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Chapter 1: Prohibitions of Riba and Gharar
It is commonplace in Islamic discourse to stress the positive injunctions to do
good and forbid evil before discussing prohibitions and other negative
injunctions. However, in the interest of saving the reader's time, we go
directly to the need for having an "Islamic finance". In this regard, financial
tools, like all other tools of social and economic interaction, can be used for
good or for evil. Using the tools of finance for good rather than evil is of
course of primary concern in the "Islamic" vs. "un-Islamic" distinction.
However, those aspects of the distinction important as they are lie beyond the
scope of this basic guide.
Our primary concern, instead, is the Muslim individual, group, or business, with
a legitimate and good financial objective (e.g. purchase a. home to house his
family, purchase real estate to establish a Masjid or school, invest available
funds in productive and permitted ways, etc.). As we shall see,, many of the
conventional financial tools currently available in North America (and most of
the rest of the world) are legally prohibited in Islam. In this chapter, we
shall review the two fundamental Islamic prohibitions which render financial
contracts invalid (batil) and forbidden (haram).
Before proceedings to the specific prohibitions, I must reiterate that we are
here concentrating on the Islamic legal aspects pertaining to the contract
itself. Needless to say, an Islamically permissible contract may still be
unIslamic for other reasons. For instance, a legal contract for purchasing an
automobile may be permissible, but the buyer may intend to use the car for evil
rather than good. Concentrating on the legality of the sale contract does not
imply that it is more important than the other considerations. It simply means
that it is one important consideration.
Most probably, the reader is familiar with the verses of prohibition of Riba in
the Qur'an. Unfortunately, negligent interpretations of the meaning of those
verses has led many individuals to assume that the prohibition only relates to
situations where the creditor is likely to charge exploitatively high rates of
interest. One of the most popular translations of the meaning of the Qur'an,
Yusuf 'Ali (1991), translates the meaning of verses [2:278 279] thus:
278. O ye who believe! Fear Allah, and give up what remains of your demand for
usury, if ye are Indeed believers.
279. If ye do not, take notice of war from Allah and His Messenger: but if ye
turn back, ye shall have your capital sums; Deal not unjustly, and ye shall not
be dealt with unjustly.
Thus, the English reader who is not familiar with the end of verse 279 "la tazlimuna wa la tuzlamun", reads this translation as a proof that the (sole?)
objective served by the prohibition of Riba is the avoidance of injustice (in
the sense of exploitation of the poor debtor by the rich creditor). However, the
meaning of the ending of the verse as explained by 'Abu Ja'far, 'Ibn 'Abbas, and
others (c.f. Al 'Imam Al Tabari (1992, vol.3, pp.109 110)) is much closer to:
"if you turn back, then you should collect your principal, without inflicting or
receiving injustice". The exegetes (ibid.) then explain "without inflicting or
receiving injustice" as "without increase or diminution", where both an increase
or a decrease of the amount returned relative to the amount lent would be
considered injustice.
Understanding the Objectives of the Law is important for students of Islamic
Law. [Note: In this regard, Islamic scholars have long debunked the explanation
of the prohibition of Riba, solely on the basis of its exploitative nature. The
interested reader my refer to Al Nawawi (continuation by Al Subki) (1995,
vo1.9: `far` fi madhahib al. `ulama' fi bayan `lllat al riba fi al 'ajnas al 'arba'ah").]
However, laymen and religious scholars alike must abide by the Law. Therefore,
what we need to understand is: what constitutes the forbidden Riba, and how can
we avoid it? In the remainder of this section, we shall cite Hadiths and
jurists' analyses which explain the forbidden Riba. Later chapters will deal
with the Islamic alternatives to Riba.
There are numerous Hadiths which detail the prohibition of Riba. In the interest
of brevity, I list only two here:
- Muslim narrated on the authority of 'Abu Said Al Khudriy; The Messenger of
Allah (pbuh) said:
"Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for
dates, and salt for salt; like for like, hand to hand, in equal amounts; and any
increase is Riba."
- Muslim narrated on the authority of 'Abu Said Al Khudriy:
Bilal visited the Messenger of Allah (pbuh) with some high quality dates, and
the Prophet (pbuh) inquired about their source. Bilal explained that he traded
two volumes of lower quality dates for one volume of higher quality. The
Messenger of Allah (pbuh) said: "this is precisely the forbidden Riba! Tao not
do this. Instead, sell the first type of dates, and use the proceeds to buy the
other."
The first Hadith enumerates six goods which are eligible for Riba. Since barter
trading (e.g. dates for dates, as in the second Had it h) is rarely of concern
today, we shall mainly be concerned with Riba as it pertains to gold and silver,
the monies (Roman and Persian, respectively) used during the Prophet's (pbuh)
time. With the exception of juristic schools which denied the use of reasoning
by legal analogy (qiyas) as a source of legislation (e.g. the Zahiris), and a
few contemporary detractors, most Islamic schools of jurisprudence accepted gold
and silver in the first Hadit h to signify money in general, including
contemporary monies. [Note: The interested reader may consult 'Ibn Rushd (199 i
; vo1.3, pp.183 184) for a summary of the major Sunni school generalizations
based on this Hadith.] In this regard, the Islamic Fiqh Council of the
Organization of Islamic Conference (OIC), in its third meeting in 1407 A.H.,
ruled as follows:
After reading the studies presented to this Council regarding this topic, the
Council has determined regarding the legal status of paper currency that it is a
form of independent money, for which apply all the legal rulings which apply to
gold and silver, including the rulings regarding Riba, Zakah, and
salam. The
legal reason for this ruling is the use of such monies as monetary numeraires,
in terms of which prices are specified (al thmaniyyah,).
The first cited Hadith makes it clear that there are two conditions for
exchanging money for money: hand to hand, and in equal quantity. This is what is
known as a currency exchange contract (`aqd al sarf), where money is traded at
the current exchange rate. However, any violation of the Hadith will result in
one of two forms of forbidden Riba:
- Riba al fail,: where money is exchanged for money hand to hand, but in
different quantities, or
- Riba al nasi'ah: where money is exchanged for money with deferment.
The latter form (Riba al nasi'ah) is the one upon which most of western finance
has been built. In the conventional financial sector, financial intermediation
is effected through lending, and the tune value of money is reflected in
interest payments. As we have seen, this is unequivocal Riba, the devourer of
which was warned of a war from Allah and His Apostle. Indeed, 'Abu Dawud
narrated on the authority of 'Ibn Mas'ud (mAbpwh) that
The Messenger of Allah (pbuh) cursed the one who devours Riba, the one who pays
it, the one who witnesses it, and the one who documents it.
Similar traditions with slightly different language were narrated in Muslim, Al Bukhari, and Al Tirmidhi. Another most damning Ijadith was narrated by Ibn Majah
and Al Hakim on the authority of 'Ibn Mas'ud (mAbpwh) that the Prophet (pbuh)
said:
There are seventy three different types of Riba, the least of which is
equivalent [in sin] to committing incest, and the worst of which is equivalent
[in sin] to destroying the honor of a Muslim.
Notice that unlike the prohibition of Gharar (risky or ambiguous sales), to
which we shall turn shortly, the prohibition of Riba is unequivocal. The jurists
have been more lenient to varying degrees with the prohibition of Gharar since
no contract can ever be totally devoid of uncertainty. However, as we shall see
shortly, most of the financial needs that can be served with contracts
containing Riba can be met without the need for Riba. In particular, Muslims do
not need to deprive themselves of credit to avoid paying Riba, nor do they need
to forego the time value of their wealth to avoid receiving Riba.
[Note: The
notion that there is no time value for wealth in Islam is false, as we shall see
in Chapter 2. The notion that money is sterile (does not grow by itself) and has
no time value is in fact part of the traditional doctrine of the Catholic
church, and rather alien to Islam. In fact, it was argued in Al Qaradawi (1999,
vol.1, pp.37 8, 139 149) that the growth potential (nama) for wealth (mal) is
one of the conditions of eligibility for Zakah. The term is derived from zaka
which means "to grow". The word Riba is derived from raba which also means "to
grow". The reader is encouraged to contemplate the constant conjunction of
Qur'anic verses of the prohibition of Riba with verses encouraging charitable
payments.]
As we shall see in the following chapter, Islamic financial contracts (e.g.
leases and credit sales) result in debts or liabilities (duyun) on the party for
whom the acquisition of an asset is financed. Charging an increase for further
deferment of the payment of such debts as a function of time (e.g. a late rental
payment in a lease, or a late installment payment in a credit sale) would
constitute Riba al jahiliyyah, the worst form of Riba condemned in the Qur'an. 'Ibn
Rushd labeled such increases the rule of "defer and increase" amhilni 'azidka)
and condemned it thus. The opposite rule, in which the amount of the debt is
reduced due to prepayment, was also listed by 'Ibn Rushd (ibid.) among the types
of Riba, under the title, "prepay and reduce"' (da' wa ta'ajjal). The
prohibition of the latter rule has been controversial historically, and it was
relaxed in recent years by various juristic bodies.
[Note: 'See, for instance, the recent rulings by resp.; Sakhr (1996, fatawa #50,1291.265,740,536).] Those opinions were recently
used to develop so called "Islamic credit cards", where purchases are
automatically financed over a fixed period (usually 12 months), and earlier
payments result in reduced charges. Despite the almost unanimous acceptance of
the juristic backing of this rule by contemporary juristic bodies, some of its
various financial applications remain controversial.
The two rules discussed above can be encompassed under the more general topic of
trading in debts. The "defer and increase" rule is in fact selling the current
debt to the debtor, where the price is an even larger debt with a longer
deferment period. As stated above, this is Riba al jahiliyyah, and it is
strictly prohibited. The sale of a debt to the debtor, therefore, must be at
face value (unless part of the debt is forgiven).
More interesting, on the other hand, is the potential of selling debts to third
parties. In conventional "asset backed securitization", a mortgage company or
bank sells its "accounts receivable" from its mortgages or other financing
instruments to third parties. In fact, if the reader currently has a mortgage
with any given company, it is almost certain that this mortgage was securitized
and sold to others (e.g. Fannie Mae, etc.), even though payments continue to be
made to the originator mortgage company.
The reason I mention this issue will become apparent in Chapter 3 below. Islamic
banks will have "accounts receivable"
[Note: An "account receivable" is any
amount owed to a business by a customer as a result of a credit sale.]
corresponding to lease or installment payments (in leases and credit
sales, resp.). In principle, those accounts receivable may be "sold" to the
public as a fixed income investment vehicle with minimal risk (the risk that the
debtor will default, and the repossessed asset sells for less than anticipated).
Debt re sale has been used extensively in the Islamic financial market in
Malaysia, following a Shafi'i ruling which permits such trading. The practice
remains controversial since the Hanafis and Hanbalis (with the exception of 'Ibn
Al Qayyim) render such transactions prohibited, and the Malikis permit it only
under very stringent conditions. While a variety of "tricks" (hiyal) under
various guises have been suggested and used in various "Islamic countries", I
shall restrict attention in Chapter 3 to the most obviously uncontroversial
alternatives which do not include such tricks.
There are numerous Hadiths forbidding Gharar sales, and specific instances
thereof. One commonly cited Hadith was narrated by Muslim, 'Ahmad, 'Abu Dawud,
Al Tirmidhi, Al Nasa'i, Al Darami and 'Ibn Majah on the authority of 'Abu
Hurayra (mAbpwh) (translation of the version in Muslim) that
The Prophet (pbuh) prohibited the pebble sale and the Gharar sale.
A good translation of Gharar is "risk" or "uncertainty”.
[Note: The term risk
(Italian: risco, French: risque) is derived from the Latin roots re = back and
secure = cut, thus reflecting the potential for a sailor to have his ship cut by
hitting a rock. In other words, "risk" means "danger of loss". This is precisely
the meaning of the Arabic term Gharar. The literal meaning of the term Gharar
according to Qadi `Iyad (c.f. Al (aarafi (n.d., vol.3, p.266)) is: "that which
has a pleasant appearance and a hated essence".] Professor Mustafa Al Zarqa'
defined it as follows:
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.
Many classical examples of Gharar were provided explicitly in the Hadith. They
include the sale of fish in the sea, birds in the sky, an unborn. calf in its
mother's womb, a runaway animal, the semen and unfertilized eggs of camels, un
ripened fruits on the tree, etc. All such cases involve the sale of an item
which may or may not exist. In such circumstances, to mention but a few, the
fish in the sea may never be caught, the calf may be still born, and the fruits
may never ripen. In all such cases., it is in the best interest of the trading
parties to be very specific about what is being sold and for what price. For
instance, 'Ahmad and 'Ibn Majah narrated on the authority of 'Abu Said Al
Khudriy (mAbpwh):
The Prophet (pbuh) has forbidden the purchase of the unborn animal in its
mother's womb, the sale of the milk in the udder without measurement, the
purchase of spoils of war prior to their distribution, the purchase of charities
prior to their receipt, and the purchase of the catch of a diver.
The last prohibition in this Hadith pertains to a person paying a fixed price
for whatever a diver may catch on his next dive. In this case, he does not know
what he is paying for. On the other hand, paying a fixed price to hire the diver
for a fixed period of time (where whatever he catches belongs to the buyer) is
permitted. In this case the object of sale (the diver's labor for say one hour)
is well defined. In many cases, Gharar can be eliminated from contracts by
carefully stating the object of sale and the price to eliminate unnecessary
ambiguities.
In contemporary financial transactions, the two areas where Gharar most
profoundly affects common practice are insurance and financial derivatives.
Jurists often argue against the financial insurance contract, where premia are
paid regularly to the insurance company, and the insured receives compensation
for any insured losses in the event of a loss. In this case, the jurists argue
that the insured may collect a large sum of money after paying only one monthly
premium. On the other hand, the insured may also make many monthly payments
without ever collecting any money from the insurance company. Since "insurance"
or "security" itself cannot be considered an object of sale (c.f. Al Zuhayli
(1997, vol.5, pp.3415 3420) for more details), this contract is rendered
invalid because of the forbidden Gharar. Of course, conventional insurance also
suffers from prohibition due to Riba since insurance companies tend to invest
significant portions of their funds in government bonds which earn them Riba.
The other set of relevant contracts which are rendered invalid because of Gharar
are forwards, futures, options, and other derivative securities. Forwards and
futures involve Gharar since the object of the sale may not exist at the time
the trade is to be executed. As we are going to see, Islamic Law permits certain
exceptions to this rule through the contracts of salam and 'istisna’. However,
the conditions of those contracts make it very clear that contemporary forwards
and futures are not permitted under Islamic law. Classical jurists called such
contracts where both the price and the goods were to be delivered at a future
date al bay` al mudaf, e.g. "I sell you this car for so much at the beginning of
the next month", and considered them non concluded and thus invalid.
Contemporary options were also discussed by traditional jurists, e.g. "I sell
you my house for so much if my father returns", and called it a suspended
conditional sale (all bay` al, mu'allaq). They have also rendered such sales
invalid due to Gharar (c.f. Al Gharar wa 'Atharuhu fi Al `Uqud by Siddiq Al 'Amin
(pp.137 149) for a full discussion).
I hope that the reader will find that the questions which justify the
development of an "Islamic financial" industry are well
motivated:
- If a Muslim does not possess enough cash to purchase a house, car, office
equipment, etc., does he have any options other than borrowing to finance such a
purchase (which will no doubt include Riba), or refraining from making the
purchase (which will no doubt affect his quality of life and future financial
prospects)?
- Can a Muslim (perhaps a retiree) invest his savings in a, way which will earn
him a halal income without exposing himself to too much risk?
- Is there a permissible alternative to commercial insurance?
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