Islamic Finance: Hedging Instruments and Structured Products. Dr Ken Baldwin Islamic Development Bank 27 th January 2014

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1 Islamic Finance: Hedging Instruments and Structured Products Dr Ken Baldwin Islamic Development Bank 27 th January 2014

2 Religious Context Islamic financial institutions offer products consistent with Islamic teachings and Shariah, governed by two primary sources: Holy Qur an, and Sunnah of the Prophet Mohammad (SAW): Translates as method and comprises all that the Prophet said, did, or agreed to as established in Hadith, which were collected and compiled by (amongst others) the muslim scholar Ismail ibn al-bukhari about 200 years after Mohammed (SAW) died In addition to Qur an and Sunnah, a third supplementary source exists known as Ijitihad (which means to exert oneself) to cover situations not explicitly dealt with in Qur an and Sunnah. In practice, Ijitihad reflects the consensus of Islamic scholars who apply analogy (analytical reasoning, i.e. Qiyas) to derive consensus (Ijma) rulings and interpretations. There are four Sunni schools of thought in Islamic jurisprudence (fiqh) which represent different methodologies for interpreting Shariah law. 2

3 Derivatives in Islamic Financial Systems Using derivatives in Islamic financial systems is beset by legal uncertainty from the heterogeneous assessment of Shariah compliance, which affects the legal restitution of the interests of parties to derivative transactions. For example: legal opinions of Islamic courts may deviate from previous decisions made by other Shariah scholars. there is no consistent ruling of Islamic courts on the religious compliance of securitisation transactions i.e. structures and eligible assets As a result, products may not be approved in one jurisdiction, e.g. the GCC, whereas they are approved in other jurisdictions, such as Malaysia, due to divergent interpretations Islamic derivative products are similar to those found in conventional finance or are adapted for Islamic needs 3

4 Derivatives in Conventional Financial Systems Best known products are: Forwards An agreement to buy/sell a specified quantity of goods in the future at a price agreed today No premium to enter a forward contract Type of goods are potentially unlimited. Includes currencies, commodities, equities etc. Futures Same as forward except exchange traded and margined Options Confers the right, but not the obligation, to buy/sell a specified quantity of goods in the future at a price agreed today Option buyer has to pay a premium Swaps A strip of forwards Types include currency swaps, interest rate swaps, credit default swaps, equity swaps etc. Even for hedging (versus speculative) applications, these products are not permissible in Islamic finance 4

5 Impermissibility of Conventional Derivatives The main reasons for impermissibility in Shariah are: Zero-sum games Can result in wealth accumulation by one party at the expense of another (unjust and inequitable) Deferral of both the goods and the purchase consideration Considered exchange of one debt for another debt (Bai-al-dayn-be-al-dayn) which is not permissible in almost all Islamic schools of jurisprudence (problem of double coincidence) Every transaction in Islamic finance should be based on a real asset transfer. Money cannot be traded for money (as this is usurious) and ownership cannot be separated from risk (i.e. risk cannot be commoditized). For example, a promise to sell an asset at a specified price within a specified period is permissible, but of itself cannot be bought/sold. Therefore the promisor cannot charge a fee for making such a promise. Sale of a non-existent asset or an asset not in the possession of the seller Impermissibility due to existence depends on whether the asset is specific or generic If generic, the issue is whether one can be reasonably sure of bringing the asset into existence Explicit link to short-selling in conventional finance, which is strictly prohibited in Islam Insufficient asset-linkage and potential for unilateral gains in many derivatives supplant equitable risk sharing and contractual certainty (i.e. definite performance) (Jobst 2012) An objective of Islamic hedging instruments is to achieve a desirable risk transfer which allows for mutual gain, i.e. non-zero sum games (Al- Suwailem 2006) 5

6 Islamic Derivatives Islamic derivatives can be classified as follows (Jobst 2012): Contractual forms which are customary in Islamic finance that have Implicit derivative-like features e.g. Ijara and diminishing musharaka Explicit derivative-like features e.g. Bai Salam, Bai Al-Urboun, Bai Al Khiyar, Bai bil-wafa Contractual forms which have been engineered to replicate the profiles of conventional derivatives, e.g. Islamic wrappers, foreign exchange option contracts, wa-ad based swaps Some of these products are highly controversial i.e. there is no consensus amongst Islamic scholars as to their permissibility Standardization remains challenging in light of differing schools of thought i.e. interpretation of the Qur an and Hadith Practitioners also differ as to whether standardization is a good thing in that it may entail a particular interpretation of Qur an and /or Hadith potentially to the exclusion of other interpretations Recent progress has been made via a collaboration between ISDA (International Swaps and Derivatives Association) and IIFM (International Islamic Financial Market) to develop a Tahawuut (Hedging) Master Agreement which standardizes shariah-compliant swap-based hedging instruments 6

7 Implicit Islamic Derivatives Ijara thumma al-bay murabaha Similar to a conventional sale and lease back in which the financier receives a stream of payments from the financee in return for the usufruct of an asset The financee has the right to purchase the asset at the end of the lease period (akin to a call option) The financier also has a right to sell the asset through the life of the lease period (akin to a put option) since he is a creditor-inpossession during that time Diminishing equity-musharaka Equity participation of partners who co-finance a venture One partner may have an option to buy the equity stake of the other partner over a period of time, thereby increasing his participation and proportional ownership The above derivatives are implicit because the contracts which give rise to them have as their main objective a purpose other than to create derivatives In the case of Ijara thumma al-bay murabaha the purpose is a sale and leaseback of an asset which provides an opportunity for the owner of an asset to continue to use it but to also raise funds from its sale In the case of diminishing musharaka the objective is to participate in a profit seeking venture. That one party may purchase the equity ownership interests of another partner is ancillary to the main purpose of the partnership 7

8 Explicit Islamic Derivatives These are contractual forms in Islamic finance which are well-known and have been used throughout Islamic history (and some even before that) They include Bai Salam: spot payment for deferred delivery Bai Al-Urboun: forfeitable down-payment against deferred delivery and deferred balance of payment Bai Al-Khiyar: option to rescind Bai Bil-Wafa: agreement to re-sell an asset back to the original seller Wa ad: unilateral promise By virtue directly of the their contract structures, each resemble different types of conventional derivatives, and are therefore considered explicit forms of Islamic derivatives Practitioners have applied these contract forms in an attempt to create something similar to the financial profile of conventional derivative instruments bearing resemblance The key point here is that unlike contracts with implicit (or embedded) derivatives, the objective of these contract forms is specifically to provide these types of rights or obligations to counterparties, i.e. derivative-like features are embodied within the main objectives of the contract 8

9 Explicit Islamic Derivatives: Bai Salam Seller agrees to deliver an agreed quantity of an asset of certain quality to the buyer at a predetermined future date Has been in use for many centuries and was in existence before Prophet Mohammed (SAW) Sale of an underlying asset for future delivery but payment today Compare this to futures/forward which defer payment Asset is usually agricultural but principle applies equally to other assets, and was used to provide farmers with working capital Since all cash is received upfront, the selling price is usually lower than for a spot sale If the asset is shares and a dividend is declared, then it belongs to the buyer even if delivery has not yet occurred 9

10 Explicit Islamic Derivatives : Bai Salam contd. One concern of Bai salam is volatility in the price of the underlying at maturity. For example, if I buy 100 shares under bai salam at $1 per share for delivery 6 months later, and by then the price is $0.95, I lose out As an alternative to address price fluctuations, another product (permissible in the Hanbali school of thought) is value-based salam the buyer pays in advance for an agreed value of shares for delivery in the future, as opposed to an agreed number of shares. the number of shares delivered will then depend on the value for delivery and the share price at maturity a value-based bai salam contract has nil intrinsic value to either counterparty at maturity since the underlying asset is bought and sold at the prevailing market price 10

11 Explicit Islamic Derivatives : Bai Al Urboun Buyer pays down-payment in partial consideration of the purchase price of an asset which is agreed in advance The balance payment and asset delivery are both deferred If the buyer does not want to exercise the contract for any reason, he can forego the down-payment For example, a buyer pays $10,000 of a purchase price of $1,000,000 to buy an asset a month from now. If he exercises his option a month later, he pays $990,000 to take delivery of the asset. If he decides to cancel, he foregoes $10,000 Not all Shariah scholars agree that Bai Al Urboun is permissible 11

12 Explicit Islamic Derivatives : Al-Khiyar (option) Options in mainstream finance confer rights without obligations However, in Islamic law, such options are essentially of an ethical nature. Al-Khiyar (al-shart), which is the most acceptable of the Khiyar option contracts, provides a right to confirm or cancel a contract within a stipulated time. Some Al-Khiyar are created by mutual consent from both parties to a contract, whereas others are in the nature of rights that exist for either one or the other of the parties. Al-Khiyar ensures that parties to a contract are reasonably informed about the values being exchanged and its implications. It reduces uncertainty (Gharar) by providing a reassessment period over which a party may cancel the contract of sale. 12

13 Explicit Islamic Derivatives : Al-Khiyar contd. As an example, Al-Khiyar is used when Islamic banks act as intermediaries to purchase goods from suppliers and resell to its clients. Prior to purchasing such goods, the Islamic bank receives a promise from its client that they will purchase the goods. However, there is a risk to the Islamic bank that after it has purchased the goods, the client will decide not to buy them. The Islamic bank therefore includes a stipulation allowing it to rescind its purchase from the supplier This stipulation transfers the risk to the supplier, and as countervalue, the price of purchase from the supplier is increased to compensate the supplier for this. 13

14 Explicit Islamic Derivatives : Bai Bil-Wafa This is a contract where the buyer of an asset agrees to resell it to the seller at a future date. During that time the buyer cannot sell the asset to anyone else. The repurchase price must be the same as the initial selling price, otherwise the contract is usurious. This contract is most like a conventional repo, except that for a conventional repo, the repurchase price is different to the initial selling price. The Bai Bil-Wafa combines the features of a sale (Bai) with a pledge (Rihn). 14

15 Explicit Islamic Derivatives : Wa ad This is a unilateral promise that contains option characteristics. It is not a contract, as contracts are obligations and require (offer, acceptance, and) consideration (in English law) According to the Fiqh Academy (Kuwait, 1988) and in the context of a murabaha sale, its represents a morally binding and legally enforceable contract if the promisee has incurred liabilities as a result of relying on the promise. Extension of enforceability beyond murabaha is debatable. The central point of contention amongst scholars is that wa ad is binding morally but not binding legally as fulfilment is not mandatory 15

16 Explicit Islamic Derivatives: Wa ad contd. Wa ad has been used to structure a foreign exchange option Creation of an option for hedging purposes is permissible (but not its trading without accompanying purchase/sale of underlying assets) as it reduces uncertainty (gharar) and is regarded as contributing to the public good (maslaha) Example A client promises a bank to buy USD and sell GBP in specified amount for a future date The bank makes no counter promise but pays its client a premium in respect of making the promise The bank decides on the future date whether to accept the promise or send a cancellation notice to the client The overall effect is that the bank has purchased an option to sell USD against buying GBP 16

17 Engineered Islamic Derivatives These are financial products that are created with the objective of replicating the financial profile of conventional derivatives using contract forms which are customarily used in Islamic finance for trade purposes Involves adapting standard Islamic contracts or developing new hedging technologies ( wrappers, see Deutsche Bank white paper). So far, products developed are for risk management of currency and interest rate exposure, e.g. profit rate swap, currency swap Islamic wrappers, or Total Return Swaps, which purport to provide any desired financial profile in a Shariah-compliant manner are highly controversial and unlikely to be developments which move the industry in the right direction. Nevertheless, these initiatives provide an important development-compass that helps orient future research 17

18 Engineered Islamic Derivatives: Swaps Parties to the swap agree to sell assets, usually commodities, to each other for deferred payment and agree to settle their obligations to each other in instalments (murabaha) The fixed rate payer purchases commodities at one time only and pays for these in fixed instalments over the life of the contract The floating rate payer spreads his purchases over time and pays for them in a sequenced manner Importantly, the purchase price for each asset acquired by the floating rate payer is determined in the future and each asset purchase is governed by a separate contract This gives rise to a stream of cash out flows similar to the floating rate leg of a swap when the purchase price is referenced to Libor Currency swaps simply involve the purchase and sale of commodities in different currencies 18

19 Engineered Islamic Derivatives: Total Return Swap Based on a mutually exclusive dual wa ad structure, which swaps the Shariah-compliant asset portfolio with those of a designated index or reference investment portfolio Example Wa ad 1: Bank A promises to sell Shariah-compliant assets to Bank B at price linked to the performance of a reference portfolio (wa ad selling price) Wa ad 2: Under a separate wa ad, Bank B promises to buy Shariah-compliant assets at the wa ad selling price Only one of the wa ads is ever enforced at maturity If value of wa ad selling price is higher than market value of Shariahcompliant assets, wa ad 1 is enforced If value of wa ad selling price is lower than market value of Shariahcompliant assets, wa ad 2 is enforced A significant controversy arises because the reference portfolio can contain any assets, including conventional assets 19

20 Where the industry goes from here There is a need to pioneer new products to meet risk management challenges but it remains essential to ensure new products are Shariah-compliant Financial engineers need to remain true to the spirit as well as to the form of Islamic rulings concerning permissible transactions Innovation will typically continue to come from the financial industry given the driving force of profit-seeking motives Regulation will need to keep pace with innovation Intellectual property that fosters growth of the Islamic financial services industry should always be a public good 20

21 References Jobst, A. and Sole, J. (2012) Operative Principles of Islamic Derivatives Towards a Coherent Theory. IMF Working Paper WP/12/63. Al-Suwailem, S. (2006) Hedging in Islamic Finance. Occasional Paper No. 10. Islamic Development Bank. Deutsche Bank (2007) Pioneering Innovative Shari a Compliant Solutions. White Paper. 21

22 Thank You

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