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- Funds@Work: Network Analysis Among Sharia Scholars v 4.0
- ISRA: Islamic Finance Knowledge Repository
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- Sukuk Reports: I, II, III, and IV
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Shariah Compliant Principal Protected Notes

The Structure
At the risk of being mundane, but for completeness, we thought we should describe principal protected structured product in more detail. You ask, how? How can we have benefits with no downside risk in Islamic Finance? Well, the answer is really quite trivial.

For one thing, we have talked about Shariah-Compliant Call Options (Call options thru set-off). This is just one of many possible mechanisms for a Shariah Compliant call option. Methods for generating calls include (some as yet to be discussed in this blog):
  • Set-off (as discussed, combining Salam and Murabaha with same counterparty together with contractual set-off)
  • Bay' al Arbun (downpayment with revocation sale, as allowed by Hanbalis, now with much wider acceptance)
  • Wa'd (unilateral promise, promissory note, estoppel)
And there are probably less natural ways of synthesizing calls through rolling murabahas and "Islamic Swaps" (both used more for hightly structured product).

A conventional principal protected note is merely the combination of a zero-coupon bond and some call options, with maturity and exercise set to be identical. So if we invest $100 and the zero rate for 5Y is X%, the price of the zero is 100/(1+X%)**5 and the remainder is invested into calls, typically struck at spot. Depending on the prevailing rates and underlying volatility, it may be possible to give more or less than 100% of the upside of the underlying (equities, commodities, etc).

So the last thing we need is a zero-coupon bond/money market. This can be had a number of ways including:
  • Commodity Murabaha
  • Bay al Inah (sale at spot, resale with deferment and increase)
  • Tawarruq' (basically the same as 'Inah, with a third counterparty)
An Islamic principal protected note is the combination of a Murabaha and Islamic call options, with maturity and exercise dates set to be identical.

Notes for Prospective Buyers
Once we let the cat out of the hat with a Shariah-compliant call option, and we've had a risk-free rate/money-market/zero-coupon bond for some time, combining the two was inevitable.

The payout will be the original principal + M * max(Price(T)-Strike,0), where Price(T) is the price of the equity/commodity at maturity of the note, Strike is usually set to Price(0), today's price, but can be set wherever we like (slightly harder from a Shariah perspective but should be just fine), and M is the multiplier. We can get anywhere from say around 70% to 120% multipliers (70%-120% of the upside of FTSE 100, say). The multiplier is usually the only figure that can be manipulated, so we must look to it and compare.

While this may appear wonderful to some, we should comment that, unlike more vanilla products (e.g., straight call options, or the zero-coupon bonds), pricing is not as easy to replicate and it is not absolutely trivial to know whether you are getting ripped off or not.

  • Know what you can about pricing. Try to price the call (with correct strike) and zero independently.
  • If the underlying is liquid and calls are traded on it (e.g., calls on oil, calls on gold, etc), then it is likely that only at-the-money (ATM) options are active (i.e., ATM struck at the forward price). Spot-struck options are generally less liquid, involve pricing on a skew, which you as customer are not as aware of. Expect hidden fees.
  • If the underlying is liquid but calls are not actively traded (e.g., DJIM Index), the bank will use calls on whatever similar futures that they can get ahold of. The basis or the fact that these two indices do not mimic each other exactly--they will charge extra for that. So on top of the skew, you get charged for their inability to hedge.
  • Make sure you know whether dividends are paid to you or are not? Does the index accrue w/ no dividends? It makes it cheaper for them to pay it to you, and they should pay you that much more (i.e., the multiplier on the upside should be larger).
  • Shop around. Note that even though it seems like rocket science, it isn't. Every bank and their brother does this same deal. Smart users will ask for several quotes, even of Shariah-compliant products like this (vanilla shariah-compliant). Banks are used to giving quotes for reverse-engineered products (i.e., customer describes payout, bank finds price). Banks hide fees. Redistributers are usually upfront. By the time the end-user has it, 2 points to 10 points could have been taken from the mid-price (really!). That is, you paid 10% upfront for the privilege of running this simple strategy. Smart buyers will ask for quotes from 10 banks, pick the best price and expect to pay 1%-2%.
  • Know what will affect repricing (as opposed to the payoff--the pricing before maturity--something of importance for client reports, if it was bought on a margin which doesn't sound so shariah-compliant anyway, or if you might seek to unwind the product before final maturity). Lower prices do not necessarily imply the payoff is really impaired of course:
  • Credit Spreads. Whose Zero is it anyway? The commodity was bought and sold and now you have credit exposure to a large German or a large Swiss bank. If they get downgraded, you better believe the pricing of your product (prior to maturity) will look bad.
  • If volatility drops and suddenly the world looks less risky, your valuations may suffer. You are long an option and option prices drop when vol drops. Your pricing before maturity depends very much on vol and it dynamics and the whole skew shape (interaction between the underlying price levels, strikes and vol).
  • If prices rise of course, you are long a call and should expect your valuations to rise. This may be less than you think since the rise will be proportional to the call's Delta (calculated from Black-Scholes or some other fancy option valuation model). The more ITM (in the money) your option is, i.e., the more underlyings have risen in the past, the greater your price sensitivity. The more OTM (out of the money) your option is, i.e., the more you've lost, the lesser your price sensitivity. Higher vol will lessen sensitivities in general.
  • It pays to read up on option pricing, to get an intuition for this stuff.

Structured Product, whether we take the view that it is Islamically Acceptable or not, has both some pros and some very significant cons. But, more importantly, it is pushed by investment banks primarily because the fees are juicy, the pricing opaque and the customers are not always up to snuff. Make sure you are.



Ernst & Young - World Takaful Report

Apologies for the lag in highlighting this but somehow it managed to slip through the cracks, here we include the Takaful Report compiled by Ernst & Young for both 2008 and 2009. These provide a good overview of what has got to be a crucial driver for Islamic finance - both at the retail/consumer level (i.e. Takaful policyholders and local market penetration) and at the institutional/investor level (i.e. when one considers that Takaful operators must allocate their entire portfolios/trusts into Shariah compliant instruments). Plenty of statistics to digest here, but the most intriguing statistics are the countries not yet reflected. For instance, Saudi Arabia claims top spot as the largest Takaful market in the ME region, but little mention is given to either Egypt or Turkey which have significant "dormant" industries; similarly Malaysia is the largest market in Southeast Asia but the opportunity set is vast when one considers Indonesia and India (two major Muslim countries by population) as untapped.


Lack of Profit Loss Sharing in Islamic Banking

This piece from Loughborough University provides a critical view on the profit loss sharing mechanism in Islamic finance today (actually the lack of it). Our aim is to further bring a variety of constructive criticsms to the fore, and while this paper was published in 2001 it does provide a starting point for future discussions. Effectively, we seek to explore the chasm between the theory, the principles and the inputs and what happens in practice, in the real-world, effectively what is the actual output of Islamic finance. Nonetheless, the focus is not on what is wrong but what can we do to make it right.

Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances
Humayon A. Dar and John R. Presley
Centre for International, Financial and Economics Research
Department of Economics, Loughborough University

Some excerpts: "An imbalance between management and control rights is attributed as a major cause of lack of Profit Loss Sharing (PLS) in the practice of Islamic finance. Given this dichotomy, the agency problem gets accentuated, which may put the PLS at a disadvantage vis-à-vis other modes of financing. However, there is no theoretical reason to believe that PLS is inherently inefficient. In certain circumstances, this in fact may serve some important economic function."

"Without the types of management and control discussed here, Islamic banks will persist in taking the easy and risk averse route and avoid profit and loss sharing contracts. The incentive to cheat must be eliminated, the desire to withhold information must be negligible and systems must be put in place which allow efficient and open profit and loss share instruments to develop."



New Theories of Riba II

Following our recent posting on Dr Azeemuddin Subhani's New Horizon Interview, we provide links to the beginnings of his in-depth research into the true meaning of riba.

The Islamic Doctrine of Riba Prohibition: A Modular Hermeneutical Examination
Azeemuddin Subhani, MS Thesis, McGill University, 2001

The Islamic prohibition of riba is unequivocal but textually not explicit. The traditional and liberal theological, juridical and philosophical hermeneutical effort has addressed it comprehensively but not conclusively. This inconclusiveness is due to the absence of the identification of the distinctive characteristic of ribâ, resulting from the use of limited scope pre-defined juridical and economic paradigms employing a contextual exoteric approach, excluding the broader esoteric content. This promotes an internal hermeneutical imbalance between the variables of meaning, application, rationale, underlying cause and consequence of riba, preventing the full convergence and congruence of these narrowly defined paradigms with the broadly implied paradigm in the Qur'an and the Sunna, and obstructing the promulgation of the prohibition. The resolution of this hermeneutical gridlock, predicated upon the discovery of the distinctive rationale and the derivation of the underlying cause of ribà prohibition, has a direct bearing on the expansion of scope and unreserved acceptance of the prohibition.

Please stay posted for more by Dr Subhani.



Islamic Hedge Funds: Hedging or Speculating?

RAM in the March 2009 issue of Islamic Finance Bulletin discuss, among the other interesting articles, the prospects, shariah-compliance and adherence to maqasid for Islamic Hedge Funds.

Free registration is necessary on their site before being able to download copies of Islamic Finance Bulletin. It is worth perusing as there seem to be quite a few interesting and relevant articles in the archives.


New Theories of Riba I

Dr Azeemuddin Subhani has, in the relatively short period of time since his masterpiece came out, made a significant impression on the Islamic Finance community. But rather than to rehash his contributions, below we give a link to his New Horizon Interview of 2008, and in coming weeks, Insh'Allah, we will have the pleasure of providing links to his very delving works.

Interview: A New Take On Riba, New Horizon, July 2008.

Dr Azeemuddin Subhani spent nearly three decades working as a financial advisor in the Saudi oil ministry. Though he worked in a conventional financial environment, he nevertheless harboured a passion for Islamic finance and law. When he retired in 1999, he took the opportunity to study it at McGill University in Canada. He finished a PhD in Islamic Law and Finance in April 2007. He has since presented his thesis, in which he provides a new definition of the concept of riba, at Harvard Law School in the US, where it is currently being edited for publication. Dr Subhani has been publicising it for a couple of months now, in which time Sheikh Nizam Yaqubi, a prominent Shari’ah scholar, has offered to translate it into Arabic and distribute it to libraries across the Arabic world. Others have offered to translate it into Turkish and Urdu. Here, Dr Subhani explains to NewHorizon what he thinks the true meaning of riba is all about.

Please stay tuned for more by Dr Subhani.



Islamic Finance Education at Graduate Level

One of our very first posts consisted of a survey of Islamic finance training programs and certifcations, and this in turn triggered a great deal of interest and a sustained number of inquiries on industry education (or lack thereof). Issues uncovered range from lack of local availability, costs, balancing practical-theoretical aspects, as well as whether there is global recognition for some of them. This particular article goes further in discussing the educational/curriculum approach (and being published only last year reveals there are plenty of areas that need to be strenghtened). Whilst the focus is mostly on Malaysian academic institutions and on some policy concerns, we would argue this is useful reading to anyone seriously looking to undertake an Islamic finance degree anywhere in the world.

Islamic Finance Education at Graduate Level: Current Position and Challenges
Zubair Hasan
Internarional Islamic University Malaysia (IIUM)
Some excerpts: "Programs for education in Islamic finance were hurriedly drawn up to meet the expanding demand. The haste resulted in unsuitable curricula frames and course designs; much of the research tended to be confirmative. The dearth of competent teachers worsened the situation further; compromises on the quality of instructions had to be made. Theory and practice exhibited increasing divergence."



Shariah Risk

Introduction: Shariah Risk on the Rise
While Islamic Finance spent many years in early-development bliss, recent controversies over compliance (i.e. OIC's recent announcement about Tawarruq'; Mufti Taqi Usmani's rulings on Sukuk; Sh Yusuf DeLorenzo's rulings on the Islamic Swap, the Malaysian High Court ruling against Bay' Bithaman Ajil (BBA) and the subsequent overturning by the Court of Appeals) all point to the rise of Shariah Risk.

Aside from the above types of transactions, some of today's popular products clearly have significant embedded Shariah risks (see e.g., Dr Nazim Ali's article in New Horizon for a listing of some high risk products, see this Zawya article for an overview of the many risks faced by Islamic Banks).

The more common risks each have corresponding groups in a large risk management department: Market Risk, Credit Risk, and Operational Risk (and to a lesser extent the new contender for "Risk of the Year" awards, Liquidity Risk), are all the focus of a tremendous amount of attention and their maximal NPV impact is easily understood. However, with Shariah Risk there is a great deal more uncertainty (i.e. it fits more in line with Legal Risk, Compliance Risk, Political Risk and Reputational Risk).

Shariah Risk is probably the least well-understood (and poorly modelled) form of risk faced by Islamic Banks.

Overview and Breakdown of Shariah Risk

This paper by Sh Yusuf Talal DeLorenzo on Shariah Risk highlights the operational aspects of Shariah Risk, detailing the approval process for new products, the risks of pre-fatwa failure, and even the risks that, if a fatwa is issued, it may or may not be accepted by the ummah, due to many possible factors, among which he lists the board's geographical origins and acceptance within the market, innovative interpretations of shariah, etc.

The level of detail given to describe the various pipeline risks goes a long way to filling out possible further lines of enquiry.

Clearly banks developing new products can be subject to developmental risk, and this may be overly concentrated. Sh Yusuf discusses means of alleviating some of these risks.

Islamic Finance vs Islamic Law: Shariah Risk is the Unfortunate Offspring

Taking a slightly different tack, this paper by Killian Balz outlines the systemic nature of Shariah Risk due to the disenfranchisement of Islamic Law from Islamic Finance.

As we have posted on our discussions before, English Law is usually the governing law for international contracts, and English Law has a chequered past in applying Shariah principles properly.

Balz highlights this chequered past, and the root of the issue, that Islamic Finance effectively relegates Islamic Law to a set of guiding principles rather than to apply it properly in a way that would ensure that transactions truly adhere to it. The end-product is Shariah risk, the risk that a transaction which in many standard cases appears to be halal, will, due to circumstance and court rulings, in the end be haram. Furthermore, there is the risk that the product traded was stamped "halal" using a more innovative approach to Shariah and that this stamp of approval may come into question at a later date. In both cases, the risk is real.

In the end, unlike most of the more common risks, Shariah risk can hit asset values (with possible loss of investment or loss of reinvestment income), can damage reputation, and has far greater implications for one's relationship with Allah (swt).



Case Study: Islamic Microfinance and Socially Responsible Investments

This case study from the University of Torino provides a good followup to our earlier posts on Islamic Microfinance and Sustainable Development. In particular, the author explores how both Islamic finance and Microfinance have developed and traces their convergence due to their shared aims. This "evolution" is a theme which we are encountering time and again. The paper goes on to state that:
"Even if they both constitute fairly new trends in the financial environment, the inclusion of Islamic finance and microfinance in the activities of the traditional banking system evolved in a quite similar way, because they both started from a marginal position and managed to reach a growing popularity."
Chiara Segrado
University of Torino, Italy

Also highlighted are two case studies which use a mudaraba and murabaha financing respectively:
A murabaha model example: Hodeidah Microfinance Programme, Yemen
An interesting case: the Mali-North Program of the German cooperation
The paper concludes with an outline for further industry developments:
  • Inclusion
  • Tailoring
  • Diversification
  • Social Outcomes
  • Specialization
  • Effectiveness
In addition, for a wider library of content relating to microcredit and microfinance, visit the online library of the Global Development Research Centre. Also please check the Microfinance Network of Arab Countries (Sanabel Network). Much more coming soon.



IFSB Membership - What's Your Excuse?

A myriad of industry practitioners are heading down to Singapore this week for the 6th IFSB Summit, the gathering is by no coincidence staged in Asia and it's theme is very telling as it aims to explore the "Future of Islamic Financial Services." While there is no doubt that a lot will be achieved, there are real concerns that the various industry bodies are not representative of the global industry nor reflective of what industry practitioners are clamoring for.

An industry magazine recently touted the "top 500 Islamic financial institutions" whereas the IFSB currently has 185 members. We strongly hope these figures can be revised upwards and we would invite everyone in the industry to get involved - one way of doing so being through IFSB membership (either as Full, Associate or Observer membership). An effective way to enact positive change is through involvement and engagement. In addition, the IFSB has a variety of useful published standards that are available freely on their website that are worth highlighting.

AAOIFI Membership - What's Your Excuse?

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is a mouthful of an acronym, but most likely meant to reflect the vast amount of issues and challenges faced by the industry. One would hope that AAOIFI standards would be easily accessible/available as much as they are quoted by the industry. AAOIFI has evolved into a very influental entity (whether that is positive or not can be debated) thus it seems imperative to ensure such a vocal industry body is representative and receptive to the issues that practitioners face. Case in point, AAOIFI has approximately 180 members from 40 countries whereas there are more than 165 full Takaful operators globally. Good news is there are plenty of membership levels to choose from: Associate, Supporter, Observer. The membership form is here.


OIC Fiqh Academy declares Tawarruq Impermissible

In this announcement (from ISRA) the OIC Fiqh Academy rules that organized Tawarruq is unacceptable. In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlyng Shariah).

Presumably, being a hiyal (ruse) to circumvent the ban on riba', the niyah of all participants was in contradiction with the aims of the Shariah.

Tawarruq is similar to Bay' al Inah in that it involves sale and buy-back (on deferred basis) where the aim is to lend cash to one party, financed by a second with payment increased and deferred. The difference with bay' al inah is that to prevent bans on sale and subsequent resale between two parties, a similarly morally contemptuous third party is involved to transfer the assets between the other two, a sort of triangle of cashflows and asset-movement. The asset matters little to the arrangement.

Is it only a matter of time before all similar ruses are similarly declared morally bankrupt?

Note that accidental tawarruq is still ok!

HT to Md Obaidullah on IBFNet


The Money that Prays

In the London Review of Books (LRB), Jeremy Harding posted this rather literary review of Shariah-Compliant Finance in their 30 April 2009 issue. For a review article, it touches on more subjects than most, from Riba to Gharar to Islamic Finance's recent attractions, to Islamic Finance in Britain, to the treatment of Muslims in the West, to shariah-risk and the attractions of the less-seemly sides of Western finance, exotic derivatives.

This does not have anything new in it for those who know, but it is a well-written introduction for the complete outsider, and for insiders it is, nonetheless, rather satisfying to see it in print.

HT to Ibrahim Darwish (JAK!) of Muslim College, London.