ISLAMIC DERIVATIVES SOLUTIONS: ISLAMIC DERIVATIVES SOLUTIONS: METHODOLOGY, ISSUES AND METHODOLOGY, ISSUES AND

PRODUCT STRUCTURING WITH PRODUCT STRUCTURING WITH SPECIAL REFERENCE TO PROFIT SPECIAL REFERENCE TO PROFIT

RATE SWAP AND FORWARD FOREXRATE SWAP AND FORWARD FOREX

Dr. Mohd Daud BakarDr. Mohd Daud BakarPresident/CEOPresident/CEO

International Institute of Islamic Finance Inc.International Institute of Islamic Finance Inc.mdaud@iiif-inc.com/mdaud@amanie.com.mymdaud@iiif-inc.com/mdaud@amanie.com.my

ISLAMIC METHODOLOGY ISLAMIC METHODOLOGY TOWARDS INNOVATIONTOWARDS INNOVATION

Islamic law deals with permanent (Islamic law deals with permanent (al-al-thawabitthawabit) and changeable () and changeable (al-al-mutaghayyaratmutaghayyarat) aspects of legal issues ) aspects of legal issues differently.differently.

As for permanent part of issues, no As for permanent part of issues, no alternation is permissible though its alternation is permissible though its retirement, extension and reaffirment is retirement, extension and reaffirment is encouraged (example: prohibition of riba, encouraged (example: prohibition of riba, obligation to fulfill the contract)obligation to fulfill the contract)

However, Islamic law allows room for However, Islamic law allows room for reasoning and reinterpretation in areas of reasoning and reinterpretation in areas of law which are changeable and progressive law which are changeable and progressive in character. (example: standard of in character. (example: standard of delivery, standard of certainty in pricing, delivery, standard of certainty in pricing, and underlying asset, standard in and underlying asset, standard in settlement of obligation).settlement of obligation).

While riba is a fixed prohibition in terms of While riba is a fixed prohibition in terms of definition and application, gharar (lack of definition and application, gharar (lack of knowledge that could be detrimental to knowledge that could be detrimental to parties to contract) is not. Gharar changes parties to contract) is not. Gharar changes with the change of technologies, legal with the change of technologies, legal framework, customary practice, etc.framework, customary practice, etc.

SHARI’AH ISSUES IN DERIVATIVESSHARI’AH ISSUES IN DERIVATIVES The pricing standard: Certainty and The pricing standard: Certainty and

benchmark.benchmark. Time and method of delivery with Time and method of delivery with

regard to both regard to both ribawiribawi items and non- items and non-ribawiribawi items. items.

Time and method of payment with Time and method of payment with regard to both regard to both ribawiribawi items and non- items and non-ribawiribawi items. items.

Marked to market.Marked to market. Perception!Perception!

PRODUCT STRUCTURING FOR PRODUCT STRUCTURING FOR ISLAMIC DERIVATIVESISLAMIC DERIVATIVES

Freedom of contract provided it is Freedom of contract provided it is free from riba and gharar.free from riba and gharar.

Riba takes place if there is an excess Riba takes place if there is an excess (inequality) or a delay in delivery, as (inequality) or a delay in delivery, as the case maybe, in any exchange of the case maybe, in any exchange of two similar ribawi items. Or, if there two similar ribawi items. Or, if there is a delay in delivery in any exchange is a delay in delivery in any exchange of two dissimilar ribawi items (e.g. of two dissimilar ribawi items (e.g. USD for RM).USD for RM).

Gharar-free transactions imply Gharar-free transactions imply transactions that are void of lack of transactions that are void of lack of knowledge that could bring detriment to knowledge that could bring detriment to one or the other party in a contract. Lack one or the other party in a contract. Lack of knowledge may be due to uncertainty of of knowledge may be due to uncertainty of item, price, etc.item, price, etc.

Islamic derivatives structuring, therefore Islamic derivatives structuring, therefore must be free from both must be free from both ribariba (when it (when it involves exchange of two similar or involves exchange of two similar or dissimilar dissimilar ribawiribawi items) and items) and gharargharar (when (when it involves non-ribawi items).it involves non-ribawi items).

Issues of Issues of ribariba confine to either confine to either excess (inequality) or delay in excess (inequality) or delay in delivery and payment or both.delivery and payment or both.

Issues of Issues of gharargharar centre around centre around uncertainty, inability to deliver, uncertainty, inability to deliver, unavailability, etc.unavailability, etc.

INTEREST / PROFIT RATEINTEREST / PROFIT RATESWAP / EXCHANGESWAP / EXCHANGE

DefinitionDefinition::

Involves exchanging (swapping) interest Involves exchanging (swapping) interest payments on Floating-rate debt for interest payments on Floating-rate debt for interest payments on Fixed-rate debt, with both payments on Fixed-rate debt, with both payments in the same currency.payments in the same currency.

ReasonReason::

One party actually wants fixed rate debt, but One party actually wants fixed rate debt, but can get a better deal on floating rate; the can get a better deal on floating rate; the other party wants floating rate. Both parties other party wants floating rate. Both parties can gain by swapping loan payments, usually can gain by swapping loan payments, usually through a bank as a financial intermediary through a bank as a financial intermediary which charges a fee to broker the transaction.which charges a fee to broker the transaction.

FEATURES OF INTEREST / FEATURES OF INTEREST / PROFIT SWAPPROFIT SWAP

A swap of fixed-for-floating interest rate.A swap of fixed-for-floating interest rate. A master agreement for fixed rate interest.A master agreement for fixed rate interest. A floating or variable rate which is reset A floating or variable rate which is reset

periodically.periodically. A set-off (A set-off (muqasahmuqasah) exercise at every reset ) exercise at every reset

time to swap a fixed-for-floating interest time to swap a fixed-for-floating interest rate.rate.

Floating interest rate is to based on a Floating interest rate is to based on a certain benchmark.certain benchmark.

The counterparty making fixed rate The counterparty making fixed rate payments in a swap is predominantly the payments in a swap is predominantly the less creditworthy participant.less creditworthy participant.

PROPOSED ISLAMIC PROFIT PROPOSED ISLAMIC PROFIT RATE SWAPRATE SWAP

The above characteristics of the The above characteristics of the conventional interest rate swap are to be conventional interest rate swap are to be maintained.maintained.

Therefore, it must consist of three Therefore, it must consist of three important documents:important documents:(i)(i) Master Fixed – Rate Transaction.Master Fixed – Rate Transaction.(ii)(ii) Master Revolving Floating – Rate Master Revolving Floating – Rate Transaction.Transaction.(iii)Settlement Agreement.(iii)Settlement Agreement.

The challenge in Islamic finance is to The challenge in Islamic finance is to create a mechanism which is floating and create a mechanism which is floating and revolving to assist the parties in their revolving to assist the parties in their swap transactions I.e. to give floating rate swap transactions I.e. to give floating rate profit to the party who seeks to match profit to the party who seeks to match their floating payment obligations and to their floating payment obligations and to give fixed rate profit to the party who give fixed rate profit to the party who seeks to match their fixed payment seeks to match their fixed payment obligations (in addition to achieve ‘Quality obligations (in addition to achieve ‘Quality Spread Differential’ that is spread between Spread Differential’ that is spread between fixed interest rate and variable interest fixed interest rate and variable interest rate.rate.

ISLAMIC PROFIT RATE SWAP: ISLAMIC PROFIT RATE SWAP: AN OVERVIEW (A HYPOTHETICAL CASE) AN OVERVIEW (A HYPOTHETICAL CASE)

ABC Bank has floating rate funding ABC Bank has floating rate funding and fixed rate investment. In order and fixed rate investment. In order to match funding rates with return to match funding rates with return rate (investment), ABC Bank may rate (investment), ABC Bank may decide to enter into an Islamic Profit decide to enter into an Islamic Profit Rate Swap with a counter-party.Rate Swap with a counter-party.

Stage 1: Fixed Profit RateStage 1: Fixed Profit Rate

Step 1: XYZ Bank (counter party) sells Step 1: XYZ Bank (counter party) sells an asset to ABC Bank on an asset to ABC Bank on MurabahahMurabahah basis at a selling price that comprises basis at a selling price that comprises both principal and profit margin to be both principal and profit margin to be paid upon completion of subsequent paid upon completion of subsequent transaction I.e. Stage 2. An Asset transaction I.e. Stage 2. An Asset Purchase Agreement is executed by Purchase Agreement is executed by the two parties.the two parties.

Illustration: Suppose the national principal Illustration: Suppose the national principal amount intended is BD500,000 and the amount intended is BD500,000 and the fixed mark-up is 5.75% for 2 years. The fixed mark-up is 5.75% for 2 years. The fixed mark-up profit rate amount is fixed mark-up profit rate amount is payable every 6 months for 2 years payable every 6 months for 2 years (BD500,000 x 5.75% x 5.75% x 180/365 = (BD500,000 x 5.75% x 5.75% x 180/365 = BD14,178.08)BD14,178.08)

Stage 2: Floating Profit RateStage 2: Floating Profit RateStep 1: Just prior to 6 months, ABC Bank Step 1: Just prior to 6 months, ABC Bank will sell an asset to XYZ Bank at a selling will sell an asset to XYZ Bank at a selling price of BD500,000 plus a mark-up based price of BD500,000 plus a mark-up based on CURRENT profit rate (agreed spread on CURRENT profit rate (agreed spread plus current benchmark). An Asset Sale plus current benchmark). An Asset Sale Agreement is executed by the two parties.Agreement is executed by the two parties.

Step IIStep II

Payment of selling price by both ABC Payment of selling price by both ABC and XYZ Bank is netted-off.and XYZ Bank is netted-off.

Step IIIStep III

The net difference is profit, and is paid The net difference is profit, and is paid to the receiving party as the case may to the receiving party as the case may be spelt out in the settlement be spelt out in the settlement agreement.agreement.

Stage IIIStage III

-- Floating Profit Rate (Stage II) is Floating Profit Rate (Stage II) is repeated every 6 months until repeated every 6 months until

maturity.maturity.

Islamic Rate Swap Counter-Party

Islamic Depositors ABC Islamic Funding

ILLUSTRATION

pays fixed profit rate receives floating profit rate

Floating rate Fixed rate

OTHER ALTERNATIVE / OTHER ALTERNATIVE / PROPOSALPROPOSAL

As the bottom line of swapping is to swap As the bottom line of swapping is to swap fixed for floating interest rate/profit rate to fixed for floating interest rate/profit rate to suit the financial needs, the principle of suit the financial needs, the principle of sale and lease-back (with an option to sale and lease-back (with an option to purchase) would be workable (at least in purchase) would be workable (at least in theory)theory)

As for the fixed profit rate, the sale which As for the fixed profit rate, the sale which is based on is based on MurabahaMurabaha can be initiated. can be initiated. This is followed by This is followed by ijaraijara based on current based on current benchmark, which is floating.benchmark, which is floating.

GENERAL OBSERVATION 1GENERAL OBSERVATION 1

Floating rate intended in the swap Floating rate intended in the swap transaction does not necessarily mean transaction does not necessarily mean that the rate of profit is floating (I.e. that the rate of profit is floating (I.e. moving from one rate to another). It moving from one rate to another). It means more of entering into a new means more of entering into a new contract, be it contract, be it MurabahaMurabaha, or , or IjaraIjara, or , or whatever, as the case may be, as long as whatever, as the case may be, as long as it is based on current cost of funds it is based on current cost of funds according to certain benchmark already according to certain benchmark already agreed in the formula.agreed in the formula.

GENERAL OBSERVATION 2GENERAL OBSERVATION 2 In swap no actual payment is made as the In swap no actual payment is made as the

principal amount upon which total payments principal amount upon which total payments are based are just notional. From the are based are just notional. From the Shari’ah view, this is done via the principle Shari’ah view, this is done via the principle of of Muqasa Muqasa (set-off), subject to its terms and (set-off), subject to its terms and conditions. In short, a profit rate swap is a conditions. In short, a profit rate swap is a contractual rate agreement entered into contractual rate agreement entered into between two counterparties under which between two counterparties under which each party agrees to make periodic payment each party agrees to make periodic payment to the other for an agreed period of time to the other for an agreed period of time based upon a notional amount of principal.based upon a notional amount of principal.

ISSUES OF CONCERNISSUES OF CONCERN Can the Shari’ah force one of the Can the Shari’ah force one of the

counter-party to enter into a counter-party to enter into a subsequent transactions while the subsequent transactions while the swap has not matured?swap has not matured?

ISSUES OF CONCERNISSUES OF CONCERN

Answer:Answer: Not allowed as the parties are at liberty, and no penalty Not allowed as the parties are at liberty, and no penalty

should be imposed upon refusal.should be imposed upon refusal. Allowed as both have agreed to impose these Allowed as both have agreed to impose these

conditions upon themselves from the beginning.conditions upon themselves from the beginning. Refusal to enter means Early Termination Event of the Refusal to enter means Early Termination Event of the

Master Agreement.Master Agreement.(according to International Swap and Derivatives Association (according to International Swap and Derivatives Association (ISDA), upon early termination the swap value will be determined, (ISDA), upon early termination the swap value will be determined, and a certain amount “the close-out amount” will be calculated and and a certain amount “the close-out amount” will be calculated and will be paid by the party which is “out of the money” on the swap.will be paid by the party which is “out of the money” on the swap.

ISSUES OF CONCERNISSUES OF CONCERN

MurabahaMurabaha transaction could be based transaction could be based on on TawarruqTawarruq or or ‘Inah‘Inah concept, as the concept, as the case may be.case may be.

Conditional contracts of purchase Conditional contracts of purchase and sale and subsequent contracts.and sale and subsequent contracts.

Perception.Perception.

ISSUES IN FORWARD FOREXISSUES IN FORWARD FOREX Forward FOREX involves essentially Forward FOREX involves essentially two dissimilar two dissimilar

ribawi items ribawi items i.e. two different currency. Currency i.e. two different currency. Currency is a ribawi item.is a ribawi item.

Under the principles governing any exchange of Under the principles governing any exchange of two dissimilar ribawi items, the exchange of two two dissimilar ribawi items, the exchange of two counter valuescounter values must be spot or simultaneous must be spot or simultaneous (hand to hand).(hand to hand).

Forward FOREX entails that the rate of exchange Forward FOREX entails that the rate of exchange is locked in today (the day of contract) but is locked in today (the day of contract) but delivery of two delivery of two countervaluescountervalues is being deferred to is being deferred to a future date where the delivery of these two a future date where the delivery of these two counter values will be made on spot basis.counter values will be made on spot basis.

There is a silent consensus amongst There is a silent consensus amongst the jurists that this method of the jurists that this method of exchanging a currency for another is exchanging a currency for another is not compliant to the requirement of not compliant to the requirement of “hand to hand”.“hand to hand”.

““Hand to hand” requires the delivery Hand to hand” requires the delivery of the two counter-values be made of the two counter-values be made on on the day of the contractthe day of the contract which is which is not the practice in current FOREX.not the practice in current FOREX.

ISLAMIC SOLUTIONS TO FOREXISLAMIC SOLUTIONS TO FOREX

Islamic law requires delivery to be Islamic law requires delivery to be made on the made on the day of the contractday of the contract. . However, Islamic law However, Islamic law does notdoes not prohibit prohibit promisepromise to buy and sell to buy and sell currencies on currencies on one dateone date and delivery and delivery to be made on to be made on another dateanother date because because the proper contract only concludes the proper contract only concludes on the on the day of deliveryday of delivery..

This premise of argument has led to the This premise of argument has led to the argument/construction of wa’d (promise) argument/construction of wa’d (promise) in structuring Islamic version of FOREX.in structuring Islamic version of FOREX.

Under wa’d structure, only one party Under wa’d structure, only one party (obligor/promisor) promises to buy/sell as (obligor/promisor) promises to buy/sell as the case may be wherein he is bound by the case may be wherein he is bound by that promise (binding promise). The other that promise (binding promise). The other party / promisee / obligee is not bound party / promisee / obligee is not bound however to proceed with the promise however to proceed with the promise undertaken by the promisor.undertaken by the promisor.

Binding promise from only one party Binding promise from only one party is not deemed under Islamic law as a is not deemed under Islamic law as a contract. Therefore, this can contract. Therefore, this can facilitate FOREX.facilitate FOREX.

Binding promise from both parties Binding promise from both parties are deemed to be leading to contract are deemed to be leading to contract conclusion and therefore, prohibited.conclusion and therefore, prohibited.