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Derivatives in Islamic Finance Report

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Updated: Mar 22nd, 2022

Introduction

The international financial community is getting very much interested in the Islamic Financial Products, due to its 15-25 per cent per annum anticipated growth and billions of dollars of estimated worth. (Mohammed and Rahmat, Para 1)

Shari’ a-compatible financial products have broadened significantly in the past few years, from customized products for individuals to large scale financings with set-in derivative products targeting global Markets (Mohammed and Rahmat, Para 2)

With the rapid growth of the petro-economies in the Middle East and both local as well as international investors getting comfortable with Shari’ a-compliant financial products, the Islamic finance has seen a dramatic rise, in the past two years in particular. (Mohammed and Rahmat, Para 3)

According to Moody’s estimation there are currently 250 Islamic mutual funds operating with US$ 300 billion of assets, 300 Islamic financial institutions holding US$ 250 billion of assets held in “Islamic Windows” (Mohammed and Rahmat, Para 4). McKinsey predicts that Islamic banking assets and assets under management will reach US$1 trillion by 2010 (Mohammed and Rahmat, Para 4).

Financial globalization is making possible the diversification of investment and derivatives are playing major role in such kind of financial systems. The whole capital market has been more performing after the improvement in allotment of risks and the presence of derivatives in the cash market has been helpful in the growth of liquidity (Jobst, Para 1).

The developing derivatives are playing an important role in the emerging market, which needs the presence of financial instruments to control the risks of market, interest rates and credits especially in small local capital markets (Jobst, Para 1). We will first understand the meaning of derivatives: Derivatives are exchange contracts whose main purpose is to transfer risks which are related to a fundamental benefit. So the derivatives are used for speculative purposes. They are mainly used for the profit from the growth of fundamental benefits (Elgari, Para 1).

Derivatives in Islamic finance

The derivatives so far are not able to get a clear Shari’s compatibility due to its uncertainty and speculations involved. However some school argue that the derivatives may be Shari’ah compatible if they follow the below mentioned guidelines:

  1. They address genuine hedging concerns and there is ownership in a specific underlying asset or venture.
  2. They don’t get involved in speculative or prohibited activity.
  3. They allow mutual delay of agreement only on the condition that there is actual and direct transfer of an underlying physical asset as the object.
  4. They maintain a reserve for the use of the asset yet at the same time do not provide scope that creates one sided profits from price changes of the contracted asset that is outside the scope of the transaction. (Mohammed and Rahmat, Para 37-40)

The Islamic banks and corporations deals with cross currency swap, profit rate swaps, total return swaps and fund/ index linked derivatives (Mohammed and Rahmat, Para 40).

To understand risk, it is the possibility of something which happens unexpectedly and if we relate it to the finance and investment, it means a fall in the price of an asset. It could be either to miss a profit or to make a loss. Shari’ah never says its believer to be hasty to avoid risks. To be accepted by Shari’ah, risk is never preferable for any transaction. In fact, it is more in order with Shari’ah to avoid risk when it is done through Shari’ah’s up to standard resources (Elgari, Para 3).

According to their preferences people need to transfer their risk. That is why all types of redistribution tools like insurance and derivatives have been discovered. To transfer any risks means are very important. For the benefit of any society risk transferring is an essential element. This is a well-known Shari’ah fact whose main objective is the welfare of the society (Elgari, Para 5).

The bad name of Derivatives

Due to current crisis in financial market, the word derivatives have been understood badly for its apparent role. The financial sector ruled the whole economy and compelled this sector to change its ways of doing business. It is just to meet the requirements of the market. In this whole process derivatives have played a prominent role. Derivatives are not the tools for risk management yet they are used for merely speculation. They are not fixed. They can grow for an indefinite period and can devastate the stability of the whole economy (Elgari, Para 11).

Tools for risk management: Shari’ah has similar kinds of tools of risk management which deliver the same economic effect but they assure stability of the system (Elgari, Para 12).

Call option: in this sale contract is influenced by a condition of revocation by a buyer (Elgari, Para 12).

Futures: It is a Salam contract that consists of the sale of a commodity that is not specifically owned by the seller (Elgari, Para 12).

Forward: it is Wa’ad which is used to manage exchanging risks (Elgari, Para 12).

Swap: in the Islamic banking a swap can also be done. It is done through Murabaha to exchange a stream of income (Elgari, Para 12).

Shari’ah principles

Islamic law has two sources: primary and secondary. The principal sources for Shari’ah are the Qur’an, Sunnah and Ahadith. The resulting sources of Islamic law are, a series of methods that allow further rules to be extracted from the principal sources and applied to a current environment. (Mohammed and Rahmat, Para 7)

There are five orthodox schools of thought within Shari’ah, each named after its founding jurist and linked with a particular geographic region. (Mohammed and Rahmat, Para 8)

Islamic finance is a network of financial institutions and activities that obey the rules , to the core of Shari’ah that governs commercial dealings, mainly the prohibitions on (1) receipt and payment of interest, (2) vagueness and (3) precise prohibited activities. (Mohammed and Rahmat, Para 9)

Riba (interest)

Shari’ah law is totally against receipt or payment of interest at all. Interest, as per Shari’ah, is a fixed return of money lent or advanced. This does not include gains from the exposure of the money in the commercial activities. (Mohammed and Rahmat, Para 10)

Shari’ah favours trade and sharing of commercial risk, together with the financiers and does not accept the provision of fixed return without sharing the commercial risk. (Mohammed and Rahmat, Para 11)

Gharar (vagueness)

Shari’ah does not recognize a vague or uncertain contract where in the terms are not unsure. One aspect of uncertainty is the vagueness in the result, for example gambling or speculation. Similarly, insurance is also viewed similar to gambling and are therefore prohibited. (Mohammed and Rahmat, Para 12,13)

Haram (forbidden activities)

Activities like gambling, weapons, pornography, alcohol and pork are strictly prohibited in Shari’ah. Any involvement in any of these items is specifically outlawed in Shari’ah. (Mohammed and Rahmat, Para 14)

Shari’s-compliant financing techniques

Over the period, Shari’ah has devised commercial contracts which are acceptable. Intricate business may be structured by a combination of these contracts to produce the desired deal. (Mohammed and Rahmat, Para 15)

Some of the popular kinds of these contracts are as under:

Murabaha (cost-plus financing)

A murabaha is a three sided sale deed where in the financier, supplier and consumers are involved. This profit is justified in Shari’ah as the financer takes the title to the goods and accepts the risk of their ownership before re selling. (Mohammed and Rahmat, Para 16)

Murabaha has many pioneering products. They accounts for almost three quarters of all Islamic financing due to its flexibility. (Mohammed and Rahmat, Para 17)

Istisna’a (custom manufacturing)

The contract clearly specifies the nature and quality of the product and also the sale price is set in advance. It also defines the mode of payment as, lump sum or installments. (Mohammed and Rahmat, Para 18)

The seller takes the risk of ownership and any increase in cost after the purchase price has been contracted, till the purchaser takes the delivery. (Mohammed and Rahmat, Para 19)

Once the manufacturing starts the contract becomes binding, though the goods may be rejected if they do not satisfy the contracted criteria. (Mohammed and Rahmat, Para 20)

Ijara (lease)

An Ijara is like a lease contract, where assets are exchanged. It is must that the lease be present for the whole period. The ijara must terminate if, the financial value is totally destroyed or the leased asset ceases to exist. (Mohammed and Rahmat, Para 21)

Musharaka (partnership)

A musharaka is a partnership among all the partners where all the losses and benefits are shared (Mohammed and Rahmat, Para 24). The percentage of share can be done according to an agreed formula, rather than the capital contribution of each partner. In this, none of the partners will be entitled to a pre-determined, fixed profit (Mohammed and Rahmat, Para 24.)

The losses are not subjected to the contract formula, the partner is required to share losses in proportion to their capital contribution. (Mohammed and Rahmat, Para 25)

Mudaraba (investment agency)

In this, an investment agent invests in business on behalf of the investors. The profit sharing contract can be arranged as per their agreement. But the loss is born by the investor only. (Mohammed and Rahmat, Para 26)

The sukuk product

Sukuk are medium to long term, Shari’ah compatible trust certificates. These certificates represent favourable interests in permitted assets or services. They represent a profit and risk sharing agreement between the issuer and the investor. In these products the returns must be directly linked with the performance of the asset otherwise it would be treated as unlawful interest or non Shari’ah compliant. (Mohammed and Rahmat, Para 29 – 32)

Shari’ah Fundamentals

Shari’ah, which is Islamic law, rules economic, social and political institutions (Uberoi and Evans, Para 4). It is a principle based legal system which has the capability of development. Shari’ah’s legal principles come from a progression of primary and secondary sources (Uberoi and Evans, Para 4).

Shari’ah and Conventional Interest Rate Swap: Here the parties agree to exchange fixed and floating payments. This kind of interest rate swap could be problematic from the point of view of Shari’ah. There are three types of Shari’ah prohibitions (Uberoi and Evans, Para 7): Riba- it is the receipt and payment of interest; Gharar- it is a kind of uncertainty in the principal terms of a contract; Maisir- this is a kind of speculation in contracts (Uberoi and Evans, Para 7).

Shari’ah Compliant Derivatives

There is a challenge while arranging Shari’ah complaint derivatives like the parties get the benefit from the positive risk sharing which are offered by the derivatives but it should not break the basis prohibitions which are discussed before (Uberoi and Evans, Para 7).

 The Profit Rate Swap
The Profit Rate Swap

The Basic Murabaha Structure (Uberoi and Evans, Allen & Overy, Para 9)

Documenting the Transaction (Uberoi and Evans, Para 15): The profit rate swap is known under a custom-made agreement, which will not include interest payments and debt exchange due to Shari’ah’s rules. Islamic bank are thinking of the ways to be cautious for their exposures in securitizations, project financing and loan structures (Uberoi and Evans, Para 16).

Cross Currency Swap

A conservative currency swap has three stages:

  1. exchange of principal
  2. exchange of interest payments
  3. a re-exchange of principal at the maturity of the contract (Tredgett et al, Para 6).
Full Cross Currency Swap Structure (Tredgett et al, Derivatives week, Allen & Overy)
Full Cross Currency Swap Structure (Tredgett et al, Derivatives week, Allen & Overy)

“The currency swap is documented under a custom-made master agreement which due to Shari’ah will not stick on debt exchange or any interest payment (Tredgett et al, Para 12).This whole process needs creative technology to deal with the calculation of an Early Termination Amount and some new representations which tell about Shari’ah Compliance” (Tredgett et al, Para 12).

Shari’ah Compliant Derivatives- The Cross-Currency Swap

To arrange Shari’ah compliant derivatives for generating cash flow is very challenging. It is like a conventional derivative product. Only the difference is to use a set Shari’ah compliant technique.

Wa’ad

In Quran the term wa’ad refers to a promise or to pledge or to firmly intend.Wa’ad is very useful in the structures of Sharia-compliant transactions. Among several views regarding the enforcement of wa’ad, the one which is the most reflective in today’s market is: ‘A wa’ad in the context of a classic murabaha sale is morally binding’ and it’s fulfillment may be enforceable at court. A )the promise is unilateral promise binding one of the parties to the murabaha; and b)the promise has caused the promise to incur some liabilities. The view was issued by the Islamic Fiqh Academy (IFA) IN 1988-1989 (Uberoi et al, Para 1).

Use of wa’ad in Islamic finance market: Wa’ad has gained a lot of exposure over the last few years due to its unilateral nature and inherent flexibility. It does not need to stick to the formal requirements of a ‘contract’ under Sharia (Uberoi et al, Para 2).

Use of wa’ad for FX option: The wa’ad can be used to structure an FX (i.e. currency) option. It permits the creation of an option for genuine trade hedging purposes, but does not allow the trading of an option without any purchase/sale (Uberoi et al, Para 3).

Double wa’ad structure: The double wa’ad structure enables an SPV user to use cash proceeds from an issue of Certificates to acquire a pool of Sharia-compliant assets from the market. These could be shares listed on the Dow Jones Market Indexes (DJMI) (Uberoi et al, Para 4). Under one wa’ad the issuer promises to sell Sharia-compliant assets to the Bank at a particular price ,while under the other wa’ad the Bank promises to buy Sharia-compliant assets from the Issuer at the Wa’ad Sale Price (Uberoi et al, Para 4).

The commercial significance of this structure lies in the fact that it offers the Islamic investors the opportunity to swap the returns in one basket with the returns in another basket (Uberoi et al, Para 5).

Use of wa’ad in short selling: Short selling refers to the selling what one does not own. Under Sharia one cannot sell what one does not own.So, two double wa’ad ,in combination with murabaha, or deferred payment transaction, can be used to create a similar economic Sharia-compliant manner (Uberoi et al, Para 6).

Criticism: The strongest criticism is by Yusuf Talal DeLorenzo is that the returns are determined by the performance by funds which are not Sharia compliant (Uberoi et al, Para 7).

The cash flow triggers for a series of transactions which are not necessarily Sharia compliant. The Sharia Board at Amiri Capital is of the opinion that the use of the wa’ad to imitate conventional shorting is appropriate (Uberoi et al, Para 8). Thus it seems that wa’ad has got some recognition in the Islamic derivatives market. In the current economic climate, the wa’ad has got strong potential to bring out innovations (Uberoi et al, Para 9).

In the following diagram (Uberoi et al, Para 9):

“PTP is for Promise to Purchase
PTS is for Promise to Sell
Returns for the Hedge Fund and Prime Broker

The following diagram is similarly like conventional short-selling and gives returns for both the Prime Broker and the Hedge Fund.

Prime Broker: In the following structure, PB’s return is equivalent to $2. This tell about the total spread that PB earns on (i) the murahaba transaction with HF and (ii) Double Wa’ad 1; minus (iii) the DW1 fee ($2)” (Uberoi et al, Para 9).

Hedge Fund: HF return is here equivalent to $17. That tells about (i) the amount of money that HF receives from PBunder the murahaba transaction (ii) the amount of money HF spends on purchasing the stock form the Third Party under Double Wa’ad 29i.e. $80), minus (iii) the DW2 Fee ($1) (Uberoi et al, Para 9).

Third Party: Here the Thirds Party’s return is equivalent to $1. This tells about (i) the amount of money that the Third Party receives from HF under the terms of Double Wa’ad 2 ($80), plus (ii) the DW1 Fee ($2), plus (iii) the DW2 Fee ($1), minus (iv) the amount of money Third Party pays PB under the terms of Double Wa’ad 1 ($82)” (Uberoi et al, Para 9).

Third Party

Tahawwut Master Agreement (International Swap and Derivatives Association, Inc., Para 1):

“Dated as of…………Party A……….and Party B……………may from time to time enter into one or more transactions that are or will governed by this ISDA/IIFM Tahawwut Master Agreement, which includes the schedule and the documents and other confirming evidence exchanged between the parties or otherwise effective for the purpose of confirming or evidencing those Transactions. This ISDA/IIFM Tahawwut Master Agreement and the Schedule are together referred to as this Master Agreement” (International Swap and Derivatives Association, Inc., Para 1).

In the case of any discrepancy between the provisions of any Confirmation and this Master Agreement, the Confirmation will be followed for relevant transactions (International Swap and Derivatives Association, Inc., Para 2).

The general condition will be like: (i) Each party will make each payment in each Confirmation. (ii) Each party will do Designated Future Transaction. (iii) Payments will be done on the due date. (iv) Each party will take care of any default if it occurs with other party (International Swap and Derivatives Association, Inc., Para 4).

Basic Representations: Status: It is accordingly well thought-out.

Powers: It should have the power to carry out this Agreement.

No Conflict: Such kinds of executions do not conflict with any law that are related to it (International Swap and Derivatives Association, Inc., Para 6).

Consents: It has got all governmental consents with respect to this Agreement.

Obligations Binding: its obligations make up its valid, legal and binding obligations with some relevant conditions (International Swap and Derivatives Association, Inc., Para 6)

Shari’ah Compliant Transactions: The parties, who have Shari’ah compliant transactions under this agreement, agree that time to time they can enter into such kind of transactions as follows (International Swap and Derivatives Association, Inc., Para 6):

  1. To buy or sale of commodities is called murabaha transactions
  2. To buy or sale of moveable or immoveable property
  3. To buy or sale of Shari’ah compliant securities
  4. Any other transactions agreed between the parties

Works Cited

Elgari, Mohammad Ali. “The Islamic Perspectives on Derivative”. The Frontiers of Innovation in Islamic Finance Second Oxford Islamic Finance Round-Table. 2009

“ISDA/IIFM Tahawwut Master Agreement” International Swaps and Derivatives Association Inc. International Islamic Financial Market. 2010

Jobst, Andreas A. “Derivatives In Islamic Finance”. Islamic Economic studies. Vol. 15 . No.1. 2007

Mohammad, Anzal & Rahamati, Hooman Sabeti. “Understanding Islamic Finance”. 2008. Web.

Tredgett, Richard et al. “Cross Currency Swap”. Allen & Overy. Derivatives Week. 2010

Uberoi, Priya et al. “Promises on the Horizon: An Introduction to the Wa’ad”. Allen & Overy. n.d.

Uberoi, Priya et al. “Profit Rate Swap”. Allen & Overy. 2010

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