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CHAPTER 3. The RF Valuation Disciplines of Commodity Indexation and Marking to the Market

This chapter presents the reader for the first time in the global RF (Islamic) banking and finance domain with two important and fundamental RF disciplines: the Commodity Indexation Discipline and the Marking-to- Market Discipline. In this chapter, the fundamentals of these two disciplines will be laid down and will be detailed later in Chapters 5 and 6, where these two disciplines will be applied using detailed historic stochastic data.

It is well known that Prophet Muhammad (pp), in addition to being God's commissioned Prophet, had been through many life experiences to prepare him for becoming the prophet that changed the course of history to bring the world forward on the courses charted by his predecessors, including Moses (pp) and Jesus (pp). He was a shepherd, a trusted conflict resolution arbitrator, a community leader, and a trusted manager of people's assets in caravan trading and investments. Involvement in business as a trusted, successful, and reputable business leader enabled him to see the world and taught him how the world works and how business is transacted. At the time he was commissioned as the Prophet of God, two major currencies were prevalent in business transactions: the dirham, used by the Persian Empire and made out of silver (it was also used by the Greeks and called drachma), and the denarius, used by the Roman Empire and made out of gold. At that time an important aspect of trading in caravans was transacting business in different local currencies depending on where the trade was conducted. The final step of the trader's transaction was to convert all business proceeds into the local currencies of his/her clients, who entrusted him/her with the management of their money and assets. Naturally, local currency conversion represented a great challenge for the fair-minded and God-revering businessmen and traders to make sure that transactions were expressed fairly in a universal currency without taking away the fair share of the profit or loss to which the investors were entitled.

Prophet Muhammad (pp) came with a simple but revolutionary idea to establish the principles of pricing at fair value and the free market system and to remove deceptive and fraudulent activities in such free markets. The major challenge for caravan trading was to establish standardized rules of exchange because of the variety of local currencies used in the countries they traded in at the time of the Prophet. The other challenge was to determine how to exchange different products for different uses while being fair and while ensuring that the principles of fair value pricing and fair free markets were preserved. Prophet Muhammad (pp) set the rules of a new and innovative system that would bring to bear God's teachings taught by Moses (pp) and Jesus (pp) in one final system that is riba free (RF) and would signify for the first time in history the foundation of an RF Judeo-Christian-Islamic system manifested by the Judeo-Christian-Islamic Shari'aa law.

The system called for relating the price of every item to a standard reference and calibrating commodity that was produced and/or is used in each community. The system called for pricing products and services either in terms of ounces of gold or silver (as metal commodities, called at the time metal pricing commodities) or in terms of a food item that was considered a basic staple in the community, such as — at the time of the Prophet — wheat, barley, dates, or salt. He also went on to rule that if one borrowed an ounce of gold, it should be returned to the owner in an equal amount (i.e., only an ounce of gold) even if the repayment was not done hand-to-hand and was made after one year. If the repayment was more than an ounce, the transaction was considered a riba transaction and was considered haram (divinely prohibited). However, one can exchange one ounce of gold into 10 bushels of wheat on the spot (hand-to-hand) or 15 bushels after one year. This transaction would be legitimate based on the RF law (Shari'aa) and would be considered halal (divinely allowed).

The Prophet Muhammad (pp) has ordained, according to his sayings (Hadeeth), the following rule regarding buying/selling, exchanges, trading, and bartering:

If a buy/sell agreement involves currency, then one can only exchange without increase:

■ Gold for gold in same weight.

■ Silver for silver in same weight.

If the buy/sell agreement involved food items, then one could use only a set of staple food commodities as reference/index commodity items without increase, regardless of the quality or the type of that food item. For example, exchanging 10 small dates for 2 large dates is haram and is considered a forbidden riba-based trade transaction. The rule goes further to stipulate that the rule used for precious metals is also extended to cover the following

Reference Index of Basic Food Staples Commodities:

■ Wheat for wheat

■ Barley for barley

■ Dates for dates

■ Salt for salt

To ensure and to be certain that there is no increase (riba), the exchange must be done on an on-the-spot basis (hand-to-hand) to prohibit the use of speculative futures markets activities in these reference and calibrating items that are used as measuring references for pricing activities.

The illustrative chart in Exhibit 3.1 was devised by a number of RF- interested scientists in 2010. It shows how the Commodity Indexation discipline operates on different commodities trading and barter exchanges.

Please also note that the items listed in Exhibit 3.1 were only for illustration purposes; the Prophet(s) used them because they were either the precious metals' pricing currencies used at that time (in case of the gold denarius or silver dirham) or basic and essential staple foods used then. Based on subsequent jurisprudence, as will be detailed later, and with the change in communities' lifestyle and taste, transacting behavior, important food, and new living needs such as energy, one can expand on the rule while using the same concept and discipline, depending on the prevailing conditions in a certain country or within a certain community.

This concept is similar to using an index of reference commodities as a means of checking the stability of a certain local currency on the international foreign exchange (Forex) markets, especially in a world that is run by fiat or paper money. It is interesting to note that James Baker III, former secretary of the Treasury of the United States, told world financial leaders in 1987 that the Reagan administration “is prepared to consider” using the price of gold in trying to steer its own and the world economies. Baker explained that gold could be used in a specially designed index along with other commodities to help governments discern inflation and then adjust their policies by raising interest rates or taxes, for example.

Further research was conducted by many scholars in the Judeo-Christian- Islamic Shari'aa law to expand on the concept of using the six commodities listed in Exhibit 3.1. Imam Abu Haneefah (the pioneer of a school of jurisprudence carrying his name, the Hanafi law) and Imam Ahmad (another well- placed scholar with his own school of jurisprudence — the Hanbali school of jurisprudence oir fiqh) concluded that we could expand the list of reference

EXHIBIT 3.1 RF Rules Coverning Sale or Exhange of Irems in the Marketplace

Note: The rules are based on two Hadeeth of the Prophet (pp) and the explanation provided in “Fiqh Al-Sunnah” by Sheikh Sayed Sabiq.

The Hadeeth explicitly mentioned six items categorized as food or currency. Scholars' opinion is that it also applies to any food or currency.

Source: “Islamic Finance and Capitalism: An Introduction,” a presentation prepared by Muhammad Yusuf Dadani, Ahmed Naji, Mohamed Osman, and M. Hashem Sherif. Presented at the Islamic Society of Central Jersey on Sunday, May 23, 2010.

commodities depending on the community in which we live, but with the condition that the reference and calibrating commodity can be weighed or measured accurately without having the ability for transformation over time (as in the case of perishables or metals that are susceptible to being rusted out). Imam Shafi'ee (a scholar who has his own school of jurisprudence — the Shafi'ee law) ruled that these indexation items can be eatables that can preserve their value or can be legal tender such as gold and silver (and may be other precious elements). Imam Malik (a scholar with his own school of jurisprudence, the Maliki law) suggested that these can be food commodities or items that can offer a lasting and accurately measurable store of value.

The main rule goes like this[1]:

1. In barter exchanges, if the two items are the same in elemental form (e.g., gold for gold, silver for silver, etc.) or are used in the same way (e.g., food, in the case of wheat and barley), then for this exchange to be legal, the quantity (weight, volume, or numbers of units) should be the same, regardless of the quality of the item.

The exchange must be conducted on the spot (hand-to-hand) and delivery should also be on the spot.

2. If the two items differ in substance but not in use, then fadl (or increase in exchange ratio by adding a premium or by using a multiple or a fraction) can be practiced, but riba al-nassee'aa (the charging of a delinquency penalty in case of not paying back at the promised time as agreed by the two contracting parties, due to conditions that are out of control), cannot be applied. For example, if gold was sold in terms of silver (different substance, but same use as metals used as a value of tender or as an ornament then and now as an important industrial metal) or wheat in terms of rice (wheat and rice are different substances but used for same purpose, i.e., as food), it is permissible to use a ratio that is not 1:1 as established by the free-market forces of supply and demand as required when exchanging gold for gold, silver for silver, small size dates for large size dates, and so on.

3. If the two items differ in substance and purpose of use, then it is halal (divinely permissible) to both practice fadl and defer payment over a certain period of time. For example, one can buy wheat for gold, and the payment can be deferred. There would be two prices: The on-the- spot price (hand-to-hand) can be set at 20 bushels of wheat for an ounce of gold, and the deferred price can be, say, 25 bushels of wheat for an ounce of gold after one year. However, it is very important to note that the rules of riba al-nassee'aa should be implemented (i.e., there should be no late payment penalty if the lateness in payment and settlement of the transaction is justified, as in cases of job loss; crop failure due to, for example, weather conditions; an unexpected dire need; or a change in the prevailing economic situation).

Conceptually, to be fair to all people both inside a country and internationally, the price of an item — based on the RF Commodity Indexation Discipline pioneered by the Prophet Muhammad (pp) — should always be related to the weight or volume of a reference calibration commodity that is either mined from earth in the form of a natural resource, like gold, copper, salt, oil, or silver, or is a food staple produced by the hard work of the farmer, using earth with its natural nutrients and water provided by rain, flowing rivers, and underground water tables, such as corn, wheat, dates, and barley. The Qur'aan reveals:

2:164 Behold! in the creation of the heavens and the earth; in the alternation of the night and the day; in the sailing of the ships through the ocean for the profit of mankind; in the rain which God Sends down from the skies, and the life which He gives therewith to an earth that is dead; in the beasts of all kinds that He scatters through the earth; in the change of the winds, and the clouds which they Trail like their slaves between the sky and the earth;[Here] indeed are Signs for a people that are wise.

7:57 It is He Who sendeth the winds like heralds of glad tidings, going before His mercy: when they have carried the heavy-laden clouds, We drive them to a land that is dead, make rain to descend thereon, and produce every kind of harvest therewith: thus shall We raise up the dead: perchance ye may remember.

15:22 And We send the fecundating winds, then cause the rain to descend from the sky, therewith providing you with water [in abundance], though ye are not the guardians of its stores.

It is interesting to contrast the use of these basic tangible products as calibrating references to price other items in the market. It is well known that commodities such as food, minerals, and metals are produced by the hard work of people. For minerals and metals (and now energy resources like coal, oil, and natural gas), people explore for them and mine them out of the earth. For food, people plant and cultivate it on farms, producing staples like corn, wheat, barley, soybeans, or rice, for which each requires land preparation and special climates. Therefore, there are various products in various locations. Through free trade, people not only make business deals with each other, but also toil to move from one location to another in this wide world to get to know each other and to respect each other's cultures, and in the process discover trading opportunities and start bonding these two communities or nations through trade as they conduct commercial activities together. Combining the hard work of the people with God's gifts to us, like the earth, its fertility, its water resources needed for irrigation, and the specific weather conditions in each geographic location, would produce basic staple food products and other strategic resources like precious metals and energy resources that can be used as a calibrating reference commodity index.

These products were used by the Prophet Muhammad (pp) to set references or indexes for pricing and trading. Compare this concept with the current global practice of governments using a printing press that produces paper banknotes (fiat money) with little effort, except for the smart and highly educated and sophisticated analytical minds and political ideology and domestic currents that decide how much money to print or withdraw from the monetary system, based on economic and monetary statistics. Printing too many of these banknotes (paper money) without paying attention to local economies of production can be a major contributor to inflation and economic instability that would lead to domestic and worldwide instability; the opposite can be true, as well. The system also depends on the great minds of economists, monetarists, statisticians, mathematicians, and computer-based modeling that uses the most powerful computers, modeling techniques, and carefully documented and collected historic data and logistics. Such talents, techniques, and expertise are important but are scarce. In addition, they may not be available in every country. In fact, most countries — except for a few developed nations, led by the United States, Germany, France, and the United Kingdom — are not endowed with a large pool of such talented experts and needed resources.

In an attempt to apply the preceding rules, an effort was invested to study the price history of different commodities and to apply the Commodity Indexation Discipline, introduced earlier, to one of your author's real life investment transactions. For example, in 1974 we bought a house in Plano, a suburb of Dallas, Texas, for $46,000, with a down payment of $3,500. In 1977, it was sold for $65,000. We were very happy to have realized a profit of $19,000 in almost two years by investing in this house. That translates to a price increase of 41 percent in two years on the house in terms of U.S. dollars. The total profit, in dollars, on the original out-of-pocket investment of $3,500 was $19,000, or a 543 percent total profit. It should be noted that all of these wonderful returns were in U.S. dollars. However, if we had measured the total profit in two years as a percentage of the original investment in terms of some of the six reference commodities listed earlier in the Commodity Indexation Discipline, the result would be revealing;

■ In terms of wheat, because bread (which is made out of wheat) is a staple food item in the United States: We bought the house for an equivalent of 9,957 bushels of wheat (wheat in 1974 was $4.62 a bushel). We sold it in 1977 for the equivalent of 29,630 bushels of wheat (wheat was $2.16 a bushel). That is a total profit of 300 percent on the value of the house, in terms of wheat. As to the profit made on the invested out-of-pocket capital of $3,500 in terms of wheat, or the equivalent of 757 bushels of wheat, we realized a profit of $19,000, equivalent to 8,796 bushels of wheat — a total profit in wheat terms of 11,620 percent.

■ In terms of gold, the picture is different. The value of the house was equivalent to 421 ounces of gold (the price of gold in 1974 was $103 per ounce). We sold it in 1977 for 428.6 ounces of gold (the price of gold was $149.33 per ounce). This translates to an appreciation in the price of the house of 1.8 percent in terms of gold. The total profit made on the invested capital of $19,000, or 127.23 ounces of gold, related to an original investment of $3,500, or 33.97 ounces of gold, yielded a total of 374.7 percent.

Naturally, life 1,400-plus years ago was far simpler than it is today. The matrix of an average citizen's production and demands in a country is more diversified now and is by far more complex and different from one country to another. For example, those who want to think in terms of wheat (in this case, wheat farmers) cannot live on wheat alone because they will need to buy farm equipment, as well as fuel for heating and for operating the farm equipment. They will obtain credit to finance these agricultural activities. However, we cannot live on gold because we cannot eat or drink it. It should be made clear here that in discussing the Commodity Indexation Discipline we do not imply a return to the gold standard. What is strongly recommended here is a pioneering new RF discipline and RF finance and monetary system that uses a reference commodity like gold or a basket of commodities peculiar to each country to calibrate the real value of the local currency. The contents of this basket depend on the country's production and demand matrix. This concept is similar to the concept for the basket used for measuring inflation, for defining the Special Drawing Rights (SDR) currency used by the International Monetary Fund (IMF) and the concept proposed by James Baker III in 1987 to detect economic “bubbles” in a local economy. This RF discipline clearly stipulates that fiat (paper) money can be used, and the U.S. dollar may continue to be the reserve currency of the world along with maybe the euro, but the RF Commodity Indexation Discipline proposed here complements the current fiat money system and may eventually lead to a pioneering RF monetary structure and discipline. This assures all participants that the system and discipline used by government monetary authorities is designed and structured to be fair to all people and all nations. The system also rules that this RF Commodity Indexation

Discipline is implemented in order to price things fairly in the market while detecting any overpricing “bubble” as is usually experienced, for example, in commodities markets such as with energy prices and as was experienced between 2005 and 2007 in the United States housing bubble that led to the 2008 economic and monetary meltdown. This Commodity Indexation Discipline and rules will also help central bankers with their most important jobs and goals of keeping inflation under control, stabilizing currency value on the foreign currency exchanges, and stabilizing as well as optimizing the levels of unemployment. It is interesting to note that the use of this basket of commodities concept can change, not only from country to country, but also from time to time, with changes in the production mix in a certain country. It is felt that this concept will eventually prompt nations to produce more and become efficient producers to improve the value of their currencies on the foreign currency exchange markets.

Finally, it is hoped that economic and monetary research centers around the world conduct focused research on this concept, which has been tested successfully, as will be detailed in Chapters 5 and 6, to come up with useful ideas and propose an RF monetary, economic, and financial policies that can be useful to reflect the real value of local currencies for the good of the world and its citizen in the future. This will eventually create a peaceful world that is fair and just.

  • [1] Syed Saabiq, Fiqh Al Sunnah, Arabic, Vol. 3 (Beirut, Lebanon: Daar Al Kitaab Al Araby for Publishing and Distribution, November 1971), 138.
 
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