Towards restructuring the legal framework for payment system in international Islamic trade finance

Author:Umar Oseni
Position:Department of Civil Law, Ahmad Ibrahim Kulliyyah (Faculty) of Laws, International Islamic University Malaysia, Kuala Lumpur, Malaysia

Purpose – The purpose of this paper is to examine the current legal framework for payment system in international Islamic trade finance vis-à-vis the new regime introduced by the Uniform Customs and Practice for Documentary Credits (UCP) 600 as well as the Sharī'ah Standard on Documentary Credits issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Sharī'ah Resolutions of... (see full summary)

1 Introduction

Islamic finance is generally considered the fastest growing sector of the global financial system. This growth has been sustained even after the recent global economic plummet with Sharī'ah-compliant assets hitting a record $1.3 trillion globally by the end of 2011. With a 25-30 per cent annual growth, Islamic finance represents about 1 per cent of the global financial market. However, it remains a resilient force to be reckoned with, considering its ethical approach and the need to expand Western businesses to the oil rich Gulf Cooperation Council (GCC) countries. With the integration of the Islamic finance industry into the global financial system, there is an unprecedented transnational trade intercourse among people of diverse backgrounds. This has repositioned the Islamic finance industry as an important force for bridging the gap between the East and the West.

It is against the foregoing backdrop that this paper examines the dynamics of international payment system in international Islamic trade finance through the documentary credit system. The latest rules for the documentary credit system introduced by the International Chamber of Commerce (ICC) is the Uniform Customs and Practice for Documentary Credits (UCP 600) rules ( Low, 2010 ) which is accepted and recognized worldwide for international trade finance. Nonetheless, it is important to add that there are other frameworks for documentary credit system such as the International Standby Practices (ISP98) published by the Institute of International Banking Law and Practice, and letters of credit issued under Article 5 of the New York Uniform Commercial Code ( Wood, 2008 ). Meanwhile, since the release of UCP 600 in 2007, research on the new regime for international payment system has mushroomed and there has been growing interest on the dynamics of the system.

In a similar vein, there has been an increasing interest among few scholars to establish the applicability of the documentary credit system of UCP 600 to the Islamic financial intermediation among Islamic banks across the world ( Othman et al., 2010 ). While the UCP 600 is widely used by banks and financial institutions across the world, including Islamic financial institutions, the Accounting and Auditing Organization for Islamic Financial Institutions ( AAOIFI, 2010a, b, pp. 195-211 ) issued its Sharī'ah standard on documentary credits in 2003. This paper sets out to examine the need to calibrate the existing legal framework introduced by UCP 600 to allow for Sharī'ah-compliant documentary credit system for international Islamic trade finance. One of the important questions this study seeks to examine is whether it is possible to harmonize the UCP framework with Sharī'ah principles considering the Resolutions of Sharī'ah Boards of multinational Islamic financial institutions as well as the Sharī'ah Standard of AAOIFI on documentary credits.

While conceding to the fact that the current method of payment in international trade through the use of letter of credit (LC) as regulated by the UCP 600 – the widely acceptable governing law of LC – does not completely contradict the Islamic finance principles, there are certain inconsistencies that need to be resolved through either a total overhauling of the current system or effecting some amendments of the system to ensure a standard, durable, feasible and viable framework for payment system in international trade. The Islamic financial system has a lot to offer if the relevant modes of finances are injected into the payment system in international trade.

This paper therefore examines the current framework for payment system in international trade with a view to recommending a viable alternative from the Islamic finance perspective to serve as a launching pad for further networking among Islamic financial institutions across the world. Two frameworks will be proposed as clearly outlined in the available literature. First, the possibility of harmonizing UCP 600 with Islamic finance products by modifying the former to suit the needs of the Islamic economic system; and second, the feasibility of overhauling the UCP 600-based documentary system of payment by producing an independent system for the Islamic banks across the word. Either of the two options will definitely be of tremendous benefit to multinational companies across the world particularly those offering Sharī'ah compliant products ( Abdul Gafoor, 2002 ; ‘Atiyyah, 1987 ).

2 International Islamic trade finance

The history of international trade business among Muslims dates back to over 14 centuries ago when ethical values where introduced in a society plagued with pre-Islamic exploitative practices in the Arabian Peninsula. These grand reforms introduced through divine revelation and corresponding practices of Prophet Muhammad (PBUH) introduced a new economic order, which was later to become the bedrock of the modern practice of Islamic finance ( Koehler, 2011 ). After a long period of decline in Sharī'ah compliant international trade finance, the later part of the twentieth century saw the gradual drift towards Sharī'ah compliant products with the re-emergence of the Islamic financial system. Given the fact that most Islamic finance products utilized in the modern international trade finance such as musharakah (joint venture partnership), mudarabah (trust investment contract), murabahah (cost-plus financing), wakalah (agency contract), kafalah (suretyship), etc. are common products known to many within and beyond the Islamic finance industry, this study does not intend to discuss them in details. But the most commonly used products are discussed in the appropriate places to explain how the International Islamic finance trade is structured.

From Singapore to Sharjah and Kuala Lumpur to Kuwait, many Islamic financial institutions actively engage in international Islamic trade finance through the facilitation of payments for exports and imports. From the top 345 Islamic financial institutions for 2011 ( The Banker, 2011 ), it was discovered that virtually all of them Islamic financial institutions considered adopt the prevailing documentary credit systems that are based on the conventional framework which involve some non-Sharī'ah compliant elements.

2. 1 The role of International Islamic Trade Finance Corporation

As part of its mission to further economic development, enhance social progress and advance international trade of member countries, the Islamic Development Bank (IDB) established the International Islamic Trade Finance Corporation ( ITFC, 2010 ) in May 2006 but it formally commenced operations in 2008. With the primary objective of furthering inter-trade among the members of the Organization of Islamic Cooperation (OIC), ITFC is better positioned as the main body for promoting international Islamic trade finance. Operating within the general framework of IDB and in broader terms, OIC, gives ITFC an uncommon opportunity to provide acceptable standards for a Sharī'ah-compliant framework for international trade financing. The IDB established the ITFC based on an international agreement generally known as the Articles of Agreement. Article 3 of this agreement expressly establishes the body while Article 5 sets out the purpose of establishment:

The purpose of the Corporation shall be to promote trade of the member countries of the Organization of Islamic Conference [now Cooperation] through providing trade finance and engaging in activities that facilitate intra-trade and international trade.

Meanwhile, members of the corporation were requested to domesticate the provisions of the agreement in their respective jurisdictions. A number of member jurisdictions have complied with this directive by domesticating the agreement to foster international trade. A good example of such jurisdictions is Malaysia, which gave effect to the agreement through the enactment of the International Islamic Trade Finance Corporation Act 2007 (Act 669).

It is interesting to observe that in its drive towards ensuring inter-trade among the OIC members, ITFC utilizes the documentary credit system. According to Article 8(2) (g) of its Articles of Agreement, ITFC has the power to “issue irrevocable reimbursement undertakings, or other similar arrangements, in connection with letters of credit issued for purchase of goods.” It is not clear whether the ITFC has adopted the UCP 600. But since there is no evidence to the contrary, one may...

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