What does "Salam Contract" mean in Islamic Finance?

In this contract, which may also be called Bay^us-Salam, full advance (on-the-spot) payment is made for fungible goods to be delivered on a future date. (Fungible means:goods contracted for without an individual specimen being specified, goods that are able to be replaced by another identical item; mutually interchangeable- Example rice, wheat, specific type of dates, specific type / make of car / iphone 6...etc). 

This instrument is a mode of financing future economic activity or a product that is going to be produced in the future. The seller promises to supply the specific product(s) to the buyer on the specific future date; the buyer provides the full funds in advance. This upfront payment is the key difference between "Salam" and a conventional forward contract. 

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Salam contract is a transaction where the purchase of a commodity (fungible goods) for deferred delivery in exchange for immediate payment (Advance).

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Salam is a forward financing transaction, where the financial institution pays in advance for buying specified assets, which the seller will supply on a pre-agreed date. What is given in exchange for the advance payment of the price should not in itself be in the nature of money. For the payment in advance, the contracting parties stipulate a future date for the supply of goods of specified quantity and quality. 

Salam may be considered as a kind of debt, because the object of the Salam contract is the liability of the seller, up to the agreed future date, to deliver the object for which advanced payment of the price has already been made. There is consensus among Muslim jurists on the permissibility of Salam, notwithstanding the general principle of the Shari´ah that does not permit the sale of a commodity which is not in the possession of the seller, because the object of the contract is that the goods are a recompense for the price paid in advance, just as the price is recompense paid for getting the goods in advance. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. Muslim jurists are unanimous that full payment of the purchase price is key for Salam to exist. However, Salam cannot take place in money or currencies as these are subject to rules relating to bai al-sarf, wherein exchange has to be simultaneous.

Because the Salam contract deals with the delivery of an asset which is not in existence, the Shari´ah highlights that strict rules must be adhered to in order to ensure that the right of all parties are protected. In fact, it is necessary that the quality of the commodity is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The commodity should be generally available in the market at the time of delivery. And all goods that can be categorized as belonging to the same species can be the subject of Salam. However, Salam cannot take place between identical goods. Besides, the time and place of delivery of the goods should be precisely fixed; and the quality and the quantity of the goods should be clearly specified. The specification of goods should particularly cover all those characteristics which could cause variation in price. 

Other rules applied to Salam contract, is that the seller in Salam need not be the manufacturer or producer of the asset. The seller may be an agent to deliver the asset. Furthermore, a Salam contract can stipulate that that, in the event of late delivery of the goods, the supplier pays a certain amount as a penalty to the buyer, which amount must be used for a charitable purpose; it cannot be taken into the buyer’s income. The buyer has also the right to demand security or collateral from the seller to ensure that the seller delivers the goods on the agreed date, the buyer has the right to dispose of the security and purchase the specified goods from the market; the buyer is entitled to deduct the advance payment from the proceeds of the security realised and return any surplus to the seller. 

Istisna´a, like salam, is a special kind of sale contract where a sale is transacted before the goods come into existence. However, there are several points of difference between Istisna’a and Salam. In fact, the subject of Istisna’a is always a thing which needs manufacturing, while Salam can be effected on anything, no matter whether it needs manufacturing or not. Also, it is necessary for Salam that the price is paid in full in advance, while it is not necessary in Istisna’a where payment can be made in staggered basis. And the object of the Salam is a liability on the seller to deliver, thus should be in the form of fungible. Under the Istisna’a, the asset manufactured must meet specification of the order and the buyer has the right not to take possession of the asset if the specifications are not met. In addition, the time of delivery is an essential part of the sale in Salam while it is not necessary in Istisna’a that the time of delivery is fixed. Any penalty for charged late delivery can reduce the price of an Istisna’a contract but in a Salam, the penalty amount is paid should not be taken as benefit for the buyer.

Salam is a forward financing transaction, where the financial institution pays in advance for buying specified assets, which the seller will supply on a pre-agreed date. What is given in exchange for the advance payment of the price should not in itself be in the nature of money. For the payment in advance, the contracting parties stipulate a future date for the supply of goods of specified quantity and quality. This mode of financing can be used by the modern banks and financial institutions especially to finance the agricultural sector. In Salam, the seller undertakes to supply specific goods to the buyer at a future date in exchange of an advanced price fully paid at spot. The price is in cash but the supply of purchased goods is deferred.

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Bay al-salam is a contract for deferred delivery that was originally sanctioned during the time of the Prophet, peace be upon him, to facilitate the trading activities of farmers who were awaiting the harvest of crops. In more modern times it has also been applied to the production of raw materials and fungible goods in general. Generally agreed conditions for bay al-salam are that:a) the goods sold need not be in existence at the time of contracting.b) the delivery date and location must be specified.c) full advance settlement of the agreed trade price is required at the time of contracting, otherwise the contract would sanction the trading of one debt for another which is not deemed permissible in Islam.d) the quality of the items to be delivered should be defined. Items must be fungible in nature. Hence, rare items, or those that are not precisely specifiable, cannot be the subject of the bay al-Salam contract. If the quality of the items upon delivery are found to be other than specified, the buyer has the right of refusal. e) the quantity of the items to be delivered should be defined and fixed according to the normal method of measurement of those items and should not depend upon unforeseeable factors. The quantity of goods purchased under the bay al-salam contract cannot for example be defined as that resulting from the cultivation of a given plot of land since such a quantity may vary according to unforeseeable factors.f) the buyer does not enjoy ownership of the goods until delivery has taken place.g) the buyer has the right to take surety from the seller as a form of performance bond.h) where the seller is unable to produce the contracted items on the delivery date, the buyer may nullify the bay al salam contract and exercise the performance bond.i) the seller may deliver the contracted items irrespective of the buyer's circumstances on the delivery date.

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