If you need liquidity in conventional banking, you can get an interest – based loan. You can get it from a bank but you can also get it from the so called shark lending companies, where the interest on the loan can be higher than the loan itself. In Islamic finance though, if you need liquidity you may benefit from the use of tawarruq.
The idea of tawarruq involves the participation of three parties: a seller, Mutawarriq and a third party. The Mutawarriq needs cash; in order to obtain cash, that person approaches a bank (or another financial institution) to receive financing for a commodity. After the bank grants financing, the Mutawarriq buys the commodity and then sells it to a third party. The Mutawarriq gets cash from the third party for the commodity and hence achieves the main purpose of the transaction – that is liquidity. The commodity in Tawarruq can be any object as long as it is Shari’ah-compliant. Therefore, in the use of Tawarruq in the financial market, one can see shares or stock being traded for that very purpose. What has to be emphasized here is that the securities being traded in Tawarruq should only include those companies that are not involved in any form of activity considered haram.
Tawarruq also known as reverse or commodity murabaha has been widely discussed by Shari’ah scholars. The majority of them regard Tawarruq as permissible, nevertheless, only in special and justified circumstances. It is argued that Tawarruq as such should not be practiced on a large scale as it would undermine the very idea of Islamic finance. Only if the banks (or other entities) have no other legitimate (from a Shari’ah point of view) means to obtain liquidity, then they can apply Tawarruq. Tawaruq as such usually creates debt either on the bank side or on the side of an entity if it acts as a Mutawarriq. That means that the Mutawarriq ends up with cash and a debt owed to the lender. However, as I said previously, the usage of Tawwaruq should be justified by extraordinary needs. Furthermore, Tawarruq as such should not be available for consumers and non-Islamic financial institutions.
In respect to consumers, one can claim that such approach can be seen as a discriminatory one. Why provide such form of liquidity only in the B2B form (or M2M) and not for consumers? The consumers who are in need of liquidity (cash basically) can benefit from Quard al Hasan (loan). Quard al Hasan does not require entering into many contracts and does not involve the multiplied transfer of possession of commodity in order to be valid. Moreover, in case of the European market, the financial market for consumers is subjected to EU regulations. The EU Directives on consumers ‘ credit and financial services (the so – called PSD/Payment Services Directive) provide for a wide protection of consumers when using financial services (especially in terms of loans). If an Islamic bank that operates in the EU decided to offer Tawarruq to consumers (at the same time acting against Shari’ah scholars’ opinion), it could turn out that it would not be permitted under the EU regulations. The Islamic banks that wish to enhance their position on the EU market should be more than aware of that issue.
In case of non-Islamic banks, the use of Tawarruq is not permissible. Generally, Islamic transactions are reserved for Islamic banks and Islamic financial institutions only. However, certain non-Islamic banks (for instance, HSBC) offer some Islamic products within their Islamic windows. If such Islamic products are to be Shari’ah-compliant, the capital of the bank should not be mixed with the one used only for the purpose of providing Islamic products.
As mentioned above, Tawarruq involves the participation of three parties. That means that usually three to four separate contracts have to be entered into. First, the Mutawarriq enters into a financing contract with a bank, on the grounds of which funds are received to purchase the commodity. Then the Mutawarriq buys the commodity and enters into a contract with a seller of commodity. Finally, in order to obtain liquidity, the Mutawarriq enters into a contract with a buyer of the commodity, and sells him the commodity. One must not forget that these contracts should be totally independent from each other. Otherwise, we will have safqatan fi safqatin (the existence of more than one contract in one contract) and that would invalidate the whole transaction.
Tawarruq can be used by Islamic banks and by other entities that need liquidity. Banks may apply Tawarruq in a securitization transaction (with the help of sukuk), where the claims are transferred as assets into a separate entity that will serve as Mutawarriq. The entity which is usually a special purpose vehicle (‘SPV’) issues bonds or other securities that are claims-based. The buyers of the securities provide the SPV with the sought after liquidity (money). At the same time the buyers are entitled to demand from the bank or SPV to repurchase the securities at a higher price than they paid for them. The buyers (depending on the contracts) can freely trade their securities in order to receive profits.
Such a transaction is a transparent one from the Shari’ah compliance point of view. First, the claims are grouped, and then a SPV is being established (its form depends on the legal framework available in a given jurisdiction). The claims are transferred to the SPV which issues securities that are backed by these claims. The issue may be addressed to a closed group of buyers or may refer to anyone willing to invest the money. In the aforesaid transaction, Tawwaruq will be based on mudarabah (SPV) or musharakah (SPV) and sukuk (emitting securities). However, the purpose of the whole transaction will be to obtain liquidity. In term of costs, it is difficult to assess which Tawarruq will be more expensive or time consuming. In case of ordinary Tawarruq, there will be contracts of sale – purchase and probably a murabaha contract (financing to purchase the commodity) involved. The only costs to be borne by the Mutawarriq will be the bank’s fees and the difference in the price that the Mutawarriq owes to the bank (Mutawarriq’s debt). However, the transaction can be deemed as not fully Shari’ah compliant and not transparent enough, especially if it involves a Mutawarriq to act as a banks’ agent (see below).
In respect of a Tawarruq based on securitization, such construction is mainly applied by banks and other big entities that can afford to cover the expenditures. And these include the legal fees (costs of establishing the SPV, drafting Memoranda of Association, preparing public or private offering memorandum and likewise) and the cost of maintaining the structure and its servicing. But, if we compare the transparence of both types of transaction, one can argue that the one based on securitization is a more transparent one, even if only in legal terms. One cannot forget, though, that in standard Tawarruq, the Mutawwariq can buy the commodity from the bank (or other entity ) and then sell it back. As a rule, it is not permissible for Tawarruq to act as a bank’s agent and buy the commodity on the bank’s behalf and then sell it to himself. Such transaction would not be regarded as Tawarruq (it could be seen as prohibited Bay al Inah) and would be void by the virtue of Shari’ah. Furthermore, it would question the element of good faith necessary to enter into a binding contract. One can argue of course that such strict approach to Tawarruq is an old fashioned one and should not take place in a contemporary economy. However, the issue of sadd al dhara’I should be taken into account while ruminating over the vision of Tawarruq.
First of all, any Islamic transaction should serve the general purpose of being Shari’ah-compliant, beneficial for general good and for the participants of the transaction. Secondly, the transaction has to be halal, otherwise there would be no purpose to call any transaction an Islamic one if the rules of Shari’ah are not to be observed. The third thing is that no one should attempt to legitimize the illegitimate results of a transaction. Therefore, if under Islamic finance, the use of Tawarruq is permitted solely in special circumstances, it should be applied only in such situations.
If Islamic institutions start to bend the rules in order to be more flexible and more competitive in comparison with conventional banks, we will have to ask the following questions: Will these be still Islamic banks? Will these be still Islamic finance transactions?
Modern banks have to compete all the time for the attention and money of the clients. It includes product proliferation and the constant monitoring of the market. In case of Islamic banks, the most crucial factor is their reputation and being Shari’ah-compliant, especially in terms of better and more considerate risk management. Tawarruq is often regarded as a transaction that involves increased systemic risk and as such should not be widely practiced. Such approach is fully compliant with the approach of the EU regulators. At the beginning of 2011, the European Systemic Risk Board was created in order to carefully monitor the systemic risk and apply measures to prevent and combat it. Therefore, one can see that Islamic finance benefits from the perhaps outdated but prudent approach, even if it involves the Islamic transaction like Tawarruq.
About the author
Beata Paxford, Phd, is a Polish attorney at law. She is Assistant Professor at the Chair of Commercial Law in Kozminski University in Poland. Her PhD dissertation covered the issue of Islamic finance.