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.

Bay al-Dayn

Mohd Johan Lee is an Islamic finance lawyer and managing partner of law firm J.Lee & Associates. In an article published by Reuters News on 24 June 2009 titled “No debt sales, no progress for Islamic finance?” he concluded the following;

It is indeed for the development of Islamic banking and monetary market that the sale of debt on spot be allowed. Without such practice, the creditors and bankers in an Islamic banking system cannot securitise their debts as practiced by the conventional system.

Thus, the permissibility of such debt sales is crucial to ensure the liquidity of the Islamic money market and Islamic banking system.

Without such debt sales, the Islamic finance industry can not be developed forward. This is because, without such debt trading, Islamic bankers will be stuck with their debt. As in typical banking practice, a low liquidity ratio would incapacitate the investment (and depository) business.

I’m not a lawyer or a Shariah scholar but one thing I stand by is practising Islamic banking the Islamic way, therefore I tend to not agree with his stand that “creditors and bankers in an Islamic banking system cannot securitise their debts as practiced by the conventional system, and therefore will at the losing end". My question is do we need to securitise like the conventional system? Do we need to securitise at all?

A securitisation usually involves the setting up of a Special Purpose Vehicle (SPV) to purchase debt obligations (Receivables) from a corporate or financial institution (the Originator) and issuing bonds secured over this pool of Receivables. Most conventional securitisations have some form of credit enhancements and the most popular is selling the Receivable at a discount. Receivable is a debt and Shariah doesn’t allow selling debt above or below par.

Saying “without such debt sales, the Islamic finance industry can not be developed forward” shows that he doesn’t understand that the Islamic finance industry is partnership, trade and justice driven and not debt driven like the conventional economic system. The conventional fractional reserve banking system is a system based on debt and artificial money creation but the Islamic financial system is built on real, productive economic activities.

On the same note, I find the Islamic money market a bit of an anomaly; if Shariah prohibits the trading of money, what then is traded at the Islamic money market?

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!

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.

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?

Shariah Compliant vs. Shariah Based

The difference is quite obvious; a Shariah compliant product is one that meets all compliance criteria, it may not necessarily be Shariah based (like “Shariah compliant derivatives” for example) but it is sufficient that it does not contravene any Shariah ruling. A Shariah based product on the other hand is already compliant; it is after all based on Shariah perimeters which makes compliance automatic.

Shariah compliant products may have its origins in conventional banking. To make a financial instrument Shariah compliant, all that needs to be done is to remove those elements or components which contradict with Shariah and replace them with a Shariah acceptable concept. Multiple contracts may be used to facilitate and complete the transaction and inevitably some form of legal trickery could be involved. I would agree with the definition of a Shariah compliant product being a conventional product which has been “Islamised”. An example of a Shariah compliant product is an Ijarah transaction where only the beneficial ownership is transferred and not the legal ownership.

A Shariah based product is a financial instrument which is derived from the laws of Shariah. It may share some similarities with existing conventional products but it did not originate form any conventional products. Structuring Shariah based financial solutions is easier because there is no need to find ways to circumvent Shariah prohibitions in order to achieve Shariah compliance. A Mudharabah venture capital model is an example of a Shariah based product.

Making existing financial products Shariah complaint is an easy, short term approach. It will satisfy the market’s need for Shariah compliant products but it will not distinguish Islamic finance as an alternative model to conventional banking. Merely Islamising and making existing conventional products Shariah compliant will cause the Islamic finance sector to converge with the conventional sector. Convergence means being one and the same and since Islamic finance is not the same as conventional finance; convergence should not be allowed to happen.

BBA is an example of a Shariah compliant financial product whose roots can be traced to conventional debt based lending. As a consequence, the mechanics and pricing of a Bai Bithaman Ajil financing is identical to that of a conventional loan.

Being different products running on different concepts and platforms, convergence cannot happen even on pricing. An Ijarah based mortgage carries different risks compared to a collateralised debt based mortgage. Therefore, given the different risk elements of the two similar products, the pricing cannot be identical; it should reflect the underlying risks involved.

Islamic finance is an alternative to conventional finance and hence convergence should not happen.

Bursa Suq Al Sila

I have always thought that Shariah based finance is always trade based as decreed in the Quran, 2:275 “… Allah hath permitted trade and forbidden usury …“

Based on my limited knowledge, a trade is a transaction where money and physical goods or services are exchanged. Therefore, is it a bona fide trade when the intention to take physical possession in absent?

Inah is a contract involving the movement of money form one party to another using “trade” to facilitate the transfer. The trade in Inah is (IMHO) a smokescreen, a legal trick to “legalise” the transfer of money including the additional (profit) amount. The Malaysian market has finally accepted this fact and phased out the use of Inah when conducting Shariah based financial transactions. The argument is however based on the number of contracting parties and NOT the absence of intention to take physical delivery of the traded goods. Based on the “number of contracting parties” view, the Tawarruq is formulated and deemed compliant despite the intention of taking physical delivery is still absent (OIC’s Fiqh Academy decided that Tawarruq may not be compliant after all but some scholars argue that “organised Tawarruq” should be allowed – I have no idea what organised Tawarruq is).

So, how do we move money from one party to another the Shariah compliant way? Where and how do we place idle funds?

I propose a property clearing house be set up, containing a pool of real estate assets, each individual property with their own legal title. The properties must be generating economic activity/value such as a warehouse, shophouse or residential properties, or even industrial properties/factories. The clearing house will own all the property and sell the property to those wanting to place idle funds for short periods. The properties will then be leased back to the clearing house and at the end of the agreed lease period be sold back to the clearing house at current market value. Given that the lease/investment period is short, between 1 week and 6 months, fluctuation in values should not be too drastic.

The proposed structure will at least eliminate the element of buying and selling assets purely for the purpose of transferring money and getting a little bit more back. The lease and sell back will be determined based on the prevailing market prices thus eliminating concerns concerning riba and gharar.

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.

Defaulting Sukuks

Reuters reported that industry experts are warning more Sukuk defaults are coming after Kuwaiti firm Investment Dar defaulted on their USD100 million Sukuk. At the same time, Saudi conglomerates Saad Group and Ahmad Hamad Algosaibi & Bros are restructuring their debt, triggering concerns of a spill over effect on the Islamic finance industry. Neale Downes, a Bahrain-based lawyer at Trowers & Hamlins, estimated that 5-8 percent of Islamic bonds, or sukuk, in the market are susceptible to default as many were raised for real estate projects which have been hurt by the slowdown. "The longer the global recession goes, the higher the likelihood of default," said Mohammad Faiz Azmi, global Islamic finance leader at PricewaterhouseCoopers. "People are now using reserves or savings to try to keep themselves going. How long can that last? So far what we've seen is the tip of the iceberg."

My question is; if the Sukuk is structured on a pure profit and loss sharing (PLS) concept, can it default? In my opinion, PLS structures do not recognise defaults. This is because by definition, PLS means sharing profits when they are made (according to predetermined ratios) and absorbing losses when they arise. PLS is not a contract where returns (coupons/profits/dividends) are guaranteed regardless of actual performance. Defaults are caused by the guarantee d returns element in the structure – just like in the conventional bond arrangements.

However, Sukuks structured on an Ijarah or Murabahah contracts may default if the contracted payments are not made. This is because such contracts are not contracts of partnership but instead lease contract (Ijarah) and debt contract (deferred payment Murabahah). In this case, payment of coupon/profit/lease is contracted and obligatory, non-payment will result in a default.

When reporting on Sukuk defaults, it must be made known what is the underlying contract it was based on. I am still of the opinion that partnership based Sukuks have no risk of default apart from in cases of negligence or fraud.