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.

Musharakah Mutanaqisah Asset Ownership Model

Musharakah Mutanaqisah (MM) means diminishing partnership with an imbedded Ijarah (lease) element. The model can be used to facilitate the purchase of any fixed assets and not limited to only properties.

A Musharakah venture is formed by two (or more parties) to purchase an asset, the asset is then leased to the party which intends to own the asset. The party intending to own the asset (Partner X) will pay the lease rental to the Musharakah venture and at the same time purchase shares from the other party(ies) (Partner Y).

Despite the tongue twister sounding name, this is a very simple model. Unless of course if we decide to complicate it. My version of MM home acquisition plan is as follows:

Customer and financial institution (FI) enters into a MM venture to purchase a house. Let’s say the value of the property is RM300,000 and the initial capital contribution is 10% by the customer and 90% from the FI. The customer will therefore contribute RM30,000 into the partnership and the remaining RM270,000 is contributed by the FI. Let’s assume the customer agrees to buy the FI’s share of equity over a period of 20 years, he will then have to pay the FI RM1,125 (RM270,000/240 months) every month, increasing his equity ownership of the house every month.

Assuming the market rental for an identical or similar property in the same locality is RM1,000, the customer will have to pay RM900 in lease rental to the MM venture (as 90% of the property is owned by the FI) for the first month. Subsequent rental reduces every month as the rental will be calculated based on the customer’s equity ownership.

At the end of the 240th month, the house is fully owned by the customer.

What if half way through the 20 year agreement the customer decides to sell the house? The FI, having no interest to own the house will obviously agree to sell. At the 120th month, assuming all agreed payments are made promptly, the above house is 45% and 55% owned by the customer and the FI respectively. Let’s assume the house is sold at it’s current market value which is RM390,000. The customer, owning 45% of the property will be entitled to RM175,500 and the remainder, to the FI.

Should the customer decide to pay for the house in full after ten years, all he has to do is pay the FI RM1,125 x 120 months = RM135,000 and the house is 100% his.

If the customer is unable to pay rental for whatever reason, the FI should not force-sell the property. They should take the compassionate route and help the customer to regain his financial footing and not make him worse-off by evicting him. Even if the FI decides to force-sell, the customer, by virtue of being a co-owner, is still entitled to his share of the proceeds, even if the proceeds are not enough to cover the outstanding due to the FI.

This is the rough cut of how I envisage an MM asset ownership programme to be like. It is of course not yet Shariah certified and the accounting issues have yet to be addressed. But like I said, this is only the rough cut; it will be improved over time.

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.

Paranoid Americans?

From IFN Newsletter 5th June 2009

However, it’s a completely contrary picture across the Atlantic. Politicians and special interest groups have been very successful in arousing the ire of Americans over terms such as Islam and Shariah even when they are used innocuously. There were howls of protest when the Treasury co-sponsored a forum on the basics of Islamic finance.

A law firm has created an online presentation that claims to show how Islamic finance poses “a real and present danger not just to our Western financial institutions built on disclosure and transparency but to our very system of governance and our way of life.” (http://www.davidyerushalmi.com/Law-Offices-of-David-Yerushalmi-present-Shariah-compliant-finance--disclosure--seminar-for-online-viewing-b9-p0.html) It’s a sure bet that the presentation never mentions how those in these “Western financial institutions” bilked billions of dollars and caused the system to practically collapse, while the losses were relatively minor in scale for those who used Islamic finance.

What takes the cake is that of a federal judge in Michigan who insists on continuing to hear a lawsuit challenging the federal bailout of American International Group (AIG) simply because it has subsidiaries that sell Takaful. Judge Lawrence Zatkoff contends that the US government’s majority ownership of the group raises the question of whether the government is promoting religion, contrary to the First Amendment to the US Constitution. AIG has stressed that its Takaful policies comply with all US laws. “AIG businesses, like other insurers and organizations, tailor programs for a range of religious organizations,” it said. “While they are desirable to those whose religious convictions preclude them from engaging in traditional interest-bearing structures, Takaful is also increasingly popular among non-Muslims who feel that the excess profit/charitable aspect is a socially responsible mechanism for the purchase of insurance.”

Obviously, education and confidence-building are two aspects that must be seriously undertaken if Islamic finance services, now being provided by a handful of firms, are to expand its beachhead in the US.

It is beyond me how stupid and paranoid some people can be. Shariah based finance is all about undertaking financial transactions according to the rules of Shariah. It has nothing to do with professing Islam. Using financial products which conform to the rules of Shariah does not make one a Muslim. The paranoia attached to Shariah based finance is unfounded, how could it be a funding tool for extremists if the products are offered by banks like HSBC, Deutsche, UBS, Standard Chartered, Citibank, Barclays and BNP Paribas? Are we saying these reputable Western banks are part of the extremist (terrorist) conspiracy?

These attacks on Shariah based finance not surprisingly, is sponsored by CSP (refer to my earlier posting – Someone’s Afraid of Shariah Based Finance) and a lawyer by the name of David Yerushalmi is in the forefront in waging war against Shariah based finance. I’m not sure what he is trying to achieve but one thing for sure is that he and his friends will not stop putting Shariah based finance down.

Let’s not waste time, effort and money trying to market Shariah based financial products in the US.

Commodity Trading?

I’m not a Shariah scholar but I think I know a “hilah” or legal trick when I see one.

Selling and buying back a commodity (Bai Inah) between two parties is obviously a legal trick undertaken to circumvent the laws of Shariah. But what about artificially trading and exchanging commodities between 3-4 parties? By artificially I mean the trading of the commodities does not bring any economic benefit apart from facilitating the movements of cash and enabling a sum of money today to be returned at a later date inclusive of the “profit”. Hey, I just described Commodity Murabahah.

I have been made to understand and have always believed that Shariah based trade and finance must involve productive economic activity. Transferring commodities within seconds does not create any productive economic activity. Transferring commodities for this purpose tantamount to a legal trick, hilah. Correct me if I’m wrong.

Commodity Murabahah exist for liquidity purposes. Without it, how will Shariah based financial institutions manage their liquidity? Maybe the answer lies in how Shariah based financial institutions look at liquidity management. Do they need it in the first place? Deposits undertaken under the contract of Mudharabah are not demand deposits, they are investments, and liquidating investments has its steps and conditions. Savings deposit under the contract of Wadi’ah is for safekeeping and is not supposed to be utilised. If they are, then the onus is on the FI to meet the withdrawal demands of the customers.

Conventional banks use customer deposits to fund loans. They face the problem of matching short term liabilities with long term assets. Shariah based FI do not face the same dilemma because they are NOT supposed to fund financing with customer’s (Wadi’ah) deposits. Financing are done on a profit sharing basis, it is done in a partnership. Therefore, any financing arrangement is between the customers, and the FI merely acts a facilitator, arranger, manager or if they commit their own capital, as a partner and hence liquidity issues might not occur.

What I’m trying to say is, if Shariah based financial institutions undertake Shariah based financing exactly how it is supposed to be done, they won’t need legal tricks. There is no need to complicate things just to conform to the conventional norms.

Islamic Bank – Modus Operandi

Shariah based financial system needs to be clearly distinguished from its conventional counterparts. Shariah based financial solutions can effectively promote itself only when it is seen as an alternative rather than a complement to the conventional banking system. To use transport as an analogy, Islamic and conventional banking should be seen as trains and cars and not as different brands of cars. The objectives are the same, i.e. to get from point A to point B but the mechanics, platform, driving methods, fuel system are different despite having some similarities.

So how does an Islamic bank differ from their conventional counterparts?

First and foremost is the basic principle. Shariah based banking is a built on trade and partnership whereas conventional banking is purely a lender-borrower arrangement. Therefore, the personnel in an Islamic bank must be trained towards managing a trade and/or business partnership relationship rather than that of a lender-borrower.

How different are the two relationships? When a lender lends, his objective to recoup the money lent plus a compensation for the opportunity cost, i.e. principal plus interest. Information on the utilisation of the funds is only for the purposes of obtaining credit approval and once the loan is approved, the lender plays no part in assuring the proper utilisation of the funds. The lender is only interested in getting back the loaned funds plus interest. Inability of the borrower to repay the loan will result in him losing his collateral and could even be slapped with late payment penalties.

On the other hand, when an Islamic bank enters into a trade or business partnership, the objective is to make a gain from the relationship but the gain is dependant upon the business and economic conditions. Unlike the lender-borrower relationship where the lender expects the funds to be returned regardless of the economic condition, an Islamic bank cannot demand the same. The bank has to work with the partner throughout the tenure of the relationship and any realised gains or losses are to be shared as agreed. If unfavourable economic conditions caused the venture to register lower returns or even losses; the Islamic bank cannot demand anything from the partner (unless it can be proven that the loss is caused by negligence of the partner). If the venture turns a loss, the partner should not be compelled to bear the loss alone but instead the bank should work together to recover or at least minimise the losses. The role of a Relationship Manager in an Islamic bank is wider; it also covers the role of active business partner.

Secondly, the credit evaluation process in an Islamic financial institution should not be identical to that of a conventional bank. The reason is simple; a conventional bank looks at credit from the perspective of the customer’s ability to pay whereas an Islamic bank looks at credit based on the viability of the business venture.

As with my other postings, the point I’m trying to drive through is that conventional banking and Islamic banking, despite its similar objectives, cannot be run on similar platforms. Islamic banking has to operate from its own platform, on its own terms. Unless it does, there is no point in its existence.

A short take on Takaful

Takaful is an Arabic word that means “guaranteeing each other”. Takaful can be divided into two types, social and commercial. In this context, we are looking at the commercial model because as the name suggests, a social takaful is purely charitable without the commercial elements.

Takaful, which is often referred to as Islamic insurance, provide mutual financial aid and assistance to the participants in times of need and participants mutually agree to contribute for that purpose. The participants undertake to guarantee against any loss or damage incurred by any of them by providing material assistance in time of a misfortune. Takaful is based on the principle of mutual assistance (Ta’awun) and donation (Tabarru’) therefore; the risk is shared collectively and voluntarily by all participants.

Takaful

• Risks are shared by takaful fund participants
• Takaful funds are owned by participants and operator’s funds are owned by Takaful Institution
• Surplus (or deficit) belongs to (borne by) the participants
• Investments must comply with Shariah criteria
• Two accounts – tabarru’ fund and investment fund
• Investments and policies subject to Shariah Committee’s endorsement
  

Conventional Insurance

• Risks are assumed by the insurer
• Insurance funds are owned by the insurer
• Surplus funds belongs to the insurer
• Investments can be made in non-Shariah compliant sectors
  

Differences in Terminology:

Takaful

• Contributions
• Participants
• Sum covered
  

Conventional Insurance

• Premiums
• The insured
• Sum insured
  

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.

A Review of the recently concluded IFSB Summit in Singapore

The summit concluded that there is an opportunity to nurture greater prominence and acceptance for Islamic finance during this period of uncertainty in the conventional financial market. To achieve this, three areas needs to be focused on; ensuring that the Islamic finance industry remains robust, continuous product innovation and development of the regulatory aspects.

The participants agreed that working to achieve these objectives is not without challenges. There is still a lack of standardisation in how the major organisations such as IFSB and IDB interpret the mechanics of Islamic finance. Adoption of the standards issued by IFSB and AAOIFI are purely voluntary and are not legally enforceable. It was highlighted that at the summit, participants were discussing issues which have not even been implemented in their own jurisdictions. The development of a uniform set of regulations could very well lead to a struggle for domination by a particular school of thought. Averting this will be the greatest challenge.

Also highlighted in the summit was the absence of a global Shariah compliant liquidity mechanism or inter-bank system for short term liquidity as well as for central banks to invest their reserves.

According to IFSB chairman Muhammad Sulaiman Al-Jasser, the global financial crisis has exposed the failure of self-regulation. IFSB secretary-general Rifaat Ahmed Abdel Karim said that as the global financial architecture undergoes structural reforms as a result of the financial crisis, the Islamic financial services industry would have to follow suit. The IDB and IFSB have formed a high-level task force on Islamic finance and global financial stability that will also study how the sector can dovetail with the revamp exercise for the international financial architecture, especially with regard to regulations and crisis management.

[IFN, Volume 6 Issue 19]

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.