Islamic laws on trading

This post covers the Islamic rules on trading, with a focus on what deals are permissible (”Halal“) or forbidden (”Haram“). These rules apply to any market or other types of trading and, I feel, are general enough that trading in shares, derivatives, insurance and other forms of risk are covered.

The major difference between a normal, Western, financial market and that of a Halal market is the prohibition on trading in risk, so a discussion of the detail of this, and the disagreements between the various schools of Islamic jurisprudence is the first subject to be covered.

This is the third in a series on Islamic banking. There is some overlap between this and other parts of the series, but as each is designed to stand alone I hope you do not mind the repetition.

The Holy Qur’an prohibits gambling (games of chance involving money), and “bayu al-gharar” (trading in risk, where the word gharar is taken to mean “risk”). Different schools have differing interpretations, of which the three major interpretations are:

• The Hanafi madhab (legal school) in Islam defines “gharar” as “that whose consequences are hidden”;


• The Sjafi legal school defined “gharar” as “that whose nature and consequences are hidden” or “that which admits two possibilities, with the less desirable one being more likely”; and


• The Hanbali school defined it as “that whose consequences are unknown” or “that which is undeliverable, whether it exists or not.”

The modern scholar of Islam, Professor Mustafa Al-Zarqa wrote that, “gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature which makes the trade similar to gambling”. There are a number of “hadith” (traditional sayings, many of the Prophet) that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g. selling “the birds in the sky or the fish in the water”, “the catch of the diver”, “an unborn calf in its mother’s womb”, “the sperm and/or unfertilized eggs of camels”, etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal while trading in non-minor risk (bayu al-ghasar) is deemed to be haram.

What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a “minor risk.” Derivatives instruments (such as stock options) have only become common relatively recently. Some Islamic banks do provide brokerage services for stock trading and perhaps even for derivatives trading.

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 (usuing another’s property without damaging it) 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 rental 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

This 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

It is a partnership in profit between capital and work 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.