The Stock-Exchange from an Islamic Perspective

This is an interesting study of capital markets (albeit slightly outdated) presented from a governance point of view and evaluated through Shariah guidelines, published by the King Abdulaziz University Islamic Economics Research Centre (also checkout their archive for a lot more interesting content).

The notion of a standalone Islamic stock exchange (as opposed to having conventional and Shariah compliant products side by side) is debatable due to issues relating to implementation and practicality. However, the paper's focus is on how to restrain/control gharar.

It proposes two "Shariah restraints": [1] "calling for the provision of relevant information on one hand, and [2] the analytical ability to estimate true exchange values on the other. These two main restraints are intended to attack the problem of gharar, or to put it differently, they are intended to account for closer convergence of the actual share’s price with its true expected economic value."

The paper inlcudes a curious quote from John Maynard Keynes:

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils" (1970)

Keynes, it seems, would have made for a great scholar!

The Stock-Exchange from an Islamic Perspective

Monetary Authority of Singapore - Islamic Banking Guidelines

Not often do we see regualtory bodies issuing comprehensive statements that directly address the operation of Islamic finance activities, even more so in jurisdictions that are only at the early stages of developing their market offerings. There is a lot to be said about how these guidelines provide direction (they read more as a disclaimer) to market participants and whether it is a valid approach to allow market forces to dictate what is and what is not Shariah compliant. Much to pick through here and a lot of reading between the lines, feedback and comments are - as always - highly appreciated.

Guidelines on the Application of Banking Regulations to Islamic Banking

Monetary Authority of Singapore

May 2009

Monetary Authority of Singapore - Islamic Banking Guidelines

IICMF Conference: Islamic Structured Products and Current Issues in Islamic Finance

The Securities Commission in Malaysia will host the Third International Islamic Capital Markets Forum in Kuala Lumpur (follow link for more information) on 30 July 2009, themed "Islamic Structured Products and Current Issues in Islamic Finance."

Structured products have become popular as a wholesale fund product and a popular deposit instrument for Islamic Banks as well as an investment linked product for takaful.

Mark this event in your diary now. For further details please email icmforum@seccom.com.my

• Topics will address the landscape and current views on Shariah-compliant structured products and hedging tools, an examination of the building blocks in constructing these products, the approach and philosophies in regulating the Islamic capital market in Malaysia and case studies.
• A panel of speakers will deliberate on the resilience of Islamic finance, factors which are curtailing its further expansion and the development of Islamic finance products in achieving Shariah harmonisation.
• A face-to-face deliberation with renowned practitioners, Shariah scholars as well as regulators.

Featuring two of our regular contributors: Bernardo Vizcaino and Nikan Firoozye!

Note: for those who cannot attend, we will spend some time surveying the landscape of structured product from Himalayas to Perfect Asset Allocation/Rainbow Options to TARNs to LIFTS to Range Accruals to Expert Trader Options, etc. Some are possible in Shariah-compliant format, some less easily so, and some with obvious benefit to investors, and some only with obvious benefit to issuers/investment banks (Caveat Emptor, i.e., buyer beware!). Expect some serious debate.

IICMF Conference: Islamic Structured Products and Current Issues in Islamic Finance

Shariah Compliant Profit Rate Swap

Similar in spirit to the Shariah-Compliant Swap using wa'ad (see Shariah Compliant Swap: Shariah "conversion" or subversion?, we present here some detailed papers on the Profit Rate Swap (PRS). The essential ingredients are parallel Murabahas.

In fact this first paper from Allen & Overy goes into some detail on the individual legs of the swap (the individual Murabahas/rolling murabahas).

The idea is simple enough:

• For the floating leg, we are allowed Murabahas with markups linked to LIBOR. We can enter into consecutive Murabahas on a rolling basis, with Wa'd to enter into Murabaha at the market price + market determined LIBOR to make for rolling Murabahas.
• For the exotic leg, some scholars would allow the linkage of the Profit Rate of the Murabaha to be almost anything so long as it is determined as of the time of entering into the Murabaha. So range accruals (i.e., the profit rate is LIBOR + X accruing times the number of days LIBOR is in between LowerBound and UpperBound) and almost any exotic payoff can be used as a markup so long as it is set at the time the Murabaha is entered into.

Allen & Overy's paper on Profit Rate Swaps


NOTES:

1. This not a typical exotic swap and in this case the exotic leg has a delayed payment. The typical structure for a range accrual is to pay periodically (say every 3M) LIBOR(t)+X% times the number of days LIBOR(t) is between LowerBound and UpperBound, for t between 0 and 3M, with payment made at t=3M. In the PRS version, t=3M is the first date that the coupon (oops, profit markup) is known with complete certainty and is then the date at which the Murabaha is entered into with payment of this markup at t=6M. This delay is nonstandard in the exotic world but is really only a small matter for traders/structurers/clients.
2. Sh Yusuf DeLorenzo's bjections to DB's "Shariah Conversion Technology" (link here) apply equally well to this structure. Can we asset swap Pork Bellies for LIBOR using Murabahas and make it all seem Shariah Compliant?
   

Further References

• Nathalie Schoon, Islamic Banking & Finance, (section on Murabaha + Wa'ad PRS)
• Allen & Overy on Cross Currency Swaps
• Azmi Law on Islamic Swaps in Malaysia
• Derivatives Week, article on Islamic CDS (short on details)
  

Shariah Compliant Profit Rate Swap

Case Study: Bank Runs in Turkey

This paper is presented in Topics in Middle Eastern and North African Economies (electronic journal, Volume 7, Middle East Economic Association and Loyola University Chicago, September, 2005). While the focus is on the behavioral aspects of bank runs (consumer over-reaction, information asymmetries, self-fulfilling elements, etc.) the authors also make a very interesting comparative analysis of the balance sheets of conventional banks versus Special Finance Houses (i.e. Islamic Financial Institutions in Turkey). The concluding remarks are focused on the benefits of deposit insurance, but the overall piece brings a refreshing view - one that is in stark contrast to claims of Islamic bank's "immunity." It would seem the most important behavior of consumers is their short-term memory!

Bank Runs in Emerging-Market Countries:

The Experience of Turkey’s Islamic Banks in the 2001 Crisis
Martha Starr, American University
Rasim Yilmaz, Dumlupinar University

Abstract: "This paper examines a set of runs on Turkey’s Special Finance Houses, an uninsured sub-sector of Islamic banks, during the 2001 financial crisis. We argue that, although fundamental factors were influential in initiating the runs, the magnitude of withdrawals from the SFHs was out of proportion with the risk, suggesting overreaction."

Case Study: Bank Runs in Turkey

Opalesque Islamic Finance Intelligence

Opalesque launches Islamic Finance Intelligence as industry faces great debates in a number of fronts

Setting a new standard: 19 pages of intelligence.

Welcome to the first issue of Opalesque Islamic Finance Intelligence (OIFI), designed with a practitioner approach – focused on precise and relevant content for investors, product manufacturers, and fund managers of this truly global community. This free, monthly publication complements Opalesque Islamic Finance Briefing (our daily industry news briefing) and leverages on the success of the Opalesque family of specialized publications (Alternative Market Briefing, A Square, Roundtable Series, etc).

The industry faces great debates in a number of fronts – from market gaps, distribution networks, standardisation initiatives, risk & compliance concerns, to structural question marks. These issues are faced by both current industry players as well as new entrants. A case in point is the recent debate over Tawarruq, with Nikan scrutinizing the matter in our Featured Structure section.

The range of topics is vast - Islamic finance products now extend to all asset classes (from exchange traded funds to private equity vehicles), the industry is ever-evolving in its core markets (the GCC and Southeast Asia) and product cross-pollination with conventional fund houses is an emerging trend. Our maiden edition further provides an overview of Islamic contract law - detailed by Khalil in our Editorial Column. We also debate over the outputs of the transaction: practitioners share their thoughts in our Discussion Forum on the use of conventional benchmarks (i.e. LIBOR) by Islamic banks, whilst Toby Birch of Birch Assets Ltd scrutinizes the industry pitfalls in our Allocator Interview.

Market awareness has skyrocketed in recent years - experts once touted the existence of 60 Islamic equity funds whereas the industry now boasts a universe of well over 700 Shariah compliant investment products. Growth projections usually land between 15 to 20 percent per annum, yet some of the largest Muslim countries (i.e. Indonesia, Egypt and India) remain untapped. A comprehensive product range is unheard of (in stark contrast to the conventional world), yet this bestows the industry with endless prospects. Bernardo sheds light on these by analyzing Islamic fund of funds in our Industry Tables section.

Opalesque Islamic Finance Intelligence is a free subscription- new readers can register here and make your choice from our menue of eleven specialized publications. (Note that while most of our publications are free, we also offer three premium/paid publications).

Download the first Opalesque Islamic Finance Intelligence issue here!


(Sorry for the Marketing Spiel, but we wrote it and its free).

Comments, as always, are welcome! JAK!

Opalesque Islamic Finance Intelligence

Scholars call for Shariah board under Central Bank

Lets all discuss the following points: Dr. Abozaid pointed out that there is currently a lack of a centralised control on Islamic banking products. Some products that are cleared as "Islamic" are sometimes controversial.

Until such time a central board is created, measures must be undertaken to ensure that the salaries of Shariah board members do not come from their individual retaining banks, but from a central pool. This would ensure neutrality, transparency and above-board decision-making, experts pointed out.

Scholars call for Shariah board under Central Bank
Emirates Business 24/7
By Eman Al Baik

Scholars call for Shariah board under Central Bank

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

Following our previous postings on DB's Shariah Compliant Swap, (here and here), we follow up with the last of our postings on the marked and unusual (note we do not say unwarranted) criticism of this structure.
The Criticism

"I believe that due consideration must be given to not only the literal structure of products and processes, but also to their consequences for the future of Islamic Finance. In other words, while up until now the Shariah supervisory boards of modern Islamic financial institutions have focused almost exclusively on the rules for transacting in compliance with the Shariah, it is now time for them to focus as well on the higher purposes of Islamic law or the maqasid al-Shari`ah."

Yusuf Talal DeLorenzo, The Total Returns Swap and the "Shariah Conversion Technology" Stratagem


Rather than evoke Sadd-al-Dharra'i (prohibition of legitimate means to illigitimate ends), Sh.Yusuf goes into some detail on tracing the cashflows. Unlike LIBOR based products where the LIBOR-linked return is merely the market-cost of capital or fair returns for investments, he shows this product actually enables cashflows for investment in haram activities. Were it not for the Islamic investor's cash, the haram activities would not be invested in. This is very astute, since it is clear that cash and profits flow from the Islamic investor to pork bellies, alcohol, any sort of wierd hedge fund or derivative, etc.

Moreover, Sh.Yusuf explains why Sadd-al-Dharra'i is inapplicable. Rather it can be applied in cases where illicit activities are a probable outcome of any set of halal actions. Then it can be invoked to rule out such action. In this case, the illicit activities occur with absolute certainty and since whatever is required to ensure the performance of a required act is itself required
(لا يتم الواجب إلا به فهو واجب ) and it is required to abstain from illicit acts and thus to abstain from combinations of legal acts that result in illicit activities.

Sh. Yusuf calls the fatwa that supports this the Doomsday Fatwa for Islamic Finance. Why? Because he rights states that doing this swap is easier than going through all the effort of true-sales and lease-backs and SPVs for all the sukuk out there, so why bother? It's just plain cheaper to operate in the conventional space, and then Shariah-wrap (swap) it. It makes all the effort of the past 30+ years for nothing.

This paper does raise the question of the legitimacy of rolling murabahas as a means of synthesizing structured products or the Shariah Compliant Profit Rate Swaps (PRS). LIBOR may be a cost of capital but the payoff of a commodity-linked range accrual requires hedging using commodity options, and again an Islamic Investor is setting off the action that links his cash to haram investments.

Does Islamic Finance run the risk of turning into pure legalistic formalism? In some ways this structure reminds me of the case of Observant Jews on the Sabbath who get a Gentile to light a fire for them and at least in that case there is the benefit of not freezing to death on a cold winter's night.

So what benefit can Islamically "wrapped" pork-bellies give? Do we actually believe in the prohibition on riba or are we just unduly burdened by it? How about the prohibition on Maysir? On other haram investments? What exactly do we believe in?

Stepping Back: Listing Some of the Merits
Is there merit in this structure? The answer should be yes. The criticism cannot be levied at the structure itself--rather the overreachingness of the fatwa.

Sh Yusuf's article does not indicate that he considers the structure itself to be distasteful. It is the use that can be questioned. If, on the other hand, the structure is applied to "compliant" activities, e.g.,

• Cross Currency Swaps
• Fixed for Floating (to reduce/increase duration of liabilities/assets)
  
• Other hedging where all underlyings are halal (e.g., an Islamic Fund Manager pays DJIM to reduce beta, and receives cash--LIBOR instead, etc).

then the criticism is null.

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

Islamic Microfinance Report - IDLO

A rather recent report (February 2009) authored by Allen & Overy giving an overview of Islamic microfinance for the International Development Law Organisation (IDLO), with an interesting review of microfinance initiatives across the Middle East and Southeast Asia (from Pakistan all the way to Indonesia). The report goes on to provide a review of basic Islamic law principles governing the provision of Islamic finance products and services (including a brief anlaysis of "Defaulting on Personal Debt in the United Arab Emirates and Saudi Arabia").

Islamic Microfinance Report - IDLO

Allen & Overy LLP

International Development Law Organisation (IDLO)

February 2009

Islamic Microfinance Report - IDLO

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?

A Comparative Literature Survey of Islamic Finance and Banking

This article comes from the archives of the Microfinance Gateway, it is an introductory paper but one that covers a wide range of metrics and would prove useful as an introductory reading (and a good measure of how much the industry has changed over the past decade). A brief summary is provided as well:

How can Islamic financial markets be helped grow? With Muslims comprising about 27 percent of the world population, Islamic finance is a growing niche set to reach new levels of sophistication. However, Islamic finance with identifiable products and markets is in its infancy, and many problems and challenges related to Islamic financial instruments, markets, and regulations must be addressed and resolved. This paper provides a comprehensive review of the literature of the Islamic finance as well as introduces Islamic financial instruments in order to compare them with those existing in other parts of the world. It also discusses the legal problems that investors in Islamic financial instruments encounter.

As the paper assesses the performance of the Islamic banking and financial sector and highlights the regulations, current challenges, and bottlenecks, it concludes that:

• The lack of developed markets in which Islamic financial instruments can be traded is one of the problems caused by the lack of cooperation among Muslim financial institutions;
• The further growth and development of the Islamic financial system will depend largely on the nature of innovations introduced in the market;
• The Islamic financial system can offer alternatives at the microfinance level;
• A well-developed Islamic financial system can play a vital role in the economic development of Islamic and non-Islamic countries by mobilizing dormant savings and facilitating the development of capital markets.

A Comparative Literature Survey of Islamic Finance and Banking
Tarek S. Zaher & M. Kabir Hassan
Indiana State University, Terre Haute, Indiana, University of New Orleans, Louisiana

A Comparative Literature Survey of Islamic Finance and Banking

CSR Disclosure in Malaysian Companies

We had earlier touched on the crossroads of ethical and Islamic finance in our earlier discussions and on the paper by Zubai Hasan relating to Sustainable Development from an Islamic Perspective. Another paper - also from the International Islamic University of Malasyia - delves into CSR Disclosure in Malaysian Companies, as it scrutinizes the type of information that comes under the banner of ethical or responsible behaviour. The paper does not especifically address Islamic finance or the Shariah compliance of the corporates which are under scrutiny; Nevertheless, it is very poignant in exploring the pitfalls of SRI/CSR (plenty of acronyms to choose from). It is especially critical as it relates to how profound and/or superficial these labels really are in the context of the modern politically-correct corporate culture:

"Findings from the study suggest that the disclosures have a public-relations bias, with a very general, ‘good news’ type of disclosures being the norm. Consistent with prior studies in other developing countries, quantitative or monetary disclosures, as well as ‘bad news’ disclosures are minimal."

CSR Disclosure in Malaysian Companies

Derivatives in Islamic Finance

Derivatives in Islamic Finance
Dr. Sherin Kunhibava, Researcher, ISRA
ISRA Research Paper (No. 7/2010)

"The main objective of this paper is to review the use and status of derivatives in Islamic finance. This is done by first explaining the basic derivative contracts of forwards, futures, options and swaps. Thereafter, the discussion turns to the use of derivatives with sukuk. The paper then explores the debate between scholars on the admissibility or otherwise of forwards, futures and options in Islamic finance. It then examines contracts in Islamic finance that have derivative-like features and which can be used for the same purposes of hedging as forwards, futures, options and swaps. It concludes by highlighting areas for future research."

Derivatives in Islamic Finance

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

We will stretch this topic over a few posts since there are numerous components to discuss, initially we detail the justification of Deutsche Bank for their Islamic swap product (a major developer and promoter of this instrument), later going over the structure in much more detail, and finally the criticisms that this solution has received from other industry participants.

The Shariah Justification
The structure is discussed (to a limited extent) in DB's now famous White Paper. In fact the white paper, whether you agree with the product or not is a toure de force. It is probably the best single article on the rationale for Wa'd to be legally binding.

The paper has two main arguments

1. Wa'd must be legally binding. The arguments involve maqasid, principles of commutative justice (derived from the thesis of Dr Hussein Hassan--sorry copyright prevents posting pdf), and is probably the best single source for this sort of argument.
2. Pricing of Islamic Contracts can be determined at the time of execution (see, e.g., Bay' bi Sirr al Suqq/Istijrar Revisited) and when indexed, markups need not be related to halal activities, e.g., LIBOR itself (and examples are given from Taqi Usmani's allowance of Murabaha markups related to many other more-complex payoffs).

Notably missing from their discussion are:

1. Should consideration be permissible in a wa'd? Can you pay for a wa'd?
2. Can bilateral wa'd (muwa'adah) be allowed? (Most jurists would disagree with this as a means of circumventing prohibitions on forward-starting contracts).
3. Should wa'd be legally enforceable only if there is detrimental reliance on the part of the promissee? (Maliki view). Is Wa'd the same a Promissory Estoppel?
4. Actual details of the structure of Shariah Compliant Swaps

Wa'd: Shariah-Specific Details
Wa'd, or unilateral promise has the following features/restrictions

1. Consideration is not permissible with Wa'ad. You cannot pay for a promise. (we will find an striking exception to this permitted by some scholars with Promissory Notes!)
2. Bilateral wa'd (muwa'adah) is not allowed. (Most jurists would disagree with this as a means of circumventing prohibitions on forward-starting contracts). (Note: We have already seen exceptions to this with Short-Sales Contracts using Muwa'adah)
3. Is wa'd legally enforceable only if there is detrimental reliance on the part of the promissee? (Maliki view). Is Wa'd the same a Promissory Estoppel? (this is dismissed and rather it is claimed Wa'd should be legally, not just morally upheld even if there are no damages).

For more on wa'd and on the wa'd swap, please see the following:

• al Masri, R, The Binding Unilateral Promise (wa’d) in Islamic Banking Operations: Is it Permissible for a Unilateral Promise (wa’d) to be Binding as an Alternative to a Proscribed Contract?
  
• Nurdianawati Abdullah, The Status of Wa’ad and its Implications in Contemporary Islamic Banking
  
• Aznan Hassan, Pengertian Al-Wa’ad, Al-Wa’dan Dan Al-Muwa’adah (dalam Bahasa Melayu)
• Islamic laws of Contract and Sale and purchase, Iqra University (pp 14-16)
  
• Vogel & Hayes, Islamic Law and Finance: Religion, Risk & Return (pp 125-8)
• Islamic Bankers Blog: Is Wa'ad the Next Star of Islamic Banking
• Barakat & Mehrej: The Structure and Use of Wa'ad
  
• Humayon Dar, Islamic Economist, Sharia Advisor and Transformational Thinker (for details of his seminal input from the man, the myth, the legend)
  
• Humayon Dar, Incentive Compatibility of Islamic Financing, Handbook of Islamic Finance, pp 85-96 (for a very western critique of Islamic contracts as not being "incentive compatible" except for the amazing Wa'ad swap, a matter of much possible disagreement. One might even say Islamic Finance in its current incarnation, just plain sucks according to Humayon. (sorry Humayon, but it really does sound like that!). Perhaps we can ask Mahmoud El-Gamal to critique the view that the Wa'd swap is doing a great service to Islam by allowing access to all these amazing products?)

Note that with this amazing swap, anything and everything is possible. As one Belgian banker said with excitement, "yes, it is possible to have Shariah Compliant pork bellies" (Astaghfirullah!).

For the pious, this should already raise red flags. And, presumably this should have raised red flags for the Structurers, for the Shariah board (the esteemed Dr Hussein Hamed Hassan, Dr Ali al Qaradaghi, Dr Abdul Sattar Abu Ghuddah, Dr Mohamed Elgari, and Dr Mohammed Daud Bakar) and for the Investors (which were terribly slow to take it up, and now are a bit hush-hush about it, but we suspect these include some large name public hedge funds, and DIB has been documented) .

Just given the controversial nature of this Islamic "wrapper" there is much more Shariah risk, including the risk of a change of heart of a scholar (please see: Global Islamic Funds & Sukuk, Linked In Discussion on this topic).

Please stay tuned for more details on the Shariah Compliant Swap, and the Criticisms. We will also detail other methods for constructing Shariah Compliant PRS (Profit Rate Swaps) in later posts, InshAllah.

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

Ernst & Young - Islamic Funds & Investments Report

Islamic Funds & Investments Report 2009

Here is the latest report from Ernst & Young on Shariah compliant investment funds (please follow the link to their site). Worth checking their breakdown of market sizing (individuals, insitutional, quasi institutional, etc) as well as their analysis on existing/evolving asset manager business models. This goes hand in hand with their global Takaful reports.

Ernst & Young - Islamic Funds & Investments Report

Islamic Banks and Financial Stability: An Empirical Analysis

We kickoff this month with a variety of empirical studies on Islamic finance, complementing theoretical discourse with hard facts & figures. The following working paper arrives from the IMF, scrutinizing the impact that Islamic banks have on financial stability. A very noteworthy finding is that small Islamic banks are more stable than their larger counterparts. This raises the question of whether the "mega Islamic bank" concept being touted around is actually valid! The authors argue that "as the scale of the banking operation grows, monitoring of credit risk becomes rapidly much more complex. That results in a greater prominence of problems relating to adverse selection and moral hazard [for large Islamic banks]. Another explanation is that small banks concentrate on low-risk investments and fee income, while large banks do more PLS [Profit-and-Loss Sharing] business". This further raises the issue of how robust is the risk management system of IFI's and how different should it be from that of conventional banks which focus on other metrics - such as PD (probability of default) and LGD (loss given default).

Islamic Banks and Financial Stability: An Empirical Analysis
Martin Čihák and Heiko Hesse
IMF Working Paper
Monetary and Capital Markets Department

Abstract: "We find that (i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger
than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks, which may reflect challenges of credit risk management in large Islamic banks. We also find that the market share of Islamic banks does not have a significant impact on the financial strength of other banks."

- The paper is also discussed in the May 2008 edition of the IMF Survey Magazine.
- PWC has a further discussion on this topic within their Islamic finance blog.

Islamic Banks and Financial Stability: An Empirical Analysis

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.

Shariah Compliant Principal Protected Notes

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.

Ernst & Young - World Takaful Report

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."

Lack of Profit Loss Sharing in Islamic Banking

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.

New Theories of Riba II

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.

Islamic Hedge Funds: Hedging or Speculating?

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.

New Theories of Riba I

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."

Islamic Finance Education at Graduate Level

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).

Shariah Risk

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."

Microfinance and Socially Responsible Investments

Chiara Segrado
MEDA PROJECT
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.

Case Study: Islamic Microfinance and Socially Responsible Investments

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.

IFSB Membership - What's Your Excuse?

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.

AAOIFI Membership - What's Your Excuse?

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

OIC Fiqh Academy declares Tawarruq Impermissible

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.

The Money that Prays