Tawarruq - Meaning, Example, and Contract Overview

Tawarruq Meaning:

Tawarruq contract is also referred to as Reverse Murabaha, and it is defined as: “Tawarruq is a financial instrument in which a buyer purchases a commodity from a seller on a deferred payment basis, and the buyer sells the same commodity to a third party on a spot payment basis”. To fully understand what is tawarruq, it is important to observe that in Tawarruq “Commodity” is not the actual need of the buyer, and it is only bought to fulfill the running cash requirements. Tawarruq is considered to be a form of murabahah, which is an Islamic financing structure based on a cost-plus-profit model. However, tawarruq differs from traditional murabahah in that the bank is not directly involved in the sale and purchase of a commodity. Instead, it acts as an intermediary between the customer and the third-party buyer.

Difference Between Murabaha and Tawarruq

While both Murabaha and Tawarruq are key financing mechanisms in Islamic banking, they have significant distinctions.

• Murabaha is a cost-plus-profit agreement where an Islamic bank purchases a commodity and sells it to the customer at a marked-up price, payable at a later date. The key aspect of Murabaha is that it is typically used for specific commodity transactions, with the commodity, price, and profit margin disclosed upfront.
• On the other hand, Tawarruq involves a more complex series of transactions. In a tawarruq contract, the bank purchases a commodity (like gold) and sells it to the customer. Without taking possession, the customer then sells this commodity to a third party to receive cash. Unlike Murabaha, Tawarruq is primarily used to generate cash, not to finance a specific asset.

What is Bai Al Inah?

Bai al Inah is another Islamic finance agreement similar to tawarruq but with a slight difference. In Bai Al Inah, the lender provides credit to the borrower by selling an asset at a predetermined price, along with a pre-defined profit. Subsequently, the lender promptly buys back the asset from the borrower, at the same fixed price. Bai Al Inah is primarily used for obtaining cash and is considered compliant with Shariah principles by some scholars, while others view it as a form of disguised interest. This controversy has led to limited usage of Bai al Inah in Islamic banking.

Tawarruq VS Bai al Inah

In Tawarruq, the person who acquires liquidity sells the commodity to a third party; While in Bai Al Inah, the buyer resells it to the same seller, from whom the commodity was bought, with a difference in the sale and purchase price. Here are the key differences between Tawarruq and Bai Al Inah:

1. ASSET INVOLVEMENT

• In Tawarruq, three parties are involved: the customer, the bank, and the third-party buyer. The customer purchases a commodity from the bank and sells it to a third party to receive cash.
• Bai al Inah involves only two parties: the customer and the bank. The customer sells an asset to the bank, and the bank sells it back to the customer at a higher price.

2. OWNERSHIP RISK

• In Tawarruq, the bank bears the ownership risk of the commodity until it is sold to a third party.
• In Bai al Inah, the bank does not bear any ownership risk, as the asset is immediately sold back to the customer.

3. SHARIAH COMPLIANCE

• Tawarruq is widely accepted as a Shariah-compliant transaction.
• However, Bai al Inah is controversial and considered non-compliant by some scholars, who view it as a form of disguised interest.

4. USAGE

• The tawarruq concept is commonly used in Islamic banking for financing needs.
• Bai al Inah, due to its controversy, is limited in usage.

5. PROFIT SOURCE

• In Tawarruq, the bank earns a profit by marking up the price of the commodity.
• In Bai al Inah, the bank profits by selling the asset back to the customer at an increased price.

Tawarruq Examples

Example 1: Business Finance

Let us understand the Tawarruq Contract, with the help of an example:

1. “Ali” owns a small textile mill, and to complete a $20,000 order of 1,000 shirts, he immediately needs $10,000.
2. “Ali” needs this amount to buy raw materials; such as cloth, buttons, and yarn. “Ali” is expecting to complete and deliver 1,000 shirts, and get its payment in less than 3 months.
3. So, to fulfill the cash requirement for the raw material, “Ali” purchases a car of value $11,000 from his friend “Bilal” on deferred payment, and agrees to pay this amount in three months.
4. “Ali” sells this car to another friend on a spot payment of $10,000.
5. This way, “Ali” gets $10,000 for three months, to complete the order.
6. “Ali” completes the order in 80 days, delivers it to the ordering firm, and gets his payment of $20,000.
7. “Ali” pays $11,000 to “Bilal” for the car that he bought on deferred payment.

Example 2: Car Finance

An example of a tawarruq contract in action would be as follows:

1. A customer wants to purchase a car but cannot afford to pay the full amount upfront. They approach an Islamic bank for financing.
2. The bank agrees to finance the car through tawarruq and asks the customer to choose a Shariah-compliant commodity, such as gold.
3. The bank purchases the gold on behalf of the customer at a marked-up price and immediately sells it to a third-party buyer for cash.
4. The customer receives the cash and uses it to purchase the car from the dealer.
5. The third-party buyer then sells the gold in the market for its current price, thus earning a profit.

Tawarruq and Bai Inah in the View of Jurisprudence:

1. Imam Ahmed and Imam Shafi’i:

Imam Ahmed Bin Hanbal and Imam Shafi’i generally allow Tawarruq. However, among the four Islamic jurists, it is only the Shafie school of thought that permits the utilization of the Bai Al Inah contract to some extent during times of emergency. This sheds light on why scholars in the Middle East are hesitant to acknowledge its validity. Although legally acceptable, the Bai Inah transaction is often seen as a “legal trick” or Hialh, because it facilitates a contract without any actual economic value, given that there is no transfer of assets involved.

2. Imam Malik:

Imam Malik, who is very strict about Bai Al Inah, does not see a major problem in tawarruk and considers it a way to avoid Riba.

3. Other Scholars:

Some other scholars do not see Tawarruq as permissible. However, the preferred view of all four schools of thought is that it is permissible.

4. AAOIFI:

Given AAOIFI, if a commodity is sold back to the original seller on a deferred payment, it is not valid. However, it is acceptable if the commodity is sold to a third party.

Tawarruq Contract:

Verdicts on Tawarruq:

Its nature is allowed by the Jurists. Here are some views:

1. Tawarruq sale is the purchase of a commodity acquired and possessed by the seller at a time-fixed price, which the buyer will later sell to another person.
2. Consider the Shariah Ruling: “Allah allows the selling, but forbids Riba”. And, there is no trace of a Riba in the type of this transaction.
3. Tawarruq is permissible, only if the selling price is higher than the buying price. If it is not, then it will eventually fall into an unlawful credit sale.
4. Tawarruq is to support cooperation and mercy among Muslim Brothers, to secure them from debt; and to save them from prohibited transactions.

Tawarruq Financing Agreements:

According to Islamic jurists, it consists of some simple agreements:

1. FIRST AGREEMENT:

Seller sells a commodity in his possession, to the Buyer, for a fixed particular period.

2. SECOND AGREEMENT:

The buyer sells this commodity to a third party, that has no connection with the first seller.

3. THIRD AGREEMENT:

Banks and institutions add another agreement. The bank authorizes the seller to sell commodities in the market. Islamic banks are practicing Tawarruq in the international halal stock market because stock exchanges are the shortest way to process fast sales.

Classical Tawarruq Contract:

Let us understand its classic form, through the following scenario:

• Islamic Bank purchases commodities from Trader “Ali”, on cash, and ownership is transferred to the Islamic bank.
• Islamic bank then sells the commodity to the “Bilal” on deferred payment and cost price plus profit margin basis. And the ownership of the commodity is transferred to “Bilal”.
• “Bilal” then sells the commodity to “Zayn” on a cash basis, in the commodity market, and its ownership is transferred to “Zayn”.

EXAMPLE: Mechanism of Tawarruq Contract Among Financial Institutions:

It may be executed in the following manner:

Suppose Bank-B needs funds, and Bank-A intends to place funds.

• Bank-A selects a commodity or stocks, which are liquid.
• Bank-A approaches Bank-B for the Tawarruq contract.
• Bank-A purchases the commodity on cash payment, from the market or broker.
• Bank-B bank purchases it from Bank-A on credit, or a Murabahah basis.
• After taking delivery, Bank-B sells it in the market.
• Bank-B uses this amount to fulfill its financial needs, and pays the amount to Bank-A, over the agreed period.

Tawarruq in Islamic Finance Courses

The study of Tawarruq forms an integral part of Islamic finance courses universally, including those offered by the renowned Centre for Islamic Finance. Aspiring Islamic finance professionals, be it those pursuing an Islamic Finance PhD in the UK or amassing knowledge through an MBA in Islamic Banking and Finance, delve deep into the practical applications and theoretical underpinnings of Tawarruq. Moreover, those enrolled in a Postgraduate Diploma in Islamic Finance and Banking learn about Tawarruq transactions in great detail, scrutinizing its Shariah compliance and its role in facilitating cash generation. The Islamic finance qualification also lays a strong emphasis on understanding Tawarruq.

Tawarruq in Islamic Banking:

1. Agency Agreement with Buyer:

Suppose a bank appoints a person to purchase the commodity on its behalf. If a bank is buying to sell it to the same person, this transaction is “not” valid. But if the bank sells it to that person through another contract, with an offer and acceptance, this transaction becomes valid. Here is a detail on Islamic loans based on Shariah principles.

2. Conditional Agency Agreement:

Suppose that the client, after purchasing the commodity from the bank, appoints the bank as his agent to sell it in the market. If this agency is stipulated as a condition in the contract of sale, the transaction is “not” valid. If the agency was not a condition in the sale contract and was affected after the unconditioned sale, this transaction is valid but not advisable.

3. Areas of Application:

Tawarruq Contract or Reverse Murabaha is used to provide short-term working capital financing and short-term personal finance. Along with Bai Al Inah, both are used in structuring credit cards (Tawarruq Credit Card).

4. Time Gap between Transactions:

There must be a time gap between the sale by the bank to the client, and the sale by the client in the market. This time gap is essential to expose the parties to price risk. It ensures that gains are a reward for the risk borne, and hence they are free from Riba.