Issues and Challenges in Islamic Derivatives Product: Islamic Profit Rate SWAPS By Shara Fedayu Sarif 2009309365 Graduate

Business School Faculty of Business Administration Universiti Teknologi MARA 40000 Shah Alam, Selangor. 1.0 Global Trend of Islamic Finance Islamic finance has existed since the 1970s. Traditionally concentrated in Muslim majority countries in the Middle East and Asia, in recent years, Islamic finance has expanded to other countries with smaller Muslim populations. With the establishment of Islamic Development Bank in October 1975 in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries (Islamic Development Bank, 2011). This has further supported the importance of Islamic Finance, not only to Muslim country but throughout the world. The growing interest in Islamic finance has also impacted some non-Muslim businesses and investors due its characteristic whereby it prohibits the payment and collection of interest, and bans gambling, also, the highly complex instruments such as derivatives and other creative accounting practices are banned (AsiaNews, 2010). Some consider the principles of Islamic finance to be prudent and risk-mitigating, while others are looking to diversify their portfolios or to raise new sources of capital. In Islamic finance, the price and nature of the goods being transacted are defined in detail and agreed upon by both parties to avoid the existence of gambling, and also, Islamic finance do practise sharing of risk and return (musharakah) to eliminate the win -lose situation (Aziz, 2008). From here, we can see, that t he Middle East continues to be the primary geographic centre for syariah-compliant financing. Iran accounts for about 40% of total global assets in Islamic finance. Elsewhere in the Middle East, major Islamic finance markets are Bahrain, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates (UAE). More recently, Asia has emerged as the second-largest hub for Islamic finance. Malaysia, a regional leader in Islamic finance, boasts more than half of the global share of Islamic capital market securities (Shayerah, 2010). 2.0 Emerging market of Islamic Derivatives In the past couple of decades, our market has witnessed innovations in Islamic financial products not only in Middle East geographical area, but also towards the powerful country, United State. US capital market, namely Dow Jones presented its first Islamic market index in 1999, which follows syariah-compliant stocks internationally. The Dow Jones maintains more than 100 indices in its Islamic series and is advised by an independent syariah supervisory board, which consists of five Islamic scholars from Bahrain, Malaysia, Saudi Arabia, Syria, and the United States (Shayerah, 2010). Islamic capital market securities which were first introduced has now become a fast-growing segment of the Islamic finance industry. In relation to the Islamic derivatives education, among the various Syariah norms the ones that are the most important to comply on are freedom from riba (interest), gharar (risk) and qimar or maysir (gambling). However, in term of risk exposure, a small amount of gharar is even tolerable (IRTI, 2011). Currently there are 4 types of derivatives products , namely, forward, futures, swaps and option. These products have captured the Islamic financial engineering to come out with supplemental derivatives based on syariah compliance procedure. Summary of products with the key differences are as follows: Conventional Forward y It is a sale and purchase contract where two parties undertake to complete a transaction at a future date but at a price determined today. y If the price of the product is highly volatile, then both are exposed to a risk. The producer is exposed to the risk of a price decline, while the consumer is exposed Islamic y Forward contracts are acceptable according to the syariah principles if it adhere to the contract of salam. Salam in the definition jurists a sale of a commodity whose delivery will be in a future date for a cash price, which means, it is a financial transaction in

Futures

to the risk of a price increase. Both parties can now hedge against their respective risks by entering into a forward contract. It may be noted that in the process, they also lose the potential for making a gain due to price change. y Similar to forward market but in standardized contract specification with respect to contract size, maturity product quality, place of delivery, backed by the intermediation of an organized exchange. y 2 type of settlements, i.e. physical settlement and cash settlement. Former represent physical goods are to be delivered at the maturity date, while latter represent only cash price differential is to be paid.

which price is advanced in cash to the seller who abides the delivery of commodity of determined specification on a definite due date (Nuradli & Sanep, 2006).

Options

Swaps

y An agreement between two counterparties to exchange two streams of cash flow with each other. y Two basic swaps transaction, i.e. currency swaps (foreign exchange agreement to exchange a given amount of one currency for another) and interest rate swaps (exchange of interest rate between a fixed rate party and floating rate party, vice versa) (Rosalan, Noryati, & Ho, 2010).

y Fall into compromise (sulh) and (promise gift) jialah contract (Nuradli & Sanep, 2006). This is to show that investors promise to deliver the good as gift in future. y For financial futures, it involve with no physical good, so, when the delivery date of the goods is due the sulh contract could be used whenever the seller or buyer disputes the agreement. Then the party who could not fulfill the contract (as they do not have physical asset due to earlier intention just to make profit in futures) has to offer a compromise to replace the agreed property that should be delivered with other properties such as money. y Islamic profit rate swap is basically an agreement to exchange profit rates between a fixed rate party and a floating rate party or vice versa implemented through the execution of a series of underlying contracts to trade certain assets under the Syariah contracts. Each partys payment obligation is computed using a different pricing formula. In Islamic

y Provides a right to buy or sell without any obligation can handle such uncertainties. y A call option entitles the holder the right but not the obligation to buy the underlying asset at a predetermined exercise price at or anytime before maturity. A put option on the other hand entitles the holder the right but not the obligation to sell the underlying asset at a predetermined exercise price at or before maturity (Rosalan, Noryati, & Ho, 2010). y Writer may face unlimited loss but Holder face unlimited profit.

rate profit rate swap, the notional principal is never exchanged as it netted off using the Islamic principle of Muqasah (IRTI, 2011). y It is a promise from a party to another party to buy or sell his property in a future date. y The problem in options is the premium fee that is imposed on the promise, which make the contract invalid. y Arboun or deposit is also suggested as a syariah compliance for call options. The buyer will pay a deposit for the call option and in the case of withdrawal; the deposit will be forfeited as a gift to the seller. If the buyer continue on the purchase then the deposit will treated as the purchase price (Nuradli & Sanep, 2006).

Out of those 4 types of derivatives product, this paper will discuss on one of the Profit Rate Swap-i, named Ijarah Rental Swap-i. 3.0 Ijarah Rental SWAP-i (IRS) 3.1 Overview of IRS An Ijarah Rental Swap-i is a risk management tool recently offered by Kuwait Finance House. This product is suitable for customers who have Ijarah financing arrangements that are subjected to fluctuations of the Reference Rates such as cost of funds (COF) or KLIBOR. Many are wrong by saying that IRS is one of the Islamic financing tools. IRS is not a financing tool. IRS allows the customer to exchange or modify their Ijarah rental obligations from float to fixed and vice versa. This is where an arrangement is entered into between the Bank and its customer. This structure will allow the customer to manage its lease rental obligations actively, with the view of minimizing any negative impact on rate fluctuations.

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throughout the life of the Swap (for Bullet repayment). Amortizing principal a mount could also be negotiated between the swap counterparties. 3.5 Cost of IRS There are no fees or other direct costs associated with a Swap. The price of the Swap is simply the fixed rate of Ijarah rental rate applicable to the Swap. When setting the fixed rate of Ijarah rental swap, Banks normally will takes into account a variety of factors including:
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into one. Even though, in general, the Prophet (peace be upon him) prohibited amalgamation of several contracts, there are views allowing it, but with certain conditions. Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) (2007) has outlined the guidelines and conditions for this. 1. Combining contracts should not include the cases that are explicitly banned by Syariah. For example, contracts that combine a sale and loan into one contract. 2. Combining contracts should not be used as a ploy to commit usury (riba), such as an agreement between two parties to practice a sale and buyback transaction (bay al-inah) or riba al-fadl. 3. It should not be used as an excuse for practicing riba. The two parties could misuse, for instance, contract combining when they conclude a lending contract that, at the same time, facilitates some other compensatory gains to them. For example, they could stipulate in the contract that the borrower should offer accommodation in his house to the lender, or grant him a present. Contract combining could also be misused by imposing excess repayment in terms of quantity or quality on the borrower. 4. Combined contracts should not disclose disparity or contradiction with regard to the underlying rulings and the ultimate goals. Examples of contradictory contracts include granting an asset to somebody as a gift and selling/lending it to him simultaneously, or combining murabahah (profitsharing contract) with lending the mudarabah capital to the mudarib, or currency exchange with jialah, or salam with jialah for the same contract value or leasing with selling (i.e. hire -purchase in its traditional form. 4.2 Muwaadah Mulzimah (Binding Bilateral Promises) Nearly all swap structures introduced by Islamic financial institutions at this juncture apply the waad principle. Literally, waad means a promise which is usually linked to benefit. By definition, waad means a promise that is unilateral, given by one side to do something in the future. Jurists of the past and present have debated whether waad is binding or not. Briefly, Majma al -Fiqh al-Islam (the Islamic

The amount of the Principal, the term of the Swap, the Reference Rate and the reset or payment frequency

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4.0 Issues in Profit rate Islamic SWAPS We have come to the important aspect of this paper where we will address some of the issues and challenges in profit rate Islamic Swaps. 4.1 The Issue of Combining Several Contracts If we observe the swap mechanism discussed above, it involves a combination of several contracts in one transaction. For example, in the profit -rate swap, a series of contracts (murabahah or musawamah) are executed between the contract based on a fixed rate value price and the floating rate. This certainly triggers some Syariah issues against amalgamation of two contracts (Asyraf & Shabnam, 2010). In study done by Asyraf & Shabnam (2010), most Muslim jurists agree that combining a sale with a loan is prohibited because of the difference in the nature of the sale agreement (bay) and the loan agreement (salaf). The sale (bay) is an exchange contract (muawadah) while a loan (salaf) is a charitable contract. Not only it differs in the definition but also practically on the view of time limits. The sale (bay) contract has a certain period and time limits while loan (salaf) contracts does not have time limit. This is because a sale contract involves an exchange while a loan is like serving a charitable rather than intention of profit making. Besides that, a sale is a binding contract, while a loan is not binding because it is considered an act of charity from one party to another (unilateral). Briefly, combining two such contracts is contradictory. However, on the other views of Islamic scholars, they have different opinions with respect to combining a few contracts

Fiqh Academy of the OIC) has issued two resolutions regarding waad. In its first resolution, issued in 1988 during the fifth conference in Kuwait, the Islamic Fiqh Academy resolved that waad issued by one side is binding only upon the side who makes the promise, both ethically (diyyanatan) and legally. In the profit-rate-swap structure, the bank makes a promise to the investor to execute a series of musawamah contract by paying the price based on a fixed profit rate for a certain period of time. At the same time, the investor also promises the bank to execute a series of musawamah contracts by paying the price based on a floating profit rate for a certain duration. If the examples above are observed, it is important that the agreed waad be refined so that the issue of muwaadah mulzimah (binding bilateral promises), doe s not arise, for this is not allowed by the majority of jurists (Asyraf & Shabnam, 2010). However, this issue can be overcome by ensuring waad is conducted for two separate contracts which are not linked to one another. The muwaadah mulzimah issue only happens if two promises are executed for one similar contract or for one situation that is the same. Therefore, it is very important to ensure the waad execution is further refined so that there is no issue of muwaadah, where two parties make promises to one another, for this resembles a conditional sales agreement, which is prohibited. This is also to ensure that this waad is not misused for a wrong purpose which does not fulfill the demands and objectives of Syariah. 5.0 Conclusion & Recommendations As we can see, Islamic swaps not only served as a tool of risk management, but also, reducing cost of raising resources, identifying appropriate investment opportunities, better asset-liability management and the like. These are also the benefits with conventional swaps. Islamic swaps are different in that they do not engage with any interest-related cash flows. However, Islamic swaps are not free from controversies as what we have highlighted earlier. We would recommend that, there should be a consensus on global standard of practice not only to Islamic Swaps instrument but also to all the derivatives financial instruments. Investors, and market player should be well educated and being exposed to the mechanics and procedures in order to attract them to utilise the Islamic

finance derivatives. In any basic derivatives instrument that we have, the most important syariah compliance that we have to hold are to comply on are freedom from riba (interest), gharar (risk) and qimar or maysir (gambling). With a fast-growing market in Islamic Finance, we should be more creative and innovative to produce a new instrument to cater for the same derivatives objective instead of just producing something that are already exist in conventional way.

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