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). 

The role of structured products in Islamic finance

Bloomberg reports that the International Islamic Financial Market (IIFM) is working on a master agreement for derivatives, according to the IIFM CEO Ijlal Ahmed Alvi. The article then goes on to describe Islamic structured products that are having some difficulty meeting international (as opposed to simply local) standards. Structured products combine a debt security with a derivative to provide, for example, returns based on an index performance combined with capital protection. These products are fairly common across the Islamic finance industry and financial institutions like their high fees, while investors may be attracted to the capital protection embodied in them.

However, I think they should be of limited use in the industry because they provide limited benefit to investors (although good returns to the financial institutions offering them in terms of high fees) and are, in my opinion, representative of the worst of financial replication of conventional products in Islamic finance. These products offer the promise of equity-like returns with debt-like risks. The risks of their debt characteristics is understated through claims of "capital protection"; generally these products will only be as safe as the debt offered by the institutions offering these products (or their counterparties in the commodity murabaha products that sit alongside the derivatives that provide the equity returns). It may be that the popularity of these products is due to the lack of debt-like alternatives (e.g. sukuk) for asset managers to diversify across asset classes. Instead of investing in (cheaper) sukuk funds, managers are forced to find quasi-debt investments that also give equity returns.

The reason that I find structured products objectionable is that they hide the risks of debt products with the "capital protection" (I believe they are generally unsecured debt), while generating high fees for the issuer, which can hedge the risks of paying out the upside gains through derivatives. They replicate the most cynical aspects of conventional finance (creating fancy products that generate high fees) with little benefit to investors except providing debt-like protection of capital. In my opinion, the investors would be better off using an equity investment like a mutual fund or managed portfolio of equities balanced with a fixed-income investment through a diversified portfolio of sukuk. However, it is difficult to compose a diversified portfolio of high-grade sukuk. Therefore the appeal of structured products.

Perhaps I am cynical about the rationale for structured products generally in finance. However, they don't seem to serve much purpose except where fixed income markets are lacking. For conservative investors, they would be better suited in lower-fee sukuk funds or deposit accounts at Islamic banks. Non-high net worth investors would be better served by a balance of either Islamic mutual funds or individual equities and sukuk funds. High-net-worth individuals have the resources to invest in diversified portfolios of both equities and sukuk (in addition to some alternative assets). Hiring managers within each asset class is surely a lower cost method of investing than structured products. This even omits the role that Islamic ETFs (if they were prevalent) could serve for investors just wanting to track the benchmarks with some diversification.

The IIFM has done some good work standardizing commodity murabaha contracts (the Master Agreement for Treasury Placements) and with the planned master agreement for asset-backed sukuk. Even the derivatives master agreement (Tahawwut) which has attracted criticism is valuable because Islamic banks, like other conventional financial institutions, need to hedge against currency and interest rate fluctuations (and other companies need to hedge commodity price fluctuations). However, tailoring standardized documents designed for structured products is not going to provide much benefit to the industry as a whole. It may lower costs, but that is unlikely to lower costs to issuers, but these probably will not pass through to investors who are charged high fees in conventional structured products as well.

As much as the sukuk structures are criticized for replicating conventional bonds, they at least serve a primary purpose in most, if not all, portfolios as fixed income replacement. The same cannot be said for structured products, which I suspect are favored by financial institutions for their high fees with little regard for whether they add much to the end client's portfolio.

Tahawwut slow to catch on in the GCC, Nakheel/Dubai World face trade creditors' claims

Lack of familiarity with derivatives products in the GCC has hampered the adoption and use of the Tahawwut Master Agreement for Shari'ah-compliant derivatives. There is also some skepticism that the implementation of the product is Shari'ah-compliant because the Master Agreement is just a template and not a specific product.

Although Nakheel has offered to pay trade creditors 40 percent in cash with the remainder in a tradable sukuk yielding 10%, several of Dubai World's trade creditors have taken their claims to the Dubai World Tribunal set up at the DIFC. Nakheel needs 95% agreement in order to issue the sukuk to pay the deferred portion of the amounts owed to trade creditors. One of Nakheel's trade creditors, Construction Delivery Group filed suit with the tribunal claiming it is owed Dh 50 million (13.6 million) for a construction management contract.

Other News

• Mushtak Parker provides a good assessment of an IMF report that found that Islamic banks fared better during the financial crisis.
  
• A study from Deloitte found that 79% of executives believe Islamic finance is growing. 66% believe the industry is under-regulated.
  
• Indonesia may issue a global bond or sukuk for $650 million in the first quarter of 2011. Jordan formed a committee to study the changes needed to be able to issue sukuk and a statement from a government official stated that the government is "serious about using Islamic sukuk to provide funds for carrying out vital and top priority projects.
  
• Citigroup, which co-managed the Kuveyt Turk sukuk says it is in talks for more corporate sukuk issuance in Turkey. AmIslamic Bank in Malaysia issued RM550 million in 7-year sukuk.
  
• The governor of the Kuwaiti central bank says that with five Islamic banks, the market for Islamic banking is saturated.
  
• RAM Islamic projects that the sukuk market in Malaysia will continue to grow.
  
• Qatar First Investment Bank and Gulfmena Alternative Investments are launching an Islamic asset management firm. Allfunds Bank launched an Islamic Services Unit to provide a B2B fund platform of Shari'ah-compliant funds.
  
• Luxembourg will host the 8th Annual Summit of the Islamic Financial Services Board (IFSB), the first time it has taken place in the EU. Luxembourg is the only EU member country that is a member of the IFSB.
  
• Zawya and the Ethica Institute of Islamic Finance announced a partnership for Islamic Banking certification and training.
  
• Pakistan, Afghanistan and Senegal see Islamic banking as a way to bring underbanked people into the financial system. Bloomberg updated its list of planned and expected sukuk.
  
• The Central Bank of Bahrain's 6-month sukuk al-ijara was heavily oversubscribed with BD62 million (US$164 million) in subscriptions received for the regular BD10 million issue.
  

Thursday bullets

• The UK courts threw out the case brought by the Investment Dar against Blom Bank, which relieves some questions regarding the ex post enforceability of Shari'ah-compliant contracts where one party claims Shari'ah-non-compliance.
  
• Nakheel will issue the sukuk to its largest trade creditors in mid-July according to a large contractor.
  
• Oxford Analytica has an article about the ISDA-IIFM Tahawwut Master Agreement for Shari'ah-compliant hedging.
  
• Bermuda wants to be an Islamic finance hub and may launch its first Islamic bank or takaful company by the fourth quarter. the Bermuda Stock Exchange wants to see the first sukuk listed on the exchange later in the year as well.
  
• Sumitomo Corp is working on the first Islamic financing deal in Japan. This follows the announcement about Nomura's $100 million sukuk being issued in Malaysia.
  
• AmIslamic's musharaka sukuk received a AA3 rating from RAM Ratings.
  
• Barwa Real Estate received murabaha financing from Qatari Diar.
  
• A Malaysian fund, HwangDBS Investment Management had the top performing sukuk fund in the past year.
  
• Khazanah may increase the size of its planned sukuk to $1 billion if it increases its offer for the hospital operator Parkway Holdings.
  

ISDA-IIFM Ta'Hawwut Master Agreement described by K&L Gates

K&L Gates, an international law firm based in London, released a comprehensive summary of the new ISDA-IIFM Ta'Hawwut (hedging) Master Agreement. The full description is recommended reading because it raises a number of issues with the contract's implications based on the differences with a standard ISDA derivatives Master Agreement. I will put a few quotes here, but the full article, which was released March 16, 2010, is available from K&L Gates' website.

One point of note for ISDA Master Agreements generally (from Wikipedia) is:

The ISDA Master Agreement is a bilateral framework agreement. This means it contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, tax representations, basic corporate representations, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. The ISDA Master Agreement is a pre-printed form which will not be amended itself (save for writing in the names of the parties on the front and signature pages). However, it also has a manually produced Schedule in which the parties are required to select certain options and may modify sections of the Master Agreement if desired. The Master Agreement would be modified to the extent the modification is mentioned in the Schedule.

The K&L Gates article describes the general need for Shari'ah-compliant derivatives:

"Although these [Shari'ah] restrictions may make a Shari'ah-compliant derivative seem like a contradiction in terms, OTC derivative transactions are not necessarily repugnant to Islamic finance principles if carefully drafted and appropriately limited in purpose. Islamic finance, just like conventional finance, has a need for hedging against unexpected changes in exchange rates and commodity prices. Surprisingly, hedges are also needed in some transactions against changes in interest rates, despite the prohibition on interest in Islamic finance, because Shari'ah-compliant transactions often use published interest rates as a benchmark for pricing Islamic financial products.

They provide an analogy to conventional derivatives to demonstrate that some can be viewed as speculation while others are legitimate needs for hedging. The ISDA-IIFM Master Agreement specifies that the derivatives transactions must be used for legitimate hedging activities only:

"One analogy is of an Islamic participant being (a) a conventional investor who holds a bond and buys credit default protection on that bond versus (b) an investor who buys a credit default swap on a bond he does not own. The latter position is not Shari'ah-compliant as it is pure speculation not based on any ownership of an underlying asset."

The removal of interest in the contracts may change the incentives in cases where counterparties default:

"The absence of interest may also affect the behavior of parties in a default situation. A defaulting party may potentially raise legal objections and elongate the process knowing that default interest is no disincentive. Equally, a non-defaulting party may prefer to continue with a transaction under a mechanism that has a premium attached rather than be left with a liquidated amount which carries no interest."

K&L Gates describes the basis for the transaction which includes two wa'ad (promises), one is a promise to enter into a murabaha transaction on certain terms and the other is a promise to enter into a musawama, which is like a murabaha except that the cost to the seller does not have to be disclosed to the purchaser:

"The absence of interest may also affect the behavior of parties in a default situation. A defaulting party may potentially raise legal objections and elongate the process knowing that default interest is no disincentive. Equally, a non-defaulting party may prefer to continue with a transaction under a mechanism that has a premium attached rather than be left with a liquidated amount which carries no interest."

Finally, the Ta'Hawwut Master Agreement covers Shari'ah compliance. K&L Gates describes:

"Therefore a party is only obliged to confirm that the transaction is Shari'ah-compliant as far as it wishes or is required to do so. This may lead to further discussions between the parties as to each other's stance on such issues. If a non-Islamic party is concerned, then it could attempt to exclude this representation. Due to the varied interpretations of Shari'ah law, users may also want to involve their Shari'ah advisers in approving the Ta'Hawwut Agreement."

This reliance on the two parties to determine Shari'ah-compliance is both a strength and a weakness in my opinion. It allows for different Shari'ah standards to be incorporated for the underlying transactions and also for these standards to change over time (at least as far as they don't affect the Master Agreement. However, they also present a risk not unlike the Shari'ah risk that characterizes other products. In general, the transactions are governed by a secular law (in the Ta'Hawwut it allows the choice of New York or English law). A party should not have grounds to object to the transaction after the fact based on its Shari'ah-non-compliance. However, the TID v. Blom Bank case involving a wakala agreement adds another risk factor: that an Islamic bank will claim that it is, under its corporate charter or under another national law, unable to enter into contracts that are not Shari'ah-compliant. In the TID case, the courts cast doubt on the claim, but did not dismiss it altogether. This case should provide a good indication about whether institutions which are specifically prohibited from entering into non-compliant transactions can use this as a defense under the idea of ultra vives that could allow them to void a contract after it is signed even if the company's Shari'ah board approved the contract at the outset. It will be an important decision, and the judge who wrote the decision indicated that the ultra vives defense is unlikely to be allowed in the end when it required TID to pay the principal amount from the wakala to Blom Bank in order to be able to file an appeal.

The K&L Gates article covers many more issues than I could quote in this short blog post and I would recommend reading it in full.

Tahawwut derivative contract, Islamic finance and Nakheel, BBA, Publications on Sukuk

The Tahawwut master agreement that establishes a Shari'ah-compliant derivative framework was released today. An article in Risk magazine does the best job of describing the process in detail. One of the sticking points that delayed the release was the inclusion of the murabaha contract in the agreement as well as the procedures for close-out netting of derivatives exposure. This allows parties to close out derivatives positions with offsetting contracts between counterparties. The result is that the close-out netting is allowed in jurisdictions where national law allows it, which excludes many Muslim-majority countries that do not have laws governing this. There was also probably a discussion among Shari'ah scholars about the permissibility of offsetting debts (like murabaha). In general, there are restrictions on this because it is viewed as trading in debt (bai' al-dayn), which is restricted outside of Malaysia. However, it is generally allowed where the debts are equal (i.e. exchanged at par). The standard was backed by other banks including Standard Chartered, which recently announced its own Shari'ah-compliant derivatives products. In an earlier post, I wondered whether Standard Chartered's product would be able to be competitive with an ISDA-IIFM tahawwut product based on a master agreement that could spread costs across many financial institutions.

Westlaw Business has a few quotes from a roundtable discussion they held of Islamic finance recently that mostly focus on the Dubai World/Nakheel situation. It highlights that the investor base was sophisticated and should have (and probably did) know that the sukuk were not legally backed by the government. One omission I see in the discussion (and the quotes are just selective, so it may have been raised in the discussion) is the inclusion of fully perfected mortgages over the properties backing the sukuk. While the structure was a transfer of beneficial interests in a long-term lease to the SPV, there were also mortgages granted to the SPV over the underlying properties. This should have provided investors with recourse to the land if the sukuk was not redeemed using funds provided by the government of Abu Dhabi and two government-owned banks in Abu Dhabi. There are all kinds of potential problems investors would have faced to turn those mortgages into actual ownership in the underlying lands (in part because the land was in Dubai and the sukuk used a trust structure based on English law and the concept of a trust is not recognized in the local jurisdiction). In discussing sukuk generally, this point is not necessarily relevant because most ijara sukuk do not contain mortgages on the underlying asset and the investors are generally provided with just an unsubordinated, unsecured claim against the issuer if the issuer can not or does not repurchase the asset in case of a default. An article summarizing a discussion at the recent Reuters Summit on Islamic finance looks at the Dubai World/Nakheel situation in a different light, with participants suggesting that the problems with the Nakheel sukuk highlight the need for greater product diversification in Islamic finance to allow portfolio managers to have greater opportunity for diversification.

Affin Islamic Bank, a Malaysian Islamic subsidiary of Affin Bank, says it will continue to use the bai bithamin ajil (BBA) contract, despite criticism. RHB Islamic said earlier it stopped using the BBA contract to adopt global Shari'ah standards reflecting the more stringent requirements, particularly in the Gulf. The primary difference between a BBA and murabaha contract is that in a BBA, the client makes a deposit to the seller and then transfers the rights to acquire the property to the bank which then sells it back to the client on a cost-plus basis in installments. In a murabaha, the bank buys the property and then sells it to the client on a cost-plus basis with repayment in installments. The criticism of BBA is its reliance on bai' al-inah (sale and buy-back). In contrast to the murabaha contract the transaction is executed between only two parties and therefore is viewed as a hidden (conventional) loan. The murabaha, in contrast, separates the purchase (from the third-party seller) from the sale (to the client) and is more widely viewed as legitimate.

Islamic Finance Resources has four links to recent reports on sukuk. The links are to the Zawya Collaborative Sukuk Report, the Guide to Issuing Sukuk in the DIFC, a guide to issuing sukuk from Bank Negara Malaysia and the Malaysian Securities Commission, and the description of several types of sukuk from the Malaysia International Islamic Financial Centre.


Other News

• Deutsche Bank received an international Islamic banking license from the Malaysian central bank, Bank Negara, that allows it to provide services in foreign currencies.
  
• The Central Bank of Bahrain's Sukuk al-Salam sukuk was oversubscribed with a bid-to-cover of more than 4 times with BD56.8 million in subscriptions for the BD12 million issue.
  
• An experiment in Islamic microfinance in Pakistan described in brief.
  
• Israeli fund managers are offering investment products that comply with the prohibition of interest (ribbit) as well as other prohibitions, which shows how the prohibition of riba in Islam is mirrored in other Abrahamic faiths.