CENTRE OF ISLAMIC

BANKING & ECONOMICS

POST GRADUATE DIPLOMA IN ISLAMIC BANKING & FINANCE

ISLAMIC BANKING AND FINANCIAL PRODUCTS

IB&F: 405: Trade Based Modes of Islamic Banking and Finance
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IB&F: 405
TRADE BASED MODES OF
ISLAMIC BANKING & FINANCE

If You Invest in Islamic Finance Products, You tend not to be sensitive to

developments in interest rates.

Fares Mourad, Credit Suisse

 CONTENTS

Bai 01
Murabaha 09

Salam 14

Istisna 33

Summary 33
Discussion Questions 34

Reference Material 34
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 IB&F: 405: Trade Based Modes of
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BAI (BUYING/SELLING)

'Bai' is defined in Shari'ah as 'the exchange of a thing of value by another

thing of value with mutual consent'. Islamic jurisprudence has laid down
enormous rules governing the contract of sale, and the Muslim jurists have
written a large number of books, in a number of volumes, to elaborate them
in detail.
Some Basic Rules of Bai
What is meant here is to give a summary of only those rules which are more
relevant to the transactions of Murabaha as carried out by the financial
institutions:
The subject of sale must be existing at the time of sale:
Thus, a thing which has not yet come into existence cannot be sold but if a
non-existent thing has been sold, though by mutual consent, the sale is void
according to Shari'ah.
Example: A sells the unborn calf of his cow to B. The sale is void.
The subject of sale must be in the ownership of the seller at the time of
sale:
Thus, what is not owned by the seller cannot be sold. If he sells something
before acquiring its ownership, the sale is void.
Example:
A sells to B a car which is presently owned by C, but A is hopeful that he
will buy it from C and shall deliver it to B subsequently. The sale is
void, because the car was not owned by A at the time of sale.

Glossary:

Bai: The exchange of a thing of value by another thing of value with mutual consent
is termed as Bai (Sale).

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The subject of sale must be in the physical or constructive possession of

the seller when he sells it to another person:
"Constructive possession" means a situation where the possessor has not
taken the physical delivery of the commodity, yet the commodity has come
into his control, and all the rights and liabilities of the commodity are passed
on to him, including the risk of its destruction.
Examples:
TIP

A has purchased a car from B. B has not yet delivered it to A or to his

There is a big
agent. A cannot sell the car to C. If he sells it before taking its delivery
difference between
from B, the sale is void.
an actual sale and a
A has purchased a car from B. B, after identifying the Car has placed it mere promise to
in a garage to which A has free access and B has allowed him to take sell.
the delivery from that place whenever he wishes. Thus the risk of the
Car has passed on to A. The car is in the constructive possession of A.
If A sells the car to C without acquiring physical possession, the sale is
valid.
Explanation 1:
The gist of the rules mentioned in paragraphs 1 to 3 is that a person cannot
sell a commodity unless:
It has come into existence.
It is owned by the seller.
It is in the physical or constructive possession of the seller.
Explanation 2:
There is a big difference between an actual sale and a mere promise to sell.
The actual sale cannot be effected unless the above three conditions are
fulfilled. However one can promise to sell something which is not yet owned
or possessed by him. This promise initially creates only a moral obligation on
the promisor to fulfill his promise, which is normally not justifiable.
Nevertheless, in certain situations, especially where such promise has
burdened the promise with some liability, it can be enforceable through the
courts of law. In such cases the court may force

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the promisor to fulfill his promise, i.e. to effect the sale, and if he fails to do
so, the court may order him to pay the promise the actual damages he has
incurred due to the default of the promisor.

Keep In Mind

The actual sale cannot be affected unless these three conditions are fulfilled:
first, it has come into existence. It is owned by the seller and it is in the
physical or constructive possession of the seller.

But the actual sale will have to be effected after the commodity comes into
the possession of the seller. This will require separate offer and acceptance,
and unless the sale is affected in this manner, the legal consequences of the
sale shall not follow.
Exception:
TIP

The rules mentioned in paragraphs 1 to 3 are relaxed with respect to two Thus a sale
types of sale, namely: attributed to a
Bai' Salam future date or a sale
contingent on a
Istisna'
future event is void.
The rules of these two types will be discussed later in a separate chapter.
The sale must be instant and absolute:
Thus a sale attributed to a future date or a sale contingent on a future event
is void. If the parties wish to affect a valid sale, they will have to affect it
afresh when the future date comes or the contingency actually occurs.

Glossary:

Istisna: Istisna' is a contract to build, manufacture, construct or develop the object

of sale at a definite price, over a defined period of time, according to agreed
specifications between the parties.

Salam: Salam refers to the purchase of a commodity for deferred delivery in

exchange for immediate payment.

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Examples:
A says to B on the first of January: "I sell my car to you on the first of
February". The sale is void, because it is attributed to a future date.
A says to B, "If party X wins the elections, my car stands sold to you".
The sale is void, because it is contingent on a future event.
The subject of sale must be a property of value:
Thus, a thing having no value according to the usage of trade cannot be sold
or purchased.
The subject of sale should not be a thing which is used for a Haram
purpose:
The subject of sale should not be for a thing which is used for Haram purpose
like pork, wine etc. TIP

The subject of sale must be specifically known and identified to the buyer: The subject of sale
The subject of sale or a commodity for which sale is being conducted must should not be for a
thing which is used
be in the knowledge of the buyer. All the specifications must be made known
for Haram purpose
to the buyer.
like pork, wine etc.
Example:
There is a building comprising a number of apartments built in the
same pattern. A, the owner of the building says to B, "I sell one of
these apartments to you"; B accepts. The sale is void unless the
apartment intended to be sold is specifically identified or pointed
out to the buyer.
The delivery of the sold commodity to the buyer must be certain:
The delivery of the sold commodity to the buyer must be certain and should
not depend on a contingency or chance.

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Example:
A sells his car stolen by some anonymous person and the buyer
purchases it under the hope that he will manage to take it back. The
sale is void.
Price of the commodity must be certain:
The certainty of price is a necessary condition for the validity of a sale. If the
price is uncertain, the sale is void.
Example:

A says to B, "If you pay within a month, the price is Rs. 50. But if you TIP
pay after two months, the price is Rs. 55". B agrees. The price is
uncertain and the sale is void, unless anyone of the two alternatives is In Islam, a
agreed upon by the parties at the time of sale.
conditional sale is
The sale must be unconditional: invalid
A conditional sale is invalid, unless the condition is recognized as a part of the
transaction according to the usage of trade.
Example:
A buys a car from B with a condition that B will employ his son in his
firm. The sale is conditional, hence invalid.
A buys a refrigerator from B, with a condition that B undertakes its
free service for 2 years. The condition, being recognized as a part of
the transaction, is valid and the sale is lawful.

Components of Valid Bai

The components which are necessary for a valid bai are as follows:
Contract
Subject matter
Price
Possession

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The components are depicted in the following graphical diagram:

Muslim Trade Routes

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Kinds of Bai
There are several kinds of Bai. Some of these are:
Bai Musawamah
Bai Murabaha
Bai Salam
Bai Istisna'
Bai Urboon
Bai Eenna
Bai Touliya
Bai Wadhia
Bai Tawaruq
Detail of all these kinds is given below:
Bai Musawamah: it is a negotiated sale, a general kind of sale in which the
price of the commodity to be traded is bargained between the seller and the
purchaser without any reference to the price paid or cost incurred by the
seller.
Bai Murabaha: Literally it means a sale on mutually agreed profit. Technically, TIP
it is a contract of sale in which the seller declares his cost and the profit. This
has been adopted by Islamic banks as a mode of financing. As a financing Murabaha is a
technique, it can involve a request by the client to the bank to purchase a sale on mutually
certain item for him. The bank does that for a definite profit over the cost
agreed profit.
which is stipulated in advance.
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. According to normal rules of the Shariah, no sale can
be affected unless the goods are in existence at the time of the bargain, but
Salam sale forms an exception given by the Holy Prophet (SAW) himself to the
general rule provided the goods are defined and the date of delivery is fixed. It
is necessary that the quality of the commodity intended to be purchased is
fully specified leaving no ambiguity leading to dispute.

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Bai Istisna: 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. A manufacturer or builder agrees to
produce or build a well described good or building at a given price on a given
date in the future. Price can be paid in installments, step by step as agreed
between the parties. Istisna 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 Urboon: It is essentially a down payment made by a buyer to a seller
after both parties have entered into a valid contract. The down payment
represents the commitment to purchase the goods. If the buyer is able or
decides to pay the remaining outstanding payment during a prescribed
period, the amount paid as down payment will be counted as part of the
purchase price. Otherwise, the down payment will be forfeited by the seller. TIP
Bai Eenna: Double sale by which the borrower and the lender sell and then
resell an object between them, once for cash and once for a higher price on Bai Salam is ideal
credit, with the net result of a loan with interest. for agricultural
financing.
Bai Wadiah: safe-keeping/resale of goods with a discount on the original
stated cost. It is a sale of goods at a discounted price.

Bai Tawarruq: a transaction which generates cash now for more cash later
through trade in goods, other than gold and silver. Usually it involves a
deferred payment sale of goods by the financier to the customer at a higher
price which the customer then sells to a third party for cash, thereby TIP
receiving cash now for more cash paid later to the financier.
Bai Wadiah is a sale
of goods at a
discounted price.

Trade in Islamic Era

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Murabaha is a particular kind of sale where the seller expressly mentions the
cost of the sold commodity he has incurred, and sells it to another person by
adding some profit or mark-up thereon. The profit in Murabaha can be
determined by mutual consent, either in lump sum or through an agreed
ratio of profit to be charged over the cost.
All the expenses incurred by the seller in acquiring the commodity like
freight, custom duty etc. shall be included in the cost price and the
mark-up can be applied on the aggregate cost. However, recurring
expenses of the business like salaries of the staff, the rent of the
premises etc. cannot be included in the cost of an individual
transaction.
In fact, the profit claimed over the cost takes care of these expenses.
Murabaha is valid only where the exact cost of a commodity can be
ascertained. If the exact cost cannot be ascertained, the commodity
cannot be sold on Murabaha basis. In this case the commodity must be
sold on Musawamah (bargaining) basis i.e. without any reference to the
cost or to the ratio of profit / mark-up. The price of the commodity in
such cases shall be determined in lump sum by mutual consent.

Keep In Mind

Murabaha is valid only where the exact cost of a commodity can be

ascertained. If the exact cost cannot be ascertained, the commodity cannot
be sold on Murabaha basis.

Examples:
A purchased a pair of shoes for Rs. 100/-. He wants to sell it on
Murabaha with 10% mark-up. The exact cost is known. The Murabaha
sale is valid.
A purchased a ready - made suit with a pair of shoes in a single
transaction, for a lump sum price of Rs. 500/-. A can sell the suit
including shoes on Murabaha. But he cannot sell the shoes

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separately on Murabaha, because the individual cost of the shoes is

unknown. If he wants to sell the shoes separately, he must sell it at a
lump sum price without reference to the cost or to the mark-up.
Murabaha as a Mode of Financing
Originally, Murabaha is a particular type of sale and not a mode of financing.
The ideal mode of financing according to Shari'ah is Mudarabah or
Musharaka which have been discussed in the first chapter. However, in the
perspective of the current economic set up, there are certain practical
difficulties in using Mudarabah and Musharaka instruments in some areas
of financing. Therefore, the contemporary Shari'ah experts have allowed,
subject to certain conditions, the use of the Murabaha on deferred payment
basis as a mode of financing.

Keep In Mind

There are certain practical difficulties in using Mudarabah and Musharaka

instruments in some areas of financing. Therefore, the contemporary
Shariah experts have allowed, subject to certain conditions, the use of the
Murabaha on deferred payment basis as a mode of financing.

But there are two essential points which must be fully understood in this TIP
respect:
It should never be overlooked that, originally, Murabaha is not a mode Originally,
of financing. It is only a device to escape from "interest" and not an Murabaha is a
ideal instrument for carrying out the real economic objectives of particular type of
Islam. Therefore, this instrument should be used as a transitory step sale and not a mode
taken in the process of the Islamization of the economy, and its use of financing.
should be restricted only to those cases where Mudarabah or
Musharaka are not practicable.
The second important point is that the Murabaha transaction does
not come into existence by merely replacing the word of "interest"
by the words of "profit" or "mark-up". Actually, Murabaha as a mode
of finance has been allowed by the Shari'ah

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scholars with some conditions. Unless these conditions are fully

observed, Murabaha is not permissible. In fact, it is the observance of
these conditions which can draw a clear line of distinction between an
interest-bearing loan and a transaction of Murabaha. If these
conditions are neglected, the transaction becomes invalid according to
Shari'ah.
Basic Features of Murabaha Financing
The basic features of Murabaha are as follows:
Murabaha is not a loan given on interest. It is the sale of a commodity
for a deferred price which includes an agreed profit added to the cost.
Being a sale, and not a loan, the Murabaha should fulfill all the
conditions necessary for a valid sale, especially those enumerated
earlier in this chapter.
Murabaha cannot be used as a mode of financing except where the
client needs funds to actually purchase some commodities. For TIP
example, if he wants funds to purchase cotton as a raw material for his
ginning factory, the Bank can sell him the cotton on the basis of
Murabaha. But where the funds are required for some other purposes, Murabaha should
like paying the price of commodities already purchased by him, or the fulfill all the
bills of electricity or other utilities or for paying the salaries of his staff, conditions necessary
Murabaha cannot be affected, because Murabaha requires a real sale for a valid sale
of some commodities, and not merely advancing a loan.
The financier must have owned the commodity before he sells it to his
client.
The commodity must come into the possession of the financier,
whether physical or constructive, in the sense that the commodity
must be in his risk, though for a short period.
The best way for Murabaha, according to Shari'ah, is that the financier
himself purchases the commodity and keeps it in his own possession,
or purchases the commodity through a third person appointed by him
as agent, before he sells it to the

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customer. However, in exceptional cases, where direct purchase

from the supplier is not practicable for some reason, it is also
allowed that he makes the customer himself his agent to buy the
commodity on his behalf. In this case the client first purchases the
commodity on behalf of his financier and takes its possession as TIP
such. Thereafter, he purchases the commodity from the financier for
a deferred price. His possession over the commodity in the first The sale cannot
instance is in the capacity of an agent of his financier. In this capacity take place unless
he is only a trustee, while the ownership vests in the financier and the commodity
the risk of the commodity is also borne by him as a logical comes into the
consequence of the ownership. But when the client purchases the possession of the
commodity from his financier, the ownership, as well as the risk, is
seller
transferred to the client.
As mentioned earlier, the sale cannot take place unless the
commodity comes into the possession of the seller, but the seller can
promise to sell even when the commodity is not in his possession.
The same rule is applicable to Murabaha.
It is also a necessary condition for the validity of Murabaha that the
commodity is purchased from a third party. The purchase of the
commodity from the client himself on 'buy back' agreement is not
allowed in Shari'ah. Thus Murabaha based on 'buy back' agreement
is nothing more than an interest based transaction. The above
mentioned procedure of the Murabaha financing is a complex
transaction where the parties involved have different capacities at
different stages.
Steps Involved in Murabaha
In the light of the aforementioned principles, a financial institution can use
the Murabaha as a mode of finance by adopting the following procedure:
Firstly: The client and the institution sign an over-all agreement whereby
the institution promises to sell and the client promises to buy the
commodities from time to time on an agreed ratio of profit added to the
cost. This agreement may specify the limit up to which the facility may be
availed.

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Secondly: When a specific commodity is required by the customer, the

institution appoints the client as his agent for purchasing the commodity on
its behalf, and an agreement of agency is signed by both the parties.
Thirdly: The client purchases the commodity on behalf of the institution and
takes its possession 0s an agent of the institution.
Fourthly: The client informs the institution that he has purchased the
commodity on his behalf, and at the same time, makes an offer to purchase
it from the institution.
Fifthly: The institution accepts the offer and the sale is concluded whereby
the ownership as well as the risk of the commodity is transferred to the TIP
client.
All these five stages are necessary to affect a valid Murabaha. If the The most essential
institution purchases the commodity directly from the supplier (which is element of the
preferable) it does not need any agency agreement. In this case, the second transaction is that
phase will be dropped and at the third stage the institution itself will the commodity must
purchase the commodity from the supplier, and the fourth phase will be remain in the risk of
restricted to making an offer by the client. The most essential element of the the institution
transaction is that the commodity must remain in the risk of the institution during the period
during the period between the third and the fifth stage. This is the only between the third
feature of Murabaha which can distinguish it from an interest-based and the fifth stage.
transaction. Therefore, it must be observed with due diligence at all costs,
otherwise the Murabaha transaction becomes invalid according to Shari'ah.

Keep In Mind

The most essential element of the transaction is that the commodity must
remain in the risk of the institution during the period between the third and
the fifth stage. This is the only feature of Murabaha which can distinguish it
from an interest-based transaction.

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Step By Step Murabaha Financing

Stage 1: Promise Stage
Stage 1 (A)
Client approach the bank for facility of Murabaha

Islamic Client
Bank Facility Approved

Stage 1 (B)
Client and bank sign an agreement to enter into Murabaha

Islamic Client
Murabaha Facility
Bank
Agreement

MOU

Stage 1 (C)
Client submits the purchase requisition to the bank

Islamic Client
Bank Submission of Purchase
Requisition

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Stage 2: Agency Stage

Stage 2 (A)
Client is appointed as agent to purchase goods on bank's behalf

Bank Client
Agreement to
Murabaha

Agency Agreement

Stage 2 (B)
Bank gives money to supplier through client's account for purchase of goods

Islamic
Bank
Bank Client
Agreement to Murabaha

Agency Agreement

Disbursement to the client

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Stage 3: Acquiring Possession

Client purchases goods on bank's behalf and takes their possession.

Client purchases
goods and takes
Transfer of Risk Vendor
possession

Bank Client

Stage 4: Execution of Murabaha

Stage 4 (A)

Client makes an offer to purchase the goods from bank

Bank Client

Offer to purchase

Stage 4 (B)
Bank accepts the offer and sale is concluded

Murabaha

Agreement
Bank Client
+

Transfer of Title

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Stage 4 (C)
Client pays agreed price to bank according to an agreed schedule, usually on
a deferred payment basis (Bai Muajjal)

Bank Client
CUSTOMER ISLAMICPayment
BANK Agreement VENDOR
of Price
CUSTOMER ISLAMIC BANK Agreement VENDOR

CUSTOMER ISLAMIC BANK Agreement VENDOR

General Mechanism of Murabaha

VENDOR ISLAMIC BANK Agreement CUSTOMER

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The above mentioned procedure of the Murabaha financing is a complex

transaction where the parties involved have different capacities at different
stages.
At the first stage, the institution and the client promise to sell and
purchase a commodity in future. This is not an actual sale. It is just a
promise to affect a sale in future on Murabaha basis. Thus at this
stage the relation between the institution and the client is that of a
promisor and a promise.
At the second stage, the relation between the parties is that of a
principal and an agent.
At the third stage, the relation between the institution and the
supplier is that of a buyer and seller. TIP
At the fourth and fifth stage, the relation of buyer and seller comes
into operation between the institution and the client, and since the Murabahah
sale is affected on deferred payment basis, the relation of a debtor financing is a
and creditor also emerges between them simultaneously. complex transaction
All these capacities must be kept in mind and must come into operation with where the parties
all their consequential effects, each at its relevant stage, and these different involved have
capacities should never be mixed up or confused with each other. different capacities
at different stages.
The institution may ask the client to furnish a security to its satisfaction for
the prompt payment of the deferred price. He may also ask him to sign a
promissory note or a bill of exchange, but it must be after the actual sale
takes place, i.e. at the fifth stage mentioned above. The reason is that the
promissory note is signed by a debtor in favor of his creditor, but the relation
of debtor and creditor between the institution and the client begins only at
the fifth stage, whereupon the actual sale takes place between them.
In the case of default by the buyer in the payment of price at the due date,
the price cannot be increased. However, if he has undertaken, in the
agreement to pay an amount for a charitable purpose, he shall be liable to
pay the amount undertaken by him. But the amount so recovered from the
buyer shall not form part of the income of the seller or

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the financier. He is bound to spend it for a charitable purpose on behalf of the

buyer, as will be explained later in detail.
Applications of Murabaha
Murabaha can be utilized for the following purposes:
Purchase of raw material; for meeting working capital needs of trade
and industry.
Medium to long term requirements for purchase of land, building and
equipment.
Trade finance products including imports, exports and bill purchase.

Pricing of Murabaha

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Risk Dimension of Murabaha

Credit
Risk
Liquidity
Credit
Dimension Credit

s
Banking
Interest Rate

Risks
Market

Islamic Banks also face

Foreign Exchange
-Additional asset risk
-Greater fiduciary risks
Solvency
-Greater legal risk
Operational

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SALAM AND ISTISNA

Salam (Advance Payment Deferred Delivery of Goods)
Salam is a sale whereby the seller undertakes to supply some specific goods
to the buyer at a future date in exchange for an advance price fully paid on
spot. Seller and the buyer can agree on any price at their free will. Price in
Salam can be lower than the spot sale price.
The buyer should pay the price in full to the seller at the time of finalizing the TIP
sale. Otherwise, it will be tantamount to a sale of debt against debt, which is
expressly prohibited by the Holy Prophet (Peace be upon him). The Islamic
Price in Salam can
Fiqh Academy has resolved that the seller may give a concession of two or
be lower than the
three days to the buyers but this concession should not form part of the
agreement. Because of this consideration, a debt liability of the seller spot sale price.
cannot be adjusted against price for Salam sale, in part or in full. Allama Ibn
Qudama says It is not permissible for a person to use (for instance) one
Dinar owed to him by somebody else as Salam principal for purchasing a
certain quantity of food from that person. Ibn al Monzer says: a consensus
on prohibition of this (adjusting the debt in Salam price) had been reached
by all the Ulama from whom I learned, including Malik, al Awza'i, al Thawri,
Ahmad, Es'haq, As'hab al rai and al Shafi'e. However, Ibn al Qayyim and Ibn
Taymiah allow that amount of debt can be subtracted from the price to be
paid in Salam. (Umar, Haleem; 1995, pp. 32, 33).
TIP

A debt liability of
Keep In Mind the seller cannot be
adjusted against
Allama Ibn Qudama says It is not permissible for a person to use (for
price for Salam sale,
instance) one D inar owed to him b y somebody else as Salam principal for
in part or in full
purchasing a certain quantity of food from that person.

Glossary:

Spot Sale Price: Spot Sale Price is usually the cash price for a product available for
immediate delivery it also refers to the nearest contract month for delivery.

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Although the buyer has to pay the price in full at the time the Salam contract
is finalized, yet the payment of hard cash is not necessary; banks may credit
the seller's account or issue a pay order, in favor of the seller, which will be
encashable on demand. Salam borrower (seller) may deposit the amount or
the price he receives with the same bank with which he had entered into a
Salam deal. However, granting a line of credit in Salam will not be advisable
because in that case it would be difficult to fulfill the Shari'ah conditions
relevant to Salam.
Salam can be applied in those commodities only that are normally available
in the market and whose quality and quantity can be specified exactly. It may
include any marketable goods with definable features, like raw materials,
agricultural produce or manufactured goods. The quality of the commodity
that is intended to be purchased should be fully specified leaving no
ambiguity leading to dispute. Date of delivery must be well set either by
TIP
linking it to a specific date or to an event whose happening is an absolute
certainty although the date of its occurrence may be subject to a slight
variance, provided it does not result in a conflict. Salam can be
applied in those
The time of delivery should be long enough to affect prices. Preferably, it
commodities only
should be fifteen days or one month from the date of agreement. But as the
that are normally
Holy Prophet (SAWW) did not specify any minimum period for the validity of
available in the
Salam, it is all right to have an earlier date of delivery if the seller consents to
market and whose
it and other conditions of Salam are fulfilled.
quality and quantity
The banks will receive certain commodities, not money, from their clients. can be specified
They cannot sell commodities purchased through Salam before they are exactly.
actually delivered to them. The Islamic Fiqh Academy of the OIC in its Eighth
session (21-27 June, 1993) resolved in respect of Salam that: As Salam
(forward buying) contract covers a wide scope considering its terms and
conditions, it benefits the buyer in investing his surplus funds for profit, as
well as the seller in securing adequate commodity prices.

Glossary:

Pay Order: A cheque issued by a branch of a bank against consideration received. Pay
orders are valid for a certain period as indicated on the face of the cheque.

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A commodity which is subject of a forward contract (purchased through

Salam contract) cannot be sold until it is received (Also see Mu'watta, No.
1352, P. 301).
A parallel contract of Salam, however, is possible with any third party. The
bank (buyer in Salam) can enter into a parallel Salam contract without any
condition or linkage with the original Salam contract. In one contract, the TIP
bank will be the buyer and in the second the seller. Each one of the two
contracts shall be independent of the other. They cannot be tied up in a
manner that the rights and obligations of one contract are dependant on the Parallel Salam is
rights and obligations of the parallel contract. Further, parallel Salam is allowed with a third
allowed with a third party only. For example, if a bank has purchased from party only
farmer 'A' 50 tons of wheat by way of Salam to be delivered on June 30, the
bank can contract a parallel Salam with a trader 'B' to deliver to him 50 tons
of wheat on June 30. But while contracting parallel Salam with 'B', the
delivery of wheat to him cannot be made conditional upon taking delivery
from 'A'. Even if 'A' does not deliver wheat on June 30, bank will be duty
bound to deliver 50 tons of wheat to 'B'. Bank can seek whatever recourse it
has against 'A', but he cannot back out from his liability to deliver the wheat
to 'B'. Similarly, if the farmer delivers poor quality wheat, the bank will be
still obligated to deliver the wheat of stipulated quality to 'B' according to
the original Salam contract.

Keep In Mind

A parallel contract of Salam , however, is possible with any third party. The
bank (buyer in Salam) can enter into a parallel Salam contract without any
condition or linkage with the original Salam contract. In one contract, the
bank will be the buyer and in the second the seller. Each one of the two
contracts shall be independent of the other. They cannot be tied up in a
manner that the rights and obligations of one contract are dependant on the
rights and obligations of the parallel contract.

Glossary:

Parallel Salam: Parallel Salam is based on two independent Salam contracts

whereby the financier will be both the seller and the buyer in this arrangement

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In order to ensure that the seller shall deliver the commodity on the agreed
date, bank can ask him to furnish a security, which may be in the form of a
guaranty, mortgage or hypothecation.
The jurists disallow the operation of the Islamic law of option (Khiyar) in the
case of Salam because this disturbs or delays the seller's right of ownership
over the price of the goods. In case of multiple commodities, the amount
and period of delivery for each item should be separately fixed. Salam was
allowed by the Holy Prophet (Peace be upon him) to fulfill the needs of
farmers and traders. Therefore, it is basically a mode of financing for small
farmers and traders in agricultural goods. Banks can use this mode to
finance the agricultural sector in particular and other trading activities in
TIP
general. If a parallel contract of Salam is not feasible, banks can also obtain a
promise from a third party to purchase the goods. This promise should be
unilateral from the prospective buyer. The buyers will not have to pay the Salam is basically a
price in advance as they are merely making a promise. However, bank can mode of financing
ask for earnest money. As soon as the bank receives the commodity, it will be for small farmers
sold to the third party at a pre-agreed price, according to the terms of the and traders in
promise. agricultural goods.

Keep In Mind

Salam was allowed by the Holy Prophet (Peace be up on him) to fulfill the
needs of farmers and traders. Therefore, it is basically a mode of financing
for small farmers and traders in agricultural goods. Banks can use this mode
to finance the agricultural sector in particular and other trading activities in
general.

Glossary:

Mortgage: Mortgage is a written constructive pledge of property that is used as

security for the repayment of a loan.

Hypothecation: Hypothecation is a charge that is created on movable asset as

security for a debt. However, the ownership as well as possession of the asset is
retained with the borrower.

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Regarding contemporary application of Salam, banks can use it for

Agricultural Finance, Export Finance, Working Capital Finance, Inventory
Finance, Operational Cost Management, Liquidity Management-Short term
financing, etc. Islamic Fiqh Academy (pp: 185-187) has observed that the
wide range of applications of Salam may include the following:
A Salam contract may be used to finance various agricultural
operations, in which case an Islamic bank may deal with farmers
expected to have the commodity in the right season, either from
their own crop or from that of others, which they may purchase and
deliver in case of failure on their part to honor the delivery out of
their own crops. The bank would thus have extended to them a
benefit of great value and protected them against the failure to
achieve their production targets on account of resource constraints.
A Salam contract may be used to finance agricultural or industrial
activities particularly for financing the stages before the production
and export of the manufactured goods, by means of buying them
under Salam and marketing them again at profitable prices.
A Salam contract may be applied in financing handicraftsmen, small
manufactures, farmers and industrialists by providing them with the
necessary production needs in the form of tools, equipment, or raw
material as a forward capital against access to some of their produce
and remarketing them.

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Istisna
Istisna, like Salam, is a special kind of sale where sale of a commodity is
transacted before it (the commodity) comes into existence. It is an
agreement culminating into a sale at an agreed price whereby the purchaser
places an order to manufacture, assemble or construct, or cause so to do, TIP
anything to be delivered at a future date. Istisna can be used for providing
the facility of financing the manufacture or construction of houses, plants,
Istisna is an order to
projects, building of bridges, roads and highways, etc.
manufacture and
It is used in the field of manufacturing wherein Al-Saani (manufacturer) construct anything.
would arrange both the raw material and the labor. (If material is supplied by
the purchaser and the manufacturer is required to use his labor and skill
only, it will be the contract of Ujrah and not of Istisna.) The subject of Istisna
(things to be manufactured or constructed) must be known and specified to
the extent of removing any ignorance or lack of knowledge of its kind, type,
quality, and quantity. The price should also be known in advance to the
extent of removing ignorance or lack of knowledge, and price once settled,
cannot be increased or decreased. However, it can be readjusted by the
mutual consent of the contracting parties because of making material
modification in the commodity (al-Masnoo) or due to unforeseen
contingencies or changes in prices of inputs.
It is not necessary in Istisna that the price is paid in advance (unlike Salam in
which spot payment of price is necessary). Price can be paid in installments
within a fixed time period. Against the general rule set out for Salam, the TIP
contemporary scholars have legalized it on the basis of Istihsan as the
construction of huge plants may require long gestation The subject of
istisna must be
known and
specified.

Glossary:

Ujrah: Ujrah is a contract in which any work is done against stipulated wage or fee.

Istihsan: It is a doctrine of Islamic law that allows exception to strict legal reasoning,
or guiding choice among possible legal outcomes, when considerations of human
welfare so demand.

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period and payment through installments according to the pace of

implementation of such projects. In addition to these considerations, OIC
Islamic Fiqh Academy recommends that time of manufacturing should be
fixed.
It is not necessary for al-Sanii (seller) to manufacture the commodity
himself. He may enter into a contract with a manufacturer to provide the
subject matter of Istisna. On this basis, the banks may undertake financing
based on Istisna by getting the subject of Istisna manufactured through
another such contract.
Before a manufacturer starts the work, any one of the parties may cancel the
contract by giving a notice to the other. However, after the manufacturer has
started the work, the contract cannot be canceled by the buyer unilaterally.
The Civil Law of some Muslim countries like Jordan and Sudan, the 'Unified
Arab Law' proposed by the League of Arab Countries and the Fiqh Academy
of the OIC treat Istisna a 'binding contract' provided that certain conditions
are fulfilled. If the commodity conforms to the specifications agreed at the
time of the Istisna contract, the purchaser is bound to accept the goods and
he cannot exercise the option of inspection. Al-Mustasni (purchaser) has the
right to obtain collateral from the al-Sanii for the amount he has paid and as
regards delivery of the commodity with specifications and time.

Keep In Mind

If the commodity conforms to the specifications agreed at the time of the

Istisna contract, the p urchaser is bound to accept the goods and he cannot
exercise the option of inspection.

The contract may also contain a penalty clause on account of breach of the
contract. It can be agreed, in other words, between the parties that in the
case of delay in delivery, the price shall be reduced by a specified amount.
The scholars have contended this on the basis of analogy. The classical jurists
have allowed such condition in Ijarah, e.g. if a person hires the services of a
tailor, he may tell him that the wage would be Rs 100 in case he prepares the
clothes within a week and Rs. 150 if within two

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days. By analogy, experts allow a penalty clause in the Istisna agreement in

case of delay in delivery of the subject of Istisna.
The Council of the Islamic Fiqh Academy of the OIC in its Seventh session (9-
14-May, 1992) recommended the following in respect of Istisna:
The Istisna (manufacture) contract is binding on both parties if it
meets the basic requirements and conditions.
The Istisna contract must stipulate the following:
o The nature, type, amount and required specifications of the
product to be manufactured.
o The time limit should be specified.
In the Istisna contract, payment may be deferred in full or scheduled
according to pre-determined installments and specific due dates.
It is permissible to include a penalty provision in the Istisna contract
except for inevitable circumstances.
Differences between Istisna and Salam
The differences between Istisna and Salam are as follows:
Istisna deals with manufacturing items, but Salam could or could not
be a manufacturing contract, but Salam is ideal for agriculture
sector.
In Salam advance payment is necessary, but in Istisna' it is not a
necessity.
Date and time of delivery are necessary part of bai Salam, but in
Istisna, it is not the part of the deal.
In bai Salam, it can be cancelled one sided, but in Istisna, it could be
cancelled, if production is not started yet.

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Concluding Remarks
The following three basic rules are exceptional for Salam and Istisna:
Existence of Product/Commodity
Ownership of Product/Commodity
Possession of Product/Commodity
Under Salam, 100% amount in paid in advance. The product must be
quantified, identified and Measured with quality. Date of delivery, Time,
Place must be mentioned clearly in advance and Salam is not valid for a
specific farm/land/garden.
Under Istisna, it is not necessary to pay the 100% amount in advance like in
Bai Salam. It is essential for the validity of Istisna that price must be decided
in the beginning of the contract. Moreover, qualities, quantities and
features of the products contracted must be identified.

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Summary
'Bai' is defined in Shariah as 'the exchange The ideal mode of financing according to
of a thing of value by another thing of Shariah is mudarabah or musharakah which
value with mutual consent'. Islamic have been discussed in the first chapter.
jurisprudence has laid down enormous However, in the perspective of the current
rules governing the contract of sale, and economic set up, there are certain practical
the Muslim jurists have written a large difficulties in using mudarabah and
number of books, in a number of volumes, musharakah instruments in some areas of
financing. Therefore, the contemporary
to elaborate them in detail.
Shariah experts have allowed, subject to
The subject of sale must be existing at the certain conditions, the use of the Murabahah
time of sale, the subject of sale must be in on deferred payment basis as a mode of
the ownership of the seller at the time of financing.
sale, the subject of sale must be in the A parallel contract of Salam, however, is
physical or constructive possession of the possible with any third party. The bank (buyer
seller when he sells it to another person. in Salam) can enter into a parallel Salam
There is a big difference between an actual contract without any condition or linkage with
the original Salam contract. In one contract,
sale and a mere promise to sell. The actual
the bank will be the buyer and in the second
sale cannot be effected unless the above
the seller. Each one of the two contracts shall
three conditions are fulfilled. However be independent of the other. They cannot be
one can promise to sell something which is tied up in a manner that the rights and
not yet owned or possessed by him. This obligations of one contract are dependant on
promise initially creates only a moral the rights and obligations of the parallel
obligation on the promisor to fulfill his contract.
promise, which is normally not justifiable.
Salam was allowed by the Holy Prophet
Murabahah is a particular kind of sale (Peace be upon him) to fulfill the needs of
where the seller expressly mentions the farmers and traders. Therefore, it is basically
cost of the sold commodity he has a mode of financing for small farmers and
incurred, and sells it to another person by traders in agricultural goods
adding some profit or mark-up thereon.
The profit in Murabahah can be
determined by mutual consent, either in
lump sum or through an agreed ratio of
profit to be charged over the cost.

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Discussion Questions
What is bai? Explain some basic rules of Bai?
What are the components and kinds of a valid bai?
What is Murabaha? Explain Murabaha as a mode of financing?
What are the basic features of Murabaha financing?
What is Salam? Explain its basic rules?
What is Istisna? Explain its basic rules? What are the differences between Salam and
Istisna?

Reference Material
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