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When it comes to Islamic finance, one of the oldest and most frequently used types of sales contracts is the salam contract. Salam is a type of forward sale contract, whereby the buyer pre-pays for goods and assets with delivery expected to be made at a future date.
With its origins dating back to the days of Prophet Mohamed PBUH, this type of Islamic finance method is among the oldest form of a modern-day futures contract. Today, we boil down the basics of a salam contract, its advantages and benefits, as well as its use cases.
Salam contracts are used to purchase a good or products – with delivery at a later date – by locking in a price today, giving the buyer a hedge against any potential future price fluctuations.
The buyer negotiates the price with the seller as well as the delivery date, and pays the price in full at the time of the contract. This distinguishes salam from other forward sale contracts such as an istisna. Like in an istisna, however, the specifications of the product must be clearly outlined: include size, quantity, and quality.
The seller then uses the funds to produce or purchases the goods and makes delivery at the appointed time.
It’s worth noting that goods used in salam contracts are typically standardized, such as agricultural goods, metals and other commodities.
That said, the procurement of these goods must happen at a later date and not at the time of the contract. This distinguishes salam from other contracts such as Murabaha, where the goods being bought are pre-existing.
Read more about: Your Basic Guide to Istisna
The primary benefit of a salam contract (or any futures contract in general) is that it acts as a hedge against future price fluctuations for the buyer, while securing future supplies.
It provides the seller with immediate liquidity to begin producing and delivery the goods while also factoring in profits for their labor. In the even the price of said goods drops, salam also acts as a hedge by securing them a fixed higher price.
By its very nature, salam contracts have built in mechanisms to avoid some of the forbidden activities in Islamic finance. For one, by making it mandatory to secure payment at the time of signing the contract, it prevents the contract from resembling a loan and warding off any potential interest payments.
Furthermore, setting out specific terms on quality and delivery as well choosing standardized goods, minimizes the risks with failing to meet delivery targets as well as minimizing price speculation, thus avoiding Gharar (over speculation).
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A parallel salam is a variation on the standard salam contract that includes the involvement of a third party.
This generally takes the form of the buyer in an intial salam contract then signing a separate salam with a third party to deliver the same type of goods that were bought in the original contract.
This allows the buyer in the initial contract to secure the profits from the sale of the good before even taking hold of the product.
This, however, comes with a caveat. Both contracts must be independent of the other, with the first contract having no bearing on the second.
This means that if the buyer in the first contract doesn’t receive their goods from the seller or receives it late or not up to the quality that is contracted, they then cannot break the second contract by failing to make delivery or delivering the goods at a lesser quality. They must still meet the obligations on the second contract.
The nature of salam contracts (specifically on standardized goods) make them ideal for the purchase of commodities, including agricultural goods, oil and other extracted goods.
Because prices of commodities are volatile and change depending on the season and market forces, the protections offered in a salam contract makes it ideal for commodities.
The conditions on standardization also makes them ideal for certain manufactured goods that aren’t specialized. These could vary from certain chemicals to simple manufactured products, such as nuts and bolts.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
