Documentation for Risk Mitigation in Islamic Trade Financing

Documentation for Risk Mitigation in Islamic Trade Financing

Shaikh Hamzah Razak (International Centre for Education in Islamic Finance, Malaysia), Imran-Firdauz Abu Bakar (Sinar Harapan Management, Malaysia) and Zainal Abidin Mohd Tahir (Export-Import Bank Malaysia, Malaysia)
DOI: 10.4018/978-1-7998-0218-1.ch026

Abstract

Risk mitigation is one of the key elements in trade financing. The use of documents represents one of the main techniques by banks in managing risks in trade financing. These documents play an important role in financing, insuring, and guaranteeing the banking operations. Islamic finance, on the other hand, utilizes various asset-based contracts. Islamic financial institutions in Malaysia tend to reconcile, using a combination of these contracts, to replicate the conventional banking techniques. These can be at odds with the conventional trade financing concept that “banks deal with documents and not with goods”. Hence, the undertakings may raise concerns regarding Shari'ah suitability. This chapter examines the challenges faced in the usage of documents covering all risk including Shari'ah risk management in Islamic trade financing.
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Objective Of Research

The objectives of this chapter are:

  • To investigate current trading practices in Islamic Finance

  • To analyse and discuss areas of concern with regards to Shari’ah and its compliance

  • To bring forward available solutions as well as suggest practical ways to overcome these issues

With the awareness of such issues and challenges faced by traders and financial practitioners, it is hoped that better practices and procedures will be developed in the future to avoid or even solve them.

This chapter uses a qualitative approach based on evaluation of reported sources such as central bank’s report and readily available research papers, as well as primary resources consists of interviews with experts in the field. Issues being discussed in this chapter mainly concentrate on those within the current Islamic Finance practice in Malaysia which may differ in some concepts and practices from other jurisdictions such as in the Gulf Cooperation Council (GCC) states.

This chapter focuses on issues which have not been widely discussed in today's literature regarding the handling of documents but do not include risk management strategies such as forward or future contracts and hedging techniques. Structured trade financing is also not thoroughly discussed as it is not considered pure trade but rather a product consists of combination of different concepts. For example, tolling involves financing the processing of raw materials into semi-finished or finished products. Hence, it is considered a combination of trading of raw material and working capital financing.

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Literature Review

In the current conventional trading system, banks have taken up the position as financiers to merchants using interest as the primary source of income. The presence and influence of interest is so prevalent in the whole system that zero-interest financing is virtually insignificant. The emergence of Islamic Finance in banking is mostly in response to avoid the usage of interest, instead, through various sale- and equity-based contracts. Iqbal and Quibtia (2017) give a comparison between conventional and Islamic Finance by examining the fundamental concepts used for financing. With regards to this chapter, one fundamental paradigm which is surmised is that conventional financing treats its process as independent from the primary trading activity itself. This should not be the case in Islamic Finance practice because the underlying asset is usually the goods in trade, with the exception of the recently widely used Tawarruq contract.

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