Structurally sound

As Islamic finance booms tawwaruq structures are increasingly popular. Mike Rainey argues the surge in their use should be curbed.

The enormous growth in the global Islamic finance industry is well documented and shows no signs of abating. But, as the industry continues to develop, there is a somewhat concerning trend in the use (or rather abuse) of transactions being inappropriately financed using structures which were never intended to be used in such a manner.

In particular, tawwaruq structures are increasingly being used to finance the purchase of physical assets such as real estate and businesses – rarely an appropriate mechanism for such transactions.

Looking to the future, there is a real risk that such practices could lead to tawwaruq transactions being banned altogether, as happened in 2008 when the Accounting and Auditing Organisation for Islamic Financial Institutions prohibited the use of particular structures in sukuk transactions, bringing disruption to the sukuk market.

Such a move could cause significant damage to the Islamic finance market, since tawwaruq has an important role in the management of liquidity for Islamic financial institutions and funding working capital needs for corporates.

Asset trading

Tawwaruq is a transaction which involves the sale of assets – typically a readily tradable commodity – on a murabaha basis, whereby a seller sells an asset to a buyer for an amount equal to the cost of the asset, plus a profit. The profit payable is permitted according to Islamic sharia law because it is a profit added to the price of an asset by the seller, before it sells the asset to the buyer.

In a tawwaruq transaction the buyer acquires the asset for immediate on-sale to access cash. As the buyer does not intend to hold the asset, the asset sold under a tawwaruq transaction is usually a readily tradable commodity. In a typical tawwaruq transaction the seller buys the commodities – credited to an account of the seller held with a broker – and on-sells the commodities to the buyer for the cost of the commodities plus a profit.

The commodities are moved from the seller’s account with the broker to the buyer’s account with the broker. At this point the buyer is the owner of the commodities and becomes indebted to the seller for the cost of the commodities plus the profit, to be paid on an agreed future date. It is not uncommon for the seller to ask the buyer for security to secure this debt. The buyer is then free to sell the commodities and to use the sale proceeds for any purpose it elects.

Simple problems

Tawwaruq is most appropriately used for liquidity management or working capital needs and it is a simple and effective structure. However, therein lies the problem. Its simplicity has made it an attractive alternative for the financing of physical assets which, more appropriately, should be financed using ijara (leasing), sukuk (trust certificates) financing structures and musharaka (partnership) structures.

In addition, UK tax legislation has been amended to ensure both ijara and sukuk financing can be used in the UK on a cost-effective basis. In many circumstances other forms of financing on a sharia-compliant basis are overlooked for the reason that it is more straightforward to arrange a financing using a tawwaruq structure.

This may be a little bit short sighted, however. If Islamic finance participants are not prepared to find or use alternative methods of financing themselves – other than on a tawwaruq basis – they may find the decision over whether or not to use tawwaruq is taken away from them. This would be extremely detrimental to the industry as a whole.

One way in which the Islamic finance market could be assisted to move away from financing itself using tawwaruq would be for the larger Muslim nations to agree that it is not an appropriate method of financing – except in the limited cases of managing the liquidity of the Islamic banks and financing the working capital needs of corporates.

To fill the void left by removing tawwaruq for all but liquidity and working capital requirements financial institutions, with capital raised from the larger Muslim governments,  could finance businesses using other structures such as musharaka, which is akin to a joint venture arrangement.

Discussions are at an early stage to set up such institutions, but clearly the industry needs to find a way preserve tawwaruq financing and return it to its intended use, whilst creating sharia-compliant sources of funding to be used to finance transactions using appropriate structures.

Mike Rainey is a partner in King & Spalding’s Islamic finance group