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Saturday, July 13, 2024

Advance Payments in Islamic Finance

Trade has always been the basic concept of business and the exchange of goods and services between people. The concept of trade went through many stages, from the first types such as barter, through the use of metal currencies and paper money, all the way to the modernization and globalization of economic flows, which brings us to the point that today trade can be undertaken by couple of clicks without physical effort.

There were many models and strategies of trade used throughout history, and one of them is advance payment. It is important to note that advance payments were used as a model even before the announcement of Islam, but without defining the measure and quantity of goods and time frame, and with the existence of uncertainty, which basically made this model prohibited.

With the arrival of Islam, this model is allowed with the prior removal of the prohibition elements and with clearly specified conditions. The Arabic name for advancing or paying in advance is Salam.

Salam is a sale contract whereby the purchaser pays the full price in advance and the delivery of the subject matter is postponed to a specified time in the future. This type of purchase and sale is specific because the object of sale does not exist at the time of the contract conclusion, and in this way this model deviates from the general rules of trade that are defined as Islamically permissible because it is generally forbidden to sell something that does not exist or is not in the possession of the seller at the time of concluding the contract.

salam in Islamic banking
salam in Islamic banking

The exception is the advance payment (Salam) and advance ordering (Istisna), which are allowed with precise definition of the conditions due to the need of people for this type of models. Salam, as a model, derives its legality from the primary sources of the Islamic law. This model was mainly used in agriculture because farmers needed financial resources to grow agricultural goods before harvesting.

​There are certain conditions that have to be followed in order to undertake Salam such as:

  1. It is necessary for the buyer to pay the full price of the product that is the subject of purchase to the seller at the time of concluding the contract. In case the price is not fully paid, that activity would be considered a debt-for-debt sale, which is prohibited in Islamic law.
  2. It is necessary that the quality and quantity of the goods that are the subject of the sale are fully defined.
  3. The date and place of delivery must be exactly defined by the contract.
  4. The subject of Salam can only be goods whose quality and quantity can be clearly specified. E.g. the object of Salam cannot be jewellery because each ring or form of jewellery differs from the other in terms of the quality and amount of gold or silver used in each unit of jewellery, while e.g. wheat is legitimate because each grain is almost identical to other wheat units.
  5. Salam cannot be arranged in such a way that certain goods are delivered from a certain farm or place. E.g. if the seller undertakes to deliver apples from a certain tree, the contract is not valid because there is a possibility that the fruit will not come from that particular tree.
  6. Salam cannot be concluded in the case of goods whose delivery must be immediate, such as gold and silver, because according to Islamic law, the delivery of gold and silver must be immediate.

Salam can also be used as a financing model in the contemporary context, especially in the agricultural sector because Salam is also permitted to meet the needs of small farmers and traders. Salam is more suitable for short-term financing, but it can also be used for long-term financing. Islamic financial institutions can use this model in agriculture financing in such a way that they negotiate a lower price than the one valid for products that are immediately available and the difference between the two prices becomes their profit.

This type of financial transaction can be secured by collateral (guarantor, guarantee, mortgage, pledge) whose marketability would be used for the purchase of products that were previously subject to sales. In order to undertake this model, there should be two parallel Salam contracts created between the financial institution and the supplier, and between the financial institution and the buyer.

Parallel Salam contracts are specific and burdened with a series of procedures that must be followed. In practice, Islamic banks rarely use this model for financing, and they mostly resort to models based on pure trade, such as Murabaha, because banks do not want to have assets on their balance sheets that are not relatively liquid and that can make their financing processes difficult.

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