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Home > Financing Best Practice > Tawarruq at a Glance

Financing Best Practice

Tawarruq at a Glance

by Adil Msatfa

Table of contents

Executive Summary

  • Tawarruq is a financing method used by most Islamic financial institutions in the world.

  • It consists of a sale contract whereby the client buys a commodity from the bank for deferred payment and then sells it to a third party for cash at a price that is lower than the deferred price. The result being that the bank’s client gets an immediate liquidity without having recourse to prohibited interest-based loans.

  • This mode has long been accepted by many shariah scholars as a way of acquiring liquidity.

  • However, the indiscreet use of this practice, created many shariah risk issues due to some specific structures that derived from it.

  • This has pushed many scholars, initially favorable to this mode, to call for a reassessment of its validity.

Introduction

At a time when the global Islamic finance industry is gaining increasing acceptance from both Muslim and non-Muslim investors, many challenges emanating from the lack of harmonization have yet to be overcome. The fact of the matter is that the Islamic financial market is still witnessing inconsistencies in nomenclature from one region to another, with certain products considered as halal (permissible) by some scholars and declared haram (impermissible) by others.

One of these financial products that create confusing situations in Islamic finance is tawarruq, also known as “commodity murabahah.” Tawarruq is a mode of finance that involves a tripartite sale contract whereby one party buys an asset from a vendor for deferred payment and then sells it to a third party for cash at a price that is lower than the deferred price.

This mode is very popular with bankers as a rapid and flexible way of acquiring liquidity. In fact, by using tawarruq bankers avoid constraints related to capital adequacy and allay the provision for managing doubtful debts. Tawarruq can also be used in more complex structures, such as Islamic foreign exchange swaps, where it helps to hedge against currency rate fluctuation risks. These kinds of contract combinations, replicating interest-based loans in the form of a deferred liability, have been practiced by many Islamic banks for more than three decades. However, there has never been a consensus on their permissibility, and there are even some shariah scholars who were initially open to such practices but later called for a reassessment of the product in order to avoid opening the door of riba (usury).

Before going into the arguments put forth by the proponents/opponents of the practice, it is relevant to differentiate between the different types of tawarruq. The first type is “real tawarruq,” which occurs when a person that needs cash (referred to as a mustawriq) buys a commodity from a bank at a deferred price and subsequently sells it to another party or bank for cash and hence gets his or her needed cash. The second type, “organized tawarruq,” also called “banking tawarruq,” is practiced when a person buys a commodity from a bank on a deferred-price basis and the bank arranges the sale agreement either itself or through an agent. The mustawriq and the bank execute the transactions simultaneously, usually at a lower spot price. The difference between the two types of tawarruq is that the customer in the organized tawarruq does not receive the commodity and is not engaged in selling it, while the customer of the real tawarruq has the choice to either keep the commodity or sell it himself. Most organized tawarruq involve international commodities such as minerals. There is also a third type of tawarruq, called “reverse tawarruq.” Its form is similar to organized tawarruq, except that the mustawriq is the Islamic bank and it acts as a client. The same shariah rules apply to both organized and reverse tawarruq.

Real Tawarruq

Most jurists allow real tawarruq provided that it complies with the shariah requirements on valid sale. For example, in the case that the customer appoints the bank as an agent to sell the commodity on his or her behalf, the agency contract should be independent of the sale contract and it should be made after the agreement with the bank has been signed. Among the scholars who allow real tawarruq are those of the Islamic Fiqh Academy set up by the Organization of the Islamic Conference (OIC) and the Permanent Committee for Islamic Research and Fatawa in Saudi Arabia. The scholars of these institutions consider tawarruq to be permissible as the technique is based on two sale contracts, with the ultimate buyer not being the same as the initial seller. The permission is also justified by the fact that this process allows rotation of part of the liquid assets to replace conventional credits. In addition, in an industry that remains in the embryonic stage, tawarruq helped institutions starting from inception, under severe regulatory constraints, to subsist and later to initiate a shift from debt to equity.

Other scholars, however, interpret tawarruq as similar to bai’ ’inah (a bai’ ’inah, or bai’ al ’inah, is a sale and buy-back agreement), since the only objective of the buyer of the commodity is to obtain cash. They consider that the process makes the client—for reasons of necessity—sell what he has at a loss, and that this renders the transaction a forced sale, which makes the whole transaction objectionable and sometimes prohibited.

However, the intention of the contracting parties cannot be used as an argument to justify prohibiting tawarruq. In fact, evidence may be found in a hadith (a saying of the Prophet Mohammed) that shows that it is permitted to change the form of a contract from haram to halal while keeping its characteristics unchanged. This particular hadith recounts that a man brought the Prophet Mohammed a good date, a janiib, from Khaybar (good dates are known as janiib, in contrast to jamma’, which are bad). The Prophet asked the man: “Are all dates from Khaybar like this?” The man said: “Oh messenger of Allah, we take a sa’a [measure of dates or barley] of this with two sa’a, and two sa’a with three,” to which the Prophet replied, “Do not do that; sell the bad dates, then use the cash to buy the good ones.” This shows that the sold commodity is a means for this purpose, and that it’s possible to “purify” a contract while keeping its attributes unaffected.

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Further reading

Books:

  • Karim, Shafiel A. The Islamic Moral Economy: A Study of Islamic Money and Financial Instruments. Boca Raton, FL: BrownWalker Press, 2010.
  • Venardos, Angelo M. Current Issues in Islamic Banking and Finance: Resilience and Stability in the Present System. Singapore: World Scientific, 2010.

Reports:

  • Dabu, Ibrahim Fadhil. “Tawarruq, its reality and types.” International Shari'ah Research Academy for Islamic Finance (ISRA). Online at: tinyurl.com/6gwwmc2
  • Kahf, Monzef. “Outlines of a brief framework of tawarruq (cash procurement) and securitization in shariah and Islamic banking.” AAOIFI seminar, Bahrain, February 15, 2004. Online at: tinyurl.com/5tjtq68 [PDF].
  • Mihajat, M. Iman Sastra, and Safri Haliding. “The real tawarruq concept: The product of Islamic bank for liquidity risk management.” Online at: etic.itsr.ir/Admin/Files/maghalat2/78.pdf

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