Shariah Compliant Swap II: Shariah "conversion" or subversion?

Following up on our first post on DB's Shariah Compliant Swap, we continue our discussion with details of the transaction, which apparently has been used by DIB to offer principal protected investments in some GSAM hedge fund (with GSAM it is a very lucky thing that the principal was protected!) (see article here). This has resulted in some sort of backlash (please see article here).

Although DB's is just one of the many platforms being developed for the rapid issuance of new structured product, the question is whether DB's method (and perhaps some of the others) may be a step too far?

The Structure
A total return swap (the performance of a Shariah compliant asset A swapped for the performance of a non-Shariah compliant asset B) can be split into two outperformance options.

• Party A (doing the investment in asset X - a shariah-compliant SICAV/Mutual fund) writes an outperformance option, giving the outperformance of asset X compared to asset Y to Party B - the primary DB entity

• Party B writes an outperformance option giving the outperformance of asset Y compared to asset X to Party A
  

then this combination is the same economic result as a total return swap.

A wa’d (structured as a deed) seems natural in this structure. But, in order to be both compliant and binding but without a set price, cannot be bilateral or be offered for consideration. Therefore, we need a third Party.

We now name them DB I and DB II (the "pass-through" entity, related by control to DB I)--the two subtle little blue boxes in the diagram above, I with an arrow going into it, II with an arrow going out of it-- whereby

• Customer writes an outperformance option to DBI (read: gives a promise to DBI ).
  
• DBI writes an outperformance option to DBII
• DBII assigns or transfers this same option to Customer (so Inv Bank II is in effect just a "pass-through" vehicle for Customer and has no resulting position except for a credit risk on DB II).
  

Restating the above

The cash received by issuing certificates to a client will be:

• Shares selected from DJIM (primary investment structure) or shares that qualify applying the same screening as used by DJ to obtain their Islamic universe.

The Investor will also enter into the following agreements on an at arm’s length basis:

1. Wa’d 1 agreement whereby the Investor promises unilaterally to DBI to sell a basket of above mentioned Shariah shares at a predefined Settlement Price
2. Wa’d 2 agreement whereby DBII, promises unilaterally to the Investor to buy the Basket at the Settlement Price.
   
3. (Wa'd 3 agreement between DBI and DBII is their own business)

The Settlement Price is determined using familiar mechanics of asset swaps. Please see the original posting to the white paper in order to have all payoff formulas and little actual explanation.

The Economic Effect

The economic effect of the above structure is as follows:

• Scenario I: The value of the Basket goes up more than the Index:-
  

In this case, DBI can purchase the Shares from the Investors at a price lower than the market value for such Shares at that time. DBI would hold the Investor to its promise given under Wa’d I.

The Investor will not be interested in holding DBII to its promise given under Promise 2 as selling a Basket of Shares at a value which is lower than the market value at that time would incur a loss.

• Scenario II: The value of the Basket goes up less than the Index:-

In this case, DBI can purchase the Shares from the Investor at a price higher than the market value for such Shares at that time. However, as this would incur additional expense, DBI will not hold the Investor to its promise given under Promise 1.

The Investor, on the other hand, will be interested in holding DBII to its promise given under Promise 2, as it can then sell the Shares in the relevant Basket at a value higher than the then market value for such Shares at that time.

In both Scenario I and Scenario II noted above, the Investor will sell its Basket to either DBI or DBII in return for a price as determined on the basis of the performance of an Index.

Disadvantages

• need of use of third party
• synthetic long position via Investor on Shariah compliant assets that needs to be offset via shorting (by DB)
• perception of the market that a swap cannot be made Shariah compliant

Although there are such disadvantages, it is a more cost effective structure than most murabaha-based derivatives. In fact the running costs are on the order of 10-40bp per annum. It is perhaps this cost savings combined with the rather questionable nature of this structure, the ability to offer Shariah Compliant Pork Bellies (i.e., 'completing the market' in financial lingo), that lead Sh Yusuf Talal de Lorenzo to state that the fatwa backing this was more aptly called the "Doomsday Fatwa for Islamic Banking". Or paraphrasing Sh Yusuf, why would we ever go through the trouble of structuring a sukuk through true sale or figuring offset to devise call options, or actually use commodities in murabaha transactions if we could instead just do a conventional deal and Islamically-wrap it?

Stay tuned for more posts on DB's Shariah Conversion Technology.

Next post: Criticisms.

Shariah Compliant Swap II: Shariah "conversion" or subversion?