Financial Engineering by Islamic Financial Institutions – Some Apprehensions
Financial Engineering by Islamic Financial Institutions – Some Apprehensions
By Muhammad Ayub
Financial engineering during last few decades has lead to generate a large number of investment products, without any underlying real assets, mainly by way of factoring (selling of accounts receivable) and creation of derivatives. These products include Forex trade options, warrants, interest rate swaps, interest rate futures, forward rates agreement and options on futures contracts. While all traditional banking instruments tend to earning money (interest) from money without regard to the real sector activities, many derivative products tend to give return even without involvement of money. For example, a forward rate agreement (FRA) is an agreement between the two parties on an interest rate for a specified period from a specified future settlement date, based on an agreed notional principal amount. No commitment is made between the parties to the FRAs to lend or borrow the principal amount. The exposure to both parties is only the difference between the agreed interest rate and the settlement rate applicable at the date of settlement.
Interest rate futures and options on future contracts are arrangements that allow borrowers and lenders to lock into the interest rates. Interest rate swaps basically consist of the exchange between two counterparties of a fixed interest rate for a floating interest rate. The amount of interest to be paid is calculated by reference to a notionally agreed principal. Principal amounts are not physically exchanged in interest rate swaps.
Experts on Islamic finance agree that risk can be managed but not eliminated from economic activities. The classical maxim, “gain is justified by taking liability of loss” implies that risk cannot be separated from the ownership – the owner of an asset has both risk and reward of that asset. The ‘derivatives’, on the other hand, separate risk from real economic activities and make it traded separately (see: Steinherr, A; Derivatives: The Wild Beast of Finance; John Wiley & Sons, 2000). Risk is treated as a commodity and becomes a basis for financial engineering without any valid assets. Risk-reward structure is separated from the real assets and compounded derivatives are derived based on market indices and volatilities, where no ownership of any sort exists. It ultimately multiplies the risk in the economy and only the speculators are better off while real economic agents like producers and consumers, individuals as well as economies, are worse off – they are better off if risk is minimized. Hence, the artificial risks distort real economic activities with negative impact on real investment opportunities.
Islamic finance has the provision of forward trading with strict conditions of delivery and settlement to ensure that risks and liabilities are properly taken. It is particularly relevant in case of Forex business where the requirements of bai´ al sarf have to be observed. Delivery of the Salam goods has to be made irrespective of the upward or downward movement of the price. It implies that forward trading can be used only for promoting real productive and exchange purposes. The modern derivatives like options, futures and swaps, on the other hand, have no valid subject matter even.
Some institutions have mimicked the conventional product of ‘total return swaps’ by using a wa’dah (promise) to deliver ‘Shariah compliant’ returns from non-compliant investments. The conversion technique is being adopted to use non-compliant assets to bring returns into a so-called Shariah-compliant investment. In this regard, Shaikh Yusuf Talal DeLorenzo, a renowned Shariah expert and representative of IDB Jeddah and ADB at Malaysia based Islamic Financial Services Board (IFSB), says in an interview with DinarStandard regarding his paper, “The Total Returns Swap and the “Shariah Conversion Technology” Stratagem” “..they have not discerned the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shariah compliant assets as a determinant for returns”. “The term sheet for one such product states unequivocally that its purpose is to wrap a non-Shariah compliant underlying (asset) into a Shariah compliant structure.” (emphasis added) He says about the Shariah scholars who allowed such transactions, “…they have made a serious mistake. So serious, in fact, that in my paper on the subject I have called their decision the Doomsday Fatwa… it is likely that those scholars fell into the trap of literalism”. He suggests that the Shariah Boards should minutely consider the whole transactional series and not only one part of it. He further says, “While a promise to exchange returns may be lawful, if the returns promised have been earned by illegitimate means (by funds that invest in Treasury futures, for example), then that promise may be declared unlawful as it has become a means, an ostensibly legitimate means, for illegitimate ends”.
Shar’iah requires that underlying assets of any contract must be Halal and any return must be subject to fulfilment of rules of the relevant contracts. It prohibits all such exchanges that are based on Gharar or uncertainty about the structure of the contract, the subject matter and the price. According to the rules of Islamic finance, sale of a thing having an element of absolute uncertainty (trading in risk) is not valid, like the sale for unknown consideration and till unknown period. Similarly, selling goods before taking their physical or constructive possession is prohibited. The rationale behind all such rules is that the seller should take risk and reward of his trade activity. Salam, forward sale allowed by the Shariah, also requires the parties to take asset, price and market risk.
Financial innovation without backing of any asset is directly against the philosophy of Islamic banking and finance which allows only risk based return, one way or other, depending upon the nature of the transaction: it is a loan, a debt, a trade transaction, a lease or any kind of partnership. Islamic finance requires that all accruals or any increase in one’s income / wealth must be covered by a corresponding increase in rendered labour, commodity, risk or expertise. Risk and reward / liability and right must go side by side. Earning profit is legitimized by engaging in an economic activity and thereby contributing to development of resources and the society.
Some practitioners have developed Islamic derivative options on the bases of arbūn and khiyaraat (traditional concept of buyers’ options to rescind a sale). But the majority of the Shariah scholars have not accepted this view saying that the permissibility of khiyaraat and bai al-´arboun has been misunderstood to derive permissibility of trading in derivates.
´Arbūn is defined as a sale in which a part payment is made (as earnest money) with the condition that if the buyer finally purchased the commodity, the earnest money would become part of the selling price and if he did not purchase the commodity, the advance money would be forfeited. Majority of the traditional jurists did not approve it due to involvement of Gharar and eating other’s property unjustly. Ibn Rushd, renowned jurist of Maliki School, says about this, “The majority of scholars have forbidden it because it involves Gharar, risk-taking, and the taking of money without any consideration in return”. However, most of the Hanbalis allowed it. The Islamic Fiqh Council of the OIC and AAOIFI have also allowed customary down payment sale with the condition that a time limit is specified. They have not allowed it as a tool for trading in options (see: Ayub, Understanding Islamic Finance; John Wiley & Sons, 2007; Pp. 209-211).
If we consider Arbun permissible, the question arises: can the purchaser, after paying the earnest money to the seller, dispose-of the item before finally purchasing and taking the same in his possession? In my view it should not be allowed as a policy because it is more likely to become a back-door for selling goods without taking ownership and possession and ultimately corrupt the investment practices of IFIs. We have had such bitter experiences when Shariah scholars had allowed the on-ward sale (prior to final settlement) of shares purchased with firm commitment to conclude the deal on payment of margin and some Islamic bankers practically mis-utilized the permission and resorted to serious irregularities leading to non-Shariah compliance.
The general principle of sales in the Shari´ah is that delivery has to be taken consequent upon any purchase transaction along with the asset, market and the return rate risks, and the short sale is prohibited. Arbūn in permitted form is much different from the hedging through short sales and purchases and trading in options. Hedging in the sense of natural, economic and cooperative tool for risk management is allowed in Shariah provided the general rules of the Shariah based contracts are applied. In arbūn, time has to be stipulated for the option to finalise the sale and the amount paid is adjusted in sale price when the contract is completed. It is a kind of Bai al Khiar in which the purchaser takes (3) days to finalise the sale in order to avoid possible cheating or Ghabn-e-Fahish (price over and above the market price of a commodity). On the other hand, main problem in the customary hedging instruments like options and futures is that completion of the sale process, i. e. giving / taking possession is given no importance and the parties not only deal in risk, but also transfer the risk to the other party.
For more details on possibilities of financial engineering in the framework of Shariah, the readers may like study i) El-Gamal, Mahmoud Amin (2006); Islamic Finance: law, Economics and Practice; Cambridge University Press (chapter 5 and 6; and ii) Al-Suwailem, S. (2006); Hedging in Islamic Finance; Occasional Paper No. 10; IDB, IRTI, Jeddah.
Source: http://www.alhudacibe.com/AlhudaMagazine/Issue-035/article01.php