Fiqh of Islamic Finance

Fiqh of Islamic Finance: Islamic Bonds (Sukuk)

2013 Winter Session (January 14 to March 17 2013)

Class taught by Shaikh Jamaal Zarabozo

Class Timings:

March 10 and 17 from 6:00 - 7:15 PM PDT

Recommended Textbook:

Understanding Islamic Finance by Muhammad Ayub.

Basic Outline of the Quarter:

Sukook and Possibly (time permitting): Real Estate Investment Trusts (REIT)

Required or Recommended Reading:

Suggested Reading in Ayub: Bonds/Sukuk pp. 389-412

Various articles may be e-mailed throughout the course, Allah willing

2013-01-13 Class Notes

Today the first thing we do in the lecture is to go over the research paper by Br. Abdul Qadir, who is a student in the class. Br Abdul Qadir gave the review himself.

Summary of Br Abdul Qadir’s research paper

When we study the Islamic finance industry and we ask the question what is driving this industry? Is it pleasure of Allah (swt) or just the culture of the Western finance industry driving it? Br. Abdul Qadir is the speaker who is giving summary for his research paper from the institute called …... The paper itself discusses the culture of the Islamic Banks specifically in the Islamic countries. For example, the people in Islamic banks should be praying salat, saying salam, there should be not any cheating etc.

First thing that shocked Br Abdul Qadir that he got the reply of “dear br. Abdul Qadir....” for his Salam. Br. Abdul Qadir found that the concept of banks top-down, risk management etc. are all based on non-Islamic worldview. Basically all the employees (even though they are Muslims) are being educated with the Western values. The point Br Abdul Qadir is trying to make is that workers are not able to think in Islamic terms and in the business and work they are not able to distinguish what is Islamic and what is not.

Br Abdul Qadir included 105 banks in Muslim countries which included Turkey, Bangladesh, Qatar, Pakistan, etc... and very few send him back the survey in the first place. Mission statements are mostly copy and paste from the Western banks.

Br Abdul Qadir makes a point that the Islamic Bank must be based on Servitude of Allah (swt) rather than the assumptions which is the case in the Western framework of organizations. The values should be based on Quran and Sunnah and not on the assumptions. He makes an example that a fasting Muslim will be fearing Allah (swt) in privacy and hence cheating will be lessened. The praying of Salat will bring the value of time in mind of the employee. What brother found is that Salat is not established (even though there is a place assigned for prayer) in these institutions.  

Link to Br Abdul Qadir’s PhD thesis

2013-01-20 Class Notes

Discussion of the class last week about Islamic finance industry by Br Abdul Qadir. You would think that the goal of the Islamic Institute would be to provide a product that is truly Islamic and you don’t find it in their mission statement.

Sukuk (Islamic Bonds)

Definition of 'Bond'

A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.

Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents.

Read more:


Bond is a kind of debt security. In general the one issuing the bond is grouping to paying interest (the coupon), at the end of the term, and the or maturity the bond issuer will return the principal. The bonds are considered very boring form of investment. It is a conservative way of investment and one is happy with a slow return rate.

Different types of bonds

Government Bonds

In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:

Bills - debt securities maturing in less than one year.

Notes - debt securities maturing in one to 10 years.

Bonds - debt securities maturing in more than 10 years.

Marketable securities from the U.S. government - known collectively as Treasuries - follow this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills). Technically speaking, T-bills aren't bonds because of their short maturity. (You can read more about T-bills in our Money Market tutorial.) All debt issued by Uncle Sam is regarded as extremely safe, as is the debt of any stable country. The debt of many developing countries, however, does carry substantial risk. Like companies, countries can default on payments.

Municipal Bonds

Municipal bonds, known as "munis", are the next progression in terms of risk. Cities don't go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis.

Corporate Bonds

A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Zero-Coupon Bonds

This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years.

Read more:

There is governmental form of bond (floating bond??) and company based bonds.  

Are bonds haram?

The bond is exchange of money for money. There are zero coupon bond, where one pays $850 for a $1000 bond but once you sell it one gets $1000.

Money exchange has to be a spot transaction. So this is exchange of money which should be hand-to-hand and on the same spot.

Is there risk involved with flexible bonds?

If you ever agree to negative interest, it means you are going to get less than the funds that you have given. The risk in bonds is that of the lender defaulting on it and not repaying it. There are different types of ratings from AAAA to C which are junk bonds. Does this risk of default makes it shariah compliant?

Is there any transaction that involves time and does not involve risk? No there isn’t, any time you have time involved, there is some risk.

The risk of default is a generic risk that is part of any transaction that involves time. This is not what the shariah implies that any business transaction should involve the risk of making money or losing money. And the risk of default of bonds has nothing to do with the allowable shariah risks for commerce which is required for all trade.

What about the price of bond instruments, can they go up and down, if yes how?

If you bought a 30 year bond for $1000, you will get $1000 at the end of the maturity of the bond. And let us say that you are being paid $100 every year at 10% rate. But on some other bonds the rate is 3%. And somebody could ask to buy your bonds for $1300 which is $300 more than the face value of the bonds. So the price of bonds can go and up down.

So no matter that there is risk involved or whether the price of bonds go up and down, the classroom says that it because it involves just money and there is no commodity other than money in the transaction, it has to be a spot transaction and the bonds are haraam.

So no matter whether the bonds are issued by Pakistan or Indonesia, the consensus in the class is that they are haraam. However let us discuss what some consider to be benefits of bonds.

Benefits of Bonds

Issuer: If you are a company issuing a bond, you get an influx of money without giving up equity. Issuer keeps more funds and keeps more autonomy.

Buyer: More security, guaranteed return, long-term steady flow of income.  

So there are benefits of bonds and people tried to create equivalent financial products that are shariah compliant.

How can we create a Islamic finance product that is equivalent to bonds and make it shariah compliant?

Let’s assume that we have a Islamic Financial Institute. They invest in Mudhaarabah, Muraabahah, Mushaarakah, Salem and Ijarah which are type of shariah financial instruments. They receive investments from investors or silent partners. And the various financial instruments are asset backed such as real estate, which could be good, they are not just one way flow of money because now the money will come back to the financial institution.

When Islamic institutes invest money they expect some type of returns or profits due to their involvement in those financial instruments. The Islamic Financial Institutes are silent partners. The asset could be equipment or real estate etc. So there is a flow of money from some of the financial instruments back to the Islamic Financial Institutions.

So there is money coming back and they know how much money is coming back, but some of those funds require time to mature. So a concept called securitization comes into play.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Basically you create bundles of various asset backed mudharabah and muraabahah and sell them to investors. You can tell the investors how much money they are going to get over time.

The word for bonds in Arabic is sukook, which is from Persian and the word “check” come from this word. It is a way of passing debt from one party to another.

[Due to audio problems we lost last half an hour of the class]

2013-01-27 Class Notes

Sukuk or Islamic Bonds

Since the 80s banks have had mudaarabah certificates. 1992 was the first local currency sukuk. 2002 first sukuk issued in Malaysia for $600 million. 2004=$7 billion.

The first corporate issue was for $150 million for 5 years tenure. And then global sukuk for $600 million.

Then Bahrain entered in 2002 and Pakistan in 2005 (with $600 million).

2007: UAE $33 billion. Malaysia: $25 billion.

2004: First sukuk offered by a non-Muslim govt was the sukuk offered by Saxony-Anhalt in Germany in 2004. For $100 million for 5 years for mostly Middle Eastern investors .

Recently, Lehman Brothers and the Japanese govt issued sukuk.

Since 2005, corporate issue has outnumbered govt issues.

[The Sheikh is referring to this document: -- particularly page 24]

Bahrain monetary agency:

Sukuk structure:

Which currency it is,

issue size and the number of years (usually 3-10 years)

Margin - rate of return

Six months LIBOR

Our scholars see advantages to this type of financing. Take large amounts of money and return it over time. Semi-fixed expected return.

Taqi-Ud-Din Usmani - Best way to finance large enterprise, beyond the ability of a single enterprise.

Ijara is the number one type of Sukuk.

What differentiates sukuk and bonds. Sukuk are asset-based not asset-backed.

Example: A mortgage is a debt, and if he defaults, then you can go and sell the asset. But in the case of Sukuk, it’s asset-based.

One issue is hybrid sukuk where you combine different types, but wrt sukuk you have to be very careful. If you are just receiving money and pass on that money to someone else.

Mohammed Ayoub’s book (on the chapter on sukuk): Two decades back it was considered that only an equity market was viable. This may be partly true as debts can not be sold. Hence debts can not generate any other return. But the emergence of sukuk, particularly Ijaarah sukuk, suggest that some forms of debt market are possible even in an Islamic framework. The major requirement for making an investment certificate shariah complaint is that it should not represent interest-bearing debt as dominant part of the underlying assets.

The funny thing is that many of the things that they say they are trying to create new financial instruments, but then they create tools that are much the same. Taqiuddin Usmani said that 85% of the sukuk offered in the market are not shariah compliant.  

AAOIFI has discussed 14 different types of sukuk. First they discuss investment sukuk, which is undivided ownership in assets, usufruct, …...... This type of sukuk has been labelled as investment sukuks, to distinguish it from......

Sukuk Ijaarah describe Ijaarah as certificate of ownership in leased assets. These are certificates of equal value of owned assets with the aim of selling the asset so that owners of the certificate become owners of the asset. There are also a few sukuk related to the agriculture and agriculture based industry.

The idea of sukuk is that you get all of your money originally, but you leave the money to those subscribing to the sukuk.

TU says that when it comes to sukuk you have to differentiate between what are tradeable and what are not tradeable, and this is where Malaysia has a different view from the rest of the scholars. Because if the sukuk is based on debt, then they can’t be traded. When TU said 85% are not Islamic. By far the most accepted form of sukuk amongst scholars is sukuk al ijara -- and it goes through a Special Purpose Vehicle (

2013-02-03 Class Notes

We will inshaAllah, discuss some of the financial products (Muharaba, Ijara, etc.) that the Islamic banks offer. We are going to look at them from the perspective of the banks and then discuss how the sukuk are issued.

Al Ijara is a kind of comprehensive concept and it includes leasing equipment, renting property, working for wages. Ajr can mean reward, compensation or wages earned. The principle behind Ijara are relevant to all of us, since we lease, work for compensation and invest. The ahkam related to ijara are similar to all 3 different categories. When you work for someone then they do not own you they use your labor for wages.

Lots of example in the Qur’an; e.g. the story of Musa and Shu’aib or paying the wages for the breastfeeding as mentioned in (65:6).

أَسْكِنُوهُنَّ مِنْ حَيْثُ سَكَنتُم مِّن وُجْدِكُمْ وَلَا تُضَارُّوهُنَّ لِتُضَيِّقُوا عَلَيْهِنَّ ۚ وَإِن كُنَّ أُولَاتِ حَمْلٍ فَأَنفِقُوا عَلَيْهِنَّ حَتَّىٰ يَضَعْنَ حَمْلَهُنَّ ۚ فَإِنْ أَرْضَعْنَ لَكُمْ فَآتُوهُنَّ أُجُورَهُنَّ ۖ وَأْتَمِرُوا بَيْنَكُم بِمَعْرُوفٍ ۖ وَإِن تَعَاسَرْتُمْ فَسَتُرْضِعُ لَهُ أُخْرَىٰ

Sahih International

Lodge them [in a section] of where you dwell out of your means and do not harm them in order to oppress them. And if they should be pregnant, then spend on them until they give birth. And if they breastfeed for you, then give them their payment and confer among yourselves in the acceptable way; but if you are in discord, then there may breastfeed for the father another woman.

But there is a problem with the story of Musa (صلى الله عليه وسلم) and Shu’aib and this because it’s from the shariah before the shariah of Prophet Muhammad (صلى الله عليه وسلم) and in this particular case it contradicts the shariah of Prophet Muhammad (صلى الله عليه وسلم) regarding Mahr (as it looks like Shu’aib utilizes it) so we cannot accept it here.

The Prophet (SAWS) said that he would advocate for the person who was not paid for his work. Another hadith that says a laborer should have been paid before the sweat has dried from his skin. Another clear example is the hadith about sharecropping, but he did mention the permissibility of renting land.

All 4 madhabs say that Ijara is counter-analogous contract and one cannot make analogy between Baya’ and Ijara. Ibn Taymiyyah and Ibn Qayyim says that it is analogous and every future contract is not considered illegal (provided there is not huge amount of gharar involved in the future contract). This implies that if it is an exception, then you can not make Qiyas based on the exception. However if you say it is not an exceptional ruling and it is not something unique or different, then you can make an analogy and make a new type of sale based on it. So it is not just a superficial/theoretical difference of opinion without any consequences.

The technical definition of ijara is different from each school. The Hanafi definition is that ijara is transfer of usufruct with payments. The Shafis define it as use of known desired permissible and accessible usufruct for a specific compensation. The Maliki and Hanbali say that Ijara is transfer of the ownership of the usufruct for a specified amount of payment.

Properties or characteristics of Ijara

1. It is a contract: offer & acceptance, legally binding, etc.

2. A known usufruct is transferred. The usufruct doesn’t exist at the time of the contract. Even if I’m paying now for the rental for the next month, it doesn’t exist. Therefore there has to be some conditions for that to be acceptable. The Manfaa (the thing being benefitted from) has to be clearly defined. It has to be identifiable for what one is paying for.

3. Getting the usufruct of a particular asset. And it must be of a permitted nature. E.g. cannot hire someone to murder somebody else. E.g. the property can be used in a non-Islamic manner. And must be of value from shariah point of view. E.g. singers.

4. Must be for a specified time period. In hanafi it can be for a very long time. Among Shafis there is opinion that it can be for 1 year and another says 3 years. This is due to gharar. It is accepted for the month to month lease by Urf. However, a minority opinion among Shafis is that once the contract comes to an end then it is void after that. However many scholars do not agree with this minority opinion.

5. It must be an agreed upon rental -- it must be an exchange for a determined amount. The one who is leasing or the lessee is called an ameen. He is not responsible completely for the property, he is responsible for any damage he causes, but he is not at risk wrt to the property. He can be held for water, electricity, etc.

Suppose you want to rent out the equipment because you found someone who wants to lease it but you do not own the equipment right now. Here one cannot rent it out since I do not own it. However, as a bank, I am going to buy this equipment and lease it to you. However, bank cannot sign contract with you that “I am offering to go buy and lease it to you”. This can only happen as a non-binding promise. However, in Islamic bank today the promises are being made binding.

What if for apartments someone says that give us some earnest money (deposit) to hold the apartment for you. This is acceptable since the apartment is owned by the person who is offering it to you. However, in case of the bank this does not make sense since bank does not own the equipment or property.

If the request for the item is general (e.g. a conveyer belt or 3 bedroom apartment) then this can be allowed. However, to say that i want this particular conveyer belt or this particular house then one cannot sign this contract. Suppose now that you have the equipment but you need cash now. You sell this equipment to the bank and the bank leases the same equipment to you. This is problematic.

Can we have different rates for different phases of the contract? E.g. Can we have in the contract different rates for different phases of the contract. For example, you rent the house in Makkah where during Hajj season the rent is higher. It is ok provided we define it in the beginning. However if you agree on a benchmark during the leasing period.

2013-02-10 Class Notes

Handout describing sukuk structures sent by Sh Jamaal

The way leasing agreements by the banks there is some way for them to intervene in the rental agreement. This is problematic. When you sublease a property, is it acceptable? 3 of the 4 schools say you can rent it out for more than you bought it. But Abu Hanifah considers that you must give away the difference, since it is money for money. The only exception to this is if the owner did something to the place that made it better then he can charge the place. E.g. iftikhar leases a sports to suleiman for private use, and suleiman leases it to someone else for racing, so suleiman improves it.

Ends of leasing

Under what circumstances does a lease contract end?

- If the property is damaged irreparably.

- According to some scholars, if the lessee dies, but not all.

- If the property is sold, according to most scholars, it does not end the contract

Late fees

If he is late, the person can not be charged a late fee. Majority of scholars of the view that the lessee can be penalized, but the penalty should not go to the lessor. E.g. it should be donated to charity.

Types of Lease

Financial lease -- have goods until the equipment expires. Cost of lease includes the equipment. Lease includes profit

Operating lease -- equipment is rented for shorter period of time, such that at the end of the period it still has value (e.g. 5 years). Goal of those leases is to cover costs.

The majority of leases from Islamic banks is financial lease. In an option: ijaara wa iqtinaa (إجارة و اقتيناء) -- lease with an option to buy. Essentially a financial lease.

Muslim scholars have some concerns, some of them minor. Examples: Islamic: rental starts when lessee takes over equipment, normal: when contract is signed.

But the big problem: conventional lease is two contracts in one: the lease and the final sale.

2013-02-17 Class Notes

We were discussing Ijara model of an Islamic bank. The banks also have an Ijara which is rent to own. There are couple of ways it is done. One is to give the leased item as a gift and another is to sell it for very nominal price. This promise has to be independent from the Ijara contract. The banks are not concerned about the day-to-day issues but they are more concerned about the flow of the money.

So what happens when you securitize? Is it the bank? No. It’s the sukuk buyer. How is it managed in practice? They create an entity to help manage the properties.

Recall from the course in which we discussed the mortgages, we saw that in many cases the bank finds the prospect lessee and then they lock him in and then go and buy the property and then lease it to him.  

Unfortunately, some of the shariah boards call this way of bank’s dealing shariah compliant.

Another way is where the company has the equipment and it is owned by the company. The company sells the equipment to the bank and get a lot of money from the bank. The bank then turn around and leases it back to the same company and gets money payments over the time. When the company sells then it looks like there is an agreement of some sort between bank and the company that the equipment will be leased back to them. This is like Al Ayna and this is haram. The bank securitizes this arrangement and sells it as sukuk.

The whole problem is coming since the banks are not willing to take risk. If banks were willing to take risk then many of the haram in these contracts can be avoided.

Special Purpose Vehicle (in Europe and India it is called Special Purpose Entities)

It is a recent development in Economics and it is a legal entity created to fulfil narrow and short term objectives. In case of securitization the SPVs are used to secure the loans and to ensure that ….. have the first priority to pay for the loans.

From the handout of last week the role of the SPV is to purchase assets from the seller.

In the figure 5 of the handout the asset seller is the owner of the equipment. SPV pays money to the asset seller (SPV can be set up by the bank or the gov’t). The figure below captures the steps for figure 5.

In the figure 6 the gov’t of Qatar as a borrower has sold a land parcel to the SPV $700m.

2013-02-24 Class Notes

The representative of the Guidance Financial will be here next week.

Brunei sells its sukuk as something which helps the nation grow.

Can we design a completely halal sukuk

We have $100 million with a Financial Institution (FI). Someone says lets do Sukuk al Ijara, so first question is do we have to create SPV? Answer is yes, since there is nothing in principle wrong with SPV. SPV has to be some kind of Property Manager with trust and responsibility as owner of the property of interest. Consider that the equipment gets some defect which is not due to the user then SPV is the body responsible for the maintenance of the equipment.

Can we go to someone and tell him that we will do this for you (say buy a football stadium which is next to the facility of CISCO and demolish it to make it part of CISCO facility). So we contact CISCO and after getting a letter of intent (which is a non-binding promise) which says that they are “...seriously interested...” so we decide to go ahead. So we buy (solid red $ line) the property. If we try to tell CISCO that we will sell you this land in 20 years then this is problematic so we will not do this. The CISCO gives us money (dashed $ line) and we allow CISCO to use the property.

We create a sukuk worth $120 million. This money goes back to the FI which makes FI happy. So the CISCO money for property goes to the Sukuk Buyers minus the money needed by Property Manager. In this scheme the only interest being paid is by the bank to itself which is halal.

AAOIFI has conditions:

- The sukuk to be tradeable must be owned by the sukuk holders. They must be in full possession of the asset.

- The manager (SPV) must certify the transfer of ownership to the ones who buy the sukuk and can not keep them as their owners.

- Sukuk to be tradeable they have to receivable on debt.

Let’s say we have goods worth $100 million which is with FI and it sells to CISCO overtime. The CISCO pays back $150 million for the goods. Can we make sukuk out of this? In this case we have sold the goods to CISCO so now we cannot make sukuk since we cannot make sukuk on debt. We can only transfer the debt.  

So sukuk on this example cannot work.

Continuing on AAOIFI

- It is not possible for the sukuk manager to offer payment in the case that expenses exceed any losses. However, it is acceptable to maintain a reserve account.

- It is not permissible for the owner to repurchase the assets from sukuk holders for its nominal value when the sukuk are extinguished at maturity. It is permissible to do it at net value, market value, etc.

- It is permissible for a lessee under Sukuk Al-Ijaarah for him to purchase the asset when the sukuk are extinguished for its nominal value.

- Shariah supervisory boards should not just look at the documents, but need to ensure that at every stage and that in every part it be supervised by the Shari’ah Supervisory Board.

The problem is that there’s only 45 people on all the Shari’ah boards.

2013-03-03 Class Notes

Guidance representative could not come this week for some reasons. He may come next week.

Murabaha review

Today we discuss Murabaha and lets see if we can convert it into a sukuk. Murabaha is cost-plus sales transaction and Imam Malik use to like it. The contemporary Islamic banking has converted it into a way of ….  Murabaha is basically Bai al Muajjal (delayed transaction).

They have something called MPO which is Murabaha to purchase order. So we have as usual FI (financial institution), customer and a supplier. Say supplier is 1000 cars worth $100,000. First the customer and the FI talk about cars. FI tells the customer that FI is not an expert on it and FI tells customer to go out and work out the details and then whatever is the cost plus 20%. So FI takes a binding promise/earnest money from the customer. The customer acts as an agent and after customer mentions what he wants to buy the FI buys the cars for $100,000 and then sells it for $120,000 to customer over time.

The reason why the binding  promise is needed is that if there is a “no Taqwa” case then customer can go back on his promise and then try to negotiate that I will not pay $120k but only $80k.  

The key over is here that now this has become a vehicle for financing, earlier it was just a sale. Earlier times you could purchase goods either using cash or payments over time. And this scheme of payments over time, opens the door to the above types of financing schemes.

The scholars say that this is not really good, it is bit shady, they advise them to get into contracts that are more equity based.

Footnote: There is shade of gray difference between the above scheme and Wells Fargo financing, since for purposes of the contract, the financial institution takes ownership of the items of sale for a fraction of time. And this is different than classical riba, since riba is a money for money transaction, whereas here the bank is involved at just the last moment of the contract to complete the sale.

Banks also have transactions for individuals and not just relegated to large institutions, you could avail of these shady practices to buy houses or cars in the Middle East, all the way from Morocco to Indonesia.

The genesis of all of these schemes is the key of allowing payments over time, since it was allowed by some of the scholars.

Sukuk Murabaha

How can we securitize or sukuk the murabaha?  This is the next topic. What are you really securitizing? Is it the contract? They cannot securitize the item of sale, since it has already been sold.

The only thing that they can sell you is the debt if they try to make it sukuk. The FI can only sell the debt to the sukuk holders. If FI or bank transfers the debt then the FI does not make any money. So is it possible to make sukuk here and FI still makes profit?

Create tranche of various transactions and include debt in it (or hide it)

One thing FI does (since they cannot really sell debt to make money) is to put this debt in a mixed portfolio i.e. makes pool of Murabaha, Ijarah, Salam and Mudaraba. For example, IDP (Islamic Development Bank) gave sukuk was $…..million and in that basket was some Murabaha based debt.

They claim as long as the murabaha portion is less than a certain amount, the various scholars say it is okay. And this becomes a vehicle for banks to get rid of all of their debt. Pure Sukuk Murabaha made up 5% of the Murabaha market.

There is one way to make it truly shariah compliant. Shaykh Jamaal is asking us to look at the pictorial representation of the model shown above.

Customer has made a binding promise to pay the debt in future. The bank then goes and says that I have a buyer lined up for it and they ask investors to purchase it for a share of their profits. Bank then pockets its share of the profit immediately and the investors are required to get the repayment of the debt over a period of time. Bank wants to quickly turnover its cash and move to the next transaction.

They will create an SPV and then the SPV will have all these sukuk buyers lined up and the ownership will transfer to the customer and it takes money from the customer and transfers to the sukuk buyers. The sukuk buyer is getting a risk free income overtime.

Sukuk is a blind investment, you buy it at Luxembourg or some other exchange. There are investors lined up to buy it. So banks already have investors lined up and customers who want to purchase goods over a period of time.

This concludes the discussion of murabaha transactions.

Salaf or Salam Transactions

Another transaction is Salaf or Salam which is a forward sale (or a forward contract) and it is not exactly a future sale. In future sale both buying and selling is in the future. In salam the money is exchanged now and goods are delivered later.

If I am buying dates for a car, if I am paying you dates over time, then ownership of the car will be over a period of time. This is permissible unless there is riba involved.

However there is something unique about these types of forward sales, what is it? Can you sell something that you do not possess? No you cannot.

If I am selling you 100 bags of wheat after harvest, do I have it in my possession right now before the harvest? No I do not. Can I sell something that I do not own. And I am not the farmer, I could be the middle man.

This is permissible because the Prophet (صلى الله عليه وسلم) allowed it. When the Prophet came to Medinah, the people were selling dates, one, two or three years in advance.

Narrated Ibn `Abbas:

Allah's Messenger (صلى الله عليه وسلم) came to Medina and the people used to pay in advance the price of fruits to be delivered within one or two years. (The sub-narrator is in doubt whether it was one to two years or two to three years.) The Prophet (صلى الله عليه وسلم) said, "Whoever pays money in advance for dates (to be delivered later) should pay it for known specified weight and measure (of the dates).

حَدَّثَنَا عَمْرُو بْنُ زُرَارَةَ، أَخْبَرَنَا إِسْمَاعِيلُ ابْنُ عُلَيَّةَ، أَخْبَرَنَا ابْنُ أَبِي نَجِيحٍ، عَنْ عَبْدِ اللَّهِ بْنِ كَثِيرٍ، عَنْ أَبِي الْمِنْهَالِ، عَنِ ابْنِ عَبَّاسٍ ـ رضى الله عنهما ـ قَالَ قَدِمَ رَسُولُ اللَّهِ صلى الله عليه وسلم الْمَدِينَةَ، وَالنَّاسُ يُسْلِفُونَ فِي الثَّمَرِ الْعَامَ وَالْعَامَيْنِ ـ أَوْ قَالَ عَامَيْنِ أَوْ ثَلاَثَةً‏.‏ شَكَّ إِسْمَاعِيلُ ـ فَقَالَ ‏ "‏ مَنْ سَلَّفَ فِي تَمْرٍ فَلْيُسْلِفْ فِي كَيْلٍ مَعْلُومٍ، وَوَزْنٍ مَعْلُومٍ ‏"‏‏.‏

Sahih al-Bukhari 2239

Prophet said that whoever sells in advance, should buy something that is of known quality and fixed quantity, etc. Another version also adds Ajalin Maloom to it.

Narrated Ibn `Abbas:

The Prophet (صلى الله عليه وسلم) came to Medina and the people used to pay in advance the price of dates to be delivered within two or three years. He said (to them), "Whoever pays in advance the price of a thing to be delivered later should pay it for a specified measure at specified weight for a specified period."

حَدَّثَنَا صَدَقَةُ، أَخْبَرَنَا ابْنُ عُيَيْنَةَ، أَخْبَرَنَا ابْنُ أَبِي نَجِيحٍ، عَنْ عَبْدِ اللَّهِ بْنِ كَثِيرٍ، عَنْ أَبِي الْمِنْهَالِ، عَنِ ابْنِ عَبَّاسٍ ـ رضى الله عنهما ـ قَالَ قَدِمَ النَّبِيُّ صلى الله عليه وسلم الْمَدِينَةَ، وَهُمْ يُسْلِفُونَ بِالتَّمْرِ السَّنَتَيْنِ وَالثَّلاَثَ، فَقَالَ ‏ "‏ مَنْ أَسْلَفَ فِي شَىْءٍ فَفِي كَيْلٍ مَعْلُومٍ وَوَزْنٍ مَعْلُومٍ، إِلَى أَجَلٍ مَعْلُومٍ ‏"‏‏.

Sahih al-Bukhari 2240

So you are paying up front for a good that is fungible, it is something that you can find a replacement in the market. These type of advance sales were made in Medinah for wheat, barley, dates and grape leaves??? Contemporary scholars have expanded the possibility, since more goods are now considered fungible, a lot of manufactured goods are considered to be fungible.

You are not allowed to sell a specific item, such as the harvest of a specific tree in advance, since you do not know the quality, the quantity, etc.

You cannot buy a farmer’s entire crop in advance, since there is gharar or extreme risk involved for either the buyer or seller. There could be a famine or drought and the harvest could be ruined, or there could be a bumper crop and seller is at a disadvantage. However farmer’s like these permissible Salam or Salaf schemes, since they are in perpetual debt and they like this payment up front.

Variations of Salam contracts

#1 Currency Salam

What about salam in currencies? Say I sell you $100 for six months from now for $50 right now? This does not sound alright, because currency has to be “hand to hand” and on the spot. However some Islamic banks deal with salam in currencies. Many Ulema have told them to stop and have argued that laws of gold and silver also apply to the currencies.

It is forbidden to do salam contracts where the item being sold is currency, because currency transactions have to be hand to hand and spot transactions.

#2 Reselling a Salam Contract as another Salam Contract

Is it allowed for buyer to sell his goods before he gets possession of the goods he bought? This is back to back salam and it is not allowed. And these type of back-to-back salam contracts are not allowed because of the explicit hadith disapproving it. ???Did we discuss this hadith????

Reselling a salam contract as a salam contract is forbidden because of the hadith. This is confusing, did you get it?????? I did not get it fully. All what we concluded was that hadith is weak.

#3 Parallel Salam Contracts

Banks do something which is called parallel salam. Ibn Taymiyyah and Ibn al Qayyim have said that there is no problem with this if third party is involved. It is not allowed if certain food items are involved.

Homework: how to make sukuk out of parallel salam contract? We also have to figure out how do sukuk salam operate?

2013-03-10 Class Notes

Last week we discussed Bay’ al Salam. It is a forward contract, where you pay everything now and delivery comes later.

Sukuk Salam Contracts

The following diagram describes the basic components and timelines of a sukuk salam contracts.

One thing with Salam contract is that the place of delivery has to be specified. The bank has to take possession of the material (physically or legally) by deciding on the date of delivery and place of delivery. This salam contract has some risk involved in it. So the bank can ask for some sort of collateral that can be sold off in case the farmers do not deliver.

There is no problem with the idea of the collateral in Islam since shield coat of Prophet (صلى الله عليه وسلم) was collateral with a Jew at the time of the death of Prophet (صلى الله عليه وسلم).

When the date of the Salam contract (May 1st) becomes due, then at the due time the goods are delivered according to the contract and everything is good. If there is a failure to supply the goods on the due date, and there was a flood or disease and the supplier is not able to supply the commodities. If the farmers were not able to produce, in that case bank can ask the farmers to buy the replacement and bring it to the bank. Let’s say the the rice was special and then all of it has been destroyed. In this case the buyer has some choices:

1. Wait until the goods are available.

2. Cancel the contract and recover the money that has to be paid.

3. To agree to some replacement with mutual consent.

Suppose it was a special type of date (thimar), for example Dates from Madinah, and at the time of delivery they are not available. So they agree to some alternative type. Is that acceptable? No. Because dates are a ribawi good, so they can not replace it with a greater amount.

Similarly if they supply inferior quality goods at the time of delivery. This time the buyer has three options:

1) He can ask for the quality of goods agreed upon

2) He can ask for the replacement

3) Ask the supplier for the refund

One of the major salam sukuk today is from the Central Bank of Bahrain which is available since 28th April 2008. They had $6 million on the sukuk with maturity date of 90 days. Rate of return was 2.15% which happens to be very consistent with that type of bond. Minimum subscription limit was $10,000.

Central Bank of Bahrain dealt in aluminium. They have chosen the Bahrain Islamic Bank to participate in this. So the govt of Bahrain agrees to supply a certain amount of aluminium at a future date. The buyer will appoint the govt of Bahrain as an agent to supply. So the Bahrain Islamic Bank agrees to buy them.

The one who issues the certificates is the seller of the goods. The subscribers are the buyers of the goods and the funds realized from the subscriptions are the purchase prices of the goods. The purchasers of the certificates are the owners of the goods. This is all done through creating an SPV (Special Purpose Vehicle).

What is happening is that the salam element is not in?(since Aluminium cannot be sold easily to deal with unexpected expenses) (a?) liquid (asset) and it cannot be sold to others. Due to this they are less attractive. What happens that they own the underlying commodity at the maturity date. If you end up owning the commodity then it means that you will buy the certificates only if you can sell the commodity much higher than the maturity date. This sukuk is asset based since the salam is asset based.

[Below is the Diagram]

We have the obligator and the SPV and then another obligator. Then we also have the sukuk holder. Here one obligator is undertaking the future sale of the commodity for the investors. On the other hand we have the obligator that sells the commodity in salam basis. In the creation of SPV, the first obligator is selling the commodities (which is gov’t of Bahrain) and the other obligator is selling the commodity to the SPV. So gov’t of Bahrain is just giving the money to SPV which is going to the sukuk holders. In case of Aluminium, the gov’t is just facilitating the sale of Aluminium.

It is an asset based municipal bond. The total amount of funds in this scheme are around US$ 18 million. They have this experiment because they are allowed to operate this scheme.

The creation of the SPV was to separate the liabilities of the bank from its .... and also to hide things.

Next week, we will discuss problems with Sukuk contracts. According to one author there are four problems with sukuk contracts and if you can solve them, you will be in line to receive a Nobel prize.

Mudarabah is a silent partnership. Is there a difference between mudarabah and musharakah? Yes Musharakh is not a silent partnership.

Musharakah: All of them invest in the business and participate in its operation. In Mudaarabah, that’s not the case, he doesn’t participate in the businesses. In mushaarakah, they all share the financial loss in same ratio of their investment. But Mudaarabah it is all on rabb ul maal.

Mudaarabah is meant to be project-based. But musharakah can have regular payouts. Musharakah participants share the increase in assets. In mushaarakah, all of the assets are owned by rabb ul maal.

Approved in 1988 by Majma’ al Fiqhi

Common ownership in specific projects against which the mudaarabah sukook has been issues. This ownership will be liquid unless the mudaarabah capital is in the form of debt.

The prospectus can also contain a promise made by a third party totally unrelated to the terms of the contract to donate a specific sum without any counter-benefit, in the case of loss. This is effectively FDIC insurance.

2013-03-17 Class Notes

We will finish our discussion of sukook and its differences with traditional bonds and then a study about.... and then finally a critique of sukooks by different Ulema.

Comparison of sukook and conventional bonds

AAOIFI lays out some conditions for sukooks

#1 Sukook have to be backed by assets




For the financial institution, moving things off the balance sheet is one of the advantages. Taqi Usmani said 85% of sukook from the Gulf do not comply with Shariah law. He says it is a backdoor to usury.

One thesis from Mohammad Ali Jinnah University student called Zohra Almubeen. She tested four hypotheses:

1. Sukook conform to the principles of the shari’ah.

Her conclusion:

Her conclusion: ijaarah sukook partly meets the shariah principles, and musharakah sukook, she said they do not meet the criteria. Ijaarah said they were compliant with AAOIFI, because:

1. There are underlying assets.

2. They say that there is an underlying ijaarah

3. The sale-and-lease-back part is compliant with AAOIFI requirements, but the AAOIFI requirements are vague in parts.

The parts of sukook not compliant with the principles of the Shariah

1. Rent returns to SPV (Special Purpose Vehicle) and ultimately sukook holder.

2. Distribution of loss in the case of ijaarah transaction.  

3. Distribution of profit & loss from sale and resale amongst the buyer and sellers.

Re: Musharakah sukook

The underlying assets, but sometimes the mushaarakah contract is not compliant.

Parts of the Sukook not meeting the conditions set by AAOIFI:

1. Distribution sharing.

2. Guarantees of return.

3. Repurchase agreement/redemption price.

The core of the issue is the repayment of the principal upon maturity is the issue.

2. Sukook are asset securitization instruments

She found that largely applying the AAOIFI conditions it is a true case of asset securitization. In practice, however, this is not the case. They do use money as an asset and they do securitize credit, etc.

3. Sukook transfers risk from the originators to the sukook holders and this is shari’ah compatible

The leading countries have set a few times to make laws for the global banking. The problem with Islamic banks is that they want to deal at the international level, where they have to abide by the international law. Some of these agreements are called Basel agreements.

She tests this hypothesis in the light of Basel agreements: “It was seen that significant risks of the sukook contracts still rest with the originator.” Her conclusion is that this hypothesis is false.

She then concludes that sukook are not really shari’ah compliant.

There are 3 key issues with respect to sukuk

1) ownership of assets

2) distribution of sukuk

3) guaranteed return of principal

The only way they can do that is for the original institution (which shouldn’t have anything to do with it) they are the ones who step in and “donate” into the funds.

Then you have the promise to purchase the goods at the end of the sukook.

Mustafa Zarqa says that there is a challenge to generate Shariah compliant sukook. He says that most of the issues are not in the takeoff stage but the landing stage. He says that there are some ways that we could do some sukook, they could be income generating, they would have low risk and they would be shariah compliant. The only issue is that they would be totally illiquid.

Taqi Usmani said “tradable sukook must represent real sukook assets, including all the rights and obligations of owning an asset comes along with it.” Loans to sukook holders are forbidden.

One of the benefits of bonds is that you have a reliable source of income. But does it have to be 100% reliable? Also, does it have to be for the value of the principal?

Final point about sukuk is that are sukuk like bonds in securitization. According to a study, there is a significant difference between the sukuk and the real yield of a regular bonds.

One problem is issue of supply and demand. When we take Shariah compliant products to even the Muslims, then many Muslims will go for non-Shariah based products. Besides Muslim Ummah is not strong enough to run its own Islamic Finance parallel to the non-Islamic Finance and the countries who are “power to be” will not want Islamic Finance to be successful.

The other thing is that if there is an Islamic system that was less profitable then they will probably come after it too. The Shariah compliant system is not going to be like this system. Because they are looking at all the profits they could be making and switch it to the new system.

The problem is that the systems as being Shariah-compliant, and at the same time Western people are saying it’s bogus.


The concept of stocks is perfectly valid but in practice it is not compliant with the Shariah. The concept of sukook right from the start seemed fishy. The way it is practiced is simply not compliant with the Shariah, there is no risk, there is a binding promise to purchase assets, there is no transfer of ownership, so in reality the sukook as a financial investment is not compliant with shariah.