IIFM Documentation and Product Standards An Overview Annual IIFM Seminar at Pre-Conference Day of World Islamic Banking Conference (WIBC) Monday, 4 th December 2017, ART Rotana Hotel, Amwaj Islands, Kingdom of Bahrain Ijlal Ahmed Alvi Chief Executive, IIFM About IIFM History IIFM was formed under Royal Decree No. (23) Dated 2002 and is hosted by the Central Bank of Bahrain as a non-profit standard-setting organization. IIFM was founded due to the collective efforts of Central Bank of Bahrain, Islamic Development Bank, Autoriti Monetari Brunei Darussalam, Bank Indonesia, Bank Negara Malaysia (delegated to Labuan Financial Services Authority) and the Central Bank of Sudan. IIFM Vision Active and well regulated trading and capital flows across the full spectrum of Shari ah compliant financial instruments internationally. IIFM Mission To achieve the Vision by catalyzing both national and international trading infrastructure, product innovation and information flow within strong, transparent and well regulated standards and guidelines. Promote acceptance and integration with mainstream markets. Mandate To develop standardized Islamic financial documentation and product templates. 1 1
About IIFM IIFM Value Proposition Focuses on providing well defined services to the Islamic Financial Services Industry (IFSI) as follows: Publish Practical and Ready to Use Standardized Islamic Financial Contracts and Product Templates Market Practice, Legal, Shari ah and Law Reforms Bring All Stakeholders particularly Financial Institutions on a Common Global Platform through: Consultative Process and Project Specific Working Groups Creating Industry Awareness and Technical Knowledge Sharing Seminars, Specialized Workshops and Consultative Meetings Research Report & Papers Sukuk Reports, Research and Consultative Papers 2 IIFM Published Standards To date, IIFM has published 10 Documentation and Product Standards: Seven ISDA-IIFM Islamic Hedging Standards Tahawwut Master Agreement Islamic PRS (2 Standards), Cross Currency Swap and FX Forward (2 Standards) Islamic Credit Support Deed (Variation Margin) Three IIFM Liquidity Management Standards Unrestricted Investment Master Wakalah Agreement Master Collateralized Murabahah Agreement (Islamic Alternate to Repo) Master Agreements for Treasury Placement (Murabahah and Agency Agreements) Guidance Memorandum and Notes as Part of Standards Market Practice, Operational Process, Legal and Shari ah 3 2
IIFM Other Services Research Papers IIFM Reference Paper on I aadat Al Shira a (Repo Alternatives) IIFM Concept Papers on Islamic Hedging Product Templates IIFM Concept Paper on Unrestricted Wakalah IIFM Concept Papers on Sukuk Default & Restructuring and Standardization Assessment Numerous presentations on Islamic Liquidity Management, Hedging in Islamic Finance, Sukuk and other topics Annual Sukuk Reports Regular publication since 2010 and 6 th Edition published in June 2017 Specialized Seminars, Technical Workshops and Consultative Meetings Generally 4 events each year 2017: Kuala Lumpur, London, Surabaya and Bahrain 2018 (in planning): Kuwait, Karachi, Istanbul and Bahrain (possibility of 2 more) 4 Increasing IIFM Standards and Its Value Addition Current Priority Areas of Work Master Risk Participation Agreements (funded and unfunded) for Islamic trade finance related business is in market consultation phase Sukuk Standard Documentation and Guidelines (project to commence in Q1 2018) Gold related products and documentation standardization Consultative meeting under planning for Q1 2018 Islamic FX and Commodity Hedging/Investment Standards Consultative meeting under planning for Q2 2018 Islamic Syndicated Financing Documentation standardization Consultative meeting under planning for Q3 2018 5 3
Development and Publication of IIFM Standards IIFM standards are comprehensive and provides complete solution so that the Islamic financial market participants particularly financial institutions can easily implement standards: Comprehensive Development Process I. Concept Paper and Consultative Meeting (global participants) II. Board of Directors Approval: Budget and appointment of External Legal Counsel III. Global Working Group - Comments and Feedback IV. Coordination with External Legal Counsel and Drafting V. Shari ah Board Guidance and Approval 6 Benefits of IIFM Standards Benefits to the Market Participants & Islamic Industry Cost saving Major cost benefit to users relating to Legal and Shari ah expenses Availability of fully implementable Documentation and Templates along with Shari ah Pronouncement, Legal Opinions etc., Time Efficiency Balance and Transparency Shari ah Harmonization Legal Certainty Industry Reference All standards and other services are provided free of cost to all stakeholders! 7 4
Standard-Setting Organizations Requirements Requirements of non-profit Standard-Setting Organizations Funding Can Standard-Setting Body issue standards by limited membership fee? Availability of Grant (only The Waqf Fund (Bahrain) and Islamic Development Bank has provided project specific) Availability of Waqf Fund (None for IIFM) Non-Profit hence No Capital or Equity Human Resources Regulatory Support Financial Institutions Support, Involvement and Commitment 8 Implementation of Standards 5
IIFM Standards Implementation Standards Implementation and Market Use Adaptation of Standards is voluntary and generally there is no mandatory requirement imposed by regulators There is always time lag between standard publication and adoption by the institutions Institutions internal review and approval process (operational, legal, credit and Shari ah) Institutions may decide to move to standard at the time of counter-party credit lines renewal Institutions may continue to use its own documentation and products unless counterparty wants them to use global standards Regulators recommend institutions under its jurisdiction to use the global standards as best practice 9 IIFM Standards Implementation ISDA/IIFM Tahawwut (Hedging) Master Agreement ISDA/IIFM Islamic Profit Rate Swap - Single Sale 15% 10% 8% 77% Standard used as a basis or reference document 40% 50% Standard used as a basis or reference document 10 6
IIFM Standards Implementation ISDA/IIFM Islamic Profit Rate Swap - Two Sale ISDA/IIFM Islamic Cross-Currency Swap 13% 11% 33% 37% 50% Standard used as a basis or reference document 56% Standard used as a basis or reference document 11 IIFM Standards Implementation ISDA/IIFM Islamic Foreign Exchange Forward Single Binding Wa ad based Standard ISDA/IIFM Islamic Foreign Exchange Forward Two Unilateral and Independent Wa ad based Standard 25% 50% 29% 43% 25% Standard used as a basis or reference document Standard used as a basis or reference document 28% 12 7
IIFM Standards Implementation ISDA/IIFM 2017 Credit Support Deed for Cash Collateral (Variation Margin) IIFM Master Agreements for Treasury Placement (MATP) 8% 30% 20% 50% Standard used as a basis or reference document 54% 38% Standard used as a basis or reference document 13 IIFM Standards Implementation IIFM Inter-Bank Unrestricted Master Investment Wakalah Agreement (UMWA) IIFM Master Collateralized Murabahah Agreement (MCMA) 27% 27% 46% Standard used as a basis or reference document 38% 37% 25% Standard used as a basis or reference document 14 8
Key Technical Aspects of IIFM Standards Tahawwut (Hedging) Master Agreement Tahawwut Master Agreement (TMA) Key Technical Aspects TMA is a Master Agreement and establishes terms and conditions between counterparties TMA is not a transaction document Shari ah Complaint close-out mechanism incase of early termination All transactions to be included - Murabahah and Designated Future Transactions (DFT s) Defaulting Party in the money transaction inclusion Use of Murabahah In TMA the treatment of Murabahah is defined No discounting and claim for full amount Fully delivered terminated transactions treatment (Murabahah) Non-fully delivered terminated transactions treatment (Designated Future Transactions) Use of Wa ad Both parties exchange two independent Wa ad based on different conditions at the time of entering into the transactions e.g. Profit Rate Swap In case of two Wa ad, the Wa ad are unilateral and only one Wa ad is exercisable based on meeting certain condition 15 9
Islamic Profit Rate Swap In its efforts to accelerate the use of the Tahawwut Master Agreement, IIFM in association with ISDA published the first standard product template, the Islamic Profit Rate Swap (IPRS), or Mubadalatul Arbaah. The IPRS provides the industry access to robust and well developed product documentation under the master agreement. It provides protection to the Islamic financial institution s balance-sheet from wide swings in fixed and floating profit rates and enables them to manage their cash-flow risk for various Islamic capital market instruments such as Sukuk. When dealing with the IPRS mechanism, two important points should be noted: Murabahah is used in this transaction to generate a fixed and floating payments (this includes: cost price and fixed or floating profits). It is structured on a Wa ad basis where each of the contracting parties undertake the swapping of fixed and floating profit payments at a particular time and date in the future. Normally a series of reverse Murabahah is used in this transaction to generate profit payments. IIFM Documentation and Product Standards, IIFM Pre-Conference Day Seminar at WIBC 2017, 4 th December, Bahrain 16 Islamic Cross Currency Swap Product Purpose An Islamic Cross Currency Swap (ICRCS) enables parties to hedge currency risk and the profit rate risk associated with a given currency. For example, where a party has an investment in one jurisdiction in relation to which it has obtained funding denominated in the currency of that jurisdiction (for example where the party has issued Sukuk in the relevant currency and it will have to make regular payments in that currency with respect to the Sukuk), but the party accounts in the currency of its home jurisdiction, the ICRCS provides it with the potential to hedge its foreign currency requirements into the currency of its home jurisdiction. IIFM Documentation and Product Standards, IIFM Pre-Conference Day Seminar at WIBC 2017, 4 th December, Bahrain 17 10
Islamic Foreign Exchange Forward Islamic FX Definition Islamic Foreign Exchange (IFX) is a contract that is designed as a hedging mechanism to minimize market participants exposure to market currency exchange rates which is volatile and fluctuating. IFX Forward Structures There are two structures which are commonly used in the market for Shari ah compliant IFX hedging arrangements namely: Single binding Wa ad based structure Two unilateral Wa ad based structure It is worth noting that the single binding Wa ad and the two unilateral Wa ad based structures are the most preferred in terms of consensus amongst Shari ah scholars as well as market participants. Forward IFX essentially involves two dissimilar currencies. According to Islamic Law the exchange of two dissimilar currencies / counter values must be spot or simultaneous (i.e. hand to hand) as it is considered to be interest based items (i.e. Ribawi). In the IFX Forward transaction as it is being practice in the current IFX market, the rate of exchange will be locked in the day of the contract (i.e. today) but the delivery of the two dissimilar currencies will be deferred to a future date. It is important to point out here, in this regard, that Shari ah does not prohibit a promise to buy and sell currencies on one date with delivery to be made on another date because the proper contract only concludes on the day of delivery. IIFM Documentation and Product Standards, IIFM Pre-Conference Day Seminar at WIBC 2017, 4 th December, Bahrain 18 Islamic Foreign Exchange Forward Under the single binding Wa ad structure a binding promise will be applied whereby the party who promised to buy or sell, as the case may be, is obliged to fulfil that promise. For clarification, according to Shari ah, a binding promise from only one party is not deemed as a contract. Thus, this can make the process of the Islamic FX contracts as they are currently being applied in market acceptable from Shari ah perspective. Under the two unilateral Wa ad structure, each party to the agreement unilaterally will give an independent promise (undertaking) to exchange currencies against another currency, as the case may be, on a future date at a specified amount. Each promise will contain a different set of conditions such that only one of the promises can be exercised on the settlement date with no further obligations arising under the other promise. IIFM Documentation and Product Standards, IIFM Pre-Conference Day Seminar at WIBC 2017, 4 th December, Bahrain 19 11
Shari ah Approval and Guidelines While IIFM's Shari'ah Board has approved the Hedging Product templates after extensive consideration, it is always the responsibility of each of the parties entering to the ICRCS, IPRS or IFX Forward to ensure that, to the extent that Shari'ah compliance is relevant to its dealings and corporate governance, its use of the documents in the context of the transactions which it enters into satisfies its own Shari'ah advisers that the relevant hedging transaction is Shari'ah compliant and that the documents are suitable for, and are being used appropriately in, the context of that particular hedging transaction. In order to assist market participants with regard to the DFT Terms confirmation provided to market participants by ISDA and IIFM, the IIFM Shari ah Board have provide the following guidelines regarding Shari ah compliance: Transactions should be entered into only for the purpose of hedging actual risks of the relevant party. Transactions should not be entered into for purposes of speculation, i.e. actual settlements of assets and payments must take place. No cash settlements without concluding actual transaction on deliverable assets. The asset must be Islamically lawful (i.e. Halal). No interest (whether called interest or an alternative name but which represents interest) is to be chargeable under a transaction. IIFM Documentation and Product Standards, IIFM Pre-Conference Day Seminar at WIBC 2017, 4 th December, Bahrain 20 Key Technical Aspects of IIFM Standards Inter-Bank Unrestricted Master Investment Wakalah Agreement (UMWA) IIFM Documentation and Product Standards, IIFM Pre-Conference Day Seminar at WIBC 2017, 4 th December, Bahrain 12
What is the purpose of entering into an Unrestricted Inter-Bank Wakalah Agreement? In order to diversify the range of liquidity management solutions available to the IFI s, the last few years have witnessed the active use by IFI s of Wakalah arrangements/transactions particularly Unrestricted Wakalah as an alternative liquidity management tool. The launch of IIFM Un-restricted Wakalah Standard as an liquidity management tool has resulted into wider use of this liquidity management tool by a number of banks in various jurisdictions as well as use by certain regulators as a basis of creating an investment tool for Islamic institutions 21 What are the Key Features of the Master Agreement? Clause 8 (Early Termination) This clause deals amongst other things with the right of the Muwakkil to terminate a Wakalah Investment Transaction, the Wakil s acceptance of an Early Termination Request and the ability of the Wakil to notify the Muwakkil of a Revised Anticipated Profit Rate (See Clause 8.3). Clause 9 (Late Payment Amount) This clause obliges a Party to pay a Late Payment Amount where it fails to pay a sum on a Due Date. Clause 9.2 (Calculation of Late Payment Amount) deals with how the Late Payment Amount is calculated and Clause 9.3 (Payment of Late Payment Amount) covers how such amount shall be applied. 22 13
Operational Guidance Memorandum Risk Management Does the agreement require minimum risk assessment procedures and due diligence to be carried out by the contracting parties and what are the contracting parties responsibilities? Muwakkil retains the risk of loss of principal and there is no loss indemnification by the Wakil; (clause 2.4) Muwakkil s minimum due diligence (clause 2.1 (e)) Wakil is expected to communicate with the Muwakkil in a transparent manner both before and after the execution of the Wakalah Investment Transaction until maturity. (clauses 2.3 (a), (b) and (d)) 23 Shifting the Burden of Proof of the Loss to Wakil In case of default, who has the burden to prove the loss in the transaction? Given the unrestricted nature of the arrangement, the Muwakkil would not have access to the required information, facts or circumstances to assess the validity of a loss event. Based on this situation which do exist at the present time, many of the contemporary Shari ah Scholars are of the view that the burden of proving a loss to the satisfaction of the Muwakkil should be transferred to the Wakil instead of Muwakkil. This trend is reflected in the Third Fiqh Conference for Islamic Financial Institutions held in 1430 / 2009, in the State of Kuwait. The participants in this conference have offered an alternatives solution to ensure the liability of the Wakil or Mudarib etc. in the case of claiming of loss etc. The main objective is to minimize the risks of claiming loss etc. by a Wakil in the Wakalah Investment Transaction, and they have reached to the following conclusions: 24 14
Shifting the Burden of Proof of the Loss to Wakil 1. Transferring the burden of proof to trustees (Wakil) will indeed help to protect investors funds and provide confidence and certainty. 2. The transfer of burden of proof mentioned is quite different from asking the Wakil to guarantee the principal or the outcome of the transaction as this is considered to be against the Shari ah principles 3. Demand/request the Wakil to bear the burden of proof in the case of claiming loss etc. is desirable because his claim of loss is against the main purpose of the transaction. 25 Commingle or General Treasury Pool Illustration 26 15
Segregated Pool Illustration 27 Technical Analysis The factors that may influence the on-balance sheet or off-balance sheet are given below: Investors making strategic policy as well as day to day decisions with regard to investing of funds Separate pool of assets (including ring fencing) and destination of funds for investment known to investors IFI has limited authority or little discretion in respect of the use of and deployment of the funds Off Balance sheet On Balance sheet Investor relies on the ability of the IFI for generating a profit and is normally unaware of the precise destination of the funds Commingles the pool funds belonging to investors with its own funds with little legal or constructive separation of the cash and the assets Funds received through structured investment vehicles, would need to consider if the investment vehicle is subject to consolidation rules Judgment plays an important role in agreeing and determining the approach when there is substantial doubt. 28 16
Key Technical Aspects of IIFM Standards Master Collateralized Murabahah Agreement (MCMA) Benefits of Collateralisation Alternative to Clean Lending Credit Risk Management Collateralized financing offers a structure that requires some extra operational task but does provide credit enhancement as well as providing an effective liquidity management tool for use with the Collateral Management Agent. as long as the extra collateral is managed, Counterparty exposure is reduced to the margin threshold plus Sukuk execution risk, rather than a full clean exposure. It can allow for positive capital treatment. Liquidity Management Having the comfort of collateral allows the institutions to finance for a longer duration and or larger quantum as the credit risk is reduced. Central Bank Market Intervention CB can include Islamic Banks as part of its market liquidity actions ( Add or Remove Cash from the system. Also, Islamic Financial Institutions can use this liquidity instrument to raise funds from the CB Development for Sukuk Allowing Financial institutions to maintain less cash and allocate more in income generating Sukuk. Giving rise to greater take up of Sukuk by Islamic investors 29 17
IIFM Standard MCM Agreement Objective of the MCM Agreement Entering into Murabahah Transactions Margin Maintenance Collateral Substitution Master agreement or framework agreement which sets out the terms upon which the parties can subsequently enter into Collateralized Murabahah Transaction that allows a Buyer an opportunity to raise liquidity by creating security of Shari ah compliant assets Schedule set out in the MCMA enables individual Murabahah transaction to be entered between the Buyer and Seller from time to time and initial Collateral is delivered to the Seller through the grant of security Margin Maintenance mechanism is outlined whereby the initial collateral is mark to market to maintain an agreed level of exposure. Any Shortfall or excess can be returned subject to an agreed threshold value Posted Collateral are pledged in a segregated and identifiable account. However, the initial as well as subsequent collateral can be called backed and replaced with any security acceptable to the Seller Shari ah Approval The IIFM MCMA is approved by well respected Scholars represented on IIFM Shari ah Advisory Board 30 IIFM MCM Agreement Operational Guidance Notes Is it permissible to use Bonds as Collateral Can the Seller make use the Posted Collateral What happens to the Profit received from Pledged Sukuk Does the MCMA allow FI to do two way financing Governing Law MCMA is a Shari ah Complaint Liquidity Management Agreement and envisaged to use SUKUK or other Shari ah compliant securities as collateral. Bonds and Non Shari ah compliant securities are impermissible The collateral are delivered to the seller by granting of security of the assets and they are to be held in a segregated account. The Seller cannot make use of the Posted Collateral. The Collateral may be disposed off in an event of default The Pledge Sukuk does not involve transfer of ownership. Any profits received in the segregated or identifiable account is for the benefit of the Collateral provider and needs to be returned back to the pledgor The MCMA is intended to be applied between parties in capacities in which they entered into on execution of the agreement. Separate MCMA has to be executed to allow parties roles to be Reversed Governing Law is at the option of the Parties. The MCMA has been based on the assumption that the governing law will be English Law. Each Party represents that it has satisfied itself as to Shari ah compliance of Collateralized Murabahah Transaction entered under MCMA 31 18
Shukran Wassalamu Alaikum International Islamic Financial Market (IIFM) Office 72, 7 th Floor, Zamil Tower, P.O. Box: 11454, Manama, Kingdom of Bahrain Tel: +973 17500161, Fax: +973 17500171, Email: info@iifm.net Website: www.iifm.net Disclaimer: The information herein has been obtained from sources believed to be reliable but cannot be guaranteed. The views or opinions expressed are subjected to change at any time. Neither the information nor any opinion expressed can be construed as a solicitation for the purchase or sale of any securities. International Islamic Financial Market disclaims liability in this respect. 19