Wednesday, March 28, 2012

Islamic derivatives

While writing the post yesterday on the new profit rate swap master agreement (mubadalatul arbaah), I explained the reasons why I think the master agreement can help make a difference in developing Islamic finance and providing a product that can help 'real economic activity' by providing certainty in financing costs for companies that have floating rate financing. 

However, there is an issue with Islamic derivatives in general that has been raised multiple times about the participation of 'speculators' versus those participants who are involved in 'legitimate hedging transactions'.  This is a tricky issue, and one that is very hard to even define (since what transaction doesn't involve some elements of speculation. 

In the context of derivatives, there will likely be some profit to be made and in general, it will be a profit that, if you view the transaction in the abstract will be gain for one party at the expense of the other.  This is generally viewed as akin to gambling (maysir) in Islamic finance because the gains from one party will come at the expense of the other. 

In the profit-rate swap example, viewing the transaction in the abstract misses some key elements that differentiates a profit-rate swap from others (such as, for example, a credit default swap).  In a profit-rate swap, assume that the company has a two-year $100 million floating rate ijara, with a floating rate starting at 5% annual rate, which is set at the end of year 1.  The ijara is structured so the cash flows are:

T=0: Company sells assets worth $100 million to the financier, which it will rent with rental payments adjusting, but beginning at $2 million a year (benchmarked to an interest rate that starts at 5%).  The first payment is made.
T=1: Company pays rent benchmarked to an interest rate
T=2: Company pays repurchases the asset for $100 million

At T=0, the company enters into a profit-rate swap to exchange the rent in T=1 for cashflows of $2 million at T=1 for a floating rate based on the same benchmark with a spread (through two separate commodity murabaha).  At T=1, the murabaha are paid, with the company paying $2 million and the counterparty paying $100 million * (R+e), where e is the spread paid.

Looking just at the transaction, no net payments are made when the benchmark rate is (5-e)%.  If the benchmark rate is higher than (5-e)%, then the company makes the difference between the rate and (5-e)%.  If the rate is lower, than the swap counterparty makes the difference between (5-e)% and the benchmark rate. 

For the transaction alone, the components of the transactions are common.  There is an ijara and, separately, the company enters into two murabaha with another party.  However, the murabaha transactions result in the outcome of a win-lose scenario.  An increase in the reference rate benefits the swap counterparty, while a decrease benefits the company, in equal amounts.  The criticism of this transaction is that it is not financing any 'real economic activity', and also that the counterparty is merely speculating on the direction of the reference rate (the company is hedging its exposure to changes in the reference rates, which would be viewed as legitimate hedging activity). 

There would be in most cases, a clear economic benefit of the transaction because the company would be able to lock in the cost of financing the asset it purchased.  Armed with the certainty of its costs, the company wouldn't have to incorporate the uncertainty around its financing costs in its financial planning, and could devote the resources that might be held back in case the rate increased to expand its business.  The counterparty would assume the risk of changes in the reference rate (in expectation of a lower rate or to hedge itself against its own fixed rate liabilities (most financial counterparties would be likely able to show enough fixed rate liabilities to justify its participation on the grounds that it is hedging, even if it were speculating). 

As I mentioned, the fact that the contract is executed on an OTC basis adds some risk that the counterparty cannot meet its obligation, which would moot some of the benefits to both parties of resources freed up by hedging its profit-rate exposure.  There won't be many issues with whether the parties are legitimately hedging (it is probably easy enough for the Islamic financial institution to speculate while being able to at least nominally show that it is hedging some exposure on its balance sheet).  However, it will be difficult to convince the doubters of profit-rate swaps that the transaction adds value overall and is different from a transaction like a CDS. 

Most arguments in support of the profit-rate swap assume that Islamic finance institutions are involved in liquidity transformation, just like conventional banks, but using Shari'ah-compliant contracts.  The criticism of Islamic derivatives are mainly (but not entirely) from people who believe that Islamic financial institutions should be based entirely on profit-sharing contracts.  It is difficult to offer a counter-argument, because a pure profit-sharing bank would not need to worry about liquidity constraints because it would not transform short-term liabilities into long-term assets (rather, it would, but it could pass off any losses directly to depositors). 

This is how a typical mutual fund works (the fund manager acts as a mudarib or wakeel), but it is not how Islamic banks work.  If an Islamic financial institution is working in a bank-like role (taking deposits and making loans) in an environment where pricing is based on interest rates (because the Islamic bank is competing with conventional bank), then there will be a role for instruments like a profit-rate swap.  Arguments against profit-rate swaps are mostly shifting the discussion into a theory versus practice argument.  At this point it usually turns into a discussion where people from two different perspectives are talking past one another.  

There are two different things to consider, which are entirely different, when considering profit-rate swaps:
  • Should Islamic financial institutions work within the regulatory system that exists today?  Or should they try to change the regulatory environment to allow pure profit-and-loss sharing for Islamic banks?
  • If Islamic banks work within the current banking regulations, should they be permitted to hedge their exposure to fluctuations in their profit rates which may be exposed to fluctuations determined by changes in interest rates?  And does the profit rate swap contribute to an underlying economic activity?
These are two different arguments and it is important to separate them.  If Islamic banking operating under a conventional regulatory system is problematic, then that is the issue, not whether a profit-rate swap is beneficial or not.  However, if the presumption is taken as given that Islamic banks work within a system that evolved around a conventional banking system, then the discussion around Islamic derivatives should be focused on whether it contributes to underlying activity and stability within the Islamic financial system, and is done in a Shari'ah-compliant way. 

Where I stand is that Islamic banking does operate in a regulatory environment that was designed for conventional banking and that providing a standardized way for Islamic banks to hedge against profit-rate risk will lead to a more stable banking system (counterparty issues still unresolved) and will provide a benefit to the non-financial who enter into profit-rate swaps to fix their costs as a part of their financial planning. 

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