Questioning "Shari'ah Conversion Technology": Yusuf

Talal Delorenzo
By Staff Reporter
Posted, Jan 26, 2008

Innovation is a cornerstone of the financial markets. Without the development of

securitization, derivatives, and other complex financial instruments it’s safe to argue
that it would be impossible to fuel the growth of the global economy. Since the
growing Islamic Finance industry exists as a subset of the global financial system
there is always a steady stream of new ideas being proposed and tested by Islamic
financial institutions. At the center of this process of testing new ideas are the
Shari’ah (Islamic law) supervisors who advise Islamic finance institutions on the
Shari’ah compliance of their products and investments.

Yusuf Talal DeLorenzo is currently Chief Shari’ah

Officer and Board Member at Shari’ah Capital. He is
a well-known and respected Shari’ah advisor and
Islamic scholar whose career spans more than 30
years. He serves as a Shari’ah advisor to over 20
global financial entities, including index providers,
banks, mutual funds, real estate funds, leasing
funds, institutional investors, home finance
providers, alternative asset managers and others.

Shaykh Yusuf
Talal DeLorenzo

Shaikh Yusuf is also author of the three volume “Compendium of Legal Opinions on
the Operations of Islamic Banks”, the first English reference on the fatawa (religious
ruling) issued by Shari’ah boards. Shaikh Yusuf is also a special consultant,
appointed by the Asian Development Bank and the Islamic Development Bank in
Jeddah to the International Financial Services Board (“IFSB”) on the subject of
Sukuk.

He recently delivered a paper questioning the validity of a proposed structure whose

purpose is to “wrap a non-Shari’ah compliant underlying into a Shari’ah compliant
structure.” The paper is a bold attempt to correct some of the recent attempts to
ostensibly make halal (lawful) what is clearly haram (unlawful) by calling for due
consideration for both the letter and the spirit of the Shari’ah.

Following is part of the paper's introduction that lays out the issue [available for
download here]:
 Recently, a financial stratagem known as "Shariah Conversion Technology"
was developed, the purpose of which is to affect a total returns swap or to
"Wrap a non-Shariah compliant underlying into a Shariah compliant
structure."

In other words, the objective of the mechanism is to use non-compliant

assets and their performance to bring returns into a so-called Shariah-
compliant investment or investment portfolio. This point is key to the entire
transaction, and for that reason it needs repeating. What the product
proposes to accomplish is to bring to the Islamic investor returns from
investments that are not compliant with Shariah principles and precepts.

In June of this year, 2007, a pioneering Islamic bank in the Gulf launched a
principal protected note that was the first product using this "Shariah
Conversion Technology' to be offered to the investing public. This was
followed by another such product, also offered by a Gulf-based Islamic bank.
Prior to this, the stratagem was used in structured products offered by
multinational banks to institutional investors and the treasuries of Islamic
banks and finance houses. All of these products have been approved and
certified by Shariah supervisory boards. Not all of these products, however,
bring to the Islamic investor returns from investments that are compliant
with Shariah.

The questions that such a product immediately bring to mind are: How can
Shariah boards approve such returns? Does the circumstance of direct or
indirect delivery to the Islamic investor change the ruling? When the Shariah
of Islam is understood to differ from other legal systems because it may be
characterized as both positive law and morality, is it possible to ignore the
moral aspect of a financial transaction like this?

The means of delivery, a wa'd or promise, is widely seen to comply with

Shariah norms. Since it is compliant, at least to the letter of the law, some
Shariah scholars have approved products that use a wa'd to deliver returns
from non-compliant investments. By doing so, however, they have failed to
consider the purpose of the transaction, they have failed to consider the
movement of the cash and, most importantly, they have failed to consider
the ramifications for the industry as a whole.

At a very fundamental level, the reason for these failings is that 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.

DinarStandard recently spoke to Sh. DeLorenzo about total returns swap, its impact
on Islamic finance industry, and the role and responsibility of Shari’ah supervisors
today.

DS: What is the difference between abiding by the Shari’ah (as in “Shari’ah
compliant) and circumventing it?

YTD: The difference is authenticity. Unless a financial product or service can be

certified as Shari’ah compliant by a competent Shari’ah supervisory board, that
product's authenticity is dubious. At that point, it will be the responsibility of the
individual investor or consumer to determine on his or her own that the product
complies with the principles and precepts of the Shari’ah.

In matters as complex as modern finance, there is a reason that international

standards (such as those set by AAOIFI, the Auditing and Accounting Organization
of Islamic Financial Institutions) insist that such decisions must be made by a
Shari’ah supervisory board that includes at least three Shari’ah scholars with
specialized knowledge of the Islamic laws for transacting, fiqh al mu`amalat, in
addition to knowledge of modern business, finance and economics.

DS: Do you believe some people in the industry see both as being compliant?

YTD: Those who attempt to circumvent compliance may perhaps be confused. Only
Allah knows whether or not their intentions are sincere. There can be little doubt,
however, that their actions are counterproductive and probably of benefit to no one
but themselves.

DS: How serious is the problem - of making something haram halal?

YTD: Making the halal haram or the haram halal is the right of the Almighty and the
Almighty alone. So, this is no small matter. However, what we have here is a
situation in which qualified jurists have performed ijtihad. In other words, the
members of the Shari’ah supervisory boards that have approved these swaps
(download the paper to read about the “Total Return Swap”) have given due
consideration to the matter and the result of their ijtihad is their approval for the
swaps and the products that are based on them.

"...I am certainly hopeful that the market itself will reject

these products. That, perhaps more than anything else,
will be the most important step in the process of ridding
the industry of this problem and others like it."

My view is that 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. Even so, as
qualified scholars, they have a right to their own opinions. My own opinion of such
scholars (some of whom have been my colleagues for more than twenty five years)
is to say that it is likely that those scholars fell into the trap of literalism. In Urdu
there is an expression for literalists… lakeer ka faqeer.

Whatever you call it, it seems to me that when jurists lose sight of the big picture,
of the maqasid, of the Islamic financial industry and its meaning for the future of the
entire Muslim community then it is possible to explain why they might approve such
swaps. I am happy to share with you the knowledge that several of the scholars who
first approved these swaps have since reversed their opinions. And I am certainly
hopeful that the market itself will reject these products. That, perhaps more than
anything else, will be the most important step in the process of ridding the industry
of this problem and others like it.

DS: Comment on the morality of finance - isn't the right attitude “business is
business”? How does Islam invest business with morality?

YTD: Business, in the Qur'anic sense of "profitable trade" or tijarat'un rabihah is

business that brings blessings to those who conduct it. Obviously, profits are
important as ends, but the means by which those profits are earned are even more
important. Indeed, the reason for the emphasis in the Shari’ah on proper
transacting is that Islam accords great importance to the economic welfare of
society.

DS: What is your view on how Shari’ah Supervisory Boards function? Is there really
any independence if they are retained by financial institutions?

YTD: The concept of collective decision-making, in other words, decisions made by

more than one scholar, is especially important. Shari’ah Supervisory Boards (SSBs)
function to ensure that decisions are not unilateral, and that difficult issues of
finance receive adequate consideration by a number of qualified people. The
members of such boards are paid as professionals who, like consultants, offer their
opinions to management. Whether those opinions are acceptable to management or
not, the consultants will receive their professional fees.

DS: What should be the model for Shari’ah compliance be in the future -
uniform/multilateral; uniform/unilateral (government); or heterogeneous/private
sector based?

YTD: Personally, I'm a great believer in market forces. Much like the concept of
ijma', I believe that decisions made over time by large majorities of concerned and
informed people are good decisions. At the present time, the Islamic financial
industry is just beginning. As more professionals join its ranks, the intellectual
capital of the industry will grow; and when that happens, I expect that better
decisions will be made, better processes will be developed, and the quality of every
aspect of the industry will improve. This is what progress is all about.

DS: What has the reaction been to your paper? - By practitioners, other advisors,
and the industry as a whole?

YTD: I have had a great deal of positive feed back by colleagues on Shari’ah boards,
by lawyers, bankers and by financial professionals all over the world. I will mention
Shaikh Taqi Usmani, in particular, who wrote to me to request a copy of the paper
and who, after reading it, thanked me for performing what he called "fard kifayah".
Equally as important is that I have heard from investors who feel very strongly
about the issue of authenticity; and many are upset that Shari’ah scholars have
actually approved such swaps.

DS: In recent weeks we saw reports surface of Mufti Taqi Usmani’s criticism of the
sukuk sector. With the sector growing so rapidly within Islamic finance, how has the
market reacted to Mufti Taqi's observations? How did the problem get so bad?
YTD: I must again point to the relative newness of this industry, and of this product,
Sukuk, in particular. Sukuk are based on very complex contracts; and nearly every
one is different, even if many are based on the same model. For, even when you
begin with a single concept on which to base a Sukuk issuance, if the jurisdictions
are different, if the size, the tenor, the credit enhancements, in short if all the
business and legal aspects are different, then of course the end product is going to
be very different.

Then, while AAOIFI has promulgated detailed standards for Sukuk, those standards
are applicable at the conceptual level. At the practical level, however, where all the
details are, those standards are often subject to interpretation; and that will lead
inevitably to differences. So, in a way, it should come as no surprise that there is
such divergence. The contribution of Shaikh Taqi is a responsible way of dealing with
all of this. In a like manner, I am hopeful that my paper will stimulate further
discussion and debate in keeping with the finest traditions of Muslim legal
scholarship. Finally, all of us must say: Allah knows best!

Glossary of Arabic Terms:

fatwa: an opinion on matters of Islamic law, often employed by modern Islamic

banks as formal certification for a financial product or service.
halal: lawful
haram: unlawful
Shariah: Islamic law
sukuk: Shariah-compliant securities
taqwa: one's being heedful of the Almighty
wa’d: promise