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?

Universities Joining the Islamic Finance Bandwagon

Apparently, the Islamic finance industry was not badly affected by the global financial turmoil. One of the main reasons for this is because they are not exposed to the toxic assets that brought down most of the other banks. The resilience of the Islamic banking industry may not be fully attributed to prudent credit management or exceptional management skills; they were saved by Shariah’s prohibition of speculation, gambling (maisir) and uncertainty (gharar).

This September will see new courses and postgraduate qualifications in Islamic finance springing up throughout the UK and elsewhere in Europe. This development is sort of unusual because a few years ago, Islamic finance was viewed with extreme skepticism, often associated with terrorism and human rights abuses.

In the UK, interest in the sector reflects the government's intention to promote Britain as an Islamic finance centre. The UK already leads Europe not only in the number of locally established Islamic financial institutions but also in the number of Islamic finance training courses it offers, from entry to postgraduate level. Last December, the Treasury published a paper setting out the government's aim for London to be "Europe's gateway to international Islamic finance". This acknowledged that the industry was still young and therefore not yet experiencing skills shortages, but predicted that it soon would be.

The Guardian, (Tuesday 28 July 2009) reports that a few UK Universities have responded positively to this new opportunity. Newcastle University is offering an MSc. in finance and law with Islamic finance from next academic year. Henley Business School at the University of Reading has been offering an MSc in investment banking and Islamic finance since last year, with students spending the second part of the year in Kuala Lumpur. The University of Bangor in Wales has also been running its Islamic finance MA and MSc for a year and is considering introducing a new MBA in the subject, while the first students to take an Islamic finance option as part of an executive MBA offered in Dubai by Cass Business School will graduate this summer. Durham, which has been offering postgraduate research degrees in Islamic finance for some time, is now introducing a taught MA and MSc (the MSc is more quantitative), to respond to demand. Elsewhere in Europe, Reims Management School is offering a new specialist course in Islamic banking and finance for students on its masters in management programme, taught in English.

Strangely, two specialist Islamic Masters programmes running in the UK a few years ago, at the University of Durham and Loughborough University, were cancelled. Durham still offers a summer school and is the world's largest research hub for Islamic finance, with 25 PhDs at work at the university, but Rodney Wilson, professor of economics at Durham, says there was simply not enough demand from the right students.

Stefan Szymanski, professor of economics at Cass says "You just have to measure how many billions of dollars Islamic finance already handles in a year, if that grows over the years; it (Islamic finance) will become a universal part of every business school."

This is a good development, it bodes well for the industry, let’s hope that the universities teaching Islamic finance courses possess the qualified teaching expertise and are not in it just to capitalise on the wave of interest in the subject.

Pain in the Neck

Speculators are a pain in the neck; even a slipped disc between C5 and C6 cannot inflict as much pain as these pests. I was at a birthday party sometime ago and there was this guy blaming the Arabs for the high oil prices. I’m not trying to defend the Arabs or OPEC but the fact is they are powerless to contain the sharp rise in oil prices (as if they want to contain the price increase!). They are powerless because the oil price is not determined by the economic factors of demand and supply but instead by the power of the speculators' market manipulation by creating artificial demand.

We all know that an increase in quantity demanded will push the price upwards so the speculators capitalised on this economic fact to make money for themselves at the expense of the genuine participants of the economy. Basically what they do is bid for the oil without having any intention to take physical delivery of the commodity. Their excessive bidding will push the price up resulting in the genuine buyers having to pay more for their oil. The fallout in the global financial market put a stop to these speculative activities and the speculators abandoned the market, liquidating their positions and causing the oil price to drastically drop, the opposite effect now comes into play whereby artificial supply is created. This sharp drop in oil prices again affects the genuine buyers especially those who believed that oil prices will continue to rise, hedge their oil price obligations at high levels (Malaysia Airlines is apparently looking at almost RM3billion in paper loss after hedging their fuel costs at USD95-100 per barrel).

Now, do we see why Shariah forbids any form of speculation in trade and financial transactions? Speculating is akin to cheating the market, dishonest in the sense that it does not entail any genuine economic activity. Shariah based trade and finance is all about undertaking productive economic activity to increase wealth and not merely making money out of thin air.

So, don’t blame the oil producing countries for our oil woes, just ban speculation and our problems may just disappear.

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)