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The case for interest rate swaps.

Yankson believes that while interest rates swaps will probably violate Riba, Maisir and Gharar, there is a case for arguing the contrary. The profit rate swap seeks to achieve Shari'ah compliance by using reciprocal Murabaha transactions. The primary Murabaha contract will see a floating rate payer buy a commodity from broker 1, and immediately sell the commodity to the fixed rate payer. The fixed rate payer will immediately sell the commodity to broker 2 to generate cash. The fixed rate payer will then repay floating rate payer on a deferred basis in installments on pre-agreed payment dates.

Shari'ah law would traditionally argue that the floating rate payer paying a variable amount would not be Shari'ah-compliant due to the uncertainty of the amount to be paid. One argument that would counter this is that the Arbun contract should also fall foul of Gharar as it is not certain that the buyer will actually complete the transaction.

This appears to be a far more risky situation because of the forfeit of the premium that the buyer will lose under Arbun. In an interest rate swap by comparison, it can be argued that the uncertainty of interim payment amounts is not material to the floating rate payer. What is important is that the floating rate payer agrees to pay an amount on a fixed day and with reference to a fixed reference, i.e. LIBOR. If Shari'ah requires these interim steps to be agreed and fixed at outset then an interest rate swap, by definition can never be Shari'ah compliant.

FIXING THE FLOATING RATE What about if the floating rate payer agreed to make a series of payments of fixed amounts and then would add more if the floating equivalent was higher and would receive a refund if the floating payment due on that date was lower? If these stipulations were agreed in the contract would this be Shari'ah compliant? Essentially you would now have two fixed payers, but both parties would agree that fixed payer B will either pay an additional amount or receive an additional amount based on the floating interest rate at the time of payment in the market. In my view, this may also fall foul of the Shari'ah's prohibition on uncertainty as the additional payments would also be uncertain at the time of the contract.

The profit cost swap seeks to address this issue using a series of sequential Secondary Reverse Murabaha Contracts. In brief, the fixed rate payer buys commodities every three months, sells them to the floating rate payer who onward sells them immediately and pays the fixed rate payer the cost of the commodities plus the fixed rate payers profit on the sale, which is linked to a floating rate formula.

This is where the substance versus form critics would throw their arms in the air. This sequence of Murabaha contracts comprises an element of uncertainty. The amount of the fixed rate payer's profit is uncertain as it is linked to LIBOR. Therefore, how come these contracts are allowed? Is it simply because a physical commodity changes hands? The fact that there has to be purchase and sales of commodities every three months means that what looks like separate and distinct commodity transactions are all probably agreed in the original contract. Therefore, if one looks closely at this transaction overall, the floating rate payer will pay interest based on LIBOR which is clearly uncertain. Why does Shari'ah look the other way and let these transactions pass as Shari'ah compliant?

There is a commodity changing hands, and it looks on first blush as a plain vanilla Murabaha transaction. There is, however, the uncertainty of the profit paid to the fixed rate payer. In Yankson's view this uncertainty is exactly the same as that contained in an interest rate swap contract and therefore, there is a case for arguing that those contracts should not fail for lack of Gharar.

The floating rate payer can make a Wa'ad under a Murabaha to pay the cost of the commodities plus a profit linked to LIBOR and this is Shari'ah compliant. The commodity bought and sold to allow this transaction to happen is transferred from buyer to seller within seconds. This means that the risk of owning the commodity, which, suggests Yankson, is the key to why the transaction is allowed under Shari'ah, is effectively irrelevant. This is due to the fact that no sooner has the fixed rate payer bought the asset, it is sold to the floating rate payer and onto the floating rate payer's agents. The buyer has no interest in the commodity at all. In reality, he suggests, you would probably find that the broker for the fixed rate payer acts as agent for the fixed rate payer too, and transfers the commodities to the floating rate payers agent, broker 2.

FORM OVER SUBSTANCE Therefore, there is probably no ownership risk on the commodities at all as the transaction takes seconds. If the commodities are already in the custody of broker 2 or are held in a central repository or a third party custodian, then the commodity probably never leaves its actual physical site at all during the entire transaction. In which case, the whole thing smacks of form and not substance. Provided you fulfill what the Fatwa says then the transaction is Shari'ah compliant. In substance the interest rate swap achieves exactly the same objectives, but is declared non-Shari'ah compliant because a commodity doesn't change hands, and there is too much risk due to the unknown amount of floating rate interest that will be paid. The profit cost swap has the exact same interest rate uncertainty, but is deemed Shari'ah compliant. The commodity bought and sold by both parties is the same physical amount and needs to be for the same agreed price so that the cash flows add up. In substance under the profit swap, all that is essentially happening is that a floating rate payer is paying LIBOR and a fixed rate payer is paying a fixed amount. That is it.

Speculation is definitely prohibited under Shari'ah. There is a difference in objective between hedging and speculation. Hedging is the process whereby a party seeks to reduce risk, which according to Maslaha can be a public good as it reduces overall risk.

There is also a prohibition under Shari'ah for combining more than one contract under an agreement if the contracts are mutually dependent on one another.

Presumably the profit swap circumvents this by not making each subsequent sale and purchase by the fixed rate payer dependent on the other three-monthly transactions.

By definition, the initial Murabaha, has built-in payment dates which are deferred. Therefore, the sequential Murabaha contracts designed to fulfill these deferred payment dates must be specified in the original agreement. This seems to be another area where Shari'ah law has allowed a rule, a prohibition of collateral contracts, that seems inviolable to be stretched if not broken!

NO WINNER, NO LOSER? Another factor that is worthy of mention is that when an interest rate swap is priced, the present value of the floating rate payments is equal to the present value of the fixed rate payments. This means that from the outset, both parties do not win or lose.

There is an inherent risk sharing because it could go either way. Both parties share the risk of making or losing money because they start off in an equal position. Secondly, both parties are fully aware that the equation could go in their favour or against them. Therefore, there is no unjust exploitation. There is uncertainty about which one will end up in profit or in deficit, but for a normal trading business, this is exactly the same as whether they will make any sales that day or not.

Shari'ah tends to eschew unnecessary risks arising from speculation. Indeed, most interest rate swaps are probably for speculative purposes. There are, however, a percentage that are probably for hedging purposes and it is these that need Islamic finance to provide cost-effective hedging to alleviate the business risks that they face every day.

Yankson suggests that there can be no express prohibition of financial derivatives in the Qur'an because they were not thought of at the time. If his analysis is correct with regards to interest rate swaps not being a zero-sum game, and both parties are in trading businesses, then they can both benefit. If there is no violation of the other parts of the Qur'an then, he concludes, maybe interest rate swaps are Shari'ah compliant.

Interest rate swaps can be used for both hedging and speculation. As far as hedging is concerned, they are tremendously widely used. Shari'ah-compliant profit rate swaps, however, require a commodity to be bought and sold, and the 'profit' paid by the floating rate payer can be linked to LIBOR or some other floating rate and hence uncertain reference data. Therefore, if one looks at the details or form of the interest rate swaps and profit swaps, one is left thinking that they are different. One involves a commodity sale, the other doesn't. If one looks at the overall picture, at the substance, one sees that the net cash flows for the counterparties are identical.

ISLAMIC ANOMALIES Selling exotic derivatives is off limits to Islamic institutions. In the detail of Islamic finance, however, one finds anomalies. Under Arbun, the buyer has a choice and can therefore wait and see. Under Bai Salam, the seller of a crop has to wait for the weather to see whether his crop will be harvested. Islamic law seems to allow these transactions for a variety of reasons including the nature of commerce and a sharing of the risk.

Yankson argues that in an interest rate swap both parties are sharing the risk and a case can be made for allowing interest rate swaps to be Shari'ah compliant without resorting to buying and selling commodities. Indeed, given the Islamic principle of permissibility (Ibahah), which renders all commercial transactions Shari'ah compliant in the absence of a clear and specific prohibition, he argues that futures and options could form a valid part of Islamic finance.

For the Wa'ad and profit swap structures, maybe the very fact that an asset and not a notional must be used is the important factor to their Shari'ah-compliant status. Does the asset under a profit swap have to be equal to the notional under an interest rate swap? Is it possible to have a peppercorn asset specified in the interest rate swap contract, similar to western contracts whereby consideration of $1 or Au1 have been held to be sufficient?

In Islamic finance, derivatives are not readily accepted due to their lack of transfer of a real asset and the uncertainty of the contract. The elimination of zero-sum contracts is a central theme of Islamic principles. This is because in a zero-sum game there is a winner and a loser. The winner wins at the loser's expense. If, however, the structure of the payoffs can be understood to not be a zero-sum game, or win-win then maybe derivatives in general and interest rate swaps in particular would not breach Gharar rules at all.

Moreover a contractual requirement for an asset transfer, where in reality the asset does not physically move at all, implies that in substance the Shari'ah-compliant transaction is exactly the same as an interest rate swap. Islamic finance needs to continue to develop instruments that help to mitigate risk.

2009 CPI Financial. All rights reserved.

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Publication:Islamic Business & Finance
Date:Sep 5, 2010
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