH
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Meaning of mudarabah:
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an arrangement whereby the owner of some property (termed as rabb al mal) gives a specified amount of capital to another person (termed as mudarib) who is to act as the entrepreneur to trade with the capital, the profit of which will be shared between the two parties according to the terms of their agreement. The losses will be borne by the rabb al mal as the financier, whilst the mudarib suffers the frustration of a fruitless effort

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MUDARABAH PROJECT FINANCING

Contract of Mudarabah Profit Sharing ratio X:Y

Financier Financier ( Rabb al (Rabb al Mal) Mal)

Company Company ( Amil // Mudarib ) (Amil Mudarib)

Y% to rabb al mal Profit shared in accordance to pre-agreed proportions (X:Y)

CAPITAL

X% to mudarib

Loss borne Totally by rabb al mal

Project Project Revenue Revenue

Invests Invests in in project project

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BASIC STRUCTURE OF MUSHARAKAH SUKUK

Issues sukuk

Investors Investors
Contract of Musharakah Capital contribution X:Y Profit: shared according to agreed ratio or according to ratio of capital contribution Loss shared according to ratio of capital contribution

Issuer Issuer

X%

Capital

Y%

Revenue Revenue of of Project Project

Invests Invests in in Project Project

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ASSAR SENARI RM150m MUSHARAKAH SUKUK: TRANSACTION STRUCTURE

Sukuk Sukuk Holders Holders (Investors) (Investors)
1 1

Issue Sukuk Musyarakah

Company Company

Invest Capital (87%)

1 1

Invest Capital (13%)

Musyarakah Musyarakah Venture Venture

Owned by Profit sharing (Starts 2nd Year)
Company X% Investors Y%

5 5

2 2

Lease completed IOT

User User Agreements Agreements

(RMXXX (RMXXX Million) Million)

Trustee Trustee
Project Manager (As Agent of Trustee)

Completed Completed IOT IOT

4 4 Construction period 12 18 Months

Construct & Lease IOT

3 3

Oil Oil Companies Companies

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WINGS FZCO: TRANSACTION STRUCTURE

Emirates Emirates as as obligor obligor Emirates Emirates as as lessee lessee
Rental

Emirates Emirates as as lessee lessee

Lease of New Engineering Centre

Lease of New Emirates Group Headquarters

Rental

Exercise Price Sale of units

MUSHARAKAH MUSHARAKAH
Wings Wings FZCO FZCO as as partner partner Emirates Emirates as as partner partner

Proceeds: USD550m

Land parcels valued at USD100m

Wings Wings FZCO FZCO

Emirates Emirates
a) Issues Sukuk evidence proportionate share in Musharakah b) Proceeds USD550m: used for construction of Group Headquarters & Engineering Centre

d d

c c

b b

a a

Investors Investors

c) Periodic Distribution Amount d) Dissolution Distribution Amount

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BASIC STRUCTURE OF MUDARABAH SUKUK

Issues Mudarabah Sukuk Investors Investors ( Rabb al (Rabb al Mal) Mal) Contract of Mudarabah Issuer Issuer ( Amil // Mudarib ) (Amil Mudarib)

Profit shared in accordance to pre-agreed proportions (X:Y)

Y% to rabb al mal

CAPITAL

X% to mudarib Outcome Outcome of of project project Invests Invests in in project project

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Loss borne Totally by rabb al mal

PG MUNICIPAL MUDARABAH SUKUK

Security Trustee Rabb al Mal 1

Sukuk Holders
Profit sharing
SPV X% Investors Y%

Issue Mudarabah Bonds (AAA RAM)

1st Mudarabah - Invest Capital (Bond Proceeds) RM80 m

Profit

PG Municipal (SPV)
2nd Mudarabah

Mudarib 1 & Rabb al Mal 2

Profit sharing
Administrator X% Investors Y%

PG Local Authority (Administrator) Mudarib 2 Manage and Administer Tax Collections

Profit from Tax Collection

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ISLAMIC DEPOSIT SERVICES PRODUCTS: SOME APPLICATIONS

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Islamic Deposit Services Products Islamic Savings / Current Account Wadi`ah z Islamic Accounts Mudarabah z Islamic Deposits NIDC z Islamic Deposits Murabahah Commodity
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DEPOSIT SERVICES PRODUCTS

Current Current // Saving Saving Account Account

Investment Investment Account Account

Negotiable Negotiable Islamic Islamic Deposit Deposit Certificates Certificates

Murabahah Murabahah Commodity Commodity Deposit Deposit

Sale Sale and and Buy Buy Back Back Arrangement Arrangement

Wadi`ah Wadi`ah Yad Yad Damanah Damanah

Mudarabah Mudarabah

Bay Bay al al `Inah `Inah

Murabahah Murabahah & & Tawarruq Tawarruq

Bay Bay al al Dayn Dayn

Mudarabah Mudarabah

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ISLAMIC SAVING & CURRENT ACCOUNTS

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Some Islamic banks use the concept of wadi`ah yad damanah (guaranteed safe custody) in their Islamic saving & current account Other Islamic banks use mudarabah contracts for Islamic savings & current accounts For Islamic investment accounts normally mudarabah contract is used.

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FEATURES OF WADI`AH YAD DAMANAH (GUARANTEED SAFE CUSTODY)

z z z z z z z

The custodian (bank) is both a trustee and guarantor The deposit need not be separated/segregated The deposit can be used for trading, etc. The custodian (bank) has a right to any income derived from the utilization of the deposit Depositor can take back the deposited asset at any time Wadiah Yad Damanah is more like Qard (loan); thus, all principles of loan would be applicable Wadi`ah Yad Damanah (like loan) cannot generate any preagreed benefit/income to the depositor, over and above the principal amount of deposit. Failure to safeguard this may result in riba
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MUDARABAH ACCOUNT (MODUS OPERANDI)

Work with capital

CAPITAL

Provide capital

MUDARIB MUDARIB (Manager -Bank) (Manager-Bank)

RABB RABB AL AL MAL MAL (Capital (Capital provider providerdepositors) depositors)

Profit Profit
Shared between mudarib + rabb al mal Profit sharing according to a contractually agreed ratio Profit sharing cannot be a fixed amount/a fixed percentage of capital contribution

Losses Losses
Born solely by rabb al mal Mudarib will only be personally liable if the loss is caused by his negligence

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NIDC (MODUS OPERANDI)

Sells asset

Bank Bank
(e.g. equipments for RM100,00)

Customer Customer (Depositor) (Depositor)

Method of payment: cash Islamic Deposit Buys-back asset

Bank Bank
(e.g. equipments for RM100,00 + X%)

Customer Customer (Depositor) (Depositor)

Method of payment: deferred over a period of 5 years Bank also issues NIDC to evidence the indebtedness created by the deferred payment sale

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MURABAHAH COMMODITY DEPOSIT-I

1 1 Customer buys on a spot basis USD10 million worth of LME metal warrants (commodity) from Broker A

Customer Customer
3 3 Customer sells the commodity to the Bank at USD10 million plus a profit margin payable on a deferred payment basis

LME LME Broker Broker A A

2 2 USD10 million

5 5 USD10 million

LME LME Broker Broker B B

4 4

Bank Bank

Bank sells on a spot basis the Commodity to Broker B for USD10 million

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APPLICATION OF ISLAMIC CONTRACTS IN TAKAFUL

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Contract among Takaful Participants Tabarru` Contract between Takaful Participants & Takaful Operator

CONTRACT AMONG TAKAFUL PARTICIPANTS: TABARRU

Takaful Participants

Mutual Indemnity

Donation

Mutual Indemnity

Takaful Fund
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CONTRACT BETWEEN TAKAFUL PARTICIPANTS & TAKAFUL OPERATOR

Takaful Participants
Donation

Takaful Funds

Manage

Possible Contract/s: Mudarabah Wakalah Ju`alah Wadi`ah yad damanah

Takaful Operator

Investment Investment

Pay Pay Claims Claims

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CONCLUSION
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There is a wide range of contracts that can be applied in structuring & developing Islamic financial services products The choice of contracts depends on the purpose and needs of the parties (financial institutions & their clients) For example, sales contracts have been widely used for the purpose of financing, especially for asset financing Other contracts like leasing and partnership are also widely applied in project financing and securitization transactions Takaful industry uses more of donation, agency & investment contracts There is always room for more application & diversification of Islamic contracts in Islamic financial services products
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THANK YOU
Wassalam