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Featured Structure: Tawarruq: Shariah Risk or Banking Conundrum? Nikan Firoozye, Ph.D.

Friday, July 03, 2009

Tawarruq : Shariah Risk or Banking Conundrum

By Nikan Firoozye, PhD

The landmark ruling (See reference link) by the OIC (Organization of Islamic Countries) Fiqh Council in April 2009, declaring Organized Tawarruq as non-compliant was long in the coming. The impact is immense as Tawarruq is one of the most used Islamic Financing methods available. But in spite of the repeated warnings, the Industry was far from prepared for one of the largest Shariah Risk events of a generation. Perhaps due to the extent of its entrenchment disagreements have moved from behind closed doors to the open public (rather than a clean and orderly exit from this method of finance). One might say that the Industry is in disarray, unsure about how this shall ultimately be resolved.

Tawarruq is a hugely popular financing method, and is probably the most used single liquidity providing scheme other than Malaysian BBA (Bai' Bil thaman Ajil--a form of agency based deferred payment) and Bai' al Inah (discussed in more depth below, both considered haram or impermissible outside Malaysia). Tawarruq is used in virtually every country which practices Islamic Finance. It is the basis of many credit card transactions (primarily in the GCC) and Bursa Malaysia was further developing a Tawarruq platform to launch later this year. It is used in covered drawings, in top-up facilities, in mezzanine financing, in liquidity management and in working capital finance (among other things). There is even a "Tawarruq Deal of the Year Award”. Although transaction volume is nearly impossible to gauge, the fact that banks and legal firms will proudly broadcast having arranged multi-billion dollar facilities on their clients' behalf allows us to safely claim that many billions of dollars worth of notional are changing hands.

What is Tawarruq?

Tawarruq is a financing scheme that has been used from the time of classical Islamic Jurisprudence. While it may be considered a hiyal (legal strategem or ruse to circumvent Islam's most basic prohibition on riba) the combination of purely legal strategies as a means of arranging financing was sufficient to legitimize it (under very specific circumstances according to the majority of jurists). In Islamic Finance, most transactions must have some direct involvement with the real economy. The Murabaha, a classical trade finance method, is an announced markup contract, where a trade company will sell an item or commodity to its customer at the spot price (known to all) plus a markup with delivery taking place at spot (i.e., T+0 or whatever standard spot delivery convention holds). Payment can take place at spot or, as is more common, in the future through staggered or single lump-sum payments.

In order to raise funds for a client, a bank buys a commodity at spot, sells it to a customer through delayed payment sale, and this customer in turn sells the commodity back to the market spot to raise cash. The end-result is that the bank has loaned money to the company and the commodities were merely the method by which it happened. The majority of scholars of classical fiqh would allow this, partly because the Fiqh al Mu'alamalat, the Islamic Jurisprudence of worldly endeavors, does not forbid transactions based on intangibles such as (potentially improper) intentions. Moreover, there is an element of market risk which each party is subject to and this serves as a justification of the individual legs of the trade, each of which is a valid sale transaction. An Illustration of classical Tawarruq is shown in the adjoining graph.

Source: Mohammad Amin's Islamic Finance Blog, PWC (See reference link)

In fact, although many would claim discomfort in using Tawarruq, in its classic form it is endorsed by an overwhelming majority of Fuquha (pl of faqih, or Islamic Jurisprudent) of all the major schools of Islamic Law, (see Wahbah al-Zuhaili for more detail on scholarly approval/rejection). Moreover, its supporters can trace it back at least to 'Ali Bin Abu Taleb (may Allah be Pleased with him) , the fourth Caliph (and first Shiah Imam) and the Prophet's (peace be upon him) son-in-law, as saying that “I would not abandon the Haj even if I had to do it through the Tawarruq.” The Prophet's (pbuh) wife, 'Aishah (mAbpwh), is quoted as having said something in the same vein.

AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions), one of the primary international organizations that has taken upon itself to set globally acceptable Islamic Finance standards, has a Shariah Standard for Tawarruq (Standard no 30). For the most part, scholars have made efforts to distinguish it from Bai' al Inah (which basically involves the bank's Murabaha or markup deferred payment sale to the customer and the bank's subsequent spot repurchase from the same customer as a way of effecting a loan, and is considered forbidden outside of Malaysia). And it is this distinction that drives the careful specifications of Tawarruq transactions. Each leg of the transaction must be a bona fide sale (i.e., constructive possession takes place and that each sale is outright without conditions of subsequent resale), the bank can in no way buy back the asset from the customer itself ( Bai' al Inah), the customer must be able to take constructive possession prior to resale, and each sale must have no strings attached.

Tawarruq in Practice

Tawarruq in practice has become an institution and - as in many institutional frameworks - has been streamlined and risk-managed. The actual goal of securing finance for a fixed term is emphasized over all else, since classical Tawarruq has too many moving parts and risk managers the world over could complain. The result is that the bank plays the intermediary in all transactions, the client having essentially no ownership (nor interest in actual or legal sense) in the underlying asset. The end result is called Organized Tawarruq.

An Illustration of Organized Tawarruq is in the below graph

The step-by-step approach according to Bank Islamic Malaysia (See reference link): :

i. The customer applies financing product based on Tawarruq concept from the Bank. Bank obtains Tawarruq transaction documents from the customer. ii. Bank will buy the commodity at London Metal Exchange (LME) through Broker 1. iii. Under the Murabahah contract, Bank then sells the commodity to the customer at Bank’s Selling Price (Principle + Profit) on deferred payment term. iv. Under the Wakalah contract, customer requests Bank to sell the commodity in the market. v. Acting as the appointed sale agent for the customer, Bank sells the commodity to Broker 2. vi. Bank then credits the Wariq (proceed) from the sale of commodity to the customer’s account. vii. Finally, customer pays amount due to the Bank (Principal + Profit) by way of agreed instalment method.

This structure of course shows the heart of the matter. The customer takes ownership of the underlying asset only through wakala (an agency agreement) with the bank. The bank buys the asset, sells to the customer on deferred payment (transferring ownership but keeping custody, and perhaps not even transferring constructive possession), then through an agency arrangement, sells the asset on behalf of the customer.

Banks themselves are not generally equipped to take delivery of tons of palladium or gold; rather, they use the services of brokers & custodians. These same custodians can potentially make all necessary changes of title in milliseconds before the price of the underlying can actually change and either the bank or customer might take much in the way of market risk. These custodians are also the subject of some concern among Islamic Scholars. In some circles, commodity custodians/warehousing facilities are considered a bit of a cabal, and in spite of audit, are suspected of never even bothering with reassigning ownership. According to Muhammad Ayub (Introduction to Islamic Finance), if Tawarruq is "carried out through ... exchanges wherein only brokers are doing some agency services and the goods always remain where they were without transfer of ownership from the seller to the buyer, it is vulnerable to violation of Shariah rules one way or another, because a number of conditions of a valid sale may be lacking."

The Criticism

In its 15th session the OIC Fiqh Accademy issued a statement about the permissibility of Tawarruq. But due to problems with specific structures (including placing conditions in each of the sales contracts), the Fiqh Academy later clarified this and specified its concerns with Tawarruq as practiced in their 17th Session, claiming that some forms of agency agreements and underlying procedures (e.g., transference of title) made certain Organized Tawarruq programs non-compliant.

This was merely a shot across the bow of Organized Tawarruq. But many thought the institution itself was rife with transgressions and there were moves underway to ban the practice altogether. As early as 2006, Shaykh Dr Hussein H Hassan, a professor of Fiqh, and a prominent member of many shariah boards including AAOIFI, made statements to Ash-Sharq al Awsat, a Qatari newspaper, claiming that many scholars had reached a consensus that Tawarruq was haram (impermissible). Even this caused raised temperatures. Sh Abdullah Al Manea of the Supreme Council of Ulema in Saudi Arabia, said in a further interview that he hoped Sh Hassan's criticisms were against specific Tawarruq practices, and that if instead his criticism was an unqualified dismissal of Tawarruq then he should 'fear God' knowing that many of the (sukuk) structures he had endorsed were just a ribawi (forbidden riba-based) transaction.

Clearly there were attempts to bridge the gaps and reach an agreement, but progress was made by the anti-Tawarruq camp culminating in their 19th Session April 2009 OIC Council Fatwa (See reference link). This fatwa defines Tawarruq and its types (including banking or Organized Tawarruq and a similar form termed Reverse Tawarruq) and declares that all Organized Tawarruq is impermissible primarily because its basis went against the Maqasid al-Shariah (the underlying philosophy of Islamic Law) to prohibit interest-bearing transactions. So rather than clarify issues and state what steps needed to be taken in order to ensure compliance, the entire practice was ruled non-compliant.

Shariah Risk and Shariah Confusion
Shariah Risk arises when transactions entered by Islamic Financial Institutions (IFIs) are declared impermissible. This could lead to loss of profit (returns must be “cleansed” from forbidden profit sources in order to retain compliance), loss of revenue, impact on reputation, etc. In recent years, Shariah Risk has been of note more recently with various well-regarded Shaykhs openly questioning practices of other IFIs. Recent events include Sh Taqi Usmani's stating that some 85% of all sukuk were non-compliant and subsequent AAOIFI statement clarifying sukuk structures and their validity; the Malaysian High Court Ruling that BBA was not compliant, and the subsequent Malaysian Supreme Court overturning this decision. But Shariah risk is perhaps the least well understood or analyzed risk that Islamic Banks face (on a daily basis).

The recent ruling on Tawarruq is perhaps the most significant Shariah risk event thus far. Tawarruq is firmly embedded in the Islamic Banking system in a great many countries and an undiversified revenue stream for many IFIs. Meanwhile, while all other cases involved questions that could be clarified by broader consensus, or lower court rulings which could be overturned, there are no means of overturning OIC rulings, although they are not binding. Consequently, this ruling could then be seen as one of the largest examples of Shariah Risk in recent history, attempting to nullify billions of dollars of yearly transactions in one fell swoop.

But Organized Tawarruq is an immense undertaking and many IFIs have put years of effort into developing such systems. Consequently even if it falls into some disrepute, it is unlikely to go out of fashion without a fight. In fact, shortly after the ruling, a prominent Malaysian Scholar and member of Bank Negara's Shariah Board, Sh Mohammad Akram Laldin, issued a statement (See reference link) that Organized Tawarruq was indeed Shariah-compliant. Subsequent statements were made by prominent GCC scholars openly challenging the Fiqh Council's ruling (See reference link). Sh Dr Abdul Sattar Abu Ghuddah stated that as each sale is valid, there can be no basis for calling Organized Tawarruq invalid. Sh Mohammad Sa'id Al-Buti of Syria said that modern commerce required intermediation and that Tawarruq essentially enabled intermediation. Sh Nizam Yaqubi expressed dismay that no compromise could be reached. A professor of law has made statements that Fatwas were only opinions and not binding.

Even though many would think that the OIC Fiqh Council's ruling would put the nail into the coffin of Tawarruq, this is only one more element in the confusing array of opinions. Each of these counter-arguments has its merits of course. Many would claim that clarification and monitoring were all that was necessary, that the infringements of individual transactions do not nullify the efforts of all participants. In fact, merely because of its size, Tawarruq will probably remain a mode of Islamic finance, albeit discredited, for some time to come. It is unlikely that it will retain its luster (i.e., we may, possibly, not have a 'Tawarruq of the Year Award' in the future). And clearly, the actual fine print of Shariah rulings is more likely to be adhered to more closely in the future, with Islamic Banks striving to show that their Tawarruq, although an Organized Tawarruq, complies with every detail of the Shariah. Finally, the ruling will likely lead to other alternatives being developed.

Islamic Banks are now faced with a conundrum: Tawarruq and Commodity Murabaha (closely related and viewed by many with similar suspicion and thus likely to see future rulings) are seen as the only legitimate means of doing liquidity operations (outside of Malaysian Bai' al Inah and BBA transactions). Without any viable alternative in the short run, it appears that many Islamic Banks, being banks after all, are going to continue with the status quo. Resolution may be years away.

Further References:

Muhammad Ayub, Understanding Islamic Finance, Wiley Finance, 2007, pp 349-51, 213-39. Reference Link
Salah Shalhoob, Organised Tawarruq in Islamic Law: A Study of Organised Tawarruq as Practised in the Financial Institutions in Saudi Arabia, Organized Tawarruq in Islamic Law, April 2007. See reference link

Mohammad Nejatullah Siddiqi, ECONOMICS OF TAWARRUQ: How its Mafasid overwhelm the Masalih, Workshop on Tawarruq: A Methodological issue in Shar„«`a-Compliant Finance, Feb 1, 2007. See reference link

Wahbah Al-Zuhaili, Tawarruq, Its Essence and Its Types: Mainstream Tawarruq and Organized Tawarruq, ISRA website articles on Tawarruq. See reference link

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