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11.4.09

Shariah Compliant Short-Selling: Mechanism 3

Short-Selling Through Salaam/Salaf

The Malaysian SC recently proposed mechanisms for short-selling through Salaam, something that has been proposed as well as the short-selling mechanism on the Newedge Platform (with presumably exactly the same mechanism), but only gaining currency within Saudi Arabia.

AAIOFI gives details to the Salaam contract in its 10th standard on Salaam sales, but states in Standard 21 Financial Paper (Shares & Bonds) that although the salaam sale may work for fungible commodities, they specifically restrict the use of the salaam sale for short-sales of shares. This judgement put a damper on the use of salaam sales for shorting, but the SC goes into some detail on the exact rationale for the use of the Salaam.

Much of it boils down to issues of fungibility and availability. The SC's justification is in three parts,
  1. when shares are not considered too specific an item ('ayn mu'ayyan), i.e., they can be specified as fungible
  2. salaam permitted provided object's category, type, and the date of delivery are described (i.e., the contract must specify terms to be fulfilled so the contact can be filled without dispute)
  3. delivery can be ascertained (i.e., there is a market for them)
All of these must be fulfilled for the case of commodity salaam, but for shares in particular there has been dispute about whether they are mal mithly (fungible items) or mal qimy (specified items).

Jurists usually specify that salaam is approved when the subject matter is mitly or homogeneous, i.e., objects that can be precisely determined in terms of quality and quantity (see e.g., Bus Fin Review, see Saiful Azhar Rosly and Hamdan Hj Ismail, Salaam as Mode of Agricultural Finance in Malaysia: An Analysis of Risk-Taking Behavior of Contracting Parties for a succinct summary of terms of salaam contracts or Md Ayub, p 244). Correspondingly, most jurists specify that salaam is disapproved for mal qimy. The problem with mal qimy and mal mithly is that objects can only be one or the other, they cannot be mithly some of the time and qimy the rest.

Surprisingly there are some jurists who see shares as mal qimy. I personally see this as wrong-headed. It is not unlike saying that dollar bills are specific since they have different serial numbers. Of course there can be specific categories/classes of shares and shares may not be fungible across classes. Nonetheless, if the salaam contract specifies 100 Class B Shares of XXX Company to be delivered 3M from now, then I would claim it is legitimate as long as the market for these shares is functioning.

They cite the example of a salaam on livestock (which I believe is considered to be mal qimy, i.e., usually nonfungible). Hanafis prohibit salaam sales of animals based on a relatively weak hadith. Malikis, Shafiis and Hanbalis allow it based on qiyas (analogy) of the Prophet (saws) allowed borrowing of a camel. These three schools allow salaam sale of animals conditioned on the specification of its genus, age, gender, color and approximate size (see for example Zuhayli, vol 1, p 251).

[Deleted in Original Posting] In other words, the SC rule that the illah or effective cause of prohibition of bay' as-salaam on certain articles is not whtether they are mal mithly or mal qimy but rather whether the article can be described in enough generality but with correct specification (or 'ayn ghair mu'ayyan) so that there is no dispute when it comes to delivery. The SC thus claim that mal mithly or mal qimy are both possible objects of sale in a salaam sale. This is a clear extension of the standard view of salaam, but it incorporates salaam on mal mithly and salaam on animals (legimated according to Hanafi, Maliki, and Shafi'i as mentioned above) under one umbrella. This qiyas (analogical ruling) gives greater possibilities when it comes to possible deliverables.

Some space is devoted to market failure. The interesting note is that short-sale through salaam will be different to a conventional (naked or otherwise) short-sale because in the former, a 'squeeze' or lack of availability means that the salaams are unwound according to prespecified conditions, i.e., there is not a possibility of a fail, while in conventional shorts, fails are a common market occurence, and squeezes can lead to extreme distortions. This is definitely an area where Islamic Finance can better its Western counterpart.

Comments, Criticisms and Corrections welcome. Please post here and not just on LinkedIn Forum.

(and, blog readers do take a look at LinkedIn group Global Islamic Funds & Sukuk for generally interesting and intelligent debate on this and many more topics)
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1 comment:

  1. ASIDE for instance for an extreme case of forcing fungibility:

    FN and FH MBS paper is not all similar. Each bond will be backed by different mortgages, some with different geographical distributions. But, the standard MBS TBA or 'to-be-announced' market makes fungibility a mandate by making each tradeable TBA quite broad, e.g., 6.5% FN 30Y TBA, which can include any FN MBS bond which has a 30Y original maturity and 6.5% coupon. If there is some specific value to a given bond in that general category, the seller of the TBA may not want to deliver it, but deliver a "cheaper" bond instead. The fact that the rules for fungibility are all spelled out in meticulous detail means that there are rarely if ever disputes in this market. By introducing such a contract, there is liquidity in the market. Note that because each individual mortgage bond acts differently, there is no "market" for individual bonds. But the TBA market is one of the most liquid in the world.

    MBS are all mal qimiy, but the TBA market specifies them as 'ayn ghair mu'ayyan.

    Of course TBAs and FN/FH MBS are not even close to being shariah-compliant. Nonetheless we can see the benefits of this ruling: fungibility increases liquidity tremendously.

    If we are struggling to have liquidity in markets for sukuk, perhaps having a Salaam on (generic sovereign sukuk with certain specificities, e.g., shorter than 5Y maturity, sukuk al ijara, sovereign rating >AA, etc). A traded salaam on this sukuk will possibly be much more liquid than the underlying sukuk themselves.

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