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.