Did She Say That?

http://www.financeasia.com/article.aspx?CIaNID=118130
Dubai World creditors await court definition of Sukuk
At issue with Nakheel's sukuk is how a court will handle the restructuring, note observers familiar with Islamic finance. Much depends on the structure of the instrument. A court could declare the instrument the equivalent of a conventional bond with repayment terms comparable to international norms, or it could find the sukuk to be structured as either a mudharabah (profit-sharing) product or a musyarakah (a partnership involving profit- and loss-sharing) product, both of which would likely involve the creditors sharing some of the issuer's losses.

Creditors stand to benefit if a sukuk is declared essentially the same as a conventional bond, whereas the issuer stands to benefit if it is defined first and foremost as an instrument that is compliant with Shar'iah (Islamic law) -- and thus subject to the idea of profit-sharing.

"The whole presentation of the structure is one where investors are meant to receive a share of the profits and not interest on debts - two very different obligations," said Khalid Howladar, a senior credit officer at Moody's. "It could be argued that, because an issuer is not generating profits, it should not have to pay sukuk investors."

Not everyone agrees: "This is a credit issue, not an Islamic issue," said Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia. "A sukuk is a bond and issuers need to pay back the money they borrowed."

The quandary faced by the holders of Nakheel’s Sukuk has been well documented and discussed in recent weeks. At this juncture, how they will move forward with the restructuring depends on how the courts define this instrument called Sukuk.

In the above article, the global head of Islamic markets at Bursa Malaysia claims that a Sukuk is a bond. I find it appalling that a person of such stature as Raja Teh with all her experience can come up with such a statement which IMHO seriously undermines the principles of Islamic finance.

In case she forgot, a Sukuk is defined as follows:

“Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity” by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, Standard 17).

“A document or certificate that represents the value of an asset” by The Securities Commission (SC).

A bond is defined as a fixed interest financial asset. Bonds pay the bearer a fixed amount a specified end date. A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Click here for a comparison between Sukuks and Bonds.

If Sukuk is a bond, why bother with the Shariah structures & approvals, legal documentations etc.? Why bother calling it a Sukuk?

Let’s put it this way, Sukuks and bonds are like fish and chicken, they are both sources of food and can be cooked the same way but they will NEVER look the same, taste the same, they will never be the same.

It is a credit issue, so going forward, let’s use Nakheel/Dubai World as an example and learn from it. The first and most important lesson to remember is to structure a Sukuk as a Sukuk and not as a bond. And that includes evaluating the credit from the Sukuk perspective and not the bond perspective.

For as long as the Islamic finance industry is lead by people with a conventional worldview on Islamic finance, it will never break away from being a conventional product with an Arabic name.

Wa'd

Wa’d is a unilateral promise and is considered as a voluntary contract. Al-Zarqa’ opines that it does not convey any binding effect on the promisor hence they are not obliged to fulfil the promise and will not be liable in a case where they fail to fulfil the promise made to the promisee.

The BNM Shariah Council in its 49th meeting held on 28th April 2005 / 19th Rabiul Awal 1426 resolved that an Islamic banking institution is allowed to enter into forward foreign currency transaction based on unileteral binding promise (binding only on the promisor) and the compensation for breaching of promise could be implemented. This permissibility is only applicable for currency hedging purposes. Such a transaction may be arranged between the Islamic banking institution and its customers, or between the Islamic banking institutions, or between the Islamic banking institutions and conventional banking institutions.

The fatwa of Islamic Bank of Jordan (Jordan Islamic Bank, al-Fatawa al-Syar’iyyah, 2001, v2, p.29) states that the bilateral promise made in currency exchange where it bonds both parties to the contract, is generally prohibited (umum al-nahyi) as it amounts to bai` al-kali’ bi al-kali’ (sale of debt with debt). However, if the promise is made unilaterally i.e. binding only on one party who made the promise, then the transaction is allowed.

Ibn Hazm (Ibn Hazm, al-Muhalla, Dar al-Turath, Cairo, V.9, p.583) has also allowed the promise made to sell and purchase of currency with an agreed price on the same day followed by actual conclusion of the contract afterward. The parties is also given the choice to proceed or not to proceed with the agreement made and thus do not conclude the actual contract. This is permissible according to Ibn Hazm as the promise is not binding on the parties.

Having said all that, it is clear that Wa'd is a non-binding unilateral promise meaning that in the event the promisor decides to rescind the promise, the promisee is in no position to demand compensation. In reality however, most banks demand compensation for breach of promise. How is it non-binding then?

Moving Away from Tawarruq?

Twenty-six Islamic banks signed off on a standardised Wakalah deposit agreement, which some bankers said could help the industry reduce its reliance on the controversial Commodity Murabahah structure, Reuters reports. “Besides cost and resource savings, the adoption of the standardised Wakalah placement agreement would promote transparency, consistency, operational efficiencies and robustness in Islamic deposit placement transactions,” said the Association of Islamic Banking Institutions Malaysia, which launched the template agreement. “In six months’ time, all the banks will be using the Wakalah,” said one Malaysian Islamic banker. “It has fewer issues than the Commodity Murabahah.”

Wakalah is an agency structure where a depositor or investor authorises an agent (the bank) to invest his funds in Shariah compliant assets or businesses.

Finding alternatives to replace controversial instruments is a step in the right direction and it augurs well for the industry.

Organised Tawarruq not a perfect structure

In its basic form, Tawarruq is an asset sale to a purchaser with deferred payment terms. The purchaser then sells the asset to a third party to get funds. Organised Tawarruq is similar although the transactions are executed through banks.

Reuters reports Shariah adviser Rusni Hassan saying that Organised Tawarruq as it is currently practised is not ideal from the Shariah's viewpoint.

According to the report (Nov 4, 2009), Rusni opines that organised Tawarruq should avoid specifying beforehand the parties' obligations under the contract although this protects their legal rights, backing a divisive Fiqh Academy ruling that had thrown the industry into turmoil. She objects to organised Tawarruq because the two contracts are in one when they should be independent of each other.

I agree with her views but I foresee it will further divide the industry especially when respected scholars like Nizam Yaqubi and Akram Laldin see no harm in organised Tawarruq.

Other scholars who disapprove of Tawarruq include Muhammad Nejatullah Siddiqi and Monzer Kahf.

Siddiqi views Tawarruq to be identical to interest based loans both from the functional and macroeconomic perspective. His justification for categorising Tawarruq as non-compliant is due to its harms (mafasid) being greater that its benefits (masalih). He lists;
1) creation of excessive debt;
2) exchange of money with more money in future, which is unfair in view of the risk and uncertainty involved;
3) debt proliferation, which is liken to gambling and speculation;
4) inflationary expansion;
5) inequity in the distribution of income and wealth;
6) greater instability in the economy; and
7) inefficient allocation of resources.
as the many harms of Tawarruq.

Kahf opines that Tawarruq is worse than the practice of interest-based loan legally and economically.

I have to disagree (with apologies) with Sheikhs Yaqubi and Akram on the permissibility of Tawarruq. Being of limited knowledge, I depend on the views and opinions of the scholars and in this case the arguments presented by Siddiqi make more sense to me.

Mudharabah and Musharakah are NOT Debt Contracts. Get it?

A Shariah expert claims that Asset-based Sukuk Mudarabah and Musharakah will fall out of favour as it is hard to accommodate a ruling on repurchase pledges, indicating the market would be permanently affected by the decree.

According to Moody’s, the issuance of Musharakah and Mudarabah based Sukuk fell 83 percent and 68 percent respectively last year.

Bankers and lawyers have been seeking ways to structure Sukuks that comply with a 2008 ruling by AAOIFI which forbids “borrowers” in Sukuk Mudarabah and Musharakah from promising upfront to pay back their face value at maturity. This follows a rule that parties must share risks under these structures but the industry had been concerned it would make Islamic bonds less palatable to investors. But the market is trying to find ways to accommodate the prohibition. However, Shariah adviser Dr Mohd Daud Bakar said it would be tough to do so, "It's very difficult because it goes against the very essence of Mudarabah and Musharakah because you cannot guarantee the capital (or profits) in equity-based contracts." (Reuters)

Which is exactly my point. Mudarabah and Musharakah are equity-based contracts and therefore should not be treated as debt-based contracts. Why the industry continues to structure debt papers based on an equity structure baffles me.

A Sukuk is not a bond and a Sukuk is defined by the underlying contract that governs it.

After so many years of being exposed to Shariah based finance, I’m stumped that the so called Islamic bond fund managers (and the rest of the market really) still view Mudarabah and Musharakah Sukuks as debt instruments. Well, I’m telling them again – it’s NOT. Sukuk Mudarabah and Musharakah investors are not borrowers, they are partners who are supposed to understand and willing to assume risks associated with such investments.

The market should take the lead by re-identifying their investment needs and demand the appropriate structure. If they want to invest in fixed income instruments, look for Ijarah, Murabahah or Istisna based structures.

If they want to invest in Mudarabah and Musharakah Sukuks, they better make sure they are looking at them from the equity perspective.

The reason why we are facing this problem is because we (the market/industry) continue to apply Shariah based finance on the conventional platform. If a Mudarabah and/or Musharakah based Sukuk has identical features with a conventional bond, why bother having an Islamic finance industry? Since the underlying structure is identical, we might as well merge the two since there is no difference apart from the name and legal documentation.

The growth of the Sukuk market can only be achieved if the industry accepts Sukuk as a unique instrument instead of equating it to and treating it like a conventional bond.

The Derivatives Debate

Derivatives are contracts which derive (hence the name derivative) its value from an underlying asset. Derivative contracts are used to manage risk, manage uncertainty, which is Shariah complaint. If this is so, why is there continuous debate and dispute on the status of derivatives from the Shariah perspective?

Agil Natt, chief executive of INCEIF points out that Islam encourages managing risk but he also asks how do you draw the line between risk management and gambling/speculating?

His comments are valid in the sense that the two reasons investors use derivatives are for risk management/hedging and speculation. The irony is that these two types of investors often work against each other; hedging aims to protect an investor from a volatile market (by taking an offsetting position to the investor's current position) while the speculator loves volatility, his objective is to profit from a rise or a fall in the price of a security.

Over time, simple derivative contracts like forwards have evolved into futures, options and the more complex credit default swaps and even OTC bets on bond defaults.

If the objective is to manage risk, financial instruments should focus on that – risk management. Regulators and product developers must not allow any speculative elements and/or opportunities to exist in the risk management process.

Mufti Taqi Usmani of the Fiqh Academy of Jeddah in an article answering a set of posed questions on the topic (New Horison, June 1996, pp 10-11), argues that futures contracts are invalid because:

"Firstly, it is a well recognized principle of the Shariah that purchase or sale cannot be affected for a future date. Therefore, all forward and futures contracts are invalid in Shariah; secondly, because in most futures transactions delivery of the commodities or their possession is not intended. In most cases the transactions end up with the settlement of the difference in price only, which is not allowed in the Shariah."

The Editorial of islamic-finance.com has this to say about derivatives:
"We can protect you against market volatility" the investment bankers tell their clients. But the market volatility is caused by the activities of those very same investment bankers, and so the clients are sold nothing for something. Protection against a danger that never needed to exist in the first place. Sadly, the world learned little from the derivatives explosion. By the time the internet boom collapsed, a new generation of clients was learning about the motivations that really drive bankers and advisors. The clients tend to be offered the products that provide financial institutions with the highest profit margin.

Shariah has no objections to hedging one’s risk but the industry participants must ensure that the risk management tools are Shariah based and not used for speculative purposes.

AAOIFI Shari’ah Resolutions: Issues on Sukuk

Issuer: Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

The Shari'ah Board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), in view of the increased use of Sukuk worldwide, the public interest in them, and the observations and questions raised about them, studied the subject of the issuance of Sukuk in three sessions; first, in al-Madinah al-Munawwarah, on 12 Jumada al-Akhirah 1428 AH (27 June 2007), second, in Makkah al-Mukarramah, on 26 Sh'aban 1428 AH (8 September 2007), and third, in the Kingdom of Bahrain on 7 and 8 Safar 1429AH (13 and 14 February 2008).

Following the meeting of the working group, appointed by the Board, which met in Bahrain, on 6 Muharram 1429AH (15 January 2007), which was also attended by a significant number of representatives from various Islamic banks and financial institutions, the working group presented its report to the Shari'ah Board.

After taking into consideration the deliberations in these meetings and reviewing the papers and studies presented therein, the Shari'ah Board - while re-affirming the rules provided in the AAOIFI Shari'ah Standards concerning Sukuk - advises Islamic financial institutions and Shari'ah Supervisory Boards to adhere to the following matters when issuing Sukuk:

1. Sukuk, to be tradable, must be owned by the Sukuk holders, with all the rights and obligations of ownership, in real assets, whether tangible, usufructs or services, capable of being owned and sold legally, as well as in accordance with the rules of the Shari'ah, in accordance with Articles (2) and (5/1/2) of the AAOIFI Shari'ah Standard (17) on Investment Sukuk. The Manager issuing the Sukuk must certify the transfer of ownership of such assets in its (Sukuk) books, and must not keep them as his own assets.

2. Sukuk, to be tradable, must not represent receivables or debts, except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufruct, were included unintentionally, in accordance with the guidelines mentioned in AAOIFI Shari'ah Standard (21) on Financial Papers.

3. It is not permissible for the Manager of Sukuk, whether the manager acts as the mudharib (investment manager), or sharik (partner), or wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus. It is not objectionable to distribute expected earnings, on account, in accordance with Article (8/8)3 of the AAOIFI Shari'ah Standard (13) on Mudaraba, or to obtain project financing on account of the Sukuk holders.

4. It is not permissible for the mudharib (investment manager), sharik (partner), or wakil (agent) to undertake {now} to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase, in accordance with Article (3/1/6/2) of AAOIFI Shari'ah Standard (12) on Sharikah (Musharaka) and Modern Corporations, and Articles (2/2/1) and (2/2/2) of the AAOIFI Shari'ah Standard (5) on Guarantees. It is known that a Sukuk manager is a guarantor of the capital, at its nominal value, in case of his negligent acts or omissions or his non-compliance with the investor's conditions, whether the manager is a mudharib (investment manager), sharik (partner) or wakil (agent) for investments.

In case the assets of Sukuk of al-musharaka, mudharabah, or wakalah for investment are of lesser value than the leased assets of ‘Lease to Own’ contracts (Ijarah Muntahia Bittamleek), then it is permissible for the Sukuk manager to undertake to purchase those assets - at the time the Sukuk are extinguished - for the remaining rental value of the remaining assets; since it actually represents its net value.

5. It is permissible for a lessee in a Sukuk al-ijarah to undertake to purchase the leased assets when the Sukuk are extinguished for its nominal value, provided he {lessee} is not also a partner, mudharib or investment agent.

6. Shari'ah Supervisory Boards should not limit their role to the issuance of fatwa on the permissibility of the structure of Sukuk. All relevant contracts and documents related to the actual transaction must be carefully reviewed {by them}, and then they should oversee the actual means of implementation, and then make sure that the operation complies, at every stage, with Shari'ah guidelines and requirements, as specified in the Shari'ah Standards. The investment of Sukuk proceeds and the conversion of the proceeds into assets, using one of the Shari'ah-compliant methods of investments, must conform to Article (5/1/8/5) of the AAOIFI Shari'ah Standard (17).

Furthermore, the Shari'ah Board advises Islamic financial institutions to decrease their involvements in debt-related operations and to increase true partnerships based on profit and loss sharing, in order to achieve the objectives of the Shari'ah.

In the end, all praise is due to Allah, Lord of all the Worlds!

Sukuk Ijarah, Part II – Transaction Flow

This structure applies the Ijarah Muntahiah Bittamlik contact.

Ijarah is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period upon the aqad (contract). The ownership of the leased asset remains in the hands of the lessor for the duration of the lease.
Muntahiah Bittamlik describes the transfer of the title of the leased asset to the lessee at the end of the lease tenure.

The transaction flow for my version (as opposed to the version practised in the Malaysian market) of the Sukuk Ijarah is as follows:

1. The purpose of this transaction is to raise funds, therefore; the Issuer shall identify an (a pool of) asset(s) to be sold to the Investors. The Issuer enters into a Sale and Purchase Agreement with the Investors whereby the Legal ownership of the asset(s) is transferred to the Investors at the prevailing market price and on a willing buyer willing seller basis. The cash proceeds from the sale is utilised by the Issuer as they wish.

2. Trustees shall be appointed to hold the Assets in trust on behalf of the Investors. The Investors will have a pro-rata undivided beneficial interest in the Assets.

3. In the same session, after executing the Sale and Purchase Agreement, the Issuer will execute the Ijarah Agreement with the Investors. Under the terms of the Ijarah Agreement, the Issuer leases the Assets from the Investors for a predetermined period at a predetermined Ijarah rate. The Ijarah rate shall include two elements, the rental element and the asset price element.

4. The Issuer issues Sukuk Ijarah to the Investors as evidence of their lease and its obligations. The Investors are now known as the Sukukholders

5. Under the terms of Ijarah Muntahiah Bittamlik, the beneficial ownership of the Asset is transferred to Issuer at maturity of the Sukuk Ijarah provided the Issuer meets in full the obligations stipulated under the Ijrah Agreement.

6. In an event where the Issuer fails to honour its lease obligations, the Sukukholders (Asset owners) shall repossess the Assets and dispose them to the market to recover their investment.

Note: Steps 1, 2, 3 and 4 occurs consecutively in the same session.

Sukuk Ijarah, Part I

Ijarah - is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period upon the aqad (contract). The ownership, rights and obligations as the owner of the leased asset remains in the hands of the lessor for the duration of the lease. Any costs incidental to the usage are the responsibility of the lessee.

A Fixed Asset based Sukuk Ijarah should have the characteristics of a Real Estate Investment Trust (REIT). If I was to structure a Fixed Asset Sukuk based on the Ijarah contract, it would probably have the following characteristics:

Issuer:
An SPV owned by the Trustees on behalf of the Sukukholders

Principal Activities of the Issuer/SPV:
Owner, manager and Lessor of [warehouses/hypermarket/office, commercial, industrial, educational, residential buildings/ships/aeroplanes – thereafter referred to as ASSETS].

Tenure of Investment:
5 years (for example)

Structure Description:
Investors will receive Sukuk Ijarah issued by the SPV as evidence of their investment in the SPV. SPV shall utilise the investment proceeds to acquire ASSETS (as described in [the hypothetical] Appendix A). The legal title of the ASSETS shall be transferred to the SPV and held in trust for the Investors.

The ASSETS shall not engage or be a party to any activities contrary to or forbidden by Shariah.

The ASSETS shall be leased to the market at the appropriate lease rental rates (as verified by the appointed valuer or industry expert) and for a lease period not exceeding 5 years (or any number of years as agreed by the investors).

Any costs incidental to ownership such as taxes and insurance shall be borne by the Lessor.

Any costs incidental to usage, such as utilities expenses, repairs due to wear and tear and content insurance shall be borne by the Lessee.

Lease rental net of (minimal) SPV cost shall be remitted to Sukukholders half yearly (or annually, quarterly, monthly)

SPV shall instigate legal action against lessees who deliberately and fraudulently dishonour the lease agreements. Failure of the lessees to pay rental due to economic reasons does not require immediate legal action. Instead, a solution has to be found to ensure the lessees are able to resume payment of the rental soonest possible.

Investors wishing to exit the investment, at any time, may sell their share of ownership to anyone, at the prevailing market price of the asset. The prevailing market price shall be based solely on the market value of the asset or NAV.

At the end of 5 years, the ASSETS shall be sold to the market at current prices and Investors will receive their share of the sales proceeds according to their share of investment.
The investors may decide to continue with the investment if the so wish and investors wishing to exit the investment may dispose their shares in the manner described above.


Difference from some of the Malaysian Sukuk Ijarah in the market:

• Under this structure, the SPV assumes full legal ownership of the assets, not just the beneficial ownership.
• This structure does not have a purchase undertaking with a predetermined price, the properties are disposed to the market, at market prices.
• Rental is priced at the real market rental rate and not benchmarked against any interbank rate (LIBOR etc) or interest rates.
  

This structure is basically a REIT. It is not a mind-boggling alien structure that should be scorned upon so correct me if I’m wrong, why isn’t there any such Sukuk structure out the in the market?

Islamic Hedge Funds?

"Hedge fund" is a term that was originally used to describe a type of investment pool that uses sophisticated hedging and arbitrage tools to trade in the equity markets and explicitly pursues absolute returns on their underlying investments. The most widely-accepted definition of a hedge fund is that it is a fund that uses leverage, shorting and options to achieve its investment goals, beginning with the protection of investor capital.

The first hedge fund was set up by Alfred W. Jones in 1949, the first to use short sales and leverage techniques in combination. In 1966, a "hedge fund" run A. W. Jones shocked the investment community because it outperformed all the mutual funds of its time, despite their huge 20% fee.

According to some experts, hedge funds are believed to be highly speculative and thus may run contrary to the Shariah prohibition of gharar. At an even more fundamental level, however, hedge funds use short sales to neutralise the influence of market forces; and short sales involve the sale of what one does not really own, which is haram.

Toby Birch of Birch Assets Ltd doubts whether hedge funds could in principle be Shariah-compliant, calling Islamic hedge funds "something of an oxymoron," being an area of controversy, where such structuring might obey the letter of Shariah, it is not compatible with the spirit.

Often, in structuring Shariah compliant instruments, a number of contracts are combined to achieve the desired result, a solution that meets the financial or investment needs. On the surface, combines two or more Shariah concepts may sound perfectly acceptable but indiscriminately doing so may lead to what Tarek Diwany describes as “contractum trinius”. Ahmed Abbas, of Bahrain’s Liquidity Management Centre, criticised such mechanisms as false to the spirit of Shariah. “I don’t care, if you take 20 Islamic steps in order to short sell, you cannot sell what you don’t own. “Islamic banking is not about drawing an Islamic veil over something un-Islamic.”

There have been many opinions and views as well as fatwas on whether hedge funds are Shariah compliant or not. We should be looking at the purpose of a hedge fund rather than the mechanics of the fund. This way hopefully we can up with a solution to the problem rather than modifying an existing (probably incompatible) instrument to solve the problem.

To "hedge" means to manage risk. The key word here is risk management. Our objective is to manage risk in a Shariah compliant manner. We shouldn’t be talking about Islamising hedge funds to manage risk, we should be finding means to manage risk which do not contravene Islamic laws. We should not be finding ways to Islamise hedge funds just for the sake of creating or adding to market liquidity and to enhance rice discovery.

Managing risk is permissible in Shariah based finance provided the means of managing that risk complies with the rules of Shariah. Managing risk can come in the form of full transparency, honouring contractual obligations, being accountable and acting in a professional way. Shariah based financial transactions are after all partnership and risk/reward sharing arrangements. Actions undertaken to manage and/or minimise risk should be directly related to the business venture by ensuring that it is undertaken in the proper manner.

Islamic Finance refresher

Definition:

Financial activities undertaken according to Shariah rules sourced from the Quran and traditions (hadith) of the Prophet s.a.w.

Objectives:

• Equitable creation of wealth
• Fair and Transparent transactions
• Principles of Islamic Finance:
• Finance is tied to actual economic activity
• Returns from financing activities must be based on actual performance of economic activity
• Money is an intermediary and not a commodity
• Lending is a benevolent act without the profit motive
• Equitable sharing of responsibilities, risk and rewards
  
  

Scope of Islamic Financial activities:

Economic transactions are generally accepted unless they are prohibited by Shariah

Prohibited transactions: Activities involving/related to;
1. Riba/usury based transactions (conventional, compounded bank interest)
2. Any form gambling or game of chance (casino, number forecasting, sports/horse/dog betting, bingo, lucky draws and the like)
3. Uncertainty, ambiguous contract terms (conventional insurance, derivatives and the like)
4. Alcohol production and distribution
5. Entertainment that does not adhere to the Islamic code (karaoke, cinema/theatre, bars, discotheques and the like)
6. Pork and swine related industries
7. Selling something the seller does not own (short selling)
8. Selling in pursue of a loan denotes intetion to circumvent rules prohibiting riba (hilah)

Islamic Finance is not a zero sum game where there has to be one party worse off for the other to be better off. Islamic Finance is a positive sum game where gains and losses are borne equitably together.

Will There be a New World Financial Order? by Pankaj Kumar (The Star, Business section, 21 January 2009)

Copy of the email I sent to the Editor of The Star, commenting on the need for an alternative financial model.

Dear Editor,

Quoted from Pankaj Kumar's article in The Star 21 January 2009:

"The simple argument is that asset managers or hedge fund managers do not need crude oil or other commodities for that matter or even currencies in their books.They have no business to be in these markets if they are purely speculating on price movements.They should stick to basic investment in asset classes, that is, genuine companies that use these commodities for real markets, real products and real profits. And yes, we do need a new world financial order to get rid of speculative activities which have time and again created asset bubbles and financial manias."

I cannot agree more with Pankaj's observation and would like to point out that an alternative financial order is already in place – Shariah (Islamic) based Finance.

The principles of Shariah disapprove of uncertain contract terms, prohibit gambling and abhor speculative practices. Unfortunately, these elements are prevalent in most financial instruments of late which ultimately caused the fallout in the financial markets that we are experiencing now. If undertaken in its true form, Shariah based financing can eliminate most of the problems associated with conventional financing as laid out by Pankaj in his article.

The key is however, to practice Shariah based financing as it should be, according to the principles of Shariah and not as a conventional product with an Arabic name. Shariah based finance is totally different in all respects from the conventional finance and banking the world has seen and grown to love for the past 100 years. It would be disastrous and detrimental to the development and growth of Shariah based finance if practitioners (and regulators) continue to develop so-called Shariah products based on the conventional platforms and norms.

What is needed is a paradigm shift in the way we approach and view Shariah based finance. We need to accept that although the objectives of Shariah based financing are similar to that of conventional finance, the means of achieving it is drastically different. Different here does not mean changing the product name or adding a few clauses in the transaction documents. The difference is in the mechanics, determination of profits (pricing), contractual obligations and relationship of all parties, the risk analysis and management, recovery methods, source of funds, utilisation of proceeds and remedies in the event of default.

In order for Shariah based finance to prosper, practitioners must not only be well versed in the laws of Shariah but more importantly understand the objectives of Shariah. The market also needs to be made aware of the uniqueness of Shariah based finance. Only then can we see the emergence of the true form of Shariah (Islamic) finance.

Regards,

Banks from the Shariah Perspective

A bank is essentially an intermediary between those with excess funds (depositors) and those in needing funds (borrowers). Banks take in deposits from those with surplus funds and lends them to those in need of financing. The difference between the interest charged to depositors and the interest charged to borrowers represent the bank’s income. A very simple model indeed!

Everyone wants to own a bank because banks print money (refer to Fractional Reserve Banking Causing Complete Banking Disaster). Fiat money allows banks to make so much money out of thin air.

Let me illustrate, a 1% reserve requirement (imposed by BNM recently) allows banks to lend out RM100,000 from a deposit base of only RM1000. Let’s assume the deposit rate is 2% per annum and the base lending rate (BLR) is 5.5% per annum – banks will make RM5,500 (5.5% x 100,000) but only pays out RM20 (2% x 1,000) to the depositors. Now you see how the banks make money and why so many want to own banks. Even when banks are losing money the government will bail them out (using taxpayers’ money despite most of the taxpayers not benefiting from the banks’ existence!). Granted, the banks face lots of risks, especially risk of non payment but given the cushion, the banks can afford to have an NPL (non performing loan) ratio of 50% and still make money!

I hate to be a party pooper but I don’t think Shariah will agree with the model.

Firstly, money must be backed by real assets; creating money out of thin air is a no no.

Second, money is not a commodity hence cannot be traded.

Thirdly, interest bearing loans are not allowed under Shariah laws, it has to be given out under a partnership or trading arrangement.

Fourthly, money (deposits) cannot grow unless it is put into productive purpose.

Fifth, risk sharing is absent in the conventional banking model whereby the risk is borne wholly by the borrower, they have to repay regardless of their financial state.

Banks, from the Shariah perspective are in actual fact trading houses/venture capitalist/trading partners. They still play the role of intermediary between the two groups, but the modus operandi is different. For starters, fractional reserve banking should not practised. Money is not to be traded but instead be put into real economic activity, profits and risks are shared. The basic principle of Shariah based financing is doing business in a transparent, just and equitable manner. But if one party (the one without the capital) makes 5,500 while the capital owner makes only 20, where is the equity in that?

Concepts Used in Islamic Trade (and Banking)

Some of the common contracts and concepts used to facilitate trade the Islamic way. These contracts are also used in Islamic banking and finance to facilitate financing transactions.

• "Bai-al-Dayn" - Debt-trading.
• "Bai-Bithaman Ajil (BBA)" - Deferred payment sales. Where goods are sold on a deferred payment basis at a price which includes a profit agreed by both the buyer and seller.
• "Bai Inah" - A buy and sell contract between two parties where one party sells his asset to the other (price is marked up, payment is deferred) and subsequently buys it back at the cost price paid on the spot. This is often considered a hilah to facilitate the transfer of money under the pretext of trading.
• "Bai Salam" - A contract where payment is made spot while the goods are delivered at an agreed later date. A form of advance payment trade but the goods may not necessarily be in existence.
• "Hibah"Voluntary, unilateral gift.
• "Hiwalah" - Transfer of debt.
• "Ijarah" - Lease contract. A lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period. The ownership of the leased asset remains in the hands of the lessor for the duration of the lease.
• "Ijarah Muntahiah Bittamlik" - Lease and subsequent purchase. Muntahiah Bittamlik describes the transfer of the title of the leased asset to the lessee at the end of the lease tenure.
• "Istisna" - A contract to manufacture according to given specifications. The payment terms can either be spot, deferred or in instalments.
• "Kafalah" - Guarantee or surety given by one party who agrees to discharge the liability of another party, as stipulated in the terms of the guarantee.
• "Mudharabah" - Profit sharing and loss absorbing agreement between two parties, one the capital provider (Rab-al-mal) and the other, the entrepreneur (mudahrib). The profit-sharing ratio is agreed upon upfront while losses are borne solely by the financier.
• "Murabahah" - Cost plus sale where goods are sold at a profit and the profit margin is known to the buyer.
• "Musawamah" - Bargaining sale where the seller need not disclose the cost"Musyarakah"Limited liability partnership. All partners share profits on a pre-agreed ratio but losses are shared on the basis of equity participation.
• "Qardhul Hassan" - Interest-free loan or benevolent loan without a specified repayment terms or tenure.
• "Rahn" - Collateral. Where a valuable asset is placed as collateral for a debt, he collateral may be disposed in the event of default.
• "Sarf" - Currency exchange, i.e. buying and selling of foreign currencies.
• “Tawarruq” - Used in “Commodity Murabahah” transactions where an agent is appointed by the bank to purchase certain goods (usually metals other than gold and silver) which are sold to the customer at cost price with payment made spot. The customer then appoints the bank to sell the goods to another agent at a marked up price but payment is deferred.
• "Ujr" - Commission or fee charged for services rendered.
• "Urbun" (Arboon) - Earnest money which forms part payment of the price of goods or services paid in advance.
• "Wadiah Yad Dhamanah" - Savings with guarantee. It refers to a contract between the owner of the funds (depositor) and the Bank for safe-keeping purposes and the bank, as trustee, guarantees the repayment of the whole amount of deposits, or any part thereof, upon request.
• "Wakalah" - Agency contract. It refers to the appointment of an agent who is authorised to act according to the term of the agency.

Sukuk

The Islamic Securities Guidelines (issued by the Securities Commission) defines Sukuk as: A document or certificate that represents the value of an asset; The Shariah Standard 17 under the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI) applies Sukuk to Investment Products: Certificates of equal value representing, after closing of subscription, receipt of the value of the certificates and putting to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.

Sukuk

• Undivided beneficial ownership in the underlying assets, entitled to share in the revenues generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the Sukuk assets.
• Sukuk represent ownership in existing and/or well defined assets.
• Sale of a Sukuk represents a sale of a share of assets, business activity or project.
• The subject of the contract in Sukuk is a contract based on lease or a defined business undertaking between the Sukukholders and the originator.
• The underlying Sukuk assets, business or project must be Shariah compliant in nature.

Bond

• A contractual debt obligation, the issuer is required to pay interest and principal to bondholders on certain specified dates.
• Bonds represent pure debt on the issuer.
• Sale of a bond basically represents sale of a debt.
• Bonds basically create a Lender/Borrower relationship i.e. a contract whose subject is purely earning money on money.

Sukuks and Bonds are totally different instruments, serving different purpose, with different mechanics and goals. It would be erroneous to structure a Sukuk based on the conventional platform and norms. One must always look at structuring a Sukuk purely from the Islamic perspective and this includes contracts, legal documentations, pricing and the operational mechanics/modus operandi.

What are the factors that will make issuers and investors choose Sukuk over Bonds? From my observation, the decision is made mostly based on cost and price considerations. The attractiveness of Sukuk as compared to bonds in the Malaysian market is mainly due to the various incentives given by the authorities, especially tax exemptions/allowances. However, Sukuks are often structured to fit the conventional Bond model in the pursuit of mandates from clients.

Valuation:

Sukuk valuation at any point should be done based on market value; therefore both at issuance and dissolution, the Sukuk must reflect the market value of the underlying assets (except for Musharakah or Mudharabah where the value at issuance reflects the amount of equity injected into the venture). The same is true during an event of default and investors should expect to receive trhe market value of the asset and not a predetermined amount (principal) when a default occurs.

Role of the authorities:

The authorities that govern the financial markets play a very important and crucial role in developing the Sukuk market. Incentives should not stop at tax breaks but must also include providing the right platform for the Sukuk. Platform means the infrastructure, guidelines, rules and regulation, pricing and trading mechanism. Investor as well practitioners’ continuous education is of utmost importance, being a developing science,

Islamic banking faces new challenges and new developments all the time. Above all, the market, both the sell and buy sides must be fully aware of and understand what Sukuk and Islamic finance is all about. It is not about taking a conventional debt instrument; execute a few more legal documents and giving it an Arabic name.

Riba

The prohibition of riba is the foremost issue in Islamic banking and finance. The literal definition for riba is “excess”, “increase”, or “growth”.

In Islamic banking and finance context, riba is often equated with interest. It is not inaccurate to equate riba with the interest rate as the term riba has a broader definition.

The following are the definitions of riba given by some scholars;

Abu al Ala al Maududi – a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specific period. Riba contain the following elements:

i) Excess over and above loan capital

ii) Determination of the excess in relation to time

iii) Stipulation of the excess in the loan document

Abu Bakar ibn al Arabi – riba is excess in return of which no reward is paid.

Engku Rabiah Adawiah – an increase or excess which accrues to the owner in exchange or sale of a commodity or by virtue of a loan arrangement, without giving in return equivalent counter value to the other party.

http://hazariba.com/DefinitionRiba.shtml - a forced increase of value in the medium of exchange (money/commodity) that is loaned or swapped.

Socio-economic justice is one of the main objectives of the Islamic faith. The definitions above show that riba guarantees that only one or some of the contracting parties benefits from the transaction at the expense of the other parties. Therefore, Islam prohibits riba to ensure that the principles of just and equity is preserved, enabling all contracting parties to share the benefits equitably.

Types of riba:

Riba al fadl – excess accruing in sale or barter transaction

Riba al nasiah – excess accruing from a loan transaction (similar ribawi items) in relation to time

Prohibition of Riba in Quran:

1st stage – Surah al Rum verse 39 (Makkah) – call to abolish interest bearing loans and give alms instead.

2nd stage – Surah al Nisaa verses 160-1 (Madinah) – riba was also prohibited to the Jews (reminder)

3rd stage – Surah Ali Imran verse 130 (Makkah) – stronger prohibition

4th stage – Surah al Baqarah verses 275-281 (Makkah) – Strict law prohibiting riba, establishes clear distinction between trade and riba and defines riba as any increment (however small, whatever the reason) added to the principal. Instructing to only receive principal and waive repayment if borrower is in hardship. Cites the consequences for indulging in usury.

Hadith on the prohibition of Riba

Sahih Muslim, Book 010, Number 3854:Abu Sa'id al-Khudri (r) reported Allah's Messenger (p) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to hand. He who made an addition to it, or asked for an addition, in fact dealt in riba. The receiver and the giver are equally guilty.

Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws and norms and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank, only the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Being just and equitable does not mean at the expense of profits. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid. Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions where the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not encouraged to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity. They are merely the intermediary to facilitate a transaction and therefore on its own cannot be traded.

The main characteristics of Islamic finance include;

• Prohibition of interest (riba / usury).
• Prohibition of elements of gambling and uncertainty.
• Partnership instead of lender-borrower relationship.
• Full transparency and disclosure
• Transaction must not involve prohibited goods and services such as pork, alcohol, gaming, armaments.
• Profit and loss sharing instead of fixed returns on the part of financiers.
• Shariah compliant asset backed financing.
• No short selling, i.e. full ownership must be obtained prior to selling.

Islamic finance can be used to facilitate any kind of financial transactions such as;

• Project financing
• Working capital financing
• Leasing
• Trade financing
• Liquidity management
• Sukuk (investment certificates)
• Takaful (insurance)
• Mortgages
• Asset management
• Hire purchase
  

Common contracts / concepts used in Islamic finance include:

• Murabahah (cost plus sales)
• Ijarah (leasing)
• Musharakah (joint venture)
• Mudharabah (trustee profit sharing)
• Istisna (project financing)
• Salam (forward sales)
• Wadiah (trustee safekeeping)
• Wakalah (agency)
• Kafalah (guarantee)
• Hibah (gift)
• Ibra (rebate)
• Qardul Hassan (benevolent loan)
• Tawidh (penalty)
• Ujr (fee)
• Wad (promise)
• Rahnu (collateral)