EXAMINING THE PRACTICE OF TAWARRUQ CREDIT FINANCING IN MALAYSIAN CREDIT CO-OPERATIVES

Rusni Hassan1[hrusni@iium.edu.my] and Harith Hamidi2[harithhamidi@gmail.com]

1 IIUM’s Institute Islamic Banking and Finance, Kuala Lumpur, Malaysia

2 IIUM’s Institute Islamic Banking and Finance, Kuala Lumpur, Malaysia

Abstract. Credit co-operatives are one of the co-operatives that contribute to Malaysia's economic development and progress. These co-operatives have provided credit facilities to their members, either individually or institutionally. Nowadays, credit co-operatives have applied an Islamic contract known as Tawarruq. However, there is limited research and literature on the practices of Tawarruq in this sector. Many studies only focused on the Tawaruq practices of Islamic Banking Institutions (IBs). While Tawarruq practices in IBs face some issues, the question is whether the same issues apply to the credit co-operatives. Therefore, this study focused on the application of Tawarruq practised by the credit co-operatives. This study was conducted qualitatively by compiling data and information from interviews with the management and observations on the process and other related documents. This study revealed that credit co-operatives contain two modes of Tawarruq arrangements or transactions. The first arrangement is credit co-operatives acting as principals, while the second arrangement is credit co-operatives acting as agents. Hopefully, the findings will provide a good understanding of Tawarruq practices in this sector.

Keywords: Tawarruq, Commodity Murabaha, Credit Co-operatives.

Introduction

In Malaysia, the co-operative movement began in 1922 with the primary objective of protecting rural people's welfare and preventing them from being exploited by moneylenders during that era. It was established to liberate the public from debt-bondage caused by exorbitant interest rates by providing access to a more viable credit system, specifically the co-operatives credit system[1]. This Malaysian co-operative society has grown into a variety of different co-operatives in various sectors, such as banking, credit, agriculture, housing, farmers, industry, consumer, development, transportation, and services.

A brief explanation of the co-operative society's statistics in Malaysia reveals that as of June 2020 (Table 1), Malaysia had 14,668 registered co-operatives with over 6 million members. Thus, approximately 19% of the country's population were members of a cooperative. The highest number of co-operatives was consumer co-operatives, followed by credit co-operatives. Consumer co-operatives had a total of 2 million membership, followed by credit co-operatives with a total of 1.1 million membership. However, credit co-operatives outperformed consumer co-operatives in terms of capital share/fee, asset count, and purchase value.

Table 1. A Summary Statistics of Co-operatives by Functions in June 2020

NUMBER OF CO-OPERATIVES	MEMBERSHIP	SHARES/SUBSCRIPTIONS	ASSETS	TURNOVER
MILLIONS
BANKING	2	973,897	3,943.71	114,122.33	12,800.56
CREDIT	575	1,134,916	6,547.22	16,607.27	5,524.84
AGRICULTURAL	3,254	519,924	732.16	3,871.00	680.13
HOUSING	313	129,864	198.33	1,017.71	130.83
INDUSTRIAL	363	16,596	17.54	83.66	19.72
CONSUMER	5,484	2,063,328	441.24	1,730.97	877.60
CONSTRUCTION	259	82,334	37.61	169.17	32.54
TRANSPORTATION	487	115,741	79.61	346.67	406.04
SERVICES	3,931	1,065,116	651.45	3,758.56	728.44
TOTAL	14,668	6,101,716	12,648.87	141,707.33	21,200.70

Source: SKM's websites

Literature Review

Credit Co-operatives in Malaysia

There are three distinct forms of co-operatives in Malaysia, each with a different membership structure[1]. First, Angkatan Koperasi Kebangsaan Malaysia Berhad (ANGKASA) is the sector's single apex body, comprising secondary and primary co-operatives. Second, there are those known as secondary co-operatives, which comprise primary co-operatives as a members. Thirdly, as represented in (See Fig. 1), are common co-operatives that have individuals as members.

Credit co-operatives are defined as co-operative activities that include lending, deposit taking, and providing other credit facilities to their members by their co-operative bylaws[2]. During their early years, credit co-operatives began by providing loans conventionally, charging interest on riba-based loans.

However, in 1977, a movement began to ensure that credit facilities offer Shariah-compliant products. The Koperasi Belia Islam Malaysia was the first to initiate this movement[3]. As a result, credit co-operatives began extending facilities under Shariah contracts, such as Mudarabah, Murabahah, Musyarakah, Bai Bithamin Ajil, Bay Inah, and Ar-rahnu[4]. From 1977 to 2019, the most common Shariah credit financing arrangement was Bay Inah; however, some co-operatives explored into Tawarruq for some reasons, which was a discomfort to Bay Inah's legality issues or being forced to use the Tawarruq concept by the primary financier, such as Islamic banks.

Members: Secondary Co-operatives Primary Co-operatives Members: Primary Co-operatives Members: Individual Fig. 1. Types of Co-operatives in Malaysia

Tawarruq's modus operandi appeared to be similar to Bay Inah's, except for the involvement of a third party. Therefore, it becomes more complex when involving a third party in the arrangement, and it is crucial to ensure that all the sales and purchases are promptly done. In the case of secondary co-operatives, the Tawarruq arrangement becomes more complicated. Secondary co-operatives may act as principals between themselves and their members or as agents to conduct Tawarruq transactions on their behalf.

Thus, this study discussed and illustrated the fundamental and implementation aspects of Tawarruq by reviewing its adoption in secondary credit co-operatives in Malaysia, referred to as KOOP A.

Tawarruq Contract

In March 2007, Bank Negara Malaysia (BNM) introduced the Tawarruq contract. Additionally, it is also referred to as a Commodity Murabahah contract. It is a financial instrument that emerged in the Islamic financial market to assist Islamic Financial Institutions (IFIs) in managing their liquidity[5]. It is also viewed as a contract that provides a competitive advantage in gaining more customer acceptance[6] due to their mechanism as the best alternative to the liquidity shortage faced by IFIs' worldwide[7].

Originally, Bay Inah was widely practiced as an underlying contract for personal financing in IFIs. However, this contract stipulated and raised many controversies among Islamic scholars[8]. Therefore, Tawarruq emerged as the best alternative to the IFIs. Tawarruq consists of two sale and purchase contracts[9]. The first involves the sale of an asset by a seller to a purchaser on a deferred basis. Subsequently, the purchaser of the first sale will sell the same asset to a third party on a cash and spot basis [9]. While Tawarruq contracts raise several Shariah concerns. They are viewed as a less usurious and far superior solution than diverting customers to riba-based products. As a result, Tawarruq has become the second-largest financing portfolio in the Islamic banking sector[5]. It is widely used in instruments and facilities such as deposits, financing, liquidity management, and debt restructuring, as well as in the funding of government and corporate Sukuk, risk management, and hedging[10].

Due to the commodity's inclusion as a subject matter in this contract, the commodity must adhere to a specific criterion; thus, the Shariah principle must be fully observed. Generally, IFIs will use the Murabahah Commodity Exchange Market, such as Bursa Suq al-Sila, or other commodity providers, such as Sedania, as trading platforms. These trading platforms are critical as Shariah-compliant electronic commodity trading platforms. For instance, in Bursa Suq al-Sila, all commodity sales and purchases are recorded and issued to the customers in the form of an E-certificate (E-cert). This E-cert serves as a substantial proof of ownership of the commodity[11].

The permissibility of Tawarruq also can be understood through the word of Allah SWT, which means:

".... Allah SWT has justified the sale and forbidden usury (riba)."

(al-Baqarah, 2:275)

According to the general meaning of the preceding verse, Tawarruq is justified because it is a component of buying and selling activities. It may be conducted with the intent of obtaining cash, with or without the knowledge of all related parties. Additionally, it may be undertaken in response to pressing needs or standard practices by particular political parties or institutions[12].

Findings

This section discusses the findings regarding Tawarruq's practices in Malaysia's credit co-operatives and their issues. The results were entirely based on interviews with the Shariah Manager and Credit Financing Manager. Due to the concept of anonymity and confidentiality, the credit co-operatives selected were not identified by their full names. As a result, the discussion referred to KOOP A as the chosen credit co-operative.

The study found that in credit co-operatives, there are two modes of Tawarruq process or transaction. The first category is credit co-operatives acting as principals, while the second category is credit co-operatives acting as agents. The transaction structure is discussed in detail below.

Tawarruq Contract Application in KOOP A

Tawarruq contract has been fully applied to KOOP A credit financing product since its inception in 2011. It was a big step as it was the first co-operative to adopt Tawarruq for their whole credit facilities. It is an effort to become a role model to other co-operatives to free themselves from their dependence on the Bay Inah contract. Tawarruq refers to the Muamalat arrangement involving two levels of the transaction. Buying and selling of commodity-based on suspended payment called Murabahah (where the price of the commodity cost is added to profit (margin) from a seller to buyer). Then, the commodity will be sold by cash to a third party (but not the original seller) to get the money[13].

However, in the case of KOOP A as a secondary co-operative, it becomes more complex and unique. It involves an additional level when the KOOP A appointed an agent to exercise the Tawarruq transaction in Bursa Suq al-Sila on behalf of their members. This complexity is illustrated in the sub-section below:

(a) KOOP A as a Principal

Members of KOOP A seeks a credit facility with KOOP A;

KOOP A will purchase commodities from commodity suppliers (Broker 1) by cash in the commodity market at Bursa Suq al-Sila;

KOOP A sells the commodity to the members on credit at cost plus a profit margin.

Member appoints KOOP A as a representative to resell the commodity to the commodity suppliers (Broker 2, 3 or 4, etc.), as long as not the Broker 1 in Bursa Suq al-Sila, hence in return gets cash;

Cash sales from commodity suppliers (2), (3), or (4) will be given to the members. Hence, it will enable the members to get the intended cash amount of financing;

Meanwhile, the residual sales from KOOP A to members will create financial obligations payable within the agreed period.

Fig. 2. Modus Operandi KOOP A as Principal (KOOP A ←→ Member)

(b) KOOP A as an Agent

Members of a co-operative (individual) apply for credit financing with a co-operative (a member of KOOP A), now known as KOOP B:

Fill up the application form and submit as required by KOOP B accordingly;

Fill up the three forms needed by KOOP A;

Agreement of Commodity Purchases and Appointment as an agent of purchases

Agreement of Commodity Sales and Appointment as an agent of sales

Option Consent Letter to resell the commodity or to own the commodity

KOOP B pools the application into a batch (known as financing batch) until the financing request reaches a certain amount. Only then, KOOP B will request and submit the form to KOOP A to exercise the Tawarruq transaction.

KOOP A will exercise purchase of the commodity from Broker 1 on behalf of KOOP B in Bursa Suq al-Sila.

KOOP A, as an agent of commodity purchases, sells the commodity to the Financing Batch on behalf of KOOP B.

The Financing Batch appoints the KOOP A to resell the commodity to Broker 2, 3, or 4 in Bursa Suq al-Sila to get cash in return.

KOOP A will notify KOOP B the commodity transaction has completed; therefore, KOOP B could disburse the financing amount to the member.

Fig. 3. Modus Operandi KOOP A as Agent (KOOP A ←→ Co-operative ←→ Individual Member)

Discussion

Since its inception, KOOP A has used a Tawarruq contract as its primary underlying financing contract. KOOP A has subscribed to Bursa Suq al-Sila' (BSAS) as a trading platform to engage with the commodities’ supplier to execute the commodities’ buy-sell transaction. BSAS provides a comprehensive electronic web-based shariah commodity trading platform that enables commodity-based investment and financing transactions based on the Tawarruq, Murabahah, and Musawamah principles.

There are two Tawarruq arrangements in credit co-operatives; one as a principal and the other as an agent. The arrangement of a principal is similar to the arrangement of Tawarruq practised between the IFIs with their customers. However, when it comes to the arrangement of credit co-operatives as an agent, it is becoming more complex and unique due to KOOP A's status as a secondary co-operative. This added another layer of complexity when the KOOP A is appointed as an agent to execute the Tawarruq transaction in Bursa Suq al-Sila on behalf of its members. This uniqueness may lead to various issues.

Issues Related to the Agency (Wakalah)

The Wakalah contract is critical to Tawarruq's implementation. Wakalah is an agreement in which individuals appoint another to act on their behalf. In other words, Wakalah refers to the act of authorising others to take care of specific tasks assigned to them. Wakalah contracts can be used in two situations when it comes to Tawarruq. To begin with, first, KOOP B, as a member of KOOP A, appoints KOOP A to purchase the commodities. Second, KOOP B appoints KOOP A to sell the commodities to a third party in order to obtain cash. This is KOOP A's Wakalah arrangement as the principal.

However, when KOOP A's Wakalah arrangements as an Agent, a new level of Wakalah exists. First, KOOP A acts as an agent for KOOP B, purchasing commodities on its behalf. Second, on behalf of KOOP B, KOOP A sells the commodities to the Financing Batch (members of KOOP B). Third, on behalf of Financing Batch, KOOP A sells the commodities to an open broker in BSAS. As a result, three layers form the Wakalah in this arrangement (see Fig. 4)

Fig. 4. Wakalah Layers of KOOP A as an Agent

The primary concern in this structure is that KOOP B must exercise extra caution to ensure that all Commodity Murabahah transactions in BSAS executed by KOOP A are completed before customer disbursement. This is to ensure that all ownership and commodity transfers are completed accurately and in the proper order. Thus, communication between KOOP A and KOOP B is critical to ensure that everything is completed on time.

Second, the appointment's clarity, offer, and acceptance must be precise and clear to ensure the appointment is as intended and the agent's exercise is consistent with the mandate. Otherwise, everything becomes susceptible to deception.

Issues Related to the Validity of Commodity Ownership

KOOP A prefers crude palm oil (CPO) as a preferred commodity because it has a precise specification and trades in actual values. As a result, CPO is the most frequently used in BSAS. CPOs qualify as goods in Commodity Murabahah transactions due to;

society recognises them as valuable and beneficial

their values can be quantified and determined

they exist and can be identified physically and possessed.

Most importantly, BSAS provides the customer with the option of possessing and receiving the commodity or immediately selling it back to a third party[14].

Concerning the goods' price, it is mandatory to know the currency and payment terms of the sale price, which shall be determined at the time of the contract. All pertinent information must be stated and known in precise and definite terms, including cost and profit (Murabahah). The agreement between the seller and buyer must be clear, accurate, and unambiguous, and the offer and acceptance must occur concurrently. To meet this requirement, BSAS will issue an E-certificate (E-cert) for each transaction that includes information about the buyer, seller, time and date, value date, product code and description, unit measurement, volume, currency, price, value, transaction type, Murabahah value, commodity supplier, commodity volume, and commodity location.

However, when revisiting Fig. 3 of KOOP A as an agent, a significant concern arises if one of the members of the financing batch prefers to possess and receive the commodity at Step (4) or sell the commodity independently at Step (5). Therefore, if these circumstances happen, how the BSAS treats this situation and how it will be depicted in the E-cert will be an issue. Hence, to avoid these situations from happening, KOOP A has made it mandatory for each member of the financing batch to sign the Wa'ad or promise agreement agreed not to possess the commodity. Hence, this Wa’ad creates the excessive ties and stringent requirements which indicate the absence of the right to choose; thus, this issue will be contested from a shariah perspective.

Issues Related to the Brokerage Fees

Regarding the Wakalah fee, majority of jurists and scholars agreed that the agent may charge it as long as it is not excessive[7]. In the case of KOOP A, if it is a principal, there is no agent fee. Meanwhile, if KOOP A acts as an agent, the following fee structure applies:

Table 2. Fee Structure of Financing Tranches

FINANCING TRANCHES	FEE (RM)
RM 25,000 and below	RM 1
RM 25,001 and RM 49,999	RM 2
RM 50,000 and RM 75,000	RM 3
RM 75,001 and RM 100,000	RM 4
RM 100,000 and above	RM 5

Considering that the nature of co-operatives is a small and medium entity; thus, their credit financing is also small-scale. Consequently, to avoid frequent repetitive small-scale transactions, KOOP A advises their member who wants to appoint KOOP A as an agent to pool up the financing applicant into a financing batch. Initially, this practice was perceived as a win-win situation for both KOOP A and KOOP B, which are low fee structures and not repeating an excessive number of small-scale transactions. However, this practice led to another issue. The members of financing might wait a long time for enough financing applications. This gap of time will make members feel uncomfortable as they are in need of cash. Therefore, it is suggested that KOOP B becomes a principal instead of appointing KOOP A as an agent to transact Commodity Murabahah.

Conclusion

This study identified two distinct Tawarruq arrangements in credit co-operatives — the first being a co-operative credit acting as a principal. Second, credit cooperative in the capacity of an agent. In comparison to this arrangement, the second appears to be more complex and unique. As a result, extra attention and care are required when carrying out this arrangement. This is an exploratory study to begin understanding Tawarruq in the co-operative sector; however, it is limited to the one-credit co-operative that trades on Bursa Suq al-Sila. This study suggests that future research should compare the practices of credit co-operatives to those of numerous trading platforms using multiple case studies.

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