1. ISLAMIC DERIVATIVES SOLUTIONS: METHODOLOGY, ISSUES AND PRODUCT STRUCTURING WITH SPECIAL REFERENCE TO PROFIT RATE SWAP AND FORWARD FOREX Dr. Mohd Daud Bakar President/CEO International Institute of Islamic Finance Inc. mdaud@iiif-inc.com/mdaud@amanie.com.my

2. ISLAMIC METHODOLOGY TOWARDS INNOVATION Islamic law deals with permanent (al- thawabit) and changeable (al- mutaghayyarat) aspects of legal issues differently. Islamic law deals with permanent (al- thawabit) and changeable (al- mutaghayyarat) aspects of legal issues differently. As for permanent part of issues, no alternation is permissible though its retirement, extension and reaffirment is encouraged (example: prohibition of riba, obligation to fulfill the contract) As for permanent part of issues, no alternation is permissible though its retirement, extension and reaffirment is encouraged (example: prohibition of riba, obligation to fulfill the contract)

3. However, Islamic law allows room for reasoning and reinterpretation in areas of law which are changeable and progressive in character. (example: standard of delivery, standard of certainty in pricing, and underlying asset, standard in settlement of obligation). However, Islamic law allows room for reasoning and reinterpretation in areas of law which are changeable and progressive in character. (example: standard of delivery, standard of certainty in pricing, and underlying asset, standard in settlement of obligation). While riba is a fixed prohibition in terms of definition and application, gharar (lack of knowledge that could be detrimental to parties to contract) is not. Gharar changes with the change of technologies, legal framework, customary practice, etc. While riba is a fixed prohibition in terms of definition and application, gharar (lack of knowledge that could be detrimental to parties to contract) is not. Gharar changes with the change of technologies, legal framework, customary practice, etc.

4. SHARI’AH ISSUES IN DERIVATIVES The pricing standard: Certainty and benchmark. The pricing standard: Certainty and benchmark. Time and method of delivery with regard to both ribawi items and non- ribawi items. Time and method of delivery with regard to both ribawi items and non- ribawi items. Time and method of payment with regard to both ribawi items and non- ribawi items. Time and method of payment with regard to both ribawi items and non- ribawi items. Marked to market. Marked to market. Perception! Perception!

5. PRODUCT STRUCTURING FOR ISLAMIC DERIVATIVES Freedom of contract provided it is free from riba and gharar. Freedom of contract provided it is free from riba and gharar. Riba takes place if there is an excess (inequality) or a delay in delivery, as the case maybe, in any exchange of two similar ribawi items. Or, if there is a delay in delivery in any exchange of two dissimilar ribawi items (e.g. USD for RM). Riba takes place if there is an excess (inequality) or a delay in delivery, as the case maybe, in any exchange of two similar ribawi items. Or, if there is a delay in delivery in any exchange of two dissimilar ribawi items (e.g. USD for RM).

6. Gharar-free transactions imply transactions that are void of lack of knowledge that could bring detriment to one or the other party in a contract. Lack of knowledge may be due to uncertainty of item, price, etc. Gharar-free transactions imply transactions that are void of lack of knowledge that could bring detriment to one or the other party in a contract. Lack of knowledge may be due to uncertainty of item, price, etc. Islamic derivatives structuring, therefore must be free from both riba (when it involves exchange of two similar or dissimilar ribawi items) and gharar (when it involves non-ribawi items). Islamic derivatives structuring, therefore must be free from both riba (when it involves exchange of two similar or dissimilar ribawi items) and gharar (when it involves non-ribawi items).

7. Issues of riba confine to either excess (inequality) or delay in delivery and payment or both. Issues of riba confine to either excess (inequality) or delay in delivery and payment or both. Issues of gharar centre around uncertainty, inability to deliver, unavailability, etc. Issues of gharar centre around uncertainty, inability to deliver, unavailability, etc.

8. INTEREST / PROFIT RATE SWAP / EXCHANGE Definition: Definition: Involves exchanging (swapping) interest payments on Floating-rate debt for interest payments on Fixed-rate debt, with both payments in the same currency. Reason: Reason: One party actually wants fixed rate debt, but can get a better deal on floating rate; the other party wants floating rate. Both parties can gain by swapping loan payments, usually through a bank as a financial intermediary which charges a fee to broker the transaction.

9. FEATURES OF INTEREST / PROFIT SWAP A swap of fixed-for-floating interest rate. A swap of fixed-for-floating interest rate. A master agreement for fixed rate interest. A master agreement for fixed rate interest. A floating or variable rate which is reset periodically. A floating or variable rate which is reset periodically. A set-off (muqasah) exercise at every reset time to swap a fixed-for-floating interest rate. A set-off (muqasah) exercise at every reset time to swap a fixed-for-floating interest rate. Floating interest rate is to based on a certain benchmark. Floating interest rate is to based on a certain benchmark. The counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant. The counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant.

10. PROPOSED ISLAMIC PROFIT RATE SWAP The above characteristics of the conventional interest rate swap are to be maintained. The above characteristics of the conventional interest rate swap are to be maintained. Therefore, it must consist of three important documents: Therefore, it must consist of three important documents: (i)Master Fixed – Rate Transaction. (ii)Master Revolving Floating – Rate Transaction. (iii)Settlement Agreement.

11. The challenge in Islamic finance is to create a mechanism which is floating and revolving to assist the parties in their swap transactions I.e. to give floating rate profit to the party who seeks to match their floating payment obligations and to give fixed rate profit to the party who seeks to match their fixed payment obligations (in addition to achieve ‘Quality Spread Differential’ that is spread between fixed interest rate and variable interest rate. The challenge in Islamic finance is to create a mechanism which is floating and revolving to assist the parties in their swap transactions I.e. to give floating rate profit to the party who seeks to match their floating payment obligations and to give fixed rate profit to the party who seeks to match their fixed payment obligations (in addition to achieve ‘Quality Spread Differential’ that is spread between fixed interest rate and variable interest rate.

12. ISLAMIC PROFIT RATE SWAP: AN OVERVIEW (A HYPOTHETICAL CASE) ABC Bank has floating rate funding and fixed rate investment. In order to match funding rates with return rate (investment), ABC Bank may decide to enter into an Islamic Profit Rate Swap with a counter-party. ABC Bank has floating rate funding and fixed rate investment. In order to match funding rates with return rate (investment), ABC Bank may decide to enter into an Islamic Profit Rate Swap with a counter-party.

13. Stage 1: Fixed Profit Rate Step 1: XYZ Bank (counter party) sells an asset to ABC Bank on Murabahah basis at a selling price that comprises both principal and profit margin to be paid upon completion of subsequent transaction I.e. Stage 2. An Asset Purchase Agreement is executed by the two parties.

14. Illustration: Suppose the national principal amount intended is BD500,000 and the fixed mark-up is 5.75% for 2 years. The fixed mark-up profit rate amount is payable every 6 months for 2 years (BD500,000 x 5.75% x 5.75% x 180/365 = BD14,178.08) Illustration: Suppose the national principal amount intended is BD500,000 and the fixed mark-up is 5.75% for 2 years. The fixed mark-up profit rate amount is payable every 6 months for 2 years (BD500,000 x 5.75% x 5.75% x 180/365 = BD14,178.08) Stage 2: Floating Profit Rate Stage 2: Floating Profit Rate Step 1: Just prior to 6 months, ABC Bank will sell an asset to XYZ Bank at a selling price of BD500,000 plus a mark-up based on CURRENT profit rate (agreed spread plus current benchmark). An Asset Sale Agreement is executed by the two parties.

15. Step II Payment of selling price by both ABC and XYZ Bank is netted-off. Step III The net difference is profit, and is paid to the receiving party as the case may be spelt out in the settlement agreement.

16. Stage III Stage III -Floating Profit Rate (Stage II) is repeated every 6 months until maturity.

17. Islamic Rate Swap Counter-Party Islamic Depositors ABC Islamic Funding ILLUSTRATION pays fixed profit rate receives floating profit rate Floating rate Fixed rate

18. OTHER ALTERNATIVE / PROPOSAL As the bottom line of swapping is to swap fixed for floating interest rate/profit rate to suit the financial needs, the principle of sale and lease-back (with an option to purchase) would be workable (at least in theory) As the bottom line of swapping is to swap fixed for floating interest rate/profit rate to suit the financial needs, the principle of sale and lease-back (with an option to purchase) would be workable (at least in theory) As for the fixed profit rate, the sale which is based on Murabaha can be initiated. This is followed by ijara based on current benchmark, which is floating. As for the fixed profit rate, the sale which is based on Murabaha can be initiated. This is followed by ijara based on current benchmark, which is floating.

19. GENERAL OBSERVATION 1 Floating rate intended in the swap transaction does not necessarily mean that the rate of profit is floating (I.e. moving from one rate to another). It means more of entering into a new contract, be it Murabaha, or Ijara, or whatever, as the case may be, as long as it is based on current cost of funds according to certain benchmark already agreed in the formula. Floating rate intended in the swap transaction does not necessarily mean that the rate of profit is floating (I.e. moving from one rate to another). It means more of entering into a new contract, be it Murabaha, or Ijara, or whatever, as the case may be, as long as it is based on current cost of funds according to certain benchmark already agreed in the formula.

20. GENERAL OBSERVATION 2 In swap no actual payment is made as the principal amount upon which total payments are based are just notional. From the Shari’ah view, this is done via the principle of Muqasa (set-off), subject to its terms and conditions. In short, a profit rate swap is a contractual rate agreement entered into between two counterparties under which each party agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. In swap no actual payment is made as the principal amount upon which total payments are based are just notional. From the Shari’ah view, this is done via the principle of Muqasa (set-off), subject to its terms and conditions. In short, a profit rate swap is a contractual rate agreement entered into between two counterparties under which each party agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal.

21. ISSUES OF CONCERN Can the Shari’ah force one of the counter-party to enter into a subsequent transactions while the swap has not matured? Can the Shari’ah force one of the counter-party to enter into a subsequent transactions while the swap has not matured?

22. ISSUES OF CONCERN Answer: Not allowed as the parties are at liberty, and no penalty should be imposed upon refusal. Not allowed as the parties are at liberty, and no penalty should be imposed upon refusal. Allowed as both have agreed to impose these conditions upon themselves from the beginning. Allowed as both have agreed to impose these conditions upon themselves from the beginning. Refusal to enter means Early Termination Event of the Master Agreement. Refusal to enter means Early Termination Event of the Master Agreement. (according to International Swap and Derivatives Association (ISDA), upon early termination the swap value will be determined, and a certain amount “the close-out amount” will be calculated and will be paid by the party which is “out of the money” on the swap.

23. ISSUES OF CONCERN Murabaha transaction could be based on Tawarruq or ‘Inah concept, as the case may be. Murabaha transaction could be based on Tawarruq or ‘Inah concept, as the case may be. Conditional contracts of purchase and sale and subsequent contracts. Conditional contracts of purchase and sale and subsequent contracts. Perception. Perception.

24. ISSUES IN FORWARD FOREX Forward FOREX involves essentially two dissimilar ribawi items i.e. two different currency. Currency is a ribawi item. Forward FOREX involves essentially two dissimilar ribawi items i.e. two different currency. Currency is a ribawi item. Under the principles governing any exchange of two dissimilar ribawi items, the exchange of two counter values must be spot or simultaneous Under the principles governing any exchange of two dissimilar ribawi items, the exchange of two counter values must be spot or simultaneous (hand to hand). Forward FOREX entails that the rate of exchange is locked in today (the day of contract) but delivery of two countervalues is being deferred to a future date where the delivery of these two counter values will be made on spot basis. Forward FOREX entails that the rate of exchange is locked in today (the day of contract) but delivery of two countervalues is being deferred to a future date where the delivery of these two counter values will be made on spot basis.

25. There is a silent consensus amongst the jurists that this method of exchanging a currency for another is not compliant to the requirement of “hand to hand”. There is a silent consensus amongst the jurists that this method of exchanging a currency for another is not compliant to the requirement of “hand to hand”. “Hand to hand” requires the delivery of the two counter-values be made on the day of the contract which is not the practice in current FOREX. “Hand to hand” requires the delivery of the two counter-values be made on the day of the contract which is not the practice in current FOREX.

26. ISLAMIC SOLUTIONS TO FOREX Islamic law requires delivery to be made on the day of the contract. However, Islamic law does not prohibit promise to buy and sell currencies on one date and delivery to be made on another date because the proper contract only concludes on the day of delivery. Islamic law requires delivery to be made on the day of the contract. However, Islamic law does not prohibit promise to buy and sell currencies on one date and delivery to be made on another date because the proper contract only concludes on the day of delivery.

27. This premise of argument has led to the argument/construction of wa’d (promise) in structuring Islamic version of FOREX. This premise of argument has led to the argument/construction of wa’d (promise) in structuring Islamic version of FOREX. Under wa’d structure, only one party (obligor/promisor) promises to buy/sell as the case may be wherein he is bound by that promise (binding promise). The other party / promisee / obligee is not bound however to proceed with the promise undertaken by the promisor. Under wa’d structure, only one party (obligor/promisor) promises to buy/sell as the case may be wherein he is bound by that promise (binding promise). The other party / promisee / obligee is not bound however to proceed with the promise undertaken by the promisor.

28. Binding promise from only one party is not deemed under Islamic law as a contract. Therefore, this can facilitate FOREX. Binding promise from only one party is not deemed under Islamic law as a contract. Therefore, this can facilitate FOREX. Binding promise from both parties are deemed to be leading to contract conclusion and therefore, prohibited. Binding promise from both parties are deemed to be leading to contract conclusion and therefore, prohibited.