CAN THERE BE INNOVATION IN ISLAMIC FINANCE?

CASE STUDY:
ESHAM

By
Prof. Dr. Murat izaka
INCEIF University
Kuala Lumpur

Paper to be presented at the 11th IFSB Summit, Knowledge Sharing Partner

Session: New Markets and Frontiers for Islamic Finance: Innovation and the
Regulatory Perimeter, to be convened on May 20th, 2014 in Mauritus.

CAN THERE BE INNOVATION IN ISLAMIC FINANCE? CASE STUDY:

ESHAM
Introduction:
The answer to the question, can there be innovation in Islamic finance? must
be affirmative. This is for a simple reason: unless there is innovation, Islamic
finance would freeze and stagnate in a rapidly changing world. A frozen and
stagnating financial system would be condemned to fall behind rival financial
systems that evolve together with the ever advancing world. So, in short, it is
the relentless competition that necessitates Islamic finance to constantly renew
itself.
While the need for constant innovation is thus clear, it is equally clear that
Islamic finance must not be opened up to just any innovation. Each innovation
to be considered must be carefully scrutinized subject to at least three criteria.
Starting with the most obvious, the innovation must not constitute riba. Second,
and by an extension of the first, it must not be an instrument of risk shifting but
one of risk sharing. Third, it must be capable of moving the society towards the
Al-Ghazali/al-Shatibi optimum.1 We will now take a highly promising
instrument of public borrowing, esham and examine it from the perspective of
these criteria. But first, the modus operandi of esham needs to be explained.
Modus Operandi of Esham:
Before the details of the modus operandi are presented, it should be noted that
esham is by no means a new innovation. In the Islamic world, its origins can be
traced back to the year 1775, when the Ottoman government had to pay a huge
war indemnity to imperial Russia after a disastrous defeat. The government had
to pay this indemnity within a year and the failure to do so, would have renewed
the hostilities. The modus operandi presented below was inspired by this
historical precedence and was then modernized by an interdisciplinary team of
scholars at INCEIF University.2

For this concept the reader is referred to Murat izaka, Islamic Capitalism and Finance:
Origins, Evolution and the Future (Cheltenhem: Edward Elgar, 2011), pp. 276-281.
2
The team comprised of two economic/financial historians, several scholars of fiqh almuamalat and a professor of finance.

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a) The Asset:
The operation starts with the issuer/borrower/obligor setting aside an
asset yielding regular annual revenue. The asset is owned and managed
by the issuer, who allocates merely a certain fraction of the annual
revenue for esham.
b) Securitization:
This revenue fraction is then securitized into equal shares and offered for
sale to the public. Each share authorizes its purchaser, the investor, to
receive his share of the allocated annual revenue pro rata. This is a fixed
amount, which makes it quite attractive to the investor. Why,
notwithstanding this feature, esham does not constitute riba, will be
discussed below.
c) Duration:
Esham shares (sing. Sehm) do not have a fixed period. With respect to
duration, there are usually two kinds of esham: limited for a life time, or
perpetual. The investor, who has purchased the sehm share, continues to
receive his share of the annual revenue for as long as he/she lives, or even
in perpetuity. The latter can also be called perpetual bonds or perpetual
sukuk, in modern parlance. But, as a matter of fact, esham differs from
both: it is neither a bond, nor a sukuk. It is not a bond because of its
specific redemption characteristic. It is not a sukuk either, because unlike
most sukuk, it does not have or need an SPV. Consequently, it is
considerably simpler than most sukuk and has lower transaction costs. A
life-time esham would be issued to a specific person and therefore be a
registered share, whereas the perpetual one would be a bearers share.
d) Pricing:
Each sehm share is sold at a certain multiple of the annuity it will yield to
the investor. Naturally, a sehm for a life time would be cheaper than a
perpetual one. While there is no fixed rule regarding the initial price of a
share, present value criteria3 can be of some relevance with time t ranging
3

Standard Present Value Criterion includes the discount rate which is based on the interest rate. In Islamic
finance internal rate of return or the required yield or the opportunity cost of investment are used. For details
see; Murat Cizakca, Tax-Farming and Resource Allocation in Past Islamic Societies, Journal of King
Abdulaziz University, Islamic Economics, vol. I, pp. 59-80, 1989. Available at:
www.kau.edu.sa/Files/320/Researches/51008_21145.pdf

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from 20, with a 20 years maturity, to an indeterminate t for an expected
life time and perpetuity. Actuarial tables can be used to approximate the
expected life time.
Esham can be traded in secondary markets and are fully negotiable.
When sold in secondary markets by the initial owner, the price of a share
fluctuates reflecting supply and demand as well as reliability of the
annuities. Listed on an exchange, they would behave like participating
preferred stocks. Historical examples inform us that a sehm could be
traded at 75 percent or at par if the annuities had been paid regularly by
the issuer (in history a government) over the long run.
e) Yield:
Esham is a hybrid fixed income and profit/loss sharing instrument. Fixed
returns are paid to the investor in the form of fixed annuities. Profit/loss
sharing occurs when it is traded in the stock exchange. Because of the
redemption specifics explained below, the annual yield can be
benchmarked to LIBOR or it can be set even higher. A reserve account
can also be set up to avoid reflecting the losses on investors.
Overall income from the asset as well as securitization is channeled into
two pools: First pool is reserved for paying the fixed annuities. Second
pool contains the retained earnings, which will be accumulated until
maturity (see the next item) and invested in the meantime.
f) Redemption:
What makes esham unique is the fact that redemption is at the discretion
not of the lender but of the borrower. Put differently, the borrower pays
back the principal when he sees fit. This means that the maturity is
decided by the borrower. While this is so, and the borrower may decide to
redeem (or not) at a certain time in the future, the investor is not obliged
to cash his esham. Thus, the issuer ends up redeeming only those esham
whose owners wish to cash.
In the case of perpetual esham, the borrower may not redeem at all. He is,
however, obliged to pay the annuity on time every year. These payments
continue either for as long as the investor lives (life-time esham) or in

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perpetuity (perpetual esham). Some current esham like instruments give
the option to the issuer to redeem the shares some twenty years after the
issuance.4
Consequently, esham would be considered not as debt but as equity a
highly advantageous situation regarding the Basel III gearing ratios. Put
differently, a company issuing esham, would be able to shore up its
capital base without deteriorating its debt/equity ratio.
g) Third Party Guarantee:
If the issuer is a government, certain taxes can be allocated by law to the
payment of annuities, or one branch of a government may provide
guarantee for the other. The former, of course, would be a far more
persuasive alternative for investors. If it is a private corporation, a reliable
and trust worthy third party may need to be found. In a recent perpetual
sukuk of RM 2.5 billion, issued by the Malaysian Airlines (the closest
example of a modern esham), third party guarantee has not been
provided. Third party guarantee pertains to fixed annuities only.
h) Relevance for Central Banks and Open Market Operations:
The above mentioned characteristics render esham an ideal instrument for
open market operations of central banks in Islamic countries. Currently,
these banks utilize commodity murabahas or tawarruqs as their monetary
policy instruments. These instruments are subject to Shari`ah risks, while
esham is not.
First Criterion: The Shari`ah Perspective:
Let us now examine if esham is a riba free instrument. But first we need to
remember, under what conditions a financial transaction becomes usurious. A
cash-cash transaction would be considered as riba, if the following conditions
simultaneously take place:
4

For more information on these instruments see, Murat izaka, Esham: A Shariah Based
Yet Fixed Return Instrument for Investment, Global Islamic Finance Review, 2013, pp. 9193.

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1) Excess or surplus over and above the loan capital to be returned to the
lender.
2) Determination of this surplus in relation to time with a definite date of
redemption
3) Stipulation of this surplus in the loan agreement.
With regard to the life time esham, the uncertainty of the lifespan of the investor
eliminates the certainty of the surplus and violates, at once, all three conditions.
With regard to the perpetual esham, the lack of a definitive date of redemption
and the fact that redemption is at the discretion of the borrower, not the lender,
violates the first and the second conditions.
In view of above, it is concluded that esham is not usurious. The fact that it was
used by the Ottoman Caliphate for more than a century also supports this
conclusion.
Second Criterion: Risk Sharing vs. Risk Shifting.
In conventional finance risk shifting occurs when the lender demands that the
borrower redeems his debt at a certain date regardless of the outcome of the
venture. Islamic risk sharing, by contrast, occurs when the parties share the
outcome (profit or loss) of the venture at a pre-determined ratio. When esham
shares are sold by an investor in secondary markets, the price will be
determined by supply and demand as well as the past payment performance of
the annuities. This will render esham a true profit or loss sharing instrument.
Moreover, with the redemption being at the discretion of the borrower/issuer,
risks are not shifted by the lender upon the borrower. Instead, a compromise is
reached by which while the issuer/borrower redeems his debt at his discretion,
the investor obtains the right to a fixed and regular income for as long as the
issuer/borrower does not redeem. Meanwhile, the investor can sell his/her
esham at the stock exchange at market prices. Thus we conclude, esham is not a
risk shifting instrument.
Third Criterion: Maqasid al-Shariah and the Al-Ghazali/Al-Shatibi Optimum.
We will now examine esham from the perspective of the maqasid al-Shariah
and its extension the Al-Ghazali/Al-Shatibi Optimum. As it is well-known, the
maqasid al-Shariah has five components, hifs al-aql, hifs al-din, hifs al-mal,
hisfs al-nafs and hifs al-nasl, or, protection of the mind, religion, property, the
self and the future generations. The essential question here is how esham would

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affect each one of these components. The concept of Al-Ghazali/Al-Shatibi
Optimum enters into the picture precisely here. It will be argued here that
providing esham does not affect any one of the components negatively but
affects even a single one positively, it should be permitted. This is because, a
situation by which one of the components is positively affected without any of
the others being negatively affected, brings us one step nearer to the optimum.
The optimum is reached only when it is no longer possible to affect any one of
the components positively without affecting any of the others negatively.
The above argument means that we can use this criterion not only for esham but
for any other innovation. Providing each new innovation affects one of the
components positively without affecting any of the others negatively, it should
be permitted and each such innovation would bring us one step nearer to the AlGhazali/Al-Shatibi Optimum.
Let us now create a table and check how esham affects each one of the
components.

IMPACT OF ESHAM ON EACH COMPONENT

Mind
Neutral

Religion
Positive

Property
Positive

Self
Positive

Future
Generations
Positive

Esham has no impact on the protection of the mind. Hence its impact is neutral.
Its impact on religion is positive, it can even be vitally important. Consider the
historical case given at the beginning of this paper, had esham not enabled the
Ottoman government to borrow a huge sum from the public and do so within a
year, this Muslim state would have been further attacked by a powerful enemy
and untold numbers of Muslims would have been either killed or driven from
their homes and become refugees. So, we conclude, with confidence, that the
impact on religion is positive.
The impact on property is also positive. Imagine an investor who has a given
amount of cash with which he/she buys esham shares. These shares would
enable her to maintain the value of her property by providing her not only fixed

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annual income for the rest of his/her life, even in perpetuity, but also the
possibility that he/she can sell the shares in the stock exchange at market prices.
Once again, we conclude that the impact is positive.
The impact on self is also positive. Indeed, we can consider esham as a selffinanced retirement scheme. Providing the investor with fixed income for the
rest of his/her life, esham, indeed acts just like a retirement scheme. A person
with fixed income for the old age can live with dignity for the rest of his/her
life. Once again, we conclude that the impact on the self is positive.
Finally, we consider the impact on future generations. Every parent wishes to
provide his/her child with some fixed income in case of death or for education
or financial independence from an unworthy spouse. Esham is the ideal
instrument for this. The impact is thus, once again, positive.
The fourth (self) and the fifth (future generations) components make esham
particularly promising for the rising middle classes in the Islamic world. With
Islamic countries enjoying the so-called demographic dividend, it is expected
that hundreds of millions of young people will become middle classes in the
near future. Middle classes, by definition, are neither wealthy enough to initiate
major projects nor so poor to go hungry. They are people who need fixed
incomes to save sometimes substantial amounts in their mid-life for their old
age and offspring. This is a powerful need felt by hundreds of millions of
Muslims all over the world. Esham provides the ideal solution for such needs
for, not only does it yield a fixed income as well as the opportunity to cash in
the investment, it does so without violating the interest prohibition.
Conclusion:
In this paper I have tried to provide a new method comprising three criteria to
assess the suitability of an innovation for Islamic finance. This paper concludes
that not only Islamic finance must innovate but that each innovation must first
be scrutinized according to the three criteria before it is permitted. A promising
old/new instrument of finance, esham, was then considered and then scrutinized
from the perspective of the three criteria. It was then concluded that the
modernized esham can be used for public borrowing by Muslim states and
companies.