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 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.

Tawarruq – a Tripartite Inah?

The OIC Fiqh Academy rules that organised Tawarruq is unacceptable (Resolution 179 (19/5) 26 – 30 April 2009). In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlying Shariah).

Tawarruq is widely used as a liquidity management tool and most scholars sanction the structure. However, some scholars argue it involves legal trickery and contains elements of interest based lending. Tawarruq does not create any enonomic activity but instead it creates debts.

What is Tawarruq? To me, it is basically an Inah with an additional contracting party. The whole process of buying and selling metals/commodities is merely a charade, a legal trick as the main purpose is to transfer cash from one party to another. I commented on the issue previously (http://shariah-finance.blogspot.com/2009/05/commodity-trading.html) and I sort of feel vindicated by OIC’s declaration.

It has always been argued by some that niyah (intention) is secondary when undertaking such contracts. I do not agree. If we exclude niyah, everything will be permissible. A lot of observers have urged Islamic finance practitioners to look at the substance behind the form when structuring Shariah based solutions, the on going debate on substance over form of Islamic banking products and services.

Dr Nikan Firoozye (http://islamic-finance-resources.blogspot.com/) opines that we should categorize products by their Shariah-risk, with hiyal (legal trick) the most risky. I wish to add that if such measure is used, the higher the Shariah-risk is, the less compliant the product is.

Dr Mohammad Akram Laldin, a respected Malaysian religious scholar, disagreed with OIC's ruling, saying organised tawarruq does not violate Islamic law principles. “From the point of view of Islamic law, there is nothing wrong with the transaction itself.” (http://islamicfinanceupdates.wordpress.com/2009/06/04/islam-allows-organised-tawarruq-asset-sales-scholar/)

I do not see this declaration as a hindrance to the growth or development of Shariah based finance. I see it as moving out and away from the conventional norms and in the long run will bode well for Islamic banking and finance. BBA and Inah based products are being gradually phased out in Malaysia and with the latest declaration, expect to see more products being out of favour. My guess is Commodity Murabahah will be next.

Project Finance

There are many definitions for project finance.

Finnerty (1996, p. 2) defines project finance as:
. . . the raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.

Nevitt and Fabozzi (2000, p. 1) define it as:
A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.

The International Project Finance Association (IPFA) defines project finance as:
...the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.

The above definitions mainly describe project finance from the debt perspective i.e. as a loan transaction.

Mechanics of a Shariah based project finance:

If a project is financed under the contract of Istisna, the project sponsor or initiator shall award the construction job to a contractor and the contractor will be paid according to the agreed terms, be it progressively, periodically or bullet payment at satisfactory completion etc. The price paid will include the contractor’s profit margin.

The project sponsor/initiator may raise the funding for the project via a Mudharabah or Musharakah arrangement whereby investors are invited to participate in the project. The returns from the Mudharabah or Musharakah venture cannot be predetermined and it shall be sourced from the cash flow or revenue of the project. It is therefore acceptable that no returns will be earned during the construction and pre-operating period. The project is owned by the Mudharabah or Musharakah investors/venture and upon completion; they may lease the asset for rental income or sell the asset for profit.

Ijarah Mausufah Fi Dhimmah is an arrangement whereby the financiers of a project are able to earn the lease rental during the construction period in the form of advanced lease. The setback of this arrangement is that should the project stall or fail, the owners will have to repay the Lessee(s) the advance lease paid.

There is always a completion risk in project financing. Should the project fail to be completed, the contractors should be paid what is due to them based on the work done. The Mudharabah or Musharakah investors will then share, according to their respective rights; the proceeds form the disposal of the project. The investors have no recourse to claim the full amount of their investment unless fraud or negligence on the part of the contractor or project manager is proven.

The main difference between Shariah based PF and conventional PF are;

(1) Ownership of assets (project)
Under conventional financing the project is held as collateral and the financers can claim from project sponsors for any shortfall in repayment.
Under Shariah financing, the asset/project is owned by the financiers and therefore they can only claim up to the value of the asset/project or the outstanding lease rental and nothing more.

(2) Returns from financing
Conventional financiers are repaid a fixed, predetermined payment over a specified period regardless of the profitability of the project. Any overdue payment will be charged a penalty and a default will force the asset to be forced-sold to recover the debt. Any shortfall will be met by the project sponsor.
Under Shariah financing, the investors are paid returns only when the project has positive cashflow. They can only claim for payment if fraud or negligence on the part of the contractor/project manager is proven.

(3) Risk
Conventional project financing places the construction, completion, market risks on the borrower and the bank (financier) only assumes the credit risk of the borrower.
Shariah financing distributes the risks amongst all the parties involved in the project. No one party can be insulated from the risk, unless fraud and negligence is proven.


Having being so used to earning predetermined returns with some recourse, banks would naturally be hesitant to finance projects the Shariah way. To overcome this, Shariah based project financing has to be marketed differently, highlighting the merits of risk-reward sharing and equitable distribution of income.

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.

Two of a Kind

All of Malaysia’s anchor banks have Islamic subsidiaries. Three of the foreign conventional banks in Malaysia have Islamic subsidiaries. When BNM directed banks to set up stand alone subsidiaries in place of the Islamic windows, it effectively doubled the number of banks in Malaysia. The country’s sole building society is re-inventing themselves as an Islamic financial institution. A large co-cooperative bank “converted” to Islamic banking some years ago.

Call me a sceptic, an unbeliever but all I see from this is just increasing the number of banks instead of increasing the number of Islamic banks. Why do I say this?

First and foremost, the products are almost identical save for the name and legal documentation. Even the pricing is almost identical. How can that be? The objective of the financial products is the same, no argument about it but the means are not. It is ok to sell lemonade at the same price as beer but it is not possible to make lemonade using the same ingredients as beer.

Secondly, the Islamic subsidiaries are sometimes still treated like a window whereby they are not allowed to compete with the mother bank. What is the purpose of having a separate entity if it is not allowed to act independently? Some of the Islamic subsidiaries’ products are evaluated and approved by conventional mother bank’s product committee. This is akin to getting one’s product approved by a competitor!

Thirdly, the risks associated with Islamic banking are similar yet different from that of a conventional banking system. The fact is that the risks undertaken in a trade or partnership based transaction cannot be identical to that of a debt based transaction. But yet the credit and risk management process in some Islamic subsidiaries are undertaken by the conventional mother bank. Anomaly?

Ok, I’m a sceptic. Or maybe I just don’t see Shariah based banking the same way as the other bankers do. But I strongly believe that the same mindset and approach cannot be used to run distinctly different business models.

Shariah “camouflage”

The Middle East market apparently has the perception that Islamic financial products developed in Asia are not truly Shariah in nature but instead only have a Shariah “camouflage”.

After going through the Monetary Authority of Singapore’s (MAS) Guidelines on the Application of Banking Regulations to Islamic Banking, I am inclined to agree with the above statement.

In Section 2, it was stated that both Islamic and conventional banks face similar risks and therefore MAS has adopted the same regulatory approach. Yes, most of the risks are similar if not identical but when it comes to credit risk and Shariah compliance risk, the picture changes altogether. The difference in Shariah interpretation and opinions poses a major risk especially when a dispute arises, although the governing law is defined in the terms, it would be unfair and somewhat illogical if Islamic law is not taken into consideration when resolving disputes.

Credit risk faced by institutions offering Islamic financial products cannot be similar to those of conventional banks. Most Islamic financial transactions are supposed to be partnership based whereby the returns are not predetermined, unlike a typical loan or bond. The terms which underlies an Ijarah transaction is not (should not) be identical to that of a conventional finance lease contract. Even a Murabahah transaction which in effect is a debt transaction has different risk considerations due to the Shariah call for justice, equity and transparency.

Given that, I do not totally agree with the risk management approach pursued by MAS.

In section 4.17 (Ijarah wa Iqtina), the bank has ownership of the asset but despite being the owner it is not to assume any ownership risks. Well, this is fine, if a willing agent can be found to assume the risk, why not? But what is not fine is when MAS expects the banks to ensure that they are protected against any losses from movements in the market value of the asset. This goes against the spirit of Ijarah, labelling such products as Ijarah would tantamount to mockery. IMHO.

Section 4.21 (Diminishing Musharakah) says that the bank should not be exposed to fluctuations in the market value of the asset, except in the event of a default. It goes on to say that the bank may structure the loan (yes, the term loan was used for a partnership based arrangement).

To ensure the success of Shariah based financial instruments, the regulators must be the main driver and should provide guidelines that truly conforms the uniqueness of Islamic banking. Drawing up a guideline that resembles (copies) the conventional infrastructure would not help in the growth of Islamic banking and finance but instead will cause Islamic finance to be seen as no different from their conventional counterparts.

Risk sharing? What risk sharing?

An Ijarah wa Iqtina transaction typically involves the bank purchasing an asset at the request of the customer and leasing the asset to the same customer for a specified period. The lease is terminated at the end of the period whereby the bank transfers the ownership of the asset to the customer, or by the customer terminating the lease prematurely by paying a pre-agreed price to the bank. Although the bank has ownership of the asset during the tenure of the lease, they are not expected to assume any risks associated with ownership and are protected against any negative movements in the market value of the asset. Instead it is the customer (lessee) who has to bear the risks of ownership and the risks of fluctuation in asset value. The profits banks make equals the returns for providing financing and independent of the market value of the asset. Sounds very much like the conventional finance lease doesn’t it? My question is, where is the justice and equity in such a transaction? Why can’t banks treat ijarah transactions as operating leases? Unless negligence or breach on the part of the lessee is proven, why can’t the risks be borne by the rightful party, in this case the owners of the assets? The reason why Islamic financing uses finance lease model is because it has / wants to conform to the conventional banking norms, to adapt to the conventional accounting treatment for banks and financial institutions.

Like I said before, IBF is a young, developing science but the development must be done in the right way lest it grows into a farce.

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)