Islamic Finance and the New Financial System. Alrifai Tariq

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to note about this period is that money evolved from being a unit of weight to being a unit of value. A distinction could be made between its commodity value (i.e., its weight in gold) and its specie value (its value in the market).17

      Paper Money, Promissory Notes (Sukuk), and Bills of Exchange

      Once money became a unit of value, it no longer needed to be held in commodity form. Paper money began to appear in China in the seventh century, under the Tang Dynasty.18 The development of banknotes (paper currency) was rooted in merchants' desire to avoid the weight and bulk of transporting coins to settle large commercial transactions. They developed a system whereby they would issue credit notes, which were for a limited duration and at a discount to the promised amount. This new paper currency did not replace coins until later, in the Song Dynasty, in the eleventh century. The banknotes were used alongside the coins until the central government noticed the economic advantages of printing banknotes and holding a monopoly right over their issuance.

      It was not until the thirteenth century that paper money reached Europe through the accounts of travelers, such as Marco Polo.19 In medieval Italy and Flanders, money traders started using promissory notes due to the high risk and impracticality of transporting large sums of money over long distances. These notes are considered to be the predecessor of the regular banknotes we know today. In 1661, the first European banknotes were issued by Stockholms Banco, later known as the Bank of Sweden.20

      At the same time banknotes started to appear in China, another form of paper currency began to appear in the Islamic world, the sakk, more commonly known as the promissory note. These notes were seen during the rise of the Islamic Umayyad Caliphate from the year 661 to 75 °CE.21, 22 Each note individually was called a sakk, and in the plural, sukuk, which is cognate with the European root cheque. A sakk meant any document representing a contract or conveyance of rights, obligations, or monies done in conformity with the Shariah.23 Sukuk were used extensively during the medieval period in Islamic society for the transfer of financial obligations originating from trade and other commercial activities. The essence of sukuk, in the modern Islamic perspective, lies in the concept of asset monetization, also known as securitization. Sukuk are discussed in detail in Part II.

      Europe during the Middle Ages witnessed a lot of financial innovations, not only with the development of banknotes but also with the development of trade bills of exchange. Their development was directly the result of the rapidly increasing trade throughout the region. A thriving trade business is heavily dependent on credit for expansion. Bills of exchange worked by allowing the buyer to receive the goods in return for the buyer delivering to the seller a bill of exchange, which constituted the buyer's promise to make payment at a specified date in the future. The seller could then present the bill to a merchant banker and redeem it in money at a discount to its value before it actually became due. The seller would get paid sooner and remove the risk of repaying in return for accepting a lower price against the bill's value. This transferred the risk to the merchant banker, who would accept the bill and make a profit in return for taking on the repayment risk.

      As you can imagine, merchant bankers would need to ensure that the buyer is reputable and that the bill was endorsed by a credible guarantor. This evolved into a regional credit system whereby a bill of exchange could be issued in one town and redeemed in another town through a network of merchant bankers. In England, bills of exchange became an important form of credit and money during the late eighteenth century up to the early part of the nineteenth century before banknotes, checks, and credit lines were widely available.24

      Another innovation during this period came from England in the twelfth century. The English monarchy introduced a notched piece of wood known as a tally stick to record the various amounts of taxes to be payable to the crown. The reason for using tallies was mainly because paper was rare and costly at that time. However, tallies were so popular that they continued to be used until the early nineteenth century, even after paper forms of money had become prevalent.

      Initially, tallies were simply used as a form of receipt to the taxpayer indicating that the dues had been paid. As tallies became successful for collecting taxes, the revenue department found new uses for them and began issuing tallies to denote a promise by the tax assessee to make future tax payments at specified times during the year. Each tally consisted of a matching pair: One stick was given to the assessee, representing the amount of taxes to be paid by which date, and the other was held by the revenue department, representing the amount of taxes to be collected by which date.

      It was soon discovered that these tallies could also be used to create money. When the government was short on money it would use tally receipts, which represented future tax payments due, as a form of payment to its own creditors. These creditors would be able to collect the tax revenue directly from the assessees or use the same tally to pay their own taxes to the government. This led to the development of a thriving market for trading tallies, which would be traded at a discount reflecting the length of time remaining until the tax was due for payment. The longer the time remaining on the tally, the larger the discount. Thus, the tallies became an accepted medium of exchange for some types of transactions and an accepted medium for storage of value. Once the market for tallies took off, the government realized that it could issue tallies that were not backed by any specific assessment of taxes. By doing so, the government was able to create new money that was backed by public trust and confidence in the monarchy rather than by specific revenue receipts.25

      Goldsmith Deposits and the Establishment of Banks

      As trade flourished in Europe, merchants grew to be very wealthy, and many of them amassed huge hoards of gold. The safest place to store this wealth at the time was to entrust it to the Royal Mint. However, in 1640, King Charles I of England seized the private gold stored in the mint, calling it a loan, which was to be paid back over time.26 This caused merchants to remove their gold from the mints and place it instead with goldsmiths. Goldsmiths in England had been craftsmen, bullion merchants, money changers, and money lenders since the sixteenth century, but did not actively get involved in gold storage until this event. They also possessed private vaults.

      Merchants began storing their gold in goldsmiths' vaults for a fee. In exchange for each deposit of precious metals – namely, gold and silver – the goldsmiths issued receipts certifying the quantity and purity of the metal they held in trust. These receipts could not be assigned to another party. Only the original depositor could collect the stored precious metals. With all the precious metals stored in vaults sitting idle, goldsmiths soon began lending out the metals on behalf of depositors and issuing promissory notes for money deposited. These deposits were treated as loans from the depositor to the goldsmith. The depositors allowed the goldsmith to use the money for any purpose, including advances to his customers. Goldsmiths did not charge a fee for accepting these deposits and, in many cases, paid interest on them. This was the beginning of the fractional reserve banking system, as these promissory notes were payable on demand and the loans to the goldsmith's customers were repayable over a longer time period. Gold deposits were relatively stable, often remaining in the goldsmith's vault for years, so there was little risk of default so long as the goldsmith maintained public trust and was financially sound.

      The promissory notes developed into an assignable instrument, which could circulate as a safe and convenient form of money backed by the goldsmith's promise to pay. Goldsmiths were able to advance loans, issue promissory notes, and offer checking accounts allowing depositors to draw down their balances held by issuing

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