For they have sown the wind, and they shall reap the whirlwind.
Hosea, 8:7
On an oppressively muggy June 2010 evening in Dubai, smartly dressed young executives took refuge in the opulently chilled luxury of the Emirates Towers to hear Tarek El Diwany discuss his latest book project. The book was a wide-ranging attempt to bring together views both for and against the current direction of the Islamic finance industry, and a proposal for basic reforms at institutional and contractual levels.1 Perhaps unwittingly, El Diwany had attracted something of a cult following among the professional Muslim community around the world, particularly those in the financial services industry. Shunned by mainstream bankers and conference organizers, he found his invitations to speak to the industry had become increasingly infrequent, and indeed (excepting his appearance at this glamorous location in Dubai) glittering ballrooms in five-star hotels had long since given way to dingy community halls in the East End of London.
Not that this bothered him. He had long since freed himself from the trappings of a former life as a credit derivatives dealer at Prebon Yamane in the yuppie heyday of the late 1980s. Now in his forties, gaunt but energetic, he exuded a youthful intensity and passion for his subject: the eradication of interest from the modern financial system and the return of the Islamic banking industry to its core values.
‘Actually, do you mind if I step off the stage, and come down to talk?’ he enquired of the assembled young men and women, many of whom had heard about the lecture at Friday prayer in Masjid Al-Samad. He stepped off the stage, microphone in hand, and proceeded to wander among the audience.
‘I’ve been told I look like a lunatic when I do this’, he laughed self-deprecatingly. He liked to get up close to his crowd, to engage them on a human level – a refreshing change from the London Business School stiff in an immaculately tailored suit pitching his latest magic beans from the safety of a conference lectern.
To the MBA alumni he was indeed a lunatic. The mainstream had stopped trying to debate with him long ago, perhaps because the one-dimensional world that some of them inhabited had not equipped them to imagine new possibilities or perhaps simply because they struggled to match his razor-sharp intellect. With a sound knowledge of economics and modern banking practice, as well as a keen sense of the principles of Islamic jurisprudence and the spirit of Sharia, El Diwany delivered his arguments precisely, convincingly and intensely in his plummy English accent. But despite the beard and bookish demeanour, he was no journeyman accountant or academic. He was an evangelist.
In the Emirates Towers’ Godolphin Ballroom he set the scene, as he often did, with a description of the relationship between the goldsmith moneylender and today’s fractional reserve banking system. That money could be created out of money was contrary to sense and morality, he argued.
He sought to draw parallels between the clever ruse employed by medieval financiers to circumvent the Church’s ban on usury, the contractum trinius, and the hilah, or legal tricks, employed by modern bankers to produce apparently Sharia-compliant financial products.
Several centuries ago, since Christianity formed the backbone of judicial systems in Christian nations, in such countries it had been made illegal to charge interest on a loan. Financiers entered into three contracts with borrowers: an investment, a sale of profit and an insurance contract. Each individual contract was permissible under Church law, but in combination the three contracts produced an interest-bearing loan, a transaction explicitly outlawed by the Church.
‘Imagine I made an investment of money into your business and we agree to share profits’, he suggested. ‘Then I agree to sell to you future profits on the investment for a price we agree today. Finally you agree to insure me for a loss on my investment. In the end, you have ended up paying a fee to me for money which I “invested” in you.’ Thus three contracts – the contractum trinius – are combined, leaving a loan with interest. Many in the audience shifted nervously as they recognized the parallels with the modern Islamic finance industry.
Over the course of centuries, various justifications were made by laymen and financiers for the charging of interest. They argued that money was a useful commodity: it had usufruct and thus could be rented. Christian scholars rejected this position on the basis that a rental of money was equivalent to a sale of money, and it would be unjust to sell one quantum of money for a different quantum. Lost opportunity cost was another argument put forward: the lender of money must abstain from its consumption and is therefore deprived of pleasures that he might otherwise have enjoyed, or is restricted from entering into other business activities or necessities as a result of his loan. El Diwany’s answer to this was thought provoking. ‘Do we prefer to consume now or in the future?’ he asked his audience. ‘Most people say now. But don’t you prefer to consume one breakfast every day or would you prefer all seven of your week’s breakfasts today? Of course, you want to have one a day.’
But let’s hold that thought for now. We will come back to this line of thinking when we look at how modern financial analysis techniques can defeat common sense in Chapter 8. A voracious appetite for economic growth fuelled by debt not only contributed to the post-2007 global credit crisis, but may arguably also have other side effects, such as environmental degradation or the sudden dismantling of communities. A gradual acceptance by society of usury may be a contributory factor.
In time, Church theologians would come to the position that the usury that had previously been outlawed could in fact be reclassified as an ‘excessive’ interest charge, though quite what ‘excessive’ means is a function of the borrower’s standing. And so interest became legalized and – leaving aside the clergy’s grandstanding on the greed of bankers in the light of the contemporary banking crisis – the modern Church rarely raises any objections to the practice of modern banking.
In the previous two chapters I mentioned the murabaha contract, a type of Islamic contract of exchange primarily intended as a method of financing goods on a ‘cost-plus’ basis. By means of this contract, a financier or merchant buys a product in the market at cost and sells it on to a buyer at a cost plus mark up – a real trade, in accordance with the Quranic injunction: ‘Allah has permitted trading and forbidden interest.’2
Although beneficial in this guise, use of the murabaha has become so distorted from its original intent that it has become the single most common method of funding inter-bank liquidity and corporate loans in the Islamic finance industry. How does it do this?
Sometimes known as a ‘murabaha-to-order’, the modern incarnation requires two sales to take place in order to effect the purchase of a single item with payment on a deferred basis. Imagine the customer of a bank wishes to purchase a car worth $10,000. The Islamic bank may agree to purchase the car at its known cost price of $10,000, and resell it to the customer at, say, a specified 10 per cent mark-up, the resulting $11,000 to be repaid by the customer to the bank in instalments over the specified repayment period, let’s say two years. So far, there’s absolutely nothing wrong with this: the bank is acting as a trader of goods in accordance with the Quranic injunction.
However, if the bank purchases the car, naturally it will wish to be reassured that the customer will in fact then purchase the car from the bank. The bank is, after all, not a car dealer wishing to hold inventory in stock to be resold at a later date. Thus, the bank will require the customer to sign a promise that the customer will purchase the car from the bank.
Is this combination of contracts – two sales and a promise – Sharia compliant? Although moving away from its traditional form as a simple cost-plus-profit sale agreement, it may be argued that this form of the murabaha does allow for the bank to take on asset risk to the extent that the overall effect meets the basic conditions for a valid sale and does not breach the general prohibitions stipulated in the Sharia. Nevertheless, conservative scholars such as Mufti Taqi Usmani argue that murabaha-to-order should be viewed as a transitory step towards a true profit-and-loss-sharing mode of financing, and where such modes are not practicable.3
Now let’s take this concept a stage further. What if we use the murabaha to purchase assets, let’s say liquid, readily available assets such as commodities, in order to finance other assets? In other words, use the murabaha to form the basis of a debt-financing structure. The so-called commodity murabaha, sometimes known as tawarruq financing, has become one of the most common tools in money-market transactions and asset financing among Islamic institutions today, and is perhaps the most controversial. According to those like El Diwany, it is the kind of legal trick employed by Christian financiers several centuries ago.
A legal trick – hilah in Arabic – is a contractual ruse to defeat a specific Sharia ruling by employing permissible contracts. The combination of contracts to form the medieval contractum trinius, is an example of a hilah. One ruse used by some Islamic banks until fairly recently was the bay al-ina, intended to produce the effect of an interest-bearing loan by employing two separate contracts, each individually compliant with the Sharia: the lender buys from the borrower goods for cash and then sells those goods back to him for a higher price on credit, the difference in price being the interest charged. Despite the condemnation of ina by classical and contemporary jurists,4 a number of modern financial institutions employed this method as a purported Sharia-compliant method of financing, though condemnation is so widespread that its usage is very much limited nowadays. In general, the concept of combining two sales within one is universally prohibited and supported by various recorded sayings of the Prophet in the Hadith.
Now imagine an individual wishes to purchase a car. What if the bank – recognizing that it may not combine two sale contracts into one – introduces a third party in the transaction to move the form of the contract away from the banned ina? Let’s say the bank uses a commodity as the subject of the sale, say copper. Here comes the clever bit. Assume the bank buys a quantity of copper from a supplier in the market and pays the spot price for that copper, say $10,000, which happens to be the same value as the car that the bank’s customer wishes to purchase. On the same day, the bank sells the copper to the customer on a cost plus profit basis, let’s say for $11,000, payable by the customer on deferred terms back to the bank. Also on the same day, the customer sells the copper (having already appointed the bank as its agent to sell the commodity on its behalf) into the market to another supplier on a spot basis at cost price, in other words for $10,000. The two suppliers are unrelated. Since the resale of the copper by the customer to the second supplier is organized in advance of the customer’s purchase of the copper from the bank, this type of transaction is known as ‘organized’ tawarruq. The customer now has $10,000 cash in hand today, which will enable him to purchase his car, and will repay $11,000 to the bank over an agreed duration. Just like a conventional loan.
Some scholars have permitted tawarruq where it is not organized in advance. Thus if a person buys an asset on a deferred payment basis but then decides to sell it for a spot cash price, provided the purpose of the purchase was not to sell immediately, this would not be classified as organized tawarruq. The two legs of the transaction just ‘happened’ to follow each other. However, since the majority of banks who practise tawarruq actively market their financial product as one that allows the customer to obtain cash immediately, and therefore overtly acknowledge the purpose of the product, they do not have the liberty of hiding behind the argument that the intention to resell did not exist.
Even the introduction of a third party has not persuaded the majority of scholars that this series of transactions is valid in the Sharia. By not financing against the asset, the bank has taken the same risk as in an interest-bearing loan, and the customer has received one amount of cash for another. The erudite Mufti Taqi Usmani’s view, for example, is very clear in his argument against this kind of transaction, as he espoused in the Pakistan Supreme Court’s judgement on interest.5
As Islamic finance has grown in recent years, so conventional banks have dipped their toes in the water by trying out a commodity murabaha. At first, their intentions are often to gauge demand with the simplest type of ostensibly Islamic transaction, then decide whether and how to expand the scope of their Islamic business, and some prominent scholars have tended to tolerate this practice ‘for the growth of the industry’, as they like to put it. In practice, commodity murabaha ends up becoming not only the conventional banks’ primary source of ‘Islamic’ business, but also acts as the default structure for any type of Islamic financing need.
In 2007, a consortium that included two Sharia-compliant Kuwaiti investment companies, Investment Dar and Adeem Investment, made international headlines by acquiring just over 50 per cent of James Bond’s vehicle of choice – the British luxury car maker Aston Martin – for a share purchase price of US$464 million. Journalists had a field day with the idea that something so quintessentially British could be funded with Islamic money: ‘The name is Bond. Islamic bond.’6 I must admit, even I allowed myself a little snigger at that one.
The acquisition financing package included a $393 million commodity murabaha arranged by the German bank West LB. At one of the many Islamic finance conferences in London that year, West LB executives proudly presented their award-winning transaction to an admiring audience. Though the deal was labelled as Islamic, the bankers nevertheless stumbled when asked by an audience member what was so Islamic about this form of financing. Perhaps a true murabaha, where the bank takes the asset on its balance sheet, might be a step too far for a conventional bank, but was not a simple sale and leaseback of the underlying asset possible instead? One flustered junior banker countered by suggesting that his bank’s credit committee struggled to get comfortable with a lease, and that the risks inherent in a commodity murabaha structure were close if not equal to those in a conventional loan structure, which is not surprising given that some scholars say it is a conventional loan structure.
The disconnect between the view of conventional bankers on the subject of Sharia compliance and the view of scholars (and often the Islamic banks) is neatly illustrated in an article written by a real estate banker at a bulge bracket firm for an ‘expert’ publication on Islamic investments. I write ‘expert’ in quotation marks as invariably this type of industry publication tends to cobble together a tired collection of essays, rehashed from internal memos of bankers who happened to stumble across an Islamic deal once, or academics who have been trying for years to get a job in a bank. Embarrassingly, I myself am forever tainted for having contributed a chapter to it.
After three or four pages of trite nonsense, the banker in question proffers a pearl to the reader when describing how Islamic investors may invest in a conventionally financed real estate deal:
The Islamic investors effectively sell a quantity of non-precious metal to the SPV, the value of which is equal to the amount which the Islamic investors desire to invest in the SPV. The SPV immediately sells the metal to receive cash with which it finances its real estate investment. The SPV does not immediately pay a price for the metal to the Islamic investors, so it now owes the price for the metal to the Islamic investors. The whole transaction involving the metal is usually effected through commodity derivative transactions with no exposure to market movements in the metal. When the SPV eventually sells the real estate, it uses the proceeds to repay the conventional financing and to settle its payment obligation with the Islamic investors by exchanging this obligation against equity of the SPV.7
So the Islamic investors never really took any real asset risk in the real estate, they merely lent money at a fixed mark-up. I have no doubt that this particular banker tells his colleagues that Islamic finance is a complete crock.
So we have uncovered our modern-day version of the contractum trinius, though in this case the transaction, and particularly the bay al-ina before it, more closely resemble the cruder and simpler retrovenditio (‘selling back’) used by Christian financiers of yore. And over at the Emirates Towers, El Diwany is not having any of it.
Geert Bossuyt had a problem. The Safa Tower deal, two years in the making, had still not closed, and the life expectancy of Deutsche Bank’s Islamic structuring team was rapidly diminishing. The flamboyant Yassine Bouhara had been patient up until now, but there was only so long that the Godfather of the Middle East could hold back the barbarian hordes, the conventional bankers for whom only the pursuit of profit mattered. What did the hordes care about a strategic initiative if after two years it was still not generating meaningful revenues? Why should they subsidize the salaries and bonuses of their Islamic colleagues? Dump this initiative and move on. No one needs Islamic. No one needs socially responsible investing. This is an investment bank, not a hippy commune.
But Bossuyt had a brain the size of a planet – and a plan to blow the market wide open. It was time to act on Bouhara’s call to arms, to ‘commo-dee-tize ze industry’, to ‘mek ze Eeslameec finance Beeg-uh-Mac-uh’. Bossuyt’s equity derivatives background was unique in the industry – his competition consisted of third-rate relationship managers and murabaha desk jockeys at parochial firms with limited ambition. A Belgian Catholic with a conventional derivatives background, he afforded himself the luxury of thinking about Islamic finance in unconventional, non-traditional ways, and the people he assembled around him reflected this ethos. His team would be edgy, intellectual and ambitious, just like him. And it would invent an entirely new market – Islamic derivatives.
Bossuyt had access to a small group of first-class structurers – the individuals who would design and build the structure and contracts of financial instruments from a blank sheet – and the world’s leading scholars, a structuring dream team assembling the finest minds in the industry, robustly defending their ideas over scrawlings on a flip chart in closed-session meeting rooms. Intellectual elitism may have bred some aloofness, perhaps even arrogance, in their ranks – they were the best and they knew it, but Bossuyt encouraged them to challenge each other, and challenge the scholars in the quest to invent a new industry.
But while the bank’s sales force were used to selling product to the leading institutions throughout the Middle East and Malaysia, educating them in the nuances of these new products would be a challenge in itself.
Islamic investors were poorly served. They had limited access to the kinds of asset classes that their conventional counterparts could buy off the shelf. Walk into any high-street retail bank in London or New York, and within minutes you can open an account, make term deposits, take out a mortgage, and buy shares and mutual funds online. For those with the means to open a premier or private account, a more sophisticated world of investments awaits: derivatives, structured products, hedge funds, exchange traded funds, real estate and private equity funds.
Walk into an Islamic bank and you can deposit your money, perhaps earning a return on a commodity murabaha basis (though some in the UK merely offered no return at all, just a safe place to keep your money at a zero interest rate). The more sophisticated Islamic institutions offered home-financing products, but without the flexibility of their conventional counterparts, and at substantially greater cost. They were doing the Muslim community a favour by catering for their needs.
Muslims in the UK felt a sense of alienation from the banking industry, a bitterness at the so-called Islamic banks that seemed to make a business out of ripping them off. Want to finance a home without compromising your faith? Here’s an Islamic mortgage. It looks the same, the technical terms are in Arabic, and we charge you more.
What do Islamic investors lack? Bossuyt mulled over the question and decided that where the industry was failing was in its inability to hedge the exposures of Islamic investors to various risks: macroeconomic risks such as currencies, commodity prices and rates, volatilities in equity markets, geopolitical risks around the world. Islamic financial institutions had failed to hedge themselves adequately against their various exposures, and private investors had no way to protect themselves against falling market prices, or were unable to participate in alternative investment methodologies such as the pursuit of ‘absolute returns’ through hedge funds.
Yassine Bouhara had already made a commitment to fund a 55 per cent owned subsidiary of Deutsche Bank, a company called Dar Al Istithmar (DI). A self-proclaimed think tank, DI was a joint venture with an affiliate of the University of Oxford – the Oxford Centre for Islamic Studies – and a vehicle of the Saudi Binladin Group, Saudi’s largest construction company. The Safa Tower deal had been a pilot project for the new venture and its real value add had been demonstrated in the access it provided to some of the world’s leading scholars. The Deutsche structuring team approached the chairman of DI’s Sharia board, the same Sheikh Hussain Hamed Hassan, to help them devise an all-purpose methodology for investment products, a framework on which to build a whole new range of financial instruments.
Bossuyt promised Sheikh Hussain that any structure he devised in conjunction with the Deutsche team would be attributed to the sheikh’s newly appointed management team at DI, a forceps-enabled delivery dragging the think tank into the cold harsh air of the commercial marketplace. And so the Deutsche team began to create what would become one of the most controversial pieces of work the industry had seen: the ‘wa‘d structure’, also known as the ‘double wa‘d structure’ or the ‘Islamic total return swap’, which would come to underpin the development of modern Islamic derivatives.
Let’s for a moment clarify our understanding of a ‘derivative’. A derivative is a financial contract whose value is derived from the asset or pool of assets that underpin it, also known as the underlyings. An underlying can also be in the form of an index or anything that the counterparties in the contract can choose to derive a value from. The weather, for instance. Imagine, for example, that Party A says to Party B, ‘If you give me $10 today, I will pay you $100 if it rains for more than fifteen days of this month.’ The two parties have created a derivative contract using the weather as an underlying. The value of the contract varies as the weather varies.
Derivatives need not be quite so speculative in nature, however. The value of a contract may be linked, for example, to macroeconomic movements, and the consequent payout may be part of a counterparty’s essential hedging strategy. Say, for example, that Company A manufactures cars in Germany, but sells them in the US. Its cost base is denominated in euros, but its revenues are in dollars (at least the revenues from American customers). Naturally, as currency exchange rates move, its profits will either gain or diminish. If the rate moves massively against Company A, it stands to make a loss, and there may be consequences for its shareholders, its employees and their families. The sensible thing to do would be to buy a type of insurance policy, a contract that hedges its exposure to such movements.
Company A might decide to enter into a currency forward with a counterparty, that is, it agrees to buy an amount of euros at a given point in the future for a dollar amount, the rate for which it locks in today. Let’s assume that Company B has an inverse requirement. It manufactures a product in the US but sells in Germany and wishes to purchase dollars in the future in order to pay its cost base out of the revenues it generates in euros. So Company B wants to lock in a euro price today. Assuming the two parties have equal and opposite requirements, they may agree to ‘swap’ their cash flows at pre-agreed rates on both sides for a specified duration of time. A currency swap is born. But finding two counterparties with synchronous requirements is unlikely, hence the need for investment banks to act as intermediaries in the process. These intermediaries warehouse the underlying asset class (in this case, euros and dollars), and act as the counterparty to those who wish to hedge their currency positions.
A similar type of derivative contract is used to hedge against movements in interest rates. These are known as interest rate swaps. When an individual arranges home financing, he will usually be presented with a range of pricing options including, for example, a mortgage whose rate of interest remains fixed for a duration of time, and thereafter reverts to floating in line with central bank base rates. A fixed-rate mortgage enables the buyer to manage his future cash flows on a more predictable basis but requires the bank to enter into a rate swap or similar derivative contract with other counterparties. This is because the bank generally borrows its funds in the inter-bank market on a floating rate basis, but is lending to the customer on a fixed rate basis, and therefore needs to manage this ‘gap’ risk.
The sophistication of derivative contracts can go well beyond the simple examples used above, and might include, for example, a mechanism to reassure counterparties that as the economics of a transaction moves against one party, it has the ability to repay its obligations. This might be in the form of depositing additional collateral (sometimes known as ‘posting margin’) based on what are known as ‘marked to market’ calculations, that is, the ongoing determination of the value of a derivative contract based on current market conditions. The contracts will also generally include the kind of sophisticated terms and conditions to be expected in any complex commercial transaction, such as the various representation and warranties of the counterparties involved, events of default, arbitration provisions and so on. The end result is often a lengthy and complex legal document.
There are myriads of other kinds of derivative contracts, though the only other generic derivative we will refer to for the time being is what have come to be known as ‘structured investment products’. This wide-ranging group of financial instruments is difficult to encapsulate in one single definition, but in general they are products that investors can buy in order to participate in the gains and losses of any underlying asset class (such as shares on a stock market or interest-bearing bonds). The manner in which these instruments participate in such gains or losses is rarely correlated on a perfect one-to-one basis.
For example, an investor may wish to ‘gear up’ the returns from an investment. If he wants to participate in the returns from real estate, for example, he can either buy a property outright with cash, or he can borrow money in the hope that the value of the property rises fast enough for him to pay off his loan. Generally speaking, in a rising property market investors look to leverage themselves to the greatest extent possible in order to maximize their profits from real estate investments. Conversely, of course, in a falling market, they may get badly burnt and that is the risk of gearing one’s investments in such a manner. Structured products can replicate this gearing effect without forcing the investor to buy the underlying, or engage in other trading strategies (such as taking out loans), though the economic risk they take may be the same. In some cases, they can also buy and sell these instruments in the secondary market like shares on a stock market, though of course the available universe of buyers for a typical structured investment product may be much smaller and specialized than that of share traders.
As we discovered earlier when we looked at Sheikh Yusuf DeLorenzo’s arbun-based long/short hedge fund, a ‘call option’ gives investors the right, but not the obligation, to buy a commodity or security, typically an equity share in a company. By doing so, their downside is limited to the cost of the option (typically a fraction of the cost of the underlying share), and their upside is the difference between the market price of the share and a pre-agreed ‘strike price’ set at the beginning of the contract, in other words virtually unlimited. This is a derivative (since it derives its value from the value of the underlying share) and is often used as a basic component of a structured investment product. As options and other simple derivative contracts are linked together, the net effect can become as sophisticated as the investor desires.
Let’s take an example. Imagine an ultra high net worth individual walks into the oak-panelled client room of his wealth manager in Zurich. For a while he chews the breeze about his vintage car collection and can’t help but be impressed at his relationship manager’s extensive knowledge of the difference between a 1961 Ferrari 250GT SWB SEFAC and its successor, the 250GTO.
‘You’re right, I must arbitrage this opportunity. Can you help me source one of those through your contacts?’ ‘Of course’, says the relationship manager (he read about it in Octane magazine last month), and now that he’s got his client’s undivided attention, he turns to the important matter at hand.
‘I see that you have $30 million parked in your account, which is earning you not much over the bank base rate. Have you considered redeploying these funds?’ The client is curious, but has no idea how different asset classes will perform in the near future and doesn’t want to take any undue risks. If only he could hedge his bets.
‘We have an investment product that gives you exposure to three different asset classes: commodities, global equities and bonds over the next three years. The product lets you participate in returns from the best performer among these three asset classes but without actively investing in all three. You won’t lose money in the event all three asset classes lose value, but the trade off is you’ll have to sacrifice some upside.’
The investment bank has created a structured investment product that pays out, say, 75 per cent of the increase in an index, whose value is equal to the highest performer out of the three different asset classes (let’s say the benchmarks are published global indices for commodities, equities and bonds) over a three-year period. That same product might include ‘capital protection’ such that in the event all three asset classes fall below the initial investment level, the investor still gets his initial investment back in full. So the investor now has a chance to participate in the returns from one of the three types of investment, with protection against losses. He doesn’t get to participate in the full extent of the gains (he only gets 75 per cent), but the trade off is he gets to protect his downside if his bet goes wrong. He also gets three chances to make money: if commodities don’t do well, then maybe equities will. If they don’t, then maybe bonds will rise.
The ultra high net worth client likes this product. It allows him to play the markets with minimal risk. Of course, he won’t know that the investment bank may be making as much as 10 per cent in fees off the back of this product, but then few clients really know how these products are priced and sold, and as long as he makes money he’s unlikely to demand a forensic audit trail. And because these products can be so complex and so expensive, we can’t buy them over the counter of our local high-street bank. Regulators generally don’t like retail customers being sold stuff that can be extraordinarily complex.
So now that we have a basic understanding of a derivative and the more complex structured investment products, we turn our attention to Islamic derivatives, an apparently oxymoronic concept if the traditional scholarly view is to be followed. After all, why would an Islamic investor wish to speculate on future prices of an asset by purchasing intangible constructs such as ‘rights’ or engaging in the swapping of mere cash flows? Where is the real asset? Who has legal title? Who may buy and sell this asset, or lease its usufruct? Where is the certainty, the transparency?
As far as Geert Bossuyt was concerned, the derivative was a benign and magnificent tool, something to be made freely available to people of all creeds. Why should Muslims be restricted from harnessing the power of financial markets? Surely they needed to hedge their economic exposures as well? Did they not also deserve a wider menu of investment flavours?
I mentioned earlier the murabaha-to-order, a method by which banks could help customers finance goods. This combination of two sales and a promise enabled the bank to be reassured that the customer would in fact purchase the goods from the bank through the use of the third contract: the undertaking, or promise. And it is this unilateral undertaking, known in Arabic as a ‘wa‘d’, that underpinned Bossuyt’s precocious brainchild, given corporeal essence in the form of a 2007 paper published by Deutsche Bank, ‘Pioneering Innovative Sharia Compliant Solutions’, otherwise known in the industry simply as the White Paper.
The White Paper was the theoretical basis for the ‘total return swap’ methodology pioneered by Deutsche Bank to replicate the returns from any and all conventional financial instruments, though at first the intention had been merely to create hedging products for the treasury departments of Islamic financial institutions. In other words, although this technique was aimed at helping Islamic banks to find ways to protect themselves from rate movements or currency fluctuations, it could in theory allow an Islamic investor to do anything that a conventional investor could do, such as earn profits from market movements in pork belly futures. Now that doesn’t sound very Sharia compliant, does it?
The paper described the investment structure developed by the Deutsche Bank team, which would form the basis of their structured products platform, and provided Sharia justification for the methodology, such as the nature of promises and contracts in the Sharia. This Sharia justification took the form of a narrative to present and critique the argument that the promisor in a promise has a ‘norm-creating power’.8 It may have been the first time that an investment bank had ever written such a paper, and it surely must have been the first time that an interlocutor named Ali was the central character, the fictional creation of a former University of Oxford law lecturer turned banker, Hussein Hassan (no relation to the eminent scholar), who was the primary author of the paper and the dream team’s resident expert on the jurisprudence of transactions in the Sharia.
The throngs pouring through London’s Landmark Hotel at the Euromoney Annual Islamic Finance Summit that year gawped at the glossy booklet lining the Deutsche Bank exhibition stand. Simultaneously bizarre and impressive, the White Paper was a brain dump of immense effort and achievement. One wag flicked through twenty-four pages of Sharia analysis, moral philosophy, structure diagrams and mathematical formulae to declare the glossy as nothing more than ‘intellectual masturbation’, though there was no disguising his obvious covetousness. Despite the theoretical detail, the paper did not dissect the individual contracts underpinning the overall structure, nor provide operational details of how the investment products were engineered and sold, and competitors were left wondering precisely how they would go about replicating the factory to create their own products. And although it admirably suggested that one of its intentions was to allow other financial institutions to use the fundamental elements of the structure for the benefit of their clients (thus growing the size of the market), and to encourage the use of the structure ‘in its correct context’, it also concluded by tantalizingly stating that ‘the Structure may not be applied to the provision of capital protection for Sharia-compliant structured products’.9 By keeping this critical weapon in its armoury hidden, even in its apparent magnanimity Deutsche was determined to stay one step ahead of the competition.
I’ve thought long and hard about whether to discuss in these pages the theory of the ‘double wa‘d’ structure – ‘double’ since the technique employs two simultaneous unilateral undertakings. I had to balance whether I might help the reader understand the most sophisticated contractual structure in Islamic finance today against the fact that the intricate details are, well, intricate and detailed. So in the end, I’ve compromised and consigned the technical explanation to another time, which is a shame as it means that we will have to assume that (a) the structure works from a purely technical perspective and (b) there is a disconnect between letter and spirit of the law when it comes to the Sharia compliance of the technique, if the buyer or seller of the product so desires it.
But, irrespective of the technical details, perhaps it is not hard to understand whether there are occasions when the spirit of the Sharia is breached when using this technique to replicate conventional derivatives. Let’s take an overview of the double wa‘d. The structure allows the investor to place a sum of money with an institution via an investment vehicle, a black box if you like. A shell company, which takes in cash, chews it up and spits out a derivative contract at the other end.
The investor places the cash with the special purpose vehicle, or SPV, established by Deutsche Bank for the purpose of issuing Sharia-compliant notes or certificates. The SPV issues these certificates to investors and deposits the cash proceeds into a segregated account. Segregation means a legal and physical separation of the money from any other funds, so that under no circumstances can there be a ‘co-mingling’ of investor’s cash with non-Sharia-compliant funds from other sources.
Using these segregated funds, the SPV buys Sharia-compliant assets from the market. These assets can be anything provided they meet the requirements of the Sharia, but ideally they should be liquid and tradeable so that the SPV can buy and sell them at a moment’s notice, with maximum efficiency and minimum transaction costs. Typically, the SPV chooses the public equity shares of a large multinational company, say Microsoft (assuming the company fulfils the necessary criteria – such as low levels of interest-bearing debt – to be considered Sharia compliant). Remember, these Microsoft shares are just a liquid commodity, something easily exchanged for cash whenever we need to. That’s their only real purpose, not their actual investment potential.
Here comes the clever bit. Now with full legal title to these shares, the SPV enters into a ‘total return swap’. Deutsche Bank (as the originator of the Islamic certificate) sits on one side of the trade, with the SPV (as the issuer of the certificate) sitting on the other side. The investor holds a piece of paper in his hand telling him he will one day in the future receive a return on his money linked to a given benchmark. Let’s say the investor is sophisticated and wants to make a play on the markets. He thinks there are three asset classes with a chance of rising in the future, but he’s not sure which one: they are US equities, US corporate bonds and the price of gold. So Deutsche Bank agrees that the benchmark stated in the piece of paper he holds is a formula that calculates the highest riser among those three published indices. This is now a structured investment product, much like the one bought by the vintage car connoisseur in Zurich we met earlier.
Deutsche Bank undertakes (via a promise, or wa‘d) to purchase from the SPV the Microsoft shares held by the account – and, don’t forget, those Microsoft shares have arbitrarily been chosen as something liquid and tradeable – for a price equal to the benchmark (and remember, that benchmark has nothing to do with the share price of Microsoft). On the other side of trade, the SPV undertakes (via a second wa‘d) to sell the Microsoft shares to Deutsche Bank for a price equal to the benchmark. Because the benchmark price has nothing to do with the actual market value of the Microsoft shares, it’s as if I promised to sell my house to you in a year’s time proportionate to the rise in gas prices, even though gas prices have little to do with house prices.
The conditions under which these two undertakings are exercised by the promisee are mutually exclusive, and therefore only one undertaking can be exercised. However, the nature of the promises means that the shares will always be traded for a price equal to the benchmark. Since the conditions related to the two undertakings are mutually exclusive, and both cannot be exercised at the same time, scholars who have approved this structure argue that they do not constitute a bilateral contract, thus avoiding Sharia prohibitions of ‘two sale contracts in one’. They also argue that investors’ monies remain pure since they are held in a segregated account and used to purchase only Sharia-compliant assets (in this case, shares in Microsoft).
So, without actually buying directly the underlying assets (the US equities, US corporate bonds, and gold), the Islamic investor has gained exposure to their returns according to a pre-determined formula. Deutsche Bank has managed to ‘swap away’ the return of the Microsoft shares held in the segregated account with the return on something completely unrelated. Investors’ money has not touched anything non-compliant – it hasn’t been invested in interest-bearing US corporate bonds, for example – and yet it is getting exposure to the return on those non-compliant assets. Ingenious and yet troubling at the same time.
Deutsche Bank’s Hassan understood that critics of the technique would seize upon the use of the wa‘d, as opposed to a binding sales contract, to circumvent the prohibition of a bilateral contract, and the swapping of an intangible cash flow. He therefore addressed these specific issues of jurisprudence in some detail in the White Paper.10
This piece of fundamental research was a turning point for the Islamic finance industry: scholars who had hitherto baulked at the mere mention of the word derivative were now prepared to engage in a reasoned discussion on the need for investors and institutions to hedge their risks. What had once been a discussion about speculation was now turning into a discussion about introducing stability to an industry subject to a previously unacceptable level of volatility. But it was not without significant controversy.
One of the first products Deutsche Bank created under this platform was a capital-protected investment certificate linked to the return on a Goldman Sachs hedge fund, naturally a non-Sharia-compliant underlying. The buyer was the private banking department of Dubai Islamic Bank, a client that would turn out to be the single biggest buyer of Deutsche’s Islamic structured products, its private high net worth customers being some of the hungriest investors in the retail Islamic space. It helped, of course, that Sheikh Hussain was also the chairman of DIB’s Sharia board, thus ensuring that the Sharia certification effort would not need to be duplicated for the buying institution.
In June 2007, at the press launch of the new product,11 Deutsche’s Geert Bossuyt sat alongside Sheikh Hussain and outlined the far-reaching consequences of the total return swap for the future of the industry.
‘It allows investors to meet their specific investment objectives without resorting to conventional methods, in a Sharia-compliant manner’, said Bossuyt, and went on to outline the specific investment certificate that was being sold to DIB’s high net worth Islamic investors. But in private he also made what would become his trademark remark at many subsequent conferences at which he pitched his bank’s services: ‘We create conservative products for conservative investors and aggressive products for aggressive investors.’ Away from the microphone that day, the press missed those words, yet it was undoubtedly a momentous statement of intent by the behemoth financial services flow monster, and one that would be repeated in public in the months to come.
Slowly but surely, some scholars and investors started to feel deep unease about the way in which a global investment bank was able to churn out vast quantities of sophisticated investment products, typically instruments that linked their returns to non-Sharia indices or benchmarks, and apply a ‘wrapper’ to the package, apparently miraculously rendering it halal, or permissible. The technique may well have been originally intended as a force for good, but Deutsche’s pushy Middle East sales executives were beginning to recognize the technique as an incredible cash cow, to be milked for all it was worth. No benchmark or underlying asset was too sacred to replicate, and anything was possible. Suddenly the market was wide open and 99 per cent of it belonged to Deutsche. It was a mouth-watering feast of fees and year-end bonuses too good to pass up, though at some point perhaps it had mutated from a cash cow into a golden goose, and that goose was about to die.
Shortly after the White Paper was published, Sheikh Hussain called me and my Deutsche colleagues into his office and excitedly waved a letter in front of us. ‘Look what he is saying’, he exclaimed furiously. The pugilistic scholar had a manner that could scarcely be described as delicate or reticent even on a quiet day, but on that day his magnificent vocal chords and table-thumping fist would be particularly well exercised. ‘LOOK at it! He is saying to the newspapers. To the NEWSpapers!’ BANG. Clenched fist meets table. In adjoining offices, members of Dubai Islamic Bank’s Sharia Coordination Department looked up for a brief moment as their thin walls shook, then went back to their paperwork. ‘He is calling it a DOOMSDAY fatwa!’ BANG.
A one-time colleague of Sheikh Hussain, Sheikh Yusuf DeLorenzo (now the chief Sharia officer at Shariah Capital) had not been able to hold his silence any longer and had made his views on the total return swap very public. In a paper entitled ‘The Total Returns Swap and the “Shariah Conversion Technology” Stratagem’, he proposed it to be a sham methodology, allowing investors to reap the benefit of haram (impermissible) returns, dressed up in Islamic clothes. He had written a lengthy letter to Sheikh Hussain, setting out his deep distaste for the methodology that was transforming the landscape of Islamic finance. But it was too late – a very public spat was forming where instead a scholarly forum behind closed doors might have cooled passions on both sides.
The older scholar was dismissive of the criticism and bristled at the suggestion that he had sold out. He suggested at first that Sheikh Yusuf had simply not taken the time or effort to understand the Sharia issues, and was trying to protect his job. Sheikh Yusuf, on the other hand, was explicit in his condemnation of the many scholars who were, by now, approving this structure for a number of global investment banks: ‘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…it is likely that those scholars fell into the trap of literalism.’12 He went on to suggest that scholars should consider the details of a whole transactional series, not only one part of it, perhaps mindful of the Church’s own changing attitude to usury which came about through acceptance of the contractum trinius. ‘While a promise to exchange returns may be lawful, if the returns promised have been earned by illegitimate means (by funds that invest in Treasury futures, for example), then the promise may be declared unlawful as it has become a means, an ostensibly legitimate means, for illegitimate ends.’13
Here, Sheikh Yusuf was making a critical point in his analysis. In a head-to-head debate at a conference in Dubai in early 2008, the primary author of the White Paper, Deutsche’s Hussein Hassan (confusingly with the same name as the scholar), defended the methodology through the application of sadd al-dharai, the legal device from classical jurisprudence that blocks ostensibly legitimate means when these are employed for illegitimate ends. Hassan suggested the wa‘d methodology does not inevitably lead to conventional exposures, and that the end that is in question is not a certainty to the means. If there is no necessity to use the wa‘d in order to arrive at the required end, then why should this means be prohibited and not the others?
But Hassan was fighting a losing battle for the hearts and minds of the audience. Sheikh Yusuf had no issue with the wa‘d itself. He suggested instead that the application of sadd al-dharai was unwarranted in this case, on the basis that whatever leads to involvement in the unlawful will either lead to the unlawful as a certainty or lead to the unlawful as a possibility. ‘This product’, wrote Sheikh Yusuf in his paper, ‘includes investments, even though they are entered into indirectly, that are clearly unlawful. Moreover, there is no doubt whatsoever that the transactional series leads inevitably, and repeatedly, to what is unlawful…as a certainty and not as a mere possibility.’ He concluded, ‘There is no need to resort to sadd al-dharai because the transaction is clearly unlawful.’14 On the basis of the aggressive pushiness of Deutsche’s gung-ho sales team, eager to sell all manner of credit derivatives and hedge funds wrapped in this technology, he had a point.
At the conference, Sheikh Yusuf responded to Hassan’s patient explanation of the methodology by pointing to the money flow. ‘When you accept this investment product, you accept the whole series, whether you know it or not. As the money moves, its character changes.’15 Thus, he suggested that a Muslim investor taking part in a total return swap is implicated in every investment decision, trade and cash flow that the bank subsequently takes with his funds. If the bank hedges itself on the other side of the transaction (say, by buying units of the Goldman Sachs hedge fund for its own account), the Islamic investment certificate holder is implicated in this haram trade, though he may not himself be investing directly in the non-compliant instrument.
In Sheikh Yusuf’s paper he suggested that it may be argued that conventional banks use the money of Islamic institutions with whom they trade in non-compliant ways. However, he set out a fundamental difference: that when the conventional bank receives money from an Islamic institution that money becomes its own to do with as it pleases. Money used to buy investment products under the wa‘d methodology, on the other hand, has ‘direct, predictable and immediate consequences…the Islamic client’s investment in this product triggers a series of transactions, none of which is Sharia compliant’.16
And what of the use of a benchmark, just as LIBOR is used as a benchmark for the pricing of sukuk? His paper clarified: ‘A benchmark is no more than a standard and therefore non-objectionable from a Sharia perspective. If it is used to determine the rate of repayment on a loan, then it is the interest-bearing loan that will be haram [impermissible]. LIBOR, as a mere benchmark, has no direct effect on the actual transaction or, more specifically, with the creation of revenues.’17 He went on to say, ‘Most importantly, the use of LIBOR as a benchmark for pricing in no way means that interest has entered the transaction itself…The attempt to draw a legal analogy, qiyas, between the use of LIBOR for pricing and the use of the performance of non-Sharia compliant assets for pricing is both inaccurate and misleading. The only similarity is that both are used for pricing.’
He offered a further reason why the methodology was dangerous: it risked damaging the industry. ‘Why should a bank bother to spend the extra time and money required to make a securitisation into a sukuk?’ he wrote.18 In other words, he was arguing that there was no longer any need for a company to raise capital based on a real underlying asset, like a property that is sold and leased back from investors: ‘For less money and in less time, it can simply offer conventional bonds and then use the “mechanism” to match performance, appear to sanitise the money, and satisfy the investor that the investment is halal and lawful.’ He went on to question the need to ensure the Sharia compliance of Islamic stock indices, mutual funds, real estate, infrastructure projects, private equity and home finance. If the industry did not address this potentially pernicious new product, he feared that fund managers of all descriptions would never be motivated to comply with requirements of Islamic jurisprudence to trade and do business in Islamic – in ethical, in real economy – ways, and investor confidence would eventually erode, destroying an industry that has demonstrated so much promise in recent years. ‘The question [the industry] faces now is whether it can prove that it is moral and responsible.’
Cleverly, and perhaps with the intention of repairing relations with the older scholar of whom he admitted he was a great admirer, Sheikh Yusuf left the door open for the methodology to be acceptable, under one strict condition. At the conference he concluded, ‘If you’re going to swap returns of one basket of performing assets for another, then you must insist that the assets in both baskets are halal.’19 Thus, for example, linking the return to the performance of a basket of Sharia-compliant stocks would be acceptable to him.
Some time later I caught up with Sheikh Yusuf. ‘Sheikh Hussain is one of the most thorough and thoughtful men I know’, conceded Sheikh Yusuf in private, noting a relationship that spanned almost three decades. Perhaps he regretted the manner in which the media had portrayed a schism in the industry, since not for a moment did he wish to question the ethics of a man described as the father of the modern Islamic finance industry, and one from whom he acknowledged to me that he had learnt so much. And perhaps as the debate unfolded, I noticed a softening in Sheikh Hussain’s response.
Indeed, in time, Sheikh Hussain would implicitly take on board the comments of Sheikh Yusuf by adapting the certification process that produced the fatwa for each new investment product. He undoubtedly recognized the magnitude of the concerns raised, and took pains to ensure that he be involved in both the development and distribution phases of each new product. He would even go so far as to approve the language for newspaper advertisements. What had started with the potential for acrimonious mudslinging had instead turned into an opportunity to refine the standards employed by the industry.
But it was impossible to beat the bankers. Across the industry, other firms picked up on the methodology and began issuing their own products using their own scholars, many of whom were not as intimately familiar with the structure. Corners were cut and products of dubious provenance continued to pour out from the sales desks of less scrupulous institutions.
Even Deutsche continued to consider the wa‘d at every opportunity. Deutsche Bank’s Islamic conveyor belt was now in full flow. Transactions became increasingly bizarre and far removed from the original intent of men like Sheikh Hussain. One that came to the team’s attention involved the financing of a portfolio of hotels in Europe: the Qatari buyer demanded a fatwa so that he could continue to earn from the revenues of the hotels’ restaurants, not generally considered to be Sharia compliant since a significant proportion of hotel revenue is derived from alcohol. Just as Sheikh Yusuf had foreseen, Deutsche suggested the total return swap: finance the purchase of the hotels through an investment vehicle that buys a Sharia-compliant asset (copper, Microsoft shares, whatever takes your fancy), swap away the return of the asset for the return of the hotels, and wine would miraculously turn into water. The suggestion led to some furious arguments amongst Deutsche’s rocket scientists, and the first cracks began to appear in what had been a closely knit team.
Those cracks widened as the team considered some of the more detailed issues of Sharia compliance in their investment products platform, a brand known as Al Miyar. Incredibly, the investor had no legally enforceable security interest in the Islamic assets (the liquid and tradeable investments whose returns get swapped away), but somehow there was an acceptance by all parties that these assets belonged to him.20 This couldn’t be right, but the effort involved to restructure the security package and seek reapprovals for the platform was too much. So the issue was quietly brushed under the carpet and ignored. Imagine if Deutsche Bank were to meet the same fate as the hapless Lehman Brothers. Would Islamic investors get their money back directly from their ‘segregated’ accounts? Probably not.
Equally significantly, the Al Miyar platform allowed for the Islamic assets – apparently ‘owned’ by the investor – to be reused for Deutsche Bank’s own trading purposes.21 In other words, the Islamic assets (such as Microsoft shares) could be pulled in and out of the apparently segregated Islamic investment account, as and when Deutsche Bank desired, and without the investor being informed.
In the tens of thousands of words of documentation he had reviewed in his capacity as the chairman of Dar Al Istithmar’s Sharia board, this (very fine) print had not been been brought to the attention of Sheikh Hussain. To what extent this oversight had been a deliberate obfuscation on the part of bankers and lawyers is not clear, though they were certainly aware of it in private.
As a member of that edgy Deutsche structuring team, I personally felt I had participated in the Islamic finance equivalent of the ‘Manhattan Project’, a Second World War initiative that assembled the Allies’ leading physicists in the seclusion of the Los Alamos desert to build the atom bomb before Hitler. We knew the wa‘d technology we would create could be used in good ways or bad, and had a global application, and yet in our hearts we also knew its primary use would be as a financial weapon of mass destruction by aggressive sales teams. Perhaps Sheikh Yusuf’s doomsday description of the total return swap was apt, after all.