Commodity Pricing And Indexation: Islamic Financial Systems Essay Help Websites

Abstract

Approaches to commodity pricing and indexation vary based on the varying regulations that apply in various jurisdictions and under various systems. This article explores differences in the norms of commodity pricing and indexation between conventional banking systems and Islamic banking systems in order to examine the various approaches. In an effort to attain this goal, the study traces numerous pre-Islamic forms and mediums of exchange in order to establish a basis for identifying the conventional economic faults that the Islamic banking system attempted to remedy. The research identifies the principles of gharar and riba applicable to Islamic financial systems as the primary motivators for the desire to engage in commodity pricing and indexation activities that result in high profits with low or no effort in the conventional system.

Introduction

To Muslim financial academics, disguising conventional services and goods as Islamic ones is a major issue of concern. This difficulty stems from the perception that Islamic financial institutions have recruited their human resources from the market pool of individuals trained in financial management under conventional approaches to commodity pricing and indexation over the years (Obaidullah, 2005). Creating a broad and in-depth awareness among Islamic financial market participants through training, research, and education on Islamic methods of financial management is one solution to this problem. This study paper aims to accomplish this by focusing on the laws of commodity pricing and indexation that differ between the conventional system and the Islamic system. This action contributes to establishing the foundation for Shariah-compliant commodities pricing and indexation systems.

The paper begins with a discussion of pre-Islamic modes of exchange and exchange mediums, followed by a discussion of characteristics of the barter trading system that the prophet PBUH modified, including usury and exploitation. The section then discusses rules of exchange in the Islamic system, illustrates with examples and evidence how the commodity index principle applies in the modern world, and explains how using a basket of commodities along with Fiat (paper money) constitutes a necessary strategy for reducing inflation. Other essential topics in commodity pricing and indexation covered include an introduction to the notion of market marking, types of sales permitted and prohibited in the Islamic system, and hedging instruments and their permissibility in Islam paradigms of indexation. In the final half of the study, the relationship between riba-free business models and the commodity pricing concept is demonstrated and explained.

Forms and mediums of commerce throughout the pre-Islamic period

In the Middle Ages, trade results in the formation of numerous forms and means of exchange. Before the advent of Islam, trade had already developed in the Middle East. In all urbanized regions, commerce predominated. In fact, the Prophet Muhammad was a merchant. Changes in culture and political systems compelled many regions to unify, granting the Arabs tremendous strength and allowing them to conquer numerous civilizations. During such conquests, Arabs received gold and silver, among other precious metals. These metals served as measures of value and wealth, but they were never used as a medium of trade. However, metals were essential to the quick expansion and development of the Baghdad-based Arab economy.

People have a significant disadvantage due to their lack of independence. The only way to achieve independence is through the exchange of commonalities. Prior to the birth of Islam, bartering was the most common method of transaction. Through barter trading, goods and services were directly swapped for other goods and services (El-Gamal, 2006). Prior to the development of Islam, difficulties linked with the barter system, particularly those concerned with the valuation of one product relative to another or commodity pricing, had already emerged. This factor led to the creation of new commodities whose value reflected that of the commodity swapped. Consequently, the concept of money as a medium of transaction existed before to the advent of Islam. Islam was born when the Prophet Muhammad received a divine calling. Positively, the region received trade. In the early years of the establishment of Islam, barter trade was the predominant form of exchange. However, regardless of the form of exchange or medium of exchange used, Islamic religious teaching embraced the exchange of goods and services (trade) if it was not characterized by fraud and interest.

Prophet Muhammad modified facets of the barter system

In the early years of the sixth century A.D., when Islam was created, money not only played a significant role in the lives of many people, particularly in highly developed towns, but it also facilitated numerous transactions. The Arabs had frequent and intimate relationships with people from other nations. The majority of their everyday business transactions were conducted using coins. However, the vast majority of transactions, particularly those involving agricultural goods, were conducted through barter commerce during the time and era in which the prophet Muhammad (PBUH) established the Islamic state of al-Madinah.

Following the creation of Islam, its teachings developed regulations to govern the exchange of goods in accordance with Islamic principles. The barter trade system presented a number of unique difficulties. Prophet Muhammad (PBUH) recognised these obstacles and attempted to address them by implementing appropriate changes. Prophet PBUH was concerned about commodity price difficulties arising from Islamic methods to commodity pricing and indexation, which included exploitation, usury, and injustice in addition to other ills associated with the exchange of commodities. (Rosly, 2005)

In the process of determining the value of commodities exchanged (commodity pricing) between a buyer and a seller using a barter system, the Prophet (PBUH) identified instances in which either the seller or the buyer acquired unjustified gains following an exchange involving commodities of the same type but different quantities. Trade usury (riba-al-buyu) characterizes such profits (Obaidullah, 2005). Prophet Muhammad (PBUH) encouraged his followers and all Muslims to use money as a means of exchange to prevent riba-al-buyu in barter transactions. Islamic literature also describes riba-al-buyu and riba al-khafi. Riba al-khafi covers concealed or implicit riba (El-Galfy & Khiyar, 2012), as opposed to riba al-duyun, which is jali (plain or explicit) riba (Azhar, 2010).

During the pre-Islamic era, riba was defined by exploitation and acts of injustice. Whereas barter trading entailed the exchange of one commodity for a different payment in exchange for another commodity in the future, riba involved the doubling and redoubling of commodities (Munawar & Molyneux, 2005). Consider a situation in which a person owes another person one goat in exchange for a commodity that the creditor obtained from the debtor at some point in the past in an effort to illustrate this type of riba, which the prophet Muhammad (PBUH) opposed because he believed it served injustice by encouraging exploitation: a person owes another person one goat in exchange for a commodity that the creditor obtained from the debtor in the past. In the pre-Islamic era, if a debt was not repaid within a year, the creditor would confront the debtor and demand payment, at which point the riba would double, resulting in a new debt of two goats. The debt over the following year would increase to four goats. This was not only an act of taking advantage of the debtor's inability to pay (exploitation), but it was also an injustice to the poor, as the rich continued to become wealthier while the poor became poorer.

Exchange regulations in the Islamic system

Commodity pricing and indexation refers to the practice of developing indices to not only measure but also track the performance of numerous commodities over a certain time period (Azhar, 2010). Under conventional methods, this objective is attained by speculating on future price increases. Such speculative investments are prohibited by Shariah because they include acts of deprivation. Shariah also regulates the transaction of goods to prevent undue or illegal advantages on the part of either the vendor or the purchaser. According to Obaidullah (2005), the prophet PBUH said, "sell gold for gold, silver for silver, wheat for wheat, barley for barley, date for date, salt for salt, in same quantities on the spot; and when the commodities are different, sell as you see fit, but on the spot" (p.23). Under the Islamic system, this hadith illustrates the regulations for spot markets in commodities exchange markets. The spot-market commodities exchange trade is governed by the cash-and-carry principle. As demonstrated by ahadith, the Islamic exchange system promotes spot markets in financial systems.

Although the Islamic exchange system includes spot markets, the conventional exchange system also includes future and forward markets, which are used extensively in the trading of stocks and commodities in financial markets. The Islamic exchange system applies distinct laws to these two marketplaces. The regulations prohibit superfluous profits or activities of stealing money from others (Abdul-Rahman, 2010). For a typical system of exchange, commodity exchange on futures markets entails selling the commodities in the present, but delivering them at a future date, location, and quantity. Under the system of exchange, money is not exchanged at the time of contract formation, except in exceptional circumstances when the terms of the contract require the buyer to make deposits during the due period. Upon receipt of the goods, the purchaser instantly pays for them. Under the system, commodity prices are determined by the dynamics of demand and supply at various maturities.

Hedging is the primary driver of the forward markets trading system. Conventional exchange systems justified the system on the grounds that it enables individuals, such as farmers, to develop cost-controlling strategies. Through forward markets for raw material processors, the company develops the ability to set future production schedules and future supply obligations for finished goods. In addition to hedged stocks and raw materials, conventional banking systems also accept hedged stocks and raw materials as necessary loan collateral. In forwarding markets, items of exchange do not exist when agreements that amount to contracts are made. Using standard norms for exchanges in accordance with Islamic law, such contracts are void because there is no actual exchange of goods. Islamic regulations on commodity exchange make specific provisions, such as bay'al istisna, bay'al-salam, bay'al-mua'jjal coupled with bay'al-istijrar, upon the realization of the benefits that may arise from certain forms of contracts based on the notion of forwards market (Ayub, 2002).

Under the bay'al istisna norm, a seller and a buyer may agree to exchange nonexistent goods. However, this condition applies if the supplier needs time to manufacture the commodities in accordance with the agreed-upon quality requirements, so that the agreed-upon price reflects both the quantity and quality of the products. Bay'al-Salam requires parties participating in the forward market type of commodity exchange to complete full payment of the commodities so that delay in delivery does not result in benefits for one party (Zahan & Kenett, 2012). In a typical system of exchange, where the price is determined at the moment of the commodity's delivery based on market forces of demand and supply, such gains would be realized. Any agreement for sale under forwarding markets involves a promise to sell, but not an actual sale, according to Islamic law (Warde, 2000). This characteristic indicates that such an arrangement is not enforceable under Islamic law. Under a normal exchange system, such agreements constitute contracts enforceable in accordance with local civil law standards.

The actual delivery of commodities does not occur on futures markets. Not only does the commodity exchanged not exist, but its physical transfer does not occur either. The commodity undergoes a series of transactions during which no single party can assert ownership at any given time. While there are exceptions to Islamic law that support the operation of forwarding markets and other types of commodities trading, the Shariah has a definite position on future markets.

All sorts of deals involving substantial profits from future market exchanges are prohibited. Islamic law justifies this prohibition on the grounds that numerous futures market intermediaries earn enormous sums of money without adding any sort of utility or even placing utility on the various commodities traded (Iqbal & Mirakhor, 2011). Consequently, it follows that participants participating in future markets forms of commodities trading get profits without iwad (recompensing). Charging riba without compensation is comparable to this circumstance.

The current implementation of the commodities index principle to reduce inflation when utilizing fiat currency (paper money)

The commodity index includes the index, which follows baskets of commodities in an effort to quantify their performance across markets. Commodity indexes are traded on the exchange markets, allowing investors instant access to diverse commodities without the need to participate in futures markets. Various commodity prices are determined by certain commodity qualities, similar to how stock exchanges function. In addition to tangible commodities such as precious metals, agricultural items, and even energy commodities, debts are also indexed. Inflation rates play a significant role in setting the cost and indexing of certain goods.

The manner in which the aspect of debt indexation is handled under Islamic law is one of the most contentious matters. In relation to debts, Islamic law presents numerous arguments for its divergent approaches to the time worth of money. In instance, the Islamic system prohibits prospective earnings that disadvantage the debtor in the future through several permitted forms of riba. An significant objection that has not been adequately addressed relates to inflation and the subsequent loss in the value of money payable in the future for a commodity exchanged in the past (Obaidullah, 2005). Under the conventional system of exchange, preparations are made for the reduction in purchasing power of the money paid for the commodity as a result of inflation's persistent growth. Consequently, where payment is different, inflation results in debtors gaining in the future while creditors lose. Such a benefit occurs because the debtor will pay for goods obtained in the past at a price that cannot purchase comparable quantities of goods of equal quality. The challenge is how such creditors might be paid for these losses utilizing the indexation approach with a basket of commodities and Fiat currency (paper money).

Consider a scenario in which the purchasing power of money decreases by 3 percent after two years to demonstrate the applicability of the commodities index principle in the contemporary world. Supposing also that interest (riba) of 2 percent is acceptable within this period of time in which debt will be fully settled. After the two years, this illustration implies that if the transaction

× How can I help you?