Islamic Principles of Financial Engineering
with Special Reference to Sukuk Instruments
Prof. Dr. Munawar Iqbal
Former Chief of Research
Islamic Banking and Finance
IRTI, Islamic Development Bank Group
UMP-DIFC SYMPOSIUM
Dubai, May 3 2010
1
Definition of Financial Engineering
Financial engineering can be defined as ‘the
design, development, and the implementation of
innovative financial instruments and processes,
and the formulation of creative solutions to
problems in finance’.
2
Need for Financial Engineering in Islamic
Finance
Until now, the Islamic financial tools have essentially
been limited to classical modes developed centuries ago.
They were developed to meet the needs of those
societies. While they may serve as useful guidelines for
contemporary Islamic contracts, there is no reason,
whatsoever, to be restricted only to those. Financial
markets are becoming more and more sophisticated, and
competitive. In order to exploit the fast changing market
environment and face increasing competition, financial
engineering and innovation is imperative.
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Scope for Financial Engineering in
Islamic Finance
Financial needs of both individuals and
businesses have changed. Engineers in modern
finance have designed several new ways such
as mortgages, options, derivatives, hedging,
insurance pension plans, credit cards etc., to
meet those needs. We must examine what
needs are being fulfilled by these instruments.
If the needs are genuine (Islamically speaking),
then we must either adapt them for our
purposes or invent Islamic alternatives for
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them.
Scope for Financial Engineering in
Islamic Finance-Cont.
In the light of the fast changing financial scene, “a needs
approach to financial engineering” is desirable, of course
within the known principles of Islamic finance.
In this regard, the example of bay‘ salam is very
important to remember. In general, it is not allowed to
sell anything, which is not in one’s possession. But in
case of salam, the Prophet (pbuh) allowed such sale
because of “need” of the people, but laid down clear
rules to protect the interests of both parties.
In the following slides we will attempt to provide
necessary tools and principles for FE in modern
times.
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Ten Guiding Principles for FE
1.The Doctrine of Maximising Human Welfare
2.The Doctrine of General Permissibility
3. Prohibition of Riba
4. Prohibition of Gharar
5. Prohibition of Gambling
6. Prohibition of Selling Without Having Possession and Two
Deals in One
7. No pain no gain (Al- Kharaju Bil-Daman)
8. Permissibility of Hybrid Contracts and Rules Governing
them
9. Principle of Relief (Istahsan)
10. The Doctrine of Necessity
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The Doctrine of Maximising Human Welfare
The doctrine of maslahah, (seeking of benefit and
repelling of harm) is well-recognized in Fiqh. It is
something similar to the principle of utility (securing
maximum human happiness). However, Muslim jurists
have pointed out that from a technical point of view,
maslahah means the securing of the objectives of Shariah
rather than maximisation of happiness as seen by human
beings. However, the objectives of Shariah, themselves,
aim at maximising human welfare in this life as well as
the life Hereafter. (The Creator knows what is best for His
creations) With this distinction in view, let us call it, “The
Doctrine of Maximising Human Welfare”.
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The Doctrine of General Permissibility
Islamic Ahkam (Commandments) are broadly speaking of two
kinds: (1) Ibadat (worshipping) and (2) Muamalat (Dealing
among human beings).
The general rule in the field of worshipping is that an act is
worship only when permitted by Shariah. On the other hand,
in the case of mutual dealings, the general principle is that
everything is permitted unless clearly prohibited by the
Shariah. I call it “The Doctrine of General Permissibility”. In
the Islamic theory of contracts, parties are free to agree on
any terms as long as known Islamic rules and principles are
not violated. There is an authentic hadith stating:
‫المسلمون عند شروطهم إال شرطا حرم حالل أو حلل حراما‬
“Muslims are free to determine the conditions of their
contracts unless they make something permissible as
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forbidden or something forbidden as permissible”
Prohibition of Riba
 Riba
literally means increase, addition,
expansion or growth.
 In the Shari’ah , however, the term riba refers to
anything (big or small), pecuniary or nonpecuniary, in excess of the principal in a loan
that must be paid by the borrower to the lender
along with the principal as a condition of the
loan or for an extension in its maturity.
 In this sense, Riba has the same meaning and
import as the contemporary concept of interest
in accordance with the consensus of all the
fuqaha (jurists).
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Prohibition of Gharar
Gharar refers to acts and conditions in contracts,
the full implications of which are not clearly
known to the parties.
 In economic parlance it is very close to
“Asymmetric Information.”
It has two kinds: gharar yaseer (trivial) and
gharar fahish (substantial).
The first kind is tolerated since this may be
unavoidable without causing considerable
damage to one of the parties while the second is
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prohibited.
Prohibition of Gambling (Maysar)
‫يا أيها الذين آمنوا إنما الخمر والميسر واألنصاب واأل زالم رجس من عمل‬
(.90‫ اآلية‬،‫(سورة المائدة‬
‫الشيطان فاجتنبوه لعلكم تفلحون‬

 O Ye who believe, Intoxicants and Gambling,
(Dedication of ) stones, And (Dedication of) arrows,
are an abomination, of Satan’s handiwork: Eschew
such (abomination) , That ye may prosper.
 Gambling involves to transfer of wealth without
any value added. It involves that kind of risk which
is self-created, is zero-sum game and does not add
any value to the national wealth.
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The following Hadith establishes three more
principles:
ِ ‫ول ه‬
ُ ‫قَا َل َر ُس‬
‫َش َط ِان ِِف ب َ ْيع ٍ َو َال ِربْ ُح َما ل َ ْم ت َْض َم ْن َو َال‬
ْ َ ‫ « َال َ َِي ُّل َسلَ ٌف َوب َ ْي ٌع َو َال‬-‫صىل هللا عليه وسمل‬- ‫اَّلل‬
)‫ب َ ْي ُع َما لَيْ َس ِع ْندَ كَ )أبو داود‬
1. Loan and Trade Contracts cannot be combined (more
on this later)
2. Two deals cannot be combined into one (more on this
later)
3. Right to profit is contingent upon taking
responsibility (for loss)
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Provision for Providing Relief (Istihsan)
Istihsan literally means preferring something over
the other. Technically, it has been defined in several
ways. In essence it refers to departure from a ruling
based on previous analogy (qiyas) in a particular
situation in favour of another ruling, which brings
about ease. Some people have criticized istihsan
saying it amounts to moving away from a rule
deduced through qiyas toward the personal opinion
of a jurist. However, this is not in fact the case. In
istihsan, a ruling is preferred to another based on a
stronger evidence, usually from texts (nusus), due to
consensus (ijma) or to the doctrine of necessity all of
which have sound basis in Shariah.
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Combining of Contracts
While it is possible to modify classical contracts
to suit modern conditions, a much broader scope
for financial engineering exists in developing
new contracts. These contracts could be hybrids
of old contracts or may be entirely new.
However, in hybrid contracts, there are certain
rules that govern ‘Combining of Contracts”.
Since almost all of contracts being presently
employed involve combining of contracts, it is
worthwhile to briefly mention them.
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Combining of Contracts-Cont
In principle, Islamic law should not have any objection to the
combination of contracts in view of the Doctrine of General
Permissibility. However, some scholars have raised certain
objections to certain type of contracts being combined into
one. They point out that since all rights and obligations
created by contracts bunched together are to be viewed as
inseparable obligations, one has to see the end result and
apply the Shariah rule to it. What is at dispute is not the
validity of combination of contracts in principle. The concern
is with the nature and form of such combinations. Scholars
draw attention to the qualifying clause in the hadith that is the
basis of the Doctrine of General Permissibility. It states that
all conditions mutually agreed are acceptable “unless they
make something forbidden as permissible or something
permissible as forbidden”. Therefore, in order to check the
validity of the overall deal emerging from a combination of
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contracts, certain parameters need be established.
Conditions for Combining Contracts
1. The combination must not contradict an explicit text
If there is an explicit text in the primary sources of Islamic law
that certain types of contracts cannot be combined, for whatever
reason, then any structure that involves such a combination
becomes unacceptable. If analysed, the rationale of prohibition
can also be found. Some Examples are:
(i) It is prohibited to combine a loan contract with a sales
contract. Rationale:If allowed, a lender may advance the loan on
an interest-free basis in the loan part of the deal but they can buy
something at a cheaper price in the sale part of the deal which
amounts to riba.
(ii) The Prophet prohibited “two deals in one”. Some scholars
take this hadith as a general prohibition of combining contracts.
However, actually it implies that if more than one option is
offered, one must be chosen before the deal is finalised.
Rationale: Such combination amounts to gharar in the combined
contract, which is prohibited in business contracts.
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2. A product structured on the basis of a combination of
contracts should not be intended to circumvent
impermissible transactions. Such attempts are called
hiyal (legal artifices) and are not generally allowed. For
example, the Prophet (PBUH) prohibited bay al-inah,
which is a sale and buy-back arrangement. For example,
A sells his house to B for a cash price of US$500,000
and simultaneously buys it back from B at a credit price
of US$600,000. It is easy to see that the end result is
exchange of $500,000 now for US$600,000 later. This
is nothing but riba. The “selling” and “buying back” of
the house is inconsequential. The recent ‘sukuk debacle’
was a result of similar commitment.
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3. The Combination must not involve contradictory
contracts/conditions
Each type of contract has unique legal implications
and obligations. Contracts which are mutually
contradictory cannot be combined. If the legal
consequences do not conflict each other then there is
no problem in combining them. For example, a
collateral condition supports a loan contract and is
hence acceptable. On the other hand, a condition in a
marriage contract stipulating that the spouses will
live apart, defeats the purpose of the contract and is
hence not acceptable.
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4.The Combination must not involve contingent
contracts
The Prophet (PBUH) has prohibited a sale that is
circumscribed with a condition (bay wa shart). If the
combination is such that the execution of one
contract is contingent upon another contract, such
combination is not permissible. For example, Zaid
saying to Bakar that I sell my house to you provided
Omar rents his house to me.
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The Doctrine of Necessity
In very exceptional circumstances, application of a
particular command (hukm) may be temporarily
suspended. For example, eating carrion is prohibited.
However, if someone is facing certain death due to
hunger and they have nothing but carrion to eat, the
objective of “preserving life” dictates that they are
allowed to eat of carrion but only as much as is
necessary to sustain life and only until something
permissible to eat becomes available. This doctrine is
clearly established by Quran [Qur’an 2:173]. However,
the same verse lays down three conditions for it to be
invoked: (1) The situation is that of iztarar (extreme
and unavoidable difficulty); (2) The suspension is
temporary and (3) There is firm intention to return to
the normal hukm ASAP
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Five Cs of Islamic Financial Engineering
Compatibility
Consciousness
Clarity
Capability
Commitment
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Compatibility
That the deal is fully compatible with the
requirements of the Shariah, i.e., does not
involve anything declared impermissible
by Qur'an, Sunnah or ijma.
22
Consciousness
That the parties should consciously and
willingly agree on the conditions of the
contract without any compulsion or duress.
An implication of this is that any agreement
made in the state of unconsciousness (like
under the influence of intoxicants or imposed
by force) is not valid.
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Clarity
That the parties are fully aware of all the
implications of the conditions laid down in a
contract. Any ambiguity (with the exception of
gharar yasir) will make the agreement invalid.
An implication is to minimize asymmetric
information.
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Capability
That the parties are reasonably certain that
they are capable of complying with all
conditions of the contract. An implication
of this is that in general the sale of any
goods (or services) which are not owned
and possessed by the seller at the time of
the contract is not valid.
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Commitment
That the parties intend and are committed to
respect the terms of a contract both in letter
and spirit. An implication of this is that any
subterfuge to go around any Shariah condition
through linguistic or legal tricks is not allowed.
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The Case Study of Sukuk
Sakk (singular of sukuk) literally means cheque or
promissory note for receivable. Technically sukuk refer to
financial instruments meant to mobilize resources from the
market based on the strength of one’s balance sheet,
credentials, track record, goodwill and prospects of the
proposed project. They are meant to provide an Islamic
alternative to conventional bonds. Sukuk can play a positive
role in mobilization of savings on a vast scale. They benefit
investors as well as those who have projects to finance that
bear the promise of eventually generating sufficient revenue
to meet the costs yet leave a surplus. Their proliferation
increases the efficiency of the financial system. Also, they
are capable of meeting credit needs of government and
businesses in a manner that keeps credit supply linked with
real assets.
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Sukuk- Contd
Financial engineers have come up with fancy, often confusing, names for
various types where ‘engineering’ is more in names than in substance.
The basic ideas are quite simple. Sukuk are basically, certificates based
on ownership of certain assets (or their usufruct). Generally, these
certificates are negotiable in secondary markets. They represent
‘ownership’ in the assets (or usufruct) underlying the issue. Those with
variable returns are based on mudarabah or musharakah. More popular
are those with pre-determined, fixed incomes like the one based on
ijarah, (lease). There are sukuk based on salam or istisna contracts. Also
there are hybrid issues whose underlying assets are mixtures of these.
Murabahah receivables being debt obligations are not considered fit for
sukuk issue. But they have been accepted in such a mixture as long as
they are in a minority. Due to this last point, while sukuk offer a usefully
potential mechanism for secondary market resource mobilization, they
also open the way for sale of debt receivables (as minority share in a
general sukuk issue). Since, the sale of debt except at its face value is
not generally acceptable by scholars, the use of sukuk where debt
receivable are a noticeable proportion, remain suspect from a Shariah
point of view.
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Sukuk- Contd
Even these popular ijara sukuk got a jolt when the chairman
of the Shariah Board of AAOIFI, made a remark in
November 2007 that about 85 percent of sukuk did not
comply with Islamic law because of repurchase agreements.
That sent shock waves to the sukuk market around the
globe and according to industry experts sukuk issuance
dropped to around $14 billion in 2008 as compared to some
$50 billion in 2007. Though Standard & Poors estimated in
September 2008 that the sukuk market will exceed $100
billion by 2009, even with the latest hiccup, no RELIABLE
statistics exist that can confirm that their estimation was
fulfilled.
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Sukuk- Conclusion
‘Damage control’ efforts have started earnestly, but
my own view is that even if the sukuk market
witnesses some recovery, it will in the short-run be
only due to excess liquidity in the market. Sukuk
will remain under clouds for some time and there is
a big challenge for financial engineers to come up
with new sukuk structures that can reassure
investors about their Shariah-compliance. Every
challenge is also an opportunity and this one is a
trillions-dollars opportunity. Therefore, financial
engineers better get to their drawing boards quickly.
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