‘I think that some of it is socially useless activity.’1
Adair Turner, referring to the derivatives industry and its role in the post-2007 global financial crisis
Deutsche’s wa‘d technology had opened up new horizons. Whilst its salesmen and -women criss-crossed the Middle and Far East selling exotic structured investment products to the private banking departments of Islamic financial institutions, Sheikh Hussain and the Deutsche skunk works structurers were more concerned with addressing the gap risk that Islamic institutions suffered as a result of their inability to hedge their macroeconomic exposures. Here was a real issue facing the industry: a ticking time bomb of unhedged currencies and rates on a massive scale, not some esoteric trophy investment baubles for the ultra high net worth Gulf prince. Billions of dollars’ worth of institutional exposure, not the crumbs of a few tens of millions in speculative nibbles in the hope of financing one’s next megayacht.
Treasury departments of the Islamic institutions knew they had a problem. The Islamic Development Bank, a multilateral development-financing institution owned by fifty-six member states, was haemorrhaging cash as if it were funding a war. It simply couldn’t swap dollars for euros or vice versa on an ongoing basis without resorting to the conventional markets. It couldn’t enter into rate swaps or currency forwards. Islamic institutions everywhere were funding long-term assets with short-term deposits. Without a Sharia-compliant solution to managing these risks, their volatile existence was owed to booming equity and real estate markets in the Middle East. For now, at least.
Some institutions pretended the problem didn’t exist. Turkish institutions, in particular, wouldn’t even use the word ‘Islamic’ in their name for fear of upsetting the country’s secular sensibilities. Instead they were ‘participation’ banks, though the commodity murabaha trades that were their lifeblood lacked the participation that classical Islamic concepts of risk-sharing demanded. Their notions of what constituted Sharia compliance were at odds with almost everywhere else in the Islamic finance industry: they discussed Islamic ‘repos’ – or repurchase agreements that enabled them to borrow money against liquid assets held by them such as bonds – using interest-bearing Turkish inflation-linked bonds that somewhat stretched the definition of sukuk. They were content to transact swaps on a conventional basis despite their outward adherence to Sharia principles, on the basis that there was apparently no alternative.
Even in conservative Islamic environments, treasury departments of banks often entered into currency or rate swaps and forwards on a conventional basis, simply because the effort involved in preparing the necessary documentation was so daunting, and the process of Sharia certification so alien to departments whose staff were generally sourced from conventional banks. Do the trade, hide it in the books, and almost no one will know. What’s the harm – it’s only a hedging transaction, right? It’s not as if we’re trying to profit from these trades, or selling investments to the bank’s customers. We’re just protecting our institution from external risks.
The Sharia structuring process and legal documentation was indeed daunting. Regional Islamic banks in the Middle East and Malaysia had almost no specialized personnel trained to understand and negotiate Sharia-compliant treasury swaps, nor were they generally willing to pay the kind of fees demanded by the few appropriately qualified external legal counsel and third party structuring specialists.
A stalemate was playing out. Fast-talking rocket scientists in pinstripes from the global investment banks could structure the product, but getting their counterparts at the regional Islamic banks to focus their attention on it and procure internal legal and Sharia approvals was proving tricky. When the international bankers suggested a direct approach to the Islamic banks’ Sharia boards, their counterparts often found excuses. Perhaps it was the fear of losing face in front of their colleagues in a one-on-one with their counterparts – always a cultural hot potato in much of the Islamic world (remember the Malaysian treasury official and her Sharia advisors?) – or perhaps such a direct approach threatened their own role as gatekeeper to the scholars.
The industry was crying out for a standardized set of documents. It would provide immediate access to liquidity and prudent management of balance sheets for the Islamic banks, lowering their exposure to macroeconomic volatility.
Standardized documents could be used under almost any circumstances, with changes to the key commercial parameters in the form of a schedule to a pre-formed master agreement. This type of templated transaction was already prevalent in the conventional world. An international trade organization of participants in the derivatives market, known as the International Swaps and Derivatives Association, or ISDA, had created a standardized contract known as the ISDA Master Agreement. This agreement allowed market participants to enter into ‘over-the-counter’ derivatives transactions – so-called because they take place directly between counterparties in the form of a bilateral contract rather than on an exchange – via a contract that both parties understood and were comfortable with. The specific commercial terms of the transaction are negotiated and set out in a Schedule to the Master Agreement.
The ISDA Master Agreement first came into being in 1992 as a result of work performed by ISDA on specific derivative transaction documents in the mid to late 1980s. It provided derivatives counterparties with standard terms that applied to all derivatives trades entered into between those counterparties. For every new trade, the terms of the master agreement applied automatically without the need for renegotiation.
Following the global economic turmoil of the late 1990s, the ISDA Master Agreement underwent a strategic review leading to wide-ranging revisions incorporated in the resulting 2002 Master Agreement and, at the time of writing, that is the central document around which the rest of the transaction structure is built for most over-the-counter derivative trades. This standardized document is never altered other than to insert the names of the counterparties. Global investment banks and the treasury departments of their large corporate clients tend to be intimately familiar with the agreement, as well as the credit and risk management issues associated with it. The trade is customized through the use of a schedule containing elections, additions and amendments to the master agreement. Once the master and schedule are executed by the counterparties, any future trade merely needs to make mention of the commercial terms, typically over the telephone and subsequently confirmed in writing.
The result is an industry that has mechanized the production of trillions of dollars’ worth of derivative contracts every year, and unwittingly accelerated the rate at which an institution such as the infamous AIG could stuff its balance sheets with half a trillion dollars’ worth of unhedged credit default swap contracts – a type of insurance policy in which AIG would act as the insurer against the default of loan repayments by companies and nations.2 When the economy went belly-up, AIG was forced to make good on its guarantees to creditors by writing cheques for US$562 billion. Not having this kind of money down the back of the sofa, the risk junkies of AIG were forced to beg for a bailout from the American taxpayer, who duly obliged. It was a damning indictment of the modern financial system – that the larger and more entwined a financial institution was in the fabric of a nation’s economy, the more likely it was to take larger and larger risks in the expectation that the hapless public would pay when it went wrong.
Would Islamic finance institutions benefit from a standardized template for swaps and derivative contracts, thus more efficiently managing their balance sheets and stabilizing their long-term earnings? Or would such a template lead to the creation of another uncontrollable monster of naked speculation, a harbinger of moral hazard?
Let’s first take a look at the Islamic equivalent of a conventional swap transaction before we address this question. One of the most useful types of treasury product used by Islamic financial institutions is the profit rate swap, which seeks to swap away one type of rate exposure for another, in the same way that conventional institutions may swap away a floating interest rate payment for a fixed one. Imagine you have a mortgage with a conventional high-street bank. It’s a fixed-rate mortgage with an interest rate that doesn’t change for, say, five years. However, the bank itself probably borrows money on a floating rate basis – as the ‘base rate’ changes up or down over the next five years, so will the bank’s liabilities to depositors, the capital markets and other banks in the inter-bank lending market. Clearly the bank doesn’t want to be exposed to these fluctuations in the base rate, so it hedges itself by entering into a ‘floating to fixed’ swap with a counterparty. Now its assets match its liabilities and its balance sheet is being prudently managed.
At this point, the reader may be permitted to do a double-take. Doesn’t it sound strange that Islamic financial institutions pay and receive interest-like amounts and describe them as ‘profit’? Well, whether they like it or not, these institutions exist within the fractional reserve banking system and are subject to similar capital adequacy and risk management requirements as their conventional counterparts. So they take depositors’ money and pay a return to those depositors that is benchmarked against their conventional counterparts. They invest in or lend to companies at a rate that is benchmarked to their conventional counterparts. How they pay that return and charge that rate is, of course, the critical consideration for them to be considered Sharia-compliant institutions. (Are these trades backed by some real asset? Is there perhaps some form of risk sharing involved? Have they avoided the prohibitions typical of Islamic commercial transactions?) But there is no question that benchmarks such as LIBOR continue to be a necessary metric for Islamic banks, and the overwhelming majority of scholars have come to accept this, however imperfect a solution this may seem.
The profit-rate swap utilizes the same technique discussed in the previous chapter, the wa‘d structure, though this time not to build an investment product. Previously we benchmarked the price of underlying liquid tradeable assets (such as the Microsoft shares) in the ‘black box’ SPV to the price of a set of published indices, so that the investor could participate in the returns from different asset classes. By contrast, this time we are considering a hedging product rather than an investment product. On one side of the trade, the client has a floating rate liability and wishes to swap into fixed rate, and on the other side, the bank provides the hedge. The aim of a hedging transaction is to minimize risk, not maximize profits from a speculative trade.
The two parties on either side of the trade have reciprocal undertakings. They each enter into promises to enter into murabaha arrangements, with one side generating a series of fixed payments (with the the underlying Islamic assets – such as the Microsoft shares – priced at a cost price plus a fixed profit element), and the other side generating a series of floating payments (priced at a cost price plus a floating profit element).
So far, we have merely described the structure and essential transaction documents of the profit-rate swap. If you have understood all of this, you have done extremely well: few banks, whether Islamic or conventional, have personnel who truly understand how Islamic treasury products are designed and manufactured. Even were they to get past the basic structure, the detailed terms and conditions become an intellectual effort best left to the brightest lawyers in the industry. No wonder, then, that Islamic treasury products have been so slow to take off, even though the product exists and is evidently replicable. The balance sheets of Islamic institutions remain ticking time bombs until such time as they staff up or pay up for external advisors to project manage the implementation of such products.
What’s the solution? There is no shortcut to the product: it is complicated, and no credible alternatives have been proposed at this point in time. The Islamic finance industry needs its equivalent of the ISDA 2002 Master Agreement, and each relevant institution needs to devote its resources to making standardization a reality. The first steps towards a Sharia-compliant derivatives template have been taken by ISDA in a joint venture with a standard setting body for the Islamic finance industry, the International Islamic Finance Market (IIFM). ISDA and IIFM have drawn on the pioneering work done to date by leading banks and law firms. With the help of a consultation process with both conventional and Islamic banks, and the advice of their eleven-man Sharia board, they have produced a template master agreement known as the ISDA/IIFM Tahawwut Master Agreement.
The Tahawwut, as it is generally referred to, attempts to unify the various swap documentation that has been transacted on a bespoke basis from bank to bank, the net result being a single master and schedule that has strong parallels with the 2002 ISDA Master and Schedule, and is therefore well understood already by the conventional industry. Why should it matter that its format should reflect its conventional equivalent? Simply because the conventional banks – such as Deutsche – have been driving the creation of Islamic derivatives, and continue to act as counterparties in the majority of trades. If their credit risk management departments can get comfortable with the credit risks, then it is likely that so will their regional counterparts.
Using the 2002 ISDA Master as a basis for the Tahawwut, ISDA and IIFM initially set about amending some of the big-picture principles. For example, transactions under the Tahawwut may only take place for the purpose of hedging, not speculation, though quite how this may be policed is a moot point. Interest may not be charged on transactions, and no compensation may be paid for defaulted or deferred payments. All fairly straightforward, so far.
Then it gets a little more complicated: how do we allow for the valuation and settlement of outstanding contracts in the event of an early termination? Resolving this particular thorny issue may have been a primary reason as to why it took twenty-four drafts and a consultation period spanning three and a half years to complete the Tahawwut.3
In conventional swap transactions governed by the ISDA Master Agreement, the master and the confirmations entered under it form a single agreement. Therefore the counterparties may aggregate the amounts owing to each other in separate trades and replace them with a single net payable amount by one party to the other. This is known as netting. Of particular importance is the concept of ‘close-out netting’, where the transactions under a master agreement are terminated, perhaps due to a ‘credit event’ such as one party failing to pay the other on time. In order to calculate the net amount payable by one party to another in the event of termination, an independent third party may be instructed to calculate the cost of entering into trades with identical commercial terms to the terminated transactions. This is known as the settlement amount, and its enforceability in the event of termination is of critical importance to financial institutions entering into derivative trades, since netting allows them to allocate capital only against the net figure they would have to pay on close-out of an ISDA Master Agreement.
Not only are credit lines more efficient, but close-out netting also facilitates the taking of collateral to offset exposures and lowers reserve requirements to satisfy regulatory capital requirements. With lower reserves and collateral posted for net and not gross exposures, financial institutions experience lower costs, increased liquidity and reduced credit and systemic risk. Indeed, in the aftermath of the collapse of Lehman Brothers, its counterparties were able to close out their over-the-counter trades relatively smoothly under the ISDA Master Agreement, largely because close-out netting is legally enforceable in the United States. The financial system would have experienced a much tougher test had the counterparties of Lehman Brothers needed to determine their exposures on a gross basis instead of net.
There are two areas of concern here for Sharia-compliant swap transactions: the first is the Sharia permissibility of the principle of netting, and the second is the enforceability of netting in jurisdictions where Islamic financial institutions operate.
Given that a Sharia-compliant swap requires the counterparties to enter into a sequence of murabahas,4 then naturally, in the event of early termination, a future stream of murabahas has not yet been transacted. At this point, bankers want to be reassured that only a net liability is due, and not the gross notional value of each trade individually, something that they refer to as ‘gross settlement risk’. Imagine a $1 billion notional swap value: this might potentially require the Islamic investment account to trade $1 billion worth of copper (or other Sharia-compliant asset) in order to fulfil outstanding wa‘d obligations. The credit risk management department and commodities trading desk at even the largest global investment bank will have trouble signing off on the possibility of having to find such a massive amount of copper (or Microsoft shares) to be traded at a moment’s notice, and they certainly don’t want to be left exposed on one side of the trade if their counterpart fails to honour its obligation on the other side. Clearly, bankers are looking for a close-out netting similar to that allowed under the 2002 ISDA Master Agreement. However, as we discovered earlier, in the Sharia one may not net off one sale against another within one contract in order not to fall foul of the prohibition on combining sale contracts. Nor indeed are the calculation methods available to conventional bankers – such as determining the ‘present value’ of future obligations by discounting future cash flows – necessarily considered a Sharia-compliant method of calculation (given the inherent recognition in such a calculation of interest rates and the uncertainty of future circumstances).
Outside of the ISDA/IIFM initiative, those banks that have already transacted Islamic swaps have solved the close-out netting issue in various ways. One way is to force the amount of the Islamic assets that are the subject of the wa‘d to be much smaller in value than the notional value of the swap itself, thus substantially reducing the quantum of the gross settlement risk. For example, the counterparties may agree to trade Islamic assets worth, say, one-tenth of the notional value of the swap. So a $1 billion swap may only require $100 million worth of copper as the underlying, this being the cost price of each murabaha in the sequence. Not all scholars are comfortable with this, however, since the paper value of the trade doesn’t match the real value and, after all, Islamic financial transactions are supposed to be based on something real and tangible rather than being mere paper contracts.
The Tahawwut Master Agreement deals with close-out netting by splitting the calculation of the settlement amount into two, with one calculation for concluded transactions within a swap (where delivery of an asset has been made under a murabaha), and the other for non-concluded transactions (where assets have not been fully delivered). In the former case, the originally agreed payment price is accelerated and becomes payable immediately. All payments due from one counterparty to the other under concluded transactions are accelerated and set off against each other to determine a single close-out amount.
Non-concluded transactions within the swap are a little trickier. An index is calculated based on the market quotation and loss framework as used in the 1992 ISDA Master Agreement, which determines a replacement cost for the terminated swap trade. IIFM’s scholars were able to agree to an index instead of a replacement cost valuation. The final termination settlement amount is then paid through a musawama sale contract, which is a bit like a murabaha.
The second area of concern for swaps traders is the enforceability of netting in jurisdictions where these products are traded. Typically, Islamic banks in the Middle East and South-East Asia operate in ‘non-netting’ jurisdictions, that is, jurisdictions where the legislative framework does not allow for such trades to aggregate and net each other out in the event of early termination. As a lobbying body for its member institutions, ISDA is tasked with working to achieve recognition for netting under the insolvency laws of countries around the world. Since ISDA has currently procured opinions on the legality of netting in only fifty-five countries,5 there is still much work to be done to ensure that banks and their counterparties are comfortable with the risks of entering into Sharia-compliant swap transactions.
Has the Tahawwut been a success? To date, sadly, no. Critics point to the close-out netting arrangement as being incomplete, requiring as it does the entry into a new transaction when a default has taken place. Can one bind an insolvent party into entering into another commercial transaction? In addition, the issue of non-netting jurisdictions in the majority of the Islamic world remains, and thus counterparties remain unsure of the legality of the document in the markets for which it is generally intended. Others say the Tahawwut has not gone far enough in addressing critical supplementary issues such as the Credit Support Annex that attaches to the ISDA Master Agreement, and governs the posting of collateral in derivative trades, a major tool in mitigating counterparty credit risk.
But these issues can be resolved, though they may take some time. There is something more immediate for the industry to work on: a cultural issue. Some local and regional Islamic finance institutions complain that they have not felt involved in the consultation process. In contrast, ISDA and IIFM officials have privately expressed their frustrations that early drafts were circulated to some one hundred institutions across the world but only twenty-five took an active interest, the majority of these being conventional financial institutions. Some international bankers echo this frustration. After hearing a treasury sales manager at a Middle East bank complain that the Tahawwut documents were simply too complex for ready digestion, I was tempted to advise him that sadly there is no big print version with colour pictures, there is no ‘guide for students’, and there is no shortcut to understanding it. It’s a complicated product, so man up and get studying.
International bankers found the process to be so drawn out and frustrating that in those three and a half years they corralled their own resources – legal, Sharia, credit risk management, compliance, structurers, traders, sales staff – and went ahead, producing their own internally approved Sharia-compliant liquidity management and hedging tools. The market is now awash with contracts documenting the profit-rate swap, all using roughly the same structure, but in different colours, shapes and sizes. As a result, each swap transaction continues to be negotiated on a unique, bespoke basis, and the regional Islamic institutions are overrun with the ‘suitcase’ bankers from global firms, each trying to pitch their own version of the same product.
And some bankers are still missing the point of Islamic finance’s necessary relationship with the real economy. At the World Islamic Banking Conference in November 2010, a technical workshop on the Tahawwut Master Agreement yielded a revealing question from one treasury banker in the audience – ‘Can we use this for credit derivatives?’ he asked. ‘I mean credit default swaps. How can I use this document to buy protection against sovereign defaults?’ The Islamic institution represented by this gentleman had no known exposures to Greece, or Portugal, or Ireland, or indeed many of the nations on the critical list at the time, and yet he wanted to buy an insurance policy against their default. He wasn’t trying to hedge a position, he was looking to make a sizeable profit on a speculative punt. Perhaps his institution might also try to drive that particular sovereign into default through other means.
Would the Sharia board of this institution check for existing exposures to the risk in question, or would they assume in all cases this kind of protection was a necessary hedge and allow it to take place? One of the fundamental premises of the Tahawwut is its use as a tool for hedging, not for speculation, but how does one draw a line between the two? It has been reasonably argued, for example, that without the existence of speculators in the market, there might not be sufficient liquidity for those looking to hedge their positions.
Once, MBA courses taught that firms like AIG were shining examples of the modern finance industry. And yet basic truths enshrined in Islamic law would immediately suggest otherwise: without dissecting such an institution’s balance sheet, the very fact that they encouraged counterparties to bet on the default of entities in which they held no interest should be cause for concern. Would you like your neighbour to take out a fire insurance policy on your house? Let’s hope he’s not an arsonist. That’s how the modern financial services industry works, and now Islamic bankers want what their conventional cousins already have.
Critics of the Islamic finance industry often point to the industry’s mimicry of the conventional industry, both in its products and, more importantly, in its philosophy. If the Islamic finance industry is to gain the respect of the wider (particularly Muslim) public, then it may wish to consider a step change in the way its practitioners operate within it, or give greater powers to its Sharia boards to examine ongoing trades for adherence to the spirit, as well as the letter, of Sharia.
Without such changes, there is every possibility that trades like the speculative credit default swap above could become prevalent in the Islamic finance industry, just as they have in the conventional industry. Perhaps Islamic finance might end up creating the same types of asset-backed securities linked to subprime mortgages that brought down conventional financial institutions such as Lehman Brothers. Without cultural change, the introduction of a standardized Islamic derivatives agreement may simply become the catalyst for the creation of a new monster.