Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

Chapter 3

Istisna’ and Salam

Concept of Exchange-Based Contract

Istisna’ (Manufacturing Contract)

• Istisna’: A manufacturing contract of a made-to-order
asset based on a deferred delivery basis. It is a transaction
on a commodity before the commodity is produced
• The manufacturer is morally obliged to produce items:
- at the agreed time
- in accordance with specifications (price, quality,
description)
• The price, specification, description and quality of the
commodity to be manufactured should be fixed with the
consent of the parties to the contract
Concept of Exchange-Based Contract

Istisna’ (Manufacturing Contract)

• Avoiding Gharar : The subject matter of Istisna’ must be a
commodity or fungible asset.

• In Istisna’, Gharar is avoided by the subject matter being

defined by a detailed specification.

• The currently non-existing asset is to be built according to

the buyer's specification and to be delivered on a specified
date at a fixed price.
Concept of Exchange-Based Contract

The Suitability of Istisna’

The istisna’ structure is most suited for

• Project finance
• Construction
• Manufacture and design of machinery for specific purposes
• Kuwait Finance House (KFH) uses the Istisna contract for
home financing (properties under construction) and project
financing.
• Qatar Islamic Bank (QIB) signed an Istisna agreement in
late 2010 to finance a major residential complex in the
north of Qatar.
Concept of Exchange-Based Contract
• Payment may be made in a lump sum in advance, or
progressively in accordance with the progress made.

• The delivery schedule and purchase price are agreed at the

outset and take into account aspects such as material,
labour, profit margin and other project costs.

• Settlement takes place under the Istisna’ on delivery of the

completed goods - equipment, plant or project.

• Istisna’ is commonly used as a tool for project finance or

pre-export finance, where the bank acts as an intermediary
between the producer (construction firm or manufacturer)
and the ultimate customer.
Concept of Exchange-Based Contract

• Parallel Istisna’ is usually applied because either the bank

is unable to manufacture the assets or unwilling to hold
them after completion.

• The bank enters into two mutually independent Istisna’

contracts with the same product specifications.
• The difference in price between the two contracts is the
spread or margin earned by the bank.
• Neither contract is dependent on the other in a direct
manner. according to specifi
• If the manufacturer fails to deliver cation, then the bank is
at risk of defaulting
5 – Parallel or Back-to-Back Istisna’

4 – Ownership
tranfer

Bank Client

2 – 2nd Istisna’
Contract. Value
120M Euros

3- 1 – 1st
Ownership Istisna’
transfer
Contract.
Value 100 M
Euros
l l el
ara
P n a ’
i s
Manufacturer
Ist

7
 Concept of Exchange-Based Contract

In order for the istisna' to be valid:

• The price must be fixed from the outset (predetermined).
• In the event of any unforeseen event that causes a delay in
delivery the price of istisna' can be amended, if it is
mutually agreed. (they can negotiate discount)
• After the manufacturer has started the work, the contract
cannot be cancelled unilaterally. (Istisna is not binding
contract)
 Concept of Exchange-Based Contract

Delivery and disposal of the subject matter

• Before delivery of the asset to the purchaser, it will remain

at the risk of the seller
• After delivery, risk will be transferred to the purchaser
• If manufactured goods are delivered before agreed date,
purchaser can refuse to accept the goods
• If the condition of the subject matter does not
conform to the contractual specifications at the date
of delivery, the ultimate purchaser has the right to
reject the subject matter or to accept it in its present
condition
 Concept of Exchange-Based Contract

Istisna’ Risk Mitigation

Risk Description Mitigation

Delay in delivery of goods from the

Delivery Risk .Link pricing of the istisna' to delivery
.producer to the customer at maturity

The producer is either unable or is

Non-Performance unwilling to manufacture the goods during .The price can be paid in installments
.assigned time

The producer delivers defected/inferior

Quality assurance agreement, with
Quality Risk goods, which is realized by the customer
.producer to rectify defects
.only at the time of delivery

Cost incurred by the producer turns out to

Producer to handle increase in costs,
Increased costs of Production be higher than anticipated, which causes
.unless it is due to an unforeseen event
.the producer to default on performance

In the case of parallel istisna’, the goods

once delivered by the producer will be at
Storage Risk .Insurance / Takaful
the bank's risk before being sold to the
.customer
Concept of Exchange-Based Contract

Salam or Bay Al-Salam (Forward Sale) (Salaf)

• A forward sale contract where advance payment is made for

goods to be delivered later

- does not require the commodity to exist at the time of

concluding the contract
- the delivery of the commodity is deferred

• Facilitates the commercial activities of farmers before crops

are harvested - farmers get paid in advance before a
harvest
Concept of Exchange-Based Contract

Salam (Forward Sale)

There are 10 conditions for the validity of a Salam contract as
generally agreed upon by Muslim jurists:
1. It is not necessary that the goods sold exist at the time of
conducting the contract
2. The purchase price must be paid in full by the buyer at the
time of conducting the contract
3. The exact delivery date and location should be specified in
the contract (no Imbiguity regarding the date or the
specification)
4. The actual specifications of the goods including the quality,
size, and description must be specified and agreed upon in
the contract (Full specification should be determined).
Concept of Exchange-Based Contract

Salam (Forward Sale)

5. The quality of the goods must be agreed upon in absolute
terms
6. The right to demand surety from the seller is vested in the
buyer in order to guarantee delivery of the goods
7. Ownership of the goods can only be exercised by the buyer
upon receipt of the goods
8. The buyer may nullify the contract if the seller is unable to
deliver the goods on the delivery date
9. Delivery of the goods must be made practically regardless
of the buyer’s circumstances on the delivery date
10. The contract cannot be concluded on goods than can be
delivered on the spot
Concept of Exchange-Based Contract

Salam (Forward Sale)

• The most famous hadith in this context is the one in which

the Holy Prophet ‫ ﷺ‬has said:
 
”‫ ﻭﻭﺯﻥ ﻣﻌﻠﻮﻡ ﺇﱃ ﺃﺟﻞ ﻣﻌﻠﻮﻡ‬، ‫“ﻣﻦ ﺃﺳﻠﻒ ﰲ ﺷﻲﺀ ﻓﻠﻴﺴﻠﻒ ﰲ ﻛﻴﻞ ﻣﻌﻠﻮﻡ‬
“Whoever wishes to enter into a contract of salam, he must
effect the salam according to the specified measure and the
specified weight and the specified date of delivery.”
Concept of Exchange-Based Contract

Salam (Forward Sale) Example:

• The « Pay Now Islamic Bank - PNIB » enters a Salam sale

contract with The « Deliver Later Company - DLC» under
which PNIB (as purchaser) agrees to buy 1000 copper
ingots from DLC, the manufacturer (seller), which agrees to
deliver them in two months at a price of US$50 each.

• PNIB pays US$50,000 to DLC today.

• The spot price today is US$51.

Concept of Exchange-Based Contract

Salam (Forward Sale) Example:

• After two months, when PNIB is due to take delivery of the
ingots, it has the choice of:
1. Taking delivery of the ingots and selling them for cash or
on credit; or

2. Authorising DLC to sell the ingots on its behalf, with or

without PNIB paying DLC a fee for doing this; or

3. Instructing DLC to deliver the ingots to a third party buyer

(parallel salam).