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.

The prohibition of Riba

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:

  1. 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."

  2. 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:

  1. Riba al fail,: where money is exchanged for money hand to hand, but in different quantities, or
  2. 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.]

Debt re-sale

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.

The Prohibition of Gharar

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).

Obeying the Law

I hope that the reader will find that the questions which justify the development of an "Islamic financial" industry are well motivated:

  1. 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)?
  2. 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?
  3. Is there a permissible alternative to commercial insurance?