Islamic Derivative Contracts Soon?

Reuters reports that the first template for over-the-counter Islamic derivative contract will be launched this year or by early 2010. The contract is expected to pave the way for quicker and cheaper Islamic risk management and more frequent cross-currency transactions.

According to Ijlal Ahmed Alvi, chief executive officer of the International Islamic Financial Market (IIFM), "It's a completely new instrument. We have done the consultative work. Now what we are waiting for is the Sharia meeting... some time in December". The IIFM, an industry body backed by the central banks of several Muslim countries, has been working with the International Swaps and Derivatives Association (ISDA) on the contract. Once in place, the new Islamic derivatives contract is expected to initially attract at least 150 players.

Scholars are however split on the legitimacy of derivatives; some see them as permissible instruments to hedge risks but others dismiss them as speculative transactions, which Islam forbids.

My contention is that derivative instruments is not the only solution to hedge of risks. There is no need for Shariah based finance to mimic each and every conventional instrument. Isn’t there any indigenous Shariah based risk management tool?

Islamic Structured Investment

An Islamic Structured Investment (or deposit) is an investment product which is linked to or benchmarked against a Shariah compliant underlying range of performance indicators such as equities, real estate or commodities. There are some Shariah compliant structured products in the market which is benchmarked against (Shariah compliant) indices, foreign exchange and even inter-bank offered rates. The returns from the structured investment are therefore dependant upon the performance of the underlying range of performance indicators.

A structured investment can either be principal protected or non-principal protected.

A Shariah compliant structured investment works the same way as their conventional counterpart, the only difference is in the nature of the underlying asset, it must not contravene Shariah principles.

The mechanics are as follows:
The promoter pool funds via the sales of the structured investment. The contract between the promoter and investor is usually that of a wakalah fi istithmar (investment agent).

For a principal protected structured investment, the promoter will split the funds into two, one portion will be invested in the Islamic money market or a fixed income instrument (zero coupon / discounted Sukuk) and a smaller portion will be utilised to purchase an option, applying the Urbun contract and referenced against the underlying.

The investment in the (Shariah compliant) fixed income instrument is for the purpose of reserving the principal investment and the option will provide the upside, if any.

The capital protection will only be enjoyed if the investment is held to maturity. Any premature withdrawal will result in the investment being valued at market and the investor will incur mark-to-market losses.

The maths is basically, allocate a portion based on the prevailing (profit?) rates that will ensure the capital is 100% preserved at the end of the investment tenure. The balance will be used to purchase an option. The participation rate (in the upside) of the option may not be 100% as it will depend on whether the balance after setting aside for the money market/fixed income Sukuk is sufficient. In some cases, the participation rate is less than 100% meaning the option holder is not entitled to all of the gains made from exercising the option.

Let’s dissect the structure.
Pooling of funds for investment purposes are perfectly fine and Shariah compliant.
Investing a portion to preserve capital – this would be done via the money market using Tawarruq. My stand on Tawarruq can be found here

Capital preservation is often a sticky issue with Shariah, if economic conditions go against the investment, what right does the investors have to demand full capital preservation? It becomes a zero sum game and there will be one party in the transaction who will lose out at the expense of the other. Shariah based finance is about justice and equity, sharing of profits and losses.

Buying an option using Urbun*, putting a deposit/downpayment to earn rights to purchase an asset – sounds compliant but are indices, foreign exchange and even inter-bank offered rates Shariah compliant assets? Does buying an intangible asset serve any economic purpose? I have no issues on Urbun for tangible assets like property or commodities.

My take on structured investment is it sort of looks and sounds like a mutual fund with a derivative (the option) and capital preservation elements. My views on derivatives can be found here and I’m of the opinion that capital should be positively correlated to the economy, preserving it would entail going against economic trends and causing some party somewhere to suffer more losses than necessary.


*Urbun is sometimes spelled Arboon

Islamic Profit Rate Swap (IPRS)

IPRS is the Shariah compliant version of the conventional Interest Rate Swap (IRS). The IPRS/IRS is a risk management tool whereby an institution which is contracted to pay fixed profit rates may hedge its risks by swapping the fixed rate payment obligation for another party’s floating rate obligations. IRS refers to a generic rate swap in which one party pays a fixed rate while receiving a floating rate. As in the IRS, the notional principal in an IPRS transaction is never exchanged, only the difference is settled.

The IRS is a derivative product and the widely accepted market standard is the International Swap & Derivatives Association, (ISDA).

As usual, I want to be the party pooper. My question is; is IPRS a Shariah based solution or a conventional product made Shariah compliant?

Azrulnizam Abdul Aziz of Standard Chartered Bank Malaysia (now Saadiq) describes the Islamic Profit Rate Swap as follows (Islamic Finance news (IFN) Guide 2007):
The Islamic Profit Rate Swap (IPRS) was introduced to assist in the management of profit rate risks, thus enhancing cash flows. Profit rate swap is a mechanism structured to allow bilateral exchange of profit streams using two parallel and back-to-back Islamic marked-up sale transactions (Murabahah).
It comprises of three possible structures, namely the IPRS, Islamic Cross-Currency Swap (ICCS) and Islamic Forward Rate Agreement (IFRA). In IPRS, a series of Murabahah sale and purchases are conducted, allowing parties to swap or exchange profit rates from fixed to floating rate or vice versa.

Therefore, in theory, an Islamic Profit Rate Swap would operate in the following manner:

Party A purchases assets on Murabahah (fixed mark-up/profit) terms. They know the exact amount of profit due throughout the repayment tenure.
Party B enters into a Musharakah venture. They can estimate the returns but would not know exactly how much profit is made until the accounts are finalised.
An IPRS would entail Party A paying Party B a fixed, known amount of profit while Party B pays A an amount which is only known at the end of the financial year. The two profit amounts will not be identical; being identical defeats the whole purpose of the transaction!

A Murabahah or Istisna transaction has a fixed profit rate. Ijarah transaction can have a fixed lease rate while Musharakah and Mudharabah have variable profit rates, even loss rate!

If profits are made by the Musharakah (or Mudharabah) venture, the swap works fine(-ish). What if the venture suffers a loss? What is swapped?

An IPRS utilises the controversial Tawarruq structure. If the two parties are merely paying each other the (cash) amount of profits, utilising Tawarruq clearly shows an attempt to circumvent Shariah prohibition of exchanging unequal amount of money (which results in riba).

I would conclude that the IPRS is not a solution based on Shariah principles. An IRS is created with the primary objective of capitalising on the movements of interest rates. It is a tool to make (or save) money from the movements in the price of money (interest). It does not entail any productive economic activity. It is merely a transfer of money from one party to another.

How then does an Islamic financier hedge against movements in profit rates? Profit rates, unlike conventional interest rates are dependent on the underlying transaction. There is no one universal profit rate across the board. A Murabahah profit rate for a risky aerospace venture for example, would not be equal to the profit rate of an identical Murabahah transaction involving the government’s (less risky) purchase of educational equipment. Similarly, the Ijarah rate for a residential property is not the same as that of a CBD commercial property. For equity based contract like Mudharabah and Musharakah, profits cannot be guaranteed; returns depend on actual performance of the venture.

My stand remains – continuing to develop solutions that mimic the conventional system will not develop Shariah based finance.

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.