Islamic trade Finance

Financing resources are basic necessities for firms to sustain and further diversify their business
activities. These financial resources come in the form of various financial instruments, having their
foundation based on both the conventional and Islamic principles. While the conventional financing -
instruments are based on the current market interest rate, the Islamic financing instruments are
interest-free. There are two modes of Islamic financing instruments, namely; (i) debt-creating such as
Salam, Istisna', Murabahah and Kafalah, and (ii) non-debt creating such as Mudarabah and
Musyarakah. The interest in Islamic financing instruments had grown significantly and their features
have not only captured the interest of the Muslim but also of non-Muslims. This paper will highlight
the economics of these financing.

The two modes of financing that have been used to finance business both domestic and
International are debt-creating and non-debt creating modes

What are the Major modes of Islamic banking and finance?

Ans. Following are the main modes of Islamic banking and finance:

MURABAHA
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the
seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a
financing technique, it involves a request by the client to the bank to purchase certain goods for him.
The bank does that for a definite profit over the cost, which is stipulated in advance.

IJARAH
Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or
consideration for the service or return for the benefit proposed to be taken, or for the effort or work
proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a
consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons.

IJARAH-WAL-IQTINA
A contract under which an Islamic bank provides equipment, building or other assets to the client
against an agreed rental together with a unilateral undertaking by the bank or the client that at the end
of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or
the promise does not become an integral part of the lease contract to make it conditional. The rentals
as well as the purchase price are fixed in such manner that the bank gets back its principal sum
alongwith with profit over the period of lease.

MUSAWAMAH
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is
bargained between seller and the buyer without any reference to the price paid or cost incurred by the
former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in
Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other
conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the
seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.

ISTISNA A
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in
advance and future delivery or a future payment and future delivery. Istisna’a can be used for
providing the facility of financing the manufacture or construction of houses, plants, projects and
building of bridges, roads and highways.
BAI MUAJJAL

Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks that
takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin on his
purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum
or in installments. It has to expressly mention cost of the commodity and the margin of profit is
mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot
price or higher or lower than the spot price.

MUDARABAH
A form of partnership where one party provides the funds while the other provides expertise and
management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two
parties on a pre-agreed basis, while loss is borne only by the provider of the capital.

MUSHARAKAH
Musharakah means a relationship established under a contract by the mutual consent of the parties for
sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank
provides funds, which are mixed with the funds of the business enterprise and others. All providers of
capital are entitled to participate in management, but not necessarily required to do so. The profit is
distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in
proportion to respective capital contributions.
BAI SALAM

Salam means a contract in which advance payment is made for goods to be delivered later on. The
seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance
price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be
purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods
and cannot be gold, silver or currencies. Barring this, Bai?Salam covers almost everything, which is
capable of being definitely described as to quantity, quality and workmanship.

International Trade: Exports and Imports

The most critical feature of international trade is lack of geographical proximity between trading
partners.' This gives rise to a time lag between the confirmation of an order and the delivery of goods.
Thus there is the problem of either the seller accepting a delay in payment or the buyer conceding
advance payment for future delivery. In other words, for all practical purposes, die basic transaction in
international trade is not an ordinary hand-to-hand trading deal but a forward transaction: either bai’
mu'ajjal or bai’ salam. Another label for the latter is bai’ istisna . These may be viewed as the primary
transactions between exporters and importers. In principle, both have Sharfah sanction.
But three factors complicate matters in international trade. First, risks of nonpayment for exporters and
nondelivery of goods for importers due to a lack of personal contact between the trading partners
during all stages of a transaction. Second, separate legal systems. Third, separate currencies. These
factors give rise to economically meaningful roles for other parties in the process of international
trade. The role of banks lies somewhere between collection of funds on behalf of exporters and
financing foreign trade operations.
The foreign trade process is governed by sales contracts between exporters and importers. Among
other things, a sales contract specifics complete description of goods, the price of merchandise, the
currency of payment and the payment terms — cash, draft, letter of credit and so on. The ownership of
goods is controlled through the bill of lading for merchandise, issued by a freight company to the
exporter. In a straight or non-ncgotiable bill of lading the merchandise is shipped directly in favour of
thethe importer. In the case of an order or negotiable bill of lading, the ownership of goods is
transferable to another party through proper endorsement. Except in case of cash in advance, payment
is made by way of a draft or bill of exchange.
A draft is unconditional written demand of the exporter (seller) for payment by which he charges the
importer (buyer). A draft is drawn either on the buyer himself or on the bank who assumes the legal
obligation to pay under a letter of credit (L/C) arrangement. The tenor (maturity date) of a draft
indicates when the payment is due. A draft payable upon presentation is a sight draft with tenor simply
“at sight.’’ A draft payable on a specified or a determinable date is a time draft or usance bill. The
period of time drafts usually depends on the time necessary for goods to reach their destination, be
resold and the proceeds becoming available to importers to clear their obligations. The tenor of a time
draft is stated as follows:

 June 30, 1992

o Payment is to be made on June 30, 1992 — a fixed date.
 At 60 days sight+

o Payment is to be made after 60 days of presentation of the draft to the drawee (who
may be buyer himself or his bank under an L/C).
 30 days date
o Payment is to be made 30 days from the date of the draft.

Release of title documents to merchandise follows only after the payment of a sight draft or
acceptance of a time draft. Thus the seller and/or his bank retains the control of goods until the buyer
cither pays or acknowledges the obligation to pay. An acceptance is created when the drawee (the
importer or his bank in the ease of an L/C arrangement) writes “accepted,” the date and his signature
on the face of a time draft.
Drafts are negotiable instruments if they are made payable to order or to bearer. That is, they can be
sold and the collection rights transferred, without any limit on the frequency of such transfers, by
endorsement to another party termed the holder in due course. Whoever owns the draft at the maturity
date presents it to the drawer (importer or his banker) for payment. If the drawer defaults on his
payment obligation, the holder in due course has recourse through all previous endorsers in turn back
to the drawer (seller) of the draft. The drawer has unconditional obligation to honour such a draft.
Draft plays the key role in allocating risks between the exporter and importer when the importer docs
not want to pay in advance and/or the exporter has doubts about payment. In this regard, two
arrangements with draft at the centre are documentary collection and letter of credit.
A documentary collection transaction works as follows: the exporter ships his goods and submits the
draft along with the title documents for the merchandise to his bank. The exporter’s bank may either
directly or through an intermediary bank approach the importer. If it is a D/P (documents against
payment) draft, the bank gets the payment, in return for the documents, from the importer and passes it
on to the exporter. In ease of a D/A (documents against acceptance) transaction, the importer writes
“accepted” and the date and signs across the face of the draft, thereby creating a trade acceptance. In
this way, the exporter is assured about payment. The transaction closes only after the importer has
discharged his obligation. However, the accepted draft becomes a negotiable bill of exchange. In a
documentary collection, each intermediary bank claims fee for its services.
An L/C is a written undertaking issued by a bank at the request of an importer (buyer). According to it,
the bank assumes the legal obligation to fulfil the importer’s payment commitment — within a
prescribed timeframe — upon presentation of documents in line with the terms of the L/C. For all
practical purposes, the L/C becomes a contract between the issuing bank and the exporter (seller or
beneficiary). The bank is obliged to pay to the beneficiary if the latter fulfils all terms and conditions
stated in the L/C. The bank’s obligation to pay under an L/C is at the discretion of the seller or
beneficiary unless a revocable L/C is issued. The tenor of draft submitted to the bank corresponds to
credit terms in the sales contract between the trading parties. Thus, it can be a sight draft or a usance
bill.
The role of a bank under an L/C entails some commitments as well as some risks. Normally an
importer is not required to deposit 100 percent of the L/C value with application. Thus, the bank
practically becomes a creditor to the importer from the time of payment until its reimbursement by the
latter. This exposes the bank to commercial credit risk of the importer. Sometimes the issuing bank
may have the bill of lading consigned to itself. In this ease, the bank will be the owner of merchandise
up to the time when the documents are transferred to the importer. If the importer (applicant) finds
even a minute discrepancy, he can reject the documents and deny the bank reimbursement. The
currencies in the importing and exporting countries can be different. This will lead to foreign exchange
risk for the bank.
In practice, the L/C process has several roles for intermediary banks at the exporter’s end. These
include advising the exporter on fulfilment of L/C formality by the importer, confirming an L/C,
negotiating the bill of exchange with the exporter and bankers’ acceptance for exporters. Of course,
the number of steps before the final settlement of a transaction increases in each case and so too the
costs to parties seeking credit and/or reduction in risk.
In the case of confirmation, the confirming bank assumes the responsibility for reviewing the
documents and the obligation of cashing the exporter’s draft. The confirming bank claims a payment
commission — usually a percentage of the face value of the L/C for the duration of the confirmation
— in addition to commissions for any other services.
In the negotiation ease, the intermediary bank purchases the draft and documents from the exporter,
transmits them to the issuing bank and waits for reimbursement from that bank. The right to be
reimbursed by the bank issuing L/C is transferred to the negotiating bank. Negotiation may be with a
re- course, i.e. if the issuing bank fails to reimburse the negotiating bank for any reason, the latter can
recover the funds from the exporter. Normally the negotiating bank buys the draft at a discount from
the face value; the net amount is paid to the exporter. The negotiating bank may have a right to sell the
draft and documents in the open market with the exporter’s agreement. As per the existing practices,
the negotiating bank claims from the beneficiary negotiation fees, charges for a foreign exchange
spread and interest for the period of time its funds are committed.
In the case of a bankers’ acceptance (BA), the bank establishes an acceptance facility and line of credit
for the exporter before it accepts the draft. The bank discounts the draft presented by the exporter, i.e.
it pays the exporter a sum less than the face value of the draft and creates the BA by stamping
“accepted” on the face of the draft. The significance of BA is that it may be created in lieu of a time
letter of credit or independently of it. In the second case, BA is similar to an export credit. BAs have a
secondary market with the accepting banks, dealers and investors (individuals, commercial banks and
central banks) as the players.
This completes our review of major transactions in lieu of exports and imports. In order to appreciate
the picture from the riba angle and to identify probable solutions, it is important to understand the
goals of various parties, their roles and risks faced by them in the transaction process. For the sake of
simplicity, we assume all contracts to be carefully drafted and implemented and no foreign exchange
or other controls in international trade. The key players in international trade are importer, exporter,
the importer’s bank and the exporter’s bank. Their goals, roles and anticipated risks are summarised as
follows:
The importer wants to serve a target market on profitable terms. He may face no shortage of funds. Or,
he may be short of funds but hopes to meet his payment obligations cither as they become due or some
time after he receives the goods and sells them. The importer also faces risks of no shipment of goods,
damage during transit and foreign-exchange rate fluctuations.
The exporter has a profitable proposition in the form of a confirmed or expected order from a foreign
importer. He may have all necessary funds. Or, he may be short of funds but hopes to pay back the
acquired funds according to the tenor of draft. He also faces the risks of goods not reaching their
destination, the importer delaying (even refusing) payment and foreign exchange rate fluctuations.
The importer’s bank provides simple funds transfer services and payment guarantees in the form of
L/Cs. Its role may be direct or may involve an intermediary bank. While paying under an L/C, it
effectively becomes a financier for the importer until the funds are reimbursed. It may even choose to
directly finance the entire import operation. It also faces the commercial credit risk of the importer and
the risk associated with foreign exchange rate fluctuations.
The exporter’s bank acts as intermediary between the exporter and the importer or the L/C issuing
bank. It can help in cashing the cheque in simple funds transfer as well as act as agent of the exporter
in documentary collection or payment under L/C. It can confirm the L/C and assume payment
obligations according to the tenor of the draft. It may negotiate the collection rights and
responsibilities for the bill of exchange with the exporter at a discount. In case of either confirming
L/C or negotiating bill of exchange, the bank becomes a financier until the draft matures. A similar
role is performed by creating bankers’ acceptance or providing loan to exporter against a confirmed
(or expected) order. The risks faced by the exporter’s bank depend on the degree of its involvement.
There may be only commercial credit risk of the importer’s bank in case of L/C confirmation. This
risk will be compounded by the exporter’s credit risk in the case of negotiating the draft or creating
bankers' acceptance. Direct lending to the exporter also entails the latter’s commercial credit risk. The
risk of foreign exchange-rate fluctuations may also be relevant if the bank’s fund commitment
involves currency conversion.
Wc can now proceed lo a formal analysis of the existing trade-related transactions from the riba angle.
In the context of a sales contract, an export-import transaction involves many contracts among the four
parties listed above as well as some others, such as shipping and insurance companies. Ultimate aims
behind these contracts are mostly legitimate. Sometimes modalities for the goals may be questionable.
But if one docs not lose sight of the goals, riba-free alternatives in such cases too become transparent.
Whereas our principal concern is with riba, in passing wc also touch upon some other questionable
aspects of the existing international transactions. One such example is as follows:
An exporter can safely carry his merchandise to the importer’s doorstep or contract shipping and safe
delivery with another party for a lump sum freight and insurance payment. In this regard, there is no
Shar'ie problem with the exporter signing a single shipping plus insurance contract with one party and
letting it subcontract the insurance part to a third party. But the exporter’s entering into separate
contracts with shipping and insurance companies needs some rethinking. See, when the same company
provides transportation as well as safety services, safety is provided in lieu of transportation. But if the
contracts for both purposes were independent, what would be the basis for the insurance company’s
contract with the exporter? Will it not be selling something which primarily does not exist from its
standpoint? As per the well-known Ahadith of 'Hakeem bin 'Hizam, such sales have been forbidden by
the Prophet (pbuh). Anyhow, this is not a riba issue. Riba arises mostly in financial matters.
Accordingly, we focus on the financial aspects of exports and imports and, in particular, the role of
banks.
The banks provide communication channels and payments avenues for exporters and importers. Both
the funds transfer and funds collection are legitimate functions whose expenses are claimable. The
transfer costs to importers are over and above the sum transferred. This is understandable. The
collection costs to exporters represent a slightly different case. These costs may be either paid by an
exporter separately from the sum involved or treated as a discount on the face value of the bill of
exchange. Moreover, the rights to payment for a bill of exchange can be transferred. Therefore, for all
practical purposes usance bills can be treated as tradable instruments. What is wrong then? Nothing.
The problem arises when banks’ role goes beyond collection and transfer of funds to financing of
export-import operations.
At present, banks can directly opt for interest-based loan contracts with trustworthy exporters and
importers to facilitate their operations. Practically, payments against approved L/Cs are loans against
importers until they reimburse the banks. The same applies to payments by banks confirming L/Cs
until the funds are recovered from banks issuing L/Cs. When negotiating banks buy drafts from
exporters, they in fact purchase titles to merchandise and collection rights. Technically speaking, no
loaning is involved here. This is also true for bankers’ acceptance created in lieu of an L/C. However,
a bankers, acceptance created without an L/C represents a complex case. One has to concede cither
that the bank is creating a loan or that it is buying something on paper only but with a high probability
of materialising. This latter feature makes the transaction dubious on grounds of trading something
nonexistent, while the loan aspect warrants caution against riba.
The case of riba in interest-based lending is clear. But in other instances, too, there are two important
factors contributing to the problem of riba. First, once banks commit their funds, the next transaction
along the line becomes a direct moncy-to-money exchange and any discrepancy makes the deal a
ribawi transaction. Secondly, the way in which costs are appraised and defined in existing transactions
also abet riba. The interest clauses in all standard bills of exchange reflect on the timing factor in
payments — opportunity cost of tied funds. The rate of interest also provides cover for creditors
against delays in repayment. Moreover, interest rates also embody premiums for commercial credit
risks of debtors as well as risks of exchange-rate fluctuations. Let us now consider riba- cleansing of
the existing transactions.
How Islamic finance instruments can be used in international trade?
Islamic Murabaha is used in cross-border trade, it has become one of the most commonly used
forms of Islamic financing. In Murabaha, the bank buys the assets at the request of the client and then
the asset is sold to the client at the purchase price along with the negotiated profit on a deferred
payment basis.

What is import Murabaha?

Import Murabaha is a product, used to finance a commercial transaction which consists of purchase by
the Bank (generally through an undisclosed agent) the goods from the foreign supplier and selling
them to the customer after getting the title to and possession of the goods.