Commodity Pricing and Indexation in Islamic System

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Commodity pricing and indexation can be defined as the process of designing an index to measure and monitor the performance of commodities over some time (Azhar, 2010). It is a speculative type of investment and anchors on the idea that investments are made based on speculative future prices and returns (Muhammad, 2002). Under Islamic law (Shariah), such speculative investments are prohibited since they involve the practice of taking money away from others to personally gain over a short period (Abdul-Rahman, 2010).

Over the years, financial scholars of Muslim origin have come up with an Islamic commodities trading platform to be able to invest in the commodities market dominated by conventional commodity trading systems (Warde, 2000). The Islamic platform is referred to as Bursa Souq Al-Sila and allows investors to overlook the allowed principles of investment by the Shariah Law (Zamir & Mirakhor, 2007). It is important to note that the system is not very old as Islamic banking is a recent phenomenon that has developed and seen tremendous growth in the past few decades (Munawar & Molyneux, 2005).

One of the major principles of Islamic finance is that commodities being traded-in must be real and not notional. This principle requires that the traded goods must be present at the point of sale and should be ready for immediate delivery after the completion of the sale agreement (Zahan & Kenett, 2012). Under the Shariah law, interest, referred to as Riba in Islamic finance, is defined as any amount over the initial amount loaned or given out. Conventional commodity trading is such that the buyer expects to gain in the future at the expense of the seller. This means that the buyer receives more in the future than the price agreed upon on the date of sale. In Islamic financing, however, this is not allowed as it leads to the receipt of interest (El-Galfy & Khiyar, 2012).

It should be stipulated that under Islamic financing, it is assumed that commodities should be priced fairly based on their real market value. This is encouraged to avoid misrepresentation and deception. In the conventional commodity market framework however, the prices of commodities are set by the market and that speculating on future prices is profitable (Rosly, 2005). In futures contracts such as those used in commodity trading, allowing the market to set prices of commodities is what makes trading profitable as it is all a matter of speculation and nothing is certain at any point in time (El-Gamal, 2006).

The Art of Islamic Banking and Finance (Tools and Techniques) by Dr. Yahia Abdul-Rahman gives a detailed overview of the fast-developing field of Islamic banking and Finance (Abdul-Rahman, 2010). The author runs a financial institution known as La Reba, which was started in the 1980s in Pasadena, California. Although the author discusses the banking system in America, the principles and rules presented can be applied almost anywhere, as long as they are based on the Quran and Sunnah.

Economics of An Islamic Economy by Rauf A. Azhar introduces different issues in Islamic finance like different forms of Riba, Riba Al Jahilliyya, Interest, Usury, and the issues of indexation (Azhar, 2010). The author worked as a professor at the University of Central Panjab in Pakistan.

The theory and practice of Islamic banking and finance by Muhammad Ayub is a training manual for Islamic bankers who need to learn the new rules of the trade (Muhammad, 2002). The author mainly focuses on the payment and prohibition of Riba. The book also discusses the gaps between theory and practice in Islamic finance. Muhammad Ayub works in the research department of the State Bank of Pakistan as a senior research economist.

Islamic finance (Law, economics, and practice) by El-Gamal Mahmoud provides an overview and history of Islamic finance (El-Gamal, 2006). The author suggests that Islamic finance is a rent-seeking arrangement. He further suggests that it should focus more on substance rather than form. Such a move would mean the abandonment of “Islamisation” of financial products and practice. The author is a Professor at Rice University and is the Chair of Islamic Economics, Finance, and Management.

Thirty years of the Islamic banking (history, performance, and prospects) by Munawar Iqbal and Molyneux Phillip explains the mode of operation of the Islamic banking and what it offers to investors as an alternative model of financial intermediation (Munawar & Molyneux, 2005). The authors also discuss how the performance of the Islamic banking system compares with that of the conventional banking system. Munawar Iqbal works at the Islamic Development Bank in Jeddah and holds the position of Chief of Research in Islamic banking and finance while Molyneux Philip is a Professor at the University of Wales in Bangor and holds the position of Director at the Institute of European Finance.

The introduction to Islamic finance by Zamir Iqbal and Mirakhor Abbas covers the fundamentals of Islamic banking and finance in a comprehensive manner (Zamir & Mirakhor, 2007). The authors give the fundamental characteristics of the Islamic financial system and compare and contrast it with the conventional financial system. They further explore ways in which the Islamic financial system can be improved to compete in the modern economy. Professor Zamir Iqbal is a Lead investment officer at the World Bank. Professor Mirakhor Abbas is a retired Executive Director at the IMF.

Hedging instruments in conventional and Islamic finance by Zahan Muslima & Kenett Ron is a paper that discusses hedging and risk management instruments used in both Islamic finance and conventional finance systems (Zahan & Kenett, 2012). The authors make a comparison of the models and frameworks of these instruments in the two systems. The authors work at the University of Turin in Italy in the Department of Applied Mathematics and Statistics.

Islamic banking and economic growth by El-Galfy Ahmed and Khiyar Abdalla is a paper that attempts to evaluate the impact of Islamic finance on economic growth (El-Galfy & Khiyar, 2012). The paper shows that Islamic banking affects the macroeconomic stability of a country positively. The authors work at the Gulf University of Science and Technology in Kuwait.

Islamic finance in the global economy by Warde Ibrahim explains the paradox of the Islamic financial system and how it has thrived in the modern global economy (Warde, 2000). The author traces the history of Islamic banking and finance and compares it to the conventional financial system. The author also evaluates the challenges that Islamic financial institutions face in their operations. Ibrahim Warde, the author, works at the Edinburg University.

Critical issues on the Islamic banking and financial markets by Rosly Saiful is a book that gives an overview of the practices of the Islamic banking and finance with a special focus on Malaysia (Rosly, 2005). The author presents the main principles of Islamic banking and finance under the Shariah Law. Some literature is also borrowed from the Quran to help explain some of the principles. Professor Rosly Saiful works at the INCEIF and heads consulting and executive programs.

Methodology

This study will be a qualitative evaluation of the differences between the Islamic system and the conventional system in terms of commodity pricing and indexation. Data will be collected through the use of questionnaires which will be issued to banks governed by Islamic law as well as academic experts in the fields of Islamic finance and commodity trading. The questionnaire will comprise the following questions;

Please indicate whether you are aware of any differences between the Islamic system and the conventional system in terms of commodity pricing and indexation Yes ( ) No ( )
If yes, kindly indicate the differences you are aware of
Please indicate how Islamic commodity trading differs from conventional commodity trading to interest rate payment (Riba).
About the above question, please state which system you think is better and give reasons
Please indicate how Islamic commodity trading differs from conventional commodity trading to speculation
To the above question, please state which system you think is better and give reasons
Please indicate how Islamic commodity trading differs from conventional commodity trading about the setting of prices for commodities (marking to market)
To the above question, please state which system you think is better and give reasons
Are you aware of any exceptions to Shariah Law about commodities trading? Yes ( ) No ( )
If yes, please list the exceptions you are aware of
Please give examples of any Riba Free business models you are aware of
Do you think these models will succeed in the contemporary business environment?
If you wanted to engage in commodity trading, which system would you prefer to use?
Please give reasons for your answer
Which system do you think is better for the development of financial markets particularly in emerging economies?

References

Abdul-Rahman, Y. (2010). The art of Islamic banking and finance: Tools and techniques for community-based banking. New York: John Wiley & Sons.

Azhar R. (2010). Economics of an Islamic economy.Leiden: BRILL.

El-Galfy, A. & Khiyar A. (2012). Islamic banking and economic growth: A review. The Journal of Applied Business Research. 28(5): 943-956.

El-Gamal, M. A. (2006). Islamic finance: Law, economics and practice. Cambridge: Cambridge University Press.

Muhammad, A. (2002). Islamic banking and finance: Theory and Practice. Karachi, Pakistan: State Bank of Pakistan Press.

Munawar, I & Molyneux, P. (2005). Thirty years of Islamic banking: History, performance, and prospects. New York: Palgrave-Macmillan.

Rosly, S.A. (2005). Critical issues on Islamic banking and financial markets: Islamic economics, banking and finance, investments, Takaful and financial planning. Kuala Lumpur: Dinamas Publishing.

Warde, I. (2000). Islamic finance in the global economy. Edinburg: Edinburgh University Press.

Zahan, M & Kenett, R. S. (2012). Hedging instruments in conventional and Islamic finance. Electronic Journal of Applied Statistical Analysis. 3(1): 59-74.

Zamir, I & Mirakhor, A. (2007). An introduction to Islamic Finance: Theory and Practice. New York: John Wiley & Sons.

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Commodity Pricing and Indexation in Islamic System

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