Tuesday, March 27, 2012

Profit rate swap master agreement

The International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA) announced their newest master agreement for a profit rate swap (mubadalatul arbaah).  This is a good development in my opinion because it provides a lower cost way for Islamic financial participants to hedge against fluctuations in the interest rates that are used to determine the cost of Islamic financial products. 

The idea of Islamic derivatives have been controversial because they are often viewed as instruments for speculation, which is viewed as not being in the spirit of Islamic finance.  Speculation financed by Islamic financial products (e.g. in the Dubai real estate market before the crisis) somehow escapes the same level of scrutiny as derivatives.  Other objections have focused on the synthetic nature of Islamic derivatives as being just copies of conventional products done in a way that is Shari'ah-compliant, and is somewhat condescendingly described as not being used to finance 'real economic activity'.

However, profit rate swaps are quite easily used for legitimate hedging transactions that doesn't necessarily shift risk from one party to another at least entirely (a criticism that could be more aptly pointed at talk of developing Islamic credit default swaps).  Hedging is viewed as permissible, where speculation is viewed in a negative light (again with a somewhat double standard). 

Take, for example, a situation where an Islamic bank financing a widget factory through a murabaha.  The bank only offers the company a floating rate loan.  However, the managers of the widget factory don't want to be exposed to the risk that the financing costs increase over the term of the murabaha because it could lead to additional cost that complicates their planning for the business. 

The manager of the company may then approach an investment company to lock in the financing costs, to make its finance costs predictable over the life of the murabaha.  A fund approaches the company with the offer of  a profit-rate swap that locks in the financing costs for the widget company through a profit-rate swap.  The fund receives a stream of fixed rate payments in exchange for paying a floating rate, which it expects to benefit its investors. 

The master agreement facilitates this process by lowering the costs compared to the participants having to custom build a profit-rate swap.  Without the master agreement, there would be fewer transactions, which would make an impact on the 'real economy' because fewer companies would have the opportunity to fix their financing, and effectively shift the management of interest rate fluctuations to institutions that have a focus on managing those changes. 

The one criticism I have of the profit rate swap is that it is an over the counter (OTC) swap.  The benefits of the profit-rate swap come with the cost of counterparty risk by adding a third party into the original murabaha, which exposes the widget to the company that it will lose its fixed rate protection if the counterparty in the swap cannot fulfill the terms of the contract.  However, creating an exchange for swaps is a whole different challenge that can (and probably will) wait for another day (likely well into the future). 

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