Bai As-Salam and Bai Al- Istisna’

1. Bai As-Salam and Bai Al- Istisna’

2. Definition • Bai As-salam or Salam or Salaf means a contract in which advance cash payment is made for goods to be delivered later on. • The seller undertakes to supply some specific goods e.g car to the buyer at a future date (say in 3 months) in exchange of an advance price fully paid ( say RM 50,000) at the time of contract. • Salam- also know as sales by order

3. Cont. • Salam transaction occured if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt. • Salam - a mechanism that ensures the seller has the liquidity they expected from entering into the transaction in the first place. If the price were not paid in full, the basic purpose of the transaction would have been defeated.

4. Rukun Salam • 1. Buyer- al muslim • 2. Seller-al muslam ilaihi • 3. Price-al muslam • 4. Commodity-al muslam fihi • 5. Ijab & Qabul-sighah with salam

5. Conditions for As salam • 1. Only for the quality and quantity of commodities which have been specified exactly. • 2.The quality of the commodity is fully specified, leaving no ambiguity. • 3.The quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. • 4.The exact date and place of delivery must be specified in the contract.

6. Conditions for As salam • 5. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. • For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. • 6.Salam cannot be effected in respect of things which must be delivered at spot. It must be in an agreed period of delivery.

7. Salam and Istisna’ • Bai As-Salam and Bai Al-Istisna’ are both deferred delivery contract, however both instruments have its own application. • Salam is equivalent to a forward sales for agricultural products while, • Istisna’ is a forward sales for manufacturing or construction contract.

8. Salam Total payment is paid in advanced. Commodity-agricultural products, fungible or generic goods. E.g. Paddy rice, wheat, corn etc Istisna’ Total payment can be done upfront or at the end or by installment. Commodity-construction or manufacturing products i.e. it is unique goods e.g. Buildings, set of table, car, gate etc Differences between Salam and Istisna’

9. Salam and Istisna’ • Both Salam and Istina’ are valid sale and halal – based on al istihsan and ‘uruf. • Originally, Salam was used to provide financing to small farmers and traders. • This trend has expanded to include commodity futures market and pre-shipment export finance.

10. Original Salam- illustration • “Pak Hassan have 5 acres of land that could be cultivated with paddy. He could produce 5 tonne of paddy in 6 months. However, Pak Hassan does not have enough money to start the project. He approaches an Islamic bank for financing. • The bank bought 5 tonne of paddy from Pak Hassan using a Salam contract at a price of RM 1.20/kg. The market price of paddy was RM 1.80/kg. Therefore the bank paid the total selling price (1.20 x 5,000 kg = RM6,000) to Pak Hassan on Day 1. • Pak Hassan used this money to start his project. The project cost was RM 3,500. • After 6 months. Pak Hassan delivered 5 tonne of paddy to the Islamic bank.”

11. Original Salam-Its concept • Pak Hassan would gain a gross profit of RM 2,500 (Salam price – Project Cost). • The Islamic bank could make profit by selling the paddy in the market at RM1.80/kg. Then, the bank would enjoy a gross profit of RM3,000 [(1.80-1.20)x5000 kg]. • Both parties in Salam will face the risk of price movement. If the price of paddy goes up, Pak Hassan would have to forego the opportunity of making higher profit because he has sold the paddy to the bank at the salam price, while the bank may enjoy a higher profit than the above. • On the other hand if the paddy price goes down to say RM1.00/kg, then Pak Hassan will be in a comfortable position because he has already sold to the bank at RM1.20/kg. The bank will now face the risk of loss because it could not recover its cost.

12. Parallel Salam • To manage the risks in first salam contract, the bank will usually enter into a parallel salam i.e. the bank will find another party (maybe paddy wholeseller) and enter into a another salam contract so, it could sell the paddy to the wholeseller at a fixed price. • Parallel salam – when there are 3 parties involved in salam contract.

13. Parallel Salam-illustration • Assume the wholesale price of paddy is RM 1.50/kg. • Pak Hassan sold to the bank 5 tonne of paddy at RM1.00/kg on Salam basis. • The bank paid Pak Hassan RM5,000 on Day 1. • The bank sold the 5 tonne of paddy to the wholeseller at RM1.30/kg on Salam basis. • The wholeseller paid the bank RM6,500 to the bank on Day 1 also. • After 6 months, Pak Hassan delivered the paddy to the bank.The bank consequently sent the paddy to the wholeseller. • The wholeseller makes profit by selling the paddy to the retailer at the price of RM 1.50/kg.

14. Parallel Salam • The transaction between Pak Hassan and the Islamic bank is the first Salam (Salam 1) while the transaction between the Islamic bank and the wholeseller is the second Salam (Salam 2). • This is known as Parallel or back to back salam. • One important note is that, if Pak Hassan fails to deliver in the first Salam, the bank would still have to honor the second Salam. • That’s why it is important to finance generic goods using Salam, because the bank could buy paddy in the open market and still honor the second Salam in the event, if the first Salam fails.

15. Parallel Istisna’ • Being a construction or manufacturing contract, Istisna’ is very suitable for project financing. • E.g. Commercial or residential buildings, road construction, aircraft and vessel construction • The seller could either manufacture the commodity on his own or he could find another sub-contractor to do the job. This will result in parallel or back to back istisna’.

16. Parallel Istisna’-illustration • Client asks the bank to construct a house for him with clear specification. The cost to construct the house is RM300,000. • The bank agrees and signs an Istisna’ contract with the client. (The bank is the seller in the first Istisna’. The selling price that the bank charges is RM450,000 – i.e. Cost of construction plus profit to the bank). • The bank then finds a contractor for the construction and asks him to handle the project. • The contractor agrees and signs an Istisna’ contract with the bank. (Now the contractor is the seller in the second Istisna’. The contractor charges the full construction cost, say RM400,000 ). • Upon completion, the contractor delivers to the bank and the bank delivers to the client.

17. Parallel Istisna’ • Payment in this contract could be very flexible. • Banks would release progressive payment i.e. payment according to stages of completion of construction. • Being the seller in the first Istisna’, the bank is liable to any non-completion of the house or any non-conformance to specification risk. • Therefore, it is very important to have a project management team to ensure the selection of projects to be financed using Istisna’ is carefully made.