Banks think they attract customers in the short term, but the reality is that they lose them in the long term. Retail Tawarruq is not only Shariah non-compliant most times, it is also quite possibly the worst first impression we can make as an industry.

You walk into the Islamic bank, sign some papers, “trade” in metal in some corner of the globe, and walk out with cash. Papers are pushed, money changes hands, and the metal just sits there, ready for the next customer to “trade” a few minutes later. Or can the same metal be bought and sold by different customers in the same minute? Who’s counting anyway?

Welcome to the world of Tawarruq.

Last week Ethica Institute, one of the industry’s leading Islamic finance training and certification institutes, distributed a fatwa (expert legal opinion) to its community from one of its scholars, Mufti Ismail Desai, explaining the impermissibility of a particular Tawarruq product. The product in question came to light when one of the UK’s major banks approached the institute for its training and certification services. Ethica declined to offer its services citing Shariah non-compliance of the Tawarruq product.

What some Islamic finance scholars begrudgingly allow for in extreme, case-by-case situations, banks often turn into a retail product for ordinary customers to use. Tawarruq, according to Ethica, is one of the main reasons customers question the credibility of Islamic finance. A product that began as the industry’s somewhat embarrassing black sheep over a decade ago has now grown into the eight hundred pound darling of many Islamic banks.

Ethica’s fatwa raises two important issues for an industry fast on growth but slow on establishing credibility among banking customers: first, what really is Tawarruq? And, second, importantly, if it becomes a regular product, is it still Islamic finance?

“Banks think they attract customers in the short term, but the reality is that they lose them in the long term. Ethica works with bankers and customers across multiple regions and we are seeing the same pattern: when Islamic finance’s credibility is compromised, customers leave. And they usually don’t come back. Retail Tawarruq is not only Shariah non-compliant most times, it is also quite possibly the worst first impression we can make as an industry,” said Ethica’s spokesperson.

Ethica explains that the first step to understanding Tawarruq is understanding its definition according to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the world’s leading Islamic finance standard. Tawarruq (Monetization), “refers to the process of purchasing a commodity for a deferred price determined through Musawama (Bargaining) or Murabaha (Mark-up Sale), and selling it to a third party for a spot price so as to obtain cash. Whereas Inah refers to the process of purchasing the commodity for a deferred price, and selling it for a lower spot price to the same party from whom the commodity was purchased.”

To expand on this definition,

1. Bay al-Inah is composed of two sale transactions. In the first transaction, a seller sells an item for a particular price to be paid in deferred installments. In the second transaction, after taking possession of the item, the buyer sells the item back to the seller for immediate payment of a lower price, to be paid before the installments of the first sale are due. The overwhelming majority of scholars are of the opinion that Bay al-Inah is impermissible when the price of the second sale is lower than the first sale. However, some jurists have ruled that Bay al-Inah is permissible in the instance when the price of the second sale is equal or higher than the price of the first sale.

2. Bay al-Tawarruq in the strict definition of the jurists is defined as a Monetizer (mustawriq) who buys a merchandise at a deferred price in order to sell it in cash at a lower price. Usually he sells the merchandise to a third party with the aim to obtain liquidity. Jurists have ruled that this form of Tawarruq is permissible since the laws and rules of a valid legal Shariah sale have been fulfilled.

The contemporary definition of organized Tawarruq is when a Monetizer (mustawriq) purchases merchandise/commodities on the international commodity market on a deferred price basis either through Musawamah or Murabaha. The financier arranges the sale agreement either himself or through his agent. Simultaneously, the mustawriq and the financier executes the financial transactions, usually at a lower spot price.

According to scholars, Tawarruq should be limited to individual need and necessity and not retailed to the public. The Islamic economy, they say, should be based on profit-sharing instruments like Mudarabah and Musharakah. Interest free loans (Qardh Hasan) are the ideal alternative to Tawarruq. Among the problems with Tawarruq:

1. Tawarruq in currencies are not permissible.

2. The bank cannot sell goods on behalf of the client without the client taking physical or constructive possession of the goods. This does not usually take place. Islamic banks generally sell the warrants representing the metals and not the actual metals. Therefore, the bank does not take possession when purchasing the metals from the broker initially. The Mustawriq (monetizing client) does not take possession in any form of the metals. The bank is merely appointed as an agent to sell the metals on the metal exchange without any actual Shariah realization of the contractual positions required.

3. All the transactions in a Tawarruq transaction should be separated and individualized. The various legs in most transactions are not individualized and separated.

4. Contemporary forms of organized Tawarruq are very similar to Bay al-Inah and have been largely detested by the majority of scholars including the International Council of Fiqh Academy. (Resolution 179 (19/5) in relation to Tawarruq: its meaning and types (classical applications and organized Tawarruq))

While it remains to be seen whether Tawarruq reform is likely in the industry – much like a few years ago when banks began cleaning up their Sukuks after AAOIFI’s chairman, Mufti Taqi Usmani, publicly criticized them – there is no doubt that the industry continues to suffer the long-term consequences of an expedient reading of an already borderline product.