Innovation & Financial Engineering in Islamic Finance

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Timothy Davidson
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Innovation & Financial Engineering in Islamic Finance Professor

Islamic Finance Autumn School in Istanbul jointly organised by

Foundation for Research and Education; Istanbul Commerce

financial innovation n The objective of Islamic financial

financial services industry, which replicate economic effects of

What s the point of re-inventing the wheel?

1 Innovation & Financial Engineering in Islamic Finance Professor Humayon Dar Chairman, President & CEO Presented at the Durham Islamic Finance Autumn School in Istanbul jointly organised by Durham Centre for Islamic Economics and Finance and ISAR-Istanbul Foundation for Research and Education; Istanbul Commerce University, Istanbul 19 th -22 nd September Introduction: Islamic financial innovation n The objective of Islamic financial innovation Developing new financial products for the Islamic financial services industry, which replicate economic effects of the conventional products in a Shari a compliant way n Objection What s the point of re-inventing the wheel? n The process is as important as the end result However, it is important that Haram + Haram Halal Haram + Halal Halal Islamic Finance 1

2 Introduction: new trends in Islamic financial innovation n Revised objective of Islamic financial innovation Developing new products and institutional models for Islamic finance so that this must lead to a new financial (and economic) model to replace conventional (interest-based) banking & finance n This should mean more involvement of governments and financial authorities n Malaysia provides an example of leadership role played by the government n No where else in the Islamic world, we find that kind of governmental support for Islamic finance n The market will drive this innovation and I believe it will be the Western financial institutions doing it! Introduction: new trends in Islamic financial innovation n Shari a compliancy is only a necessary condition for the sustainable success of Islamic banking & finance n A sufficient condition is commitment to social responsibility Therefore, objective of Islamic financial innovation should be developing financial structures (products and institutions) that offer distinct social value in addition to being Shari a compliant. n However, it is important not to belittle the recent financial innovation that happened in the Islamic financial services industry Islamic Finance 2

3 The Biggest Innovation in Islamic Finance in the 21 st Century n The use of promises as a tool for financial product development n Before this, Wa ad was a marginal concept in Islamic jurisprudence n In future, I believe Wa ad will become mainstream n Wa ad, as opposed to contract, should be the base level arrangement What is Wa ad? Wa ad is an undertaking by a Party A to do something (W) for another Party B for a price (P) at an agreed time or during a certain time period (T). [(A,B), (W), (P,T)] n All the elements of Wa ad must fulfill Shari a requirements n A unilateral promise is the one, which is given by one party (promisor) to another party (promisee), without receiving another equal and opposite promise from the promisee If X = [(A,B), (W), (P,T)], then Y will be an equal and opposite promise if: Y = [(B,A), (W), (P,T)] Islamic Finance 3

4 What is Wa ad? n Equal and opposite promises are known as diagonal promises (XΔY) = Contract n W could be anything Shari a permissible n An act of purchase and sell, renting, an act of charity etc. If W s (O) = act of selling O W p (O) = act of purchasing O then X = [(A,B), (W s (O)), (P,T)], and Y = [(B,A), (W p (O)), (P,T)] would be considered as diagonal (XΔY) Promises are the spring of innovation n Promises are quasi-contracts binding on just one party: the promisor n Sharia issues around promises Distinction between a promise and a contract A promise, in general is not binding and, hence, unenforceable in a court of law; a contract is binding and enforceable A promise, being unenforceable, does not have an economic value It has an economic value only if it is binding Can we write binding promises? Yes conditional upon the OIC Fiqh Academy s resolution Islamic Finance 4

5 Promises n The OIC Fiqh Academy allows writing binding promises The promise must be unilateral It must have caused the promisee to incur some costs/liabilities If the promise is to purchase something, the actual sale must take place at the appointed time by the exchange of offer and acceptance. Mere promise itself should not be taken as the concluded sale If the promisor reneges on their promise, the court may force them either to purchase the commodity or pay actual damages to the seller. The actual damages will include the actual monetary loss suffered by the promisee, and must not include the opportunity cost Promises (1) n The issue of unilateralism in promises n Case 1: A unilaterally promises to buy a stock x from B at a future date t for a price p Simultaneously, B unilaterally promises to sell a stock x to A at a future date t for a price p The two promises together are in fact a bilateral promise, which in the eyes of Sharia is binding on both parties, and hence is a full contract Islamic Finance 5

6 Promises (2) n Case 2: A unilaterally promises to buy a stock x from B at a future date t 1 for a price p Simultaneously, B unilaterally promises to sell a stock x to A at a future date t 2 for a price p The two promises together do not amount to a bilateral promise because they refer to different execution dates Promises (3) n Case 3: A unilaterally promises to buy a stock x from B at a future date t for a price p 1 Simultaneously, B unilaterally promises to sell a stock x to A at a future date t for a price p 2 The two promises together do not amount to a bilateral promise because they refer to two different settlement prices Islamic Finance 6

7 Promises (4) n Case 4: A unilaterally promises to buy a stock x from B at a future date t for a price p Simultaneously, B unilaterally promises to sell a stock y to A at a future date t for a price p The two promises together do not amount to a bilateral promise because they refer to two different objects of sale Promises (5) Promisor Promisee Object Execution date Price Comments A B X T P B A X T P Bilateral promise A B X T P 1 B A X T P 2 Two unilateral promises A B X T 1 P B A X T 2 P Two unilateral promises A B X T P B A Y T P Two unilateral promises Islamic Finance 7

8 Currency Forwards At T 0 : Bank promises to buy RM10m for a price of $0.30 per RM at T 30 Bank Party A At T 0 : Party A promises to sell RM9m for a price of RM3 per dollar at T 30 Options Party A At T 0 : A promises to sell a stock S for a price of $0.30 at T 30 Party B Islamic Finance 8

9 Options Market price = $0.55 $0.30 At T 0 : A promises to sell a stock S for a price of $0.30 at T 30 T 30 Options $0.30 At T 0 : A promises to sell a stock S for a price of $0.30 at T 30 Market price = $0.10 T 30 Islamic Finance 9

10 Islamic options (1) n A Structure A C undertakes to buy Wa d 1 C B Islamic options (2) n Suppose the agreed future price (P f ) is equal to P mur n If P f > P mar A will make C to honour its promise to buy the asset for a price of P f C will hold B to its promise to buy the asset for a price of P f n If P f < P mar A will not be interested in the promise given by C, as it will make no economic sense for A to sell the asset at a price lower than its purchase price Islamic Finance 10

11 Islamic options (3) n Payoffs When P f > P mar When P f < P mar A: P f P mar > 0 B: P mar - P C: 0 A: P mar P mur < 0 B: P mur P > 0 C: 0 Islamic options (4) n Given the payoffs of A, the structure gives downward protection to the buyer of the asset (A) n A also benefits from any upward changes in the stock price P f Islamic Finance 11

Tahawwut Master Agreement: Pertinent Issues and Legal Practices in Malaysia

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