FX & Islamic Finance

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Presentation provided at the AAOIFI World Bank Conference Dec 2, 2010 discussing the application of Wa\'d in the context of FX markets and where I perceive the most important need for it, for the benefit of legitimate trading activities by corporates and investors.

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  • Bismillah ar Rahman ar Rahim. Salam alaikum wa Rahmat Allah and Good evening to our distinguished scholars, speakers and honourable guests. My gratitude to the AAOIFI for inviting me to speak. The reason I have placed this picture on my first slide is to provide a vivid example of where Islamic finance can and should play a role, not only because I love cars. You will see my discussion revolve around a car import lot to signify legitimate trade.
  • So if you were take something away from this presentation, what would be the most important points? First, like we are finding out that microfinance was NOT as successful as all of us believed it to be, Islamic finance, for many reasons, is failing to serve the common man… Second, while I generally am averse towards derivatives, much like the world’s greatest investor, Mr. Warren Buffett, I acknowledge their problems while at the same time, acknowledge where their creators MAY HAVE GOTTEN IT RIGHT and WHERE THEY MAY BE PERMISSIBLE SHARI’A APPLICATIONS, based on my extremely humble knowledge of the Fiqh. Finally, of all derivative applications which involve a lot of different ruses around Wa’d and Murabahas, the only one I believe to hold any merit is the unilateral Wa’d. WHY? Becos it is only one sided, no additional synthetic trades and sustainable/efficient volumes are possible to promote the development of LIQUID Islamic capital markets.
  • Islamic Finance has failed the man on the street. As you can see on this map here, the concentration of muslims is by far much wider than the concentration of Islamic finance
  • And this map shows you where Islamic finance exists and where it is developing. Distinguished speakers and guests, Islamic finance only serves the needs of the RICH!
  • CLICK NOW Derivatives have earned a bad name in conventional finance to the extent that the best investor in the world, Mr. Warren Buffett, has called them financial weapons of mass destruction. CLICK NOW And why have they been called Financial WMDs? CLICK NOW Because the size of derivatives and the impact of them on financial markets is huge: let’s just say 10 times larger than the size of the productive value of the world economy!!! CLICK NOW Similarly, they have gained the ire of numerous scholars in Islamic finance and have generally been prohibited outrightly in Islamic finance; PAUSE pretty much for the same reason why it is disliked in the west. WHY? CLICK NOW First it is the trading of financial rights, so it is artificial leveraging without linkage to real assets CLICK Second, It involves heavy speculation by majority of market players, without any necessary useful need to be in the market CLICK Third, the asset link is so far removed in most derivatives that now I can offer a derivative without knowing what the underlying assets are in specific, let alone owning the underlying asset. In the beginning nevertheless, they did have utility.
  • :CLICK Let’s investigate why derivatives are disliked in a lit bit more detail and why us in Islamic finance and the rest of the world have much in common CLICK First, because it creates notional value against a very minute percentage of real assets and the size of this notional amount is huge, small movements have extreme consequences for markets.. CLICK Second, because most of the traders who do all this notional value trading are doing it for making a speculative gain, as opposed to hedging against risk, the price of the derivative or the underlying asset has no relation to the fundamentals or the supply and demand for the asset CLICK Third, because of repeated repackaging of commitments and derivatives, such as CDO squared, if the credit defaults, investors do not have anything real to sell that has any value, other than the artificial value ascribed by the markets.
  • However, it wasn’t always the case that forwards were dominated by speculators. CLICK Historically speaking, we saw the application of forward going back to Prophet Jacob’s (alayhe salam) time when he was promised by his father in law, the hand of Rachel, if he worked for 7 years. The growth of forwards really took off with the development of the Chicago grain market in the 19 th century. CLICK This was developed solely for the use of the grain farmers who wanted to hedge their price risk on their commodity, as a result of volatility in supply. In Islamic finance, we have had the forward contract possibly before the time of the Prophet Muhammad (alayhe salam). And the Qur’an was explicit in stating that when you deal in transactions involving future obligations, put it in writing. Hence, it’s not always the case that forwards as a form of derivatives were something ALWAYS disliked The key is to limit applications by putting in place stringent regulations. The Shari’a is the best to do this, as all Islamic banks must have a Shari’a audit department.
  • So is there a real utility to these contracts or am I propagating that speculators should take over Islamic finance? CLICK Let’s take a look at the simple and easy to relate to, example of a car importer who wants to buy 1000 cars from japan. CLICK At today’s foreign exchange rates, he has his share of the market and can make decent earning for himself. CLICK However, if exchange rates move against him, that is Yen appreciates in value, then the relative value of his products will be diminished and he may loose his customers. Now, this may not be important for big companies that has cushion there losses or manage this, but for smaller companies, a small loss and that is the end of their business… going back to the need for SMEs CLICK The two important features I wanted to highlight is that we all agree that there is a legitimate business purpose for this car importer and there is a specific loss unrelated to the core trading and his business itself, but related to financial markets, that the importer wants to avoid.
  • And this legitimate need for foreign exchange risk related to trading is growing extremely fast. CLICK The diagram on the left of the screen displays the growth of ‘external assets and liabilities’ of countries with Islamic finance presence, while the diagram on right shows growth rate of countries with Islamic finance presence, the GCC and versus the world. As you can see, the growth is substantially higher for the “Islamic Finance” countries, including the GCC. YET Islamic finance is unable to service the needs of these legitimate ‘trade based’ ‘Risk protection’ seekers.
  • So why do I suggest Wa’d?
  • Well let’s look at the options that car importer has. He can do a physical hedge Exchange the currency now and hold onto it until his time to exchange it He can do a number of nice conventional solutions which are electronically traded or traded OTC, such as an call option or a currency forward. If he is determined to do Islamic, he can go to one of the conventional bank’s Islamic windows and he can do several things, all of which cost a lot or alternatively involve a lot of complications from a processing point of view. So, in this case, because of the hardship that Islamic finance imposes, he really has very little option to protect himself.
  • The other option he has is that he can do a unilateral wa’d with a bank, whereby he provides the bank with a promise to exchange a certain amount of currency in the future. THIS IS ALREADY BEING PRACTICED AND HAS ALREADY BEEN APPROVED BY A SHARI’A BOARD OF A MAJOR GLOBAL BANK The unique aspect of this transaction is its simplicity and the fact that there is no contract per se, until the point in time the actual exchange occurs. BUT, IMPORTANT QUESTION, DOES IT PASS THE ‘SMELL TEST’ of SHARI’A COMPLIANCE?
  • Well lets look at the three step process for shari’a compliant derivatives: These products must not violate core Shari’a rules Asset must be valuable There must be effective delivery and possession You cannot do deferment of one or both legs of a currency transaction You cannot do bilateral promises Wa’d does not involve any of these. Because it is not a contract, it doesn’t qualify for deferment. It is merely a one-sided promise 2. THERE MUST BE A GENUINE NEEED AND IT MUST FALL UNDER THE RISKS THAT CAN BE INSURED AGAINST 3. The form/structure must nevertheless be Shari’a compliant.
  • I need not go into this in detail, but generally accepted Fiqh perspectives suggest that once a promisor gives a Wa’d, he must fulfill his promise or ELSE, he must pay in the event that CLICK The promise is one sided the promisee incurs some loss and the promisor failed to undertake his promise out of ordinary causes
  • So let’s revisit the impact of derivatives and why WA’d might be a more Shari’a BASED solution. First, Because you cannot trade a promise, or a financial right, a Wa’d cannot be the subject of a financial market, hence for 1 billion of assets, you can only have 1 billion of protection CLICK Second, speculative traders would not be allowed CLICK Third, the wa’d must involve legitimate assets and not indices etc, hence always linked to assets of some sort AS IS EVIDENT, WA’d is the only practical solution for legitimate protection from FX risk.
  • So lets revisit our conclusion again. As is very self evident, Islamic finance is failing to serve the needs of the common man.. Derivatives are disliked by both Islamic finance and those with wisdom in the west.. The wa’d is one solutions that has the ability to serve a legitimate business need, more so than Profit Rate swap etc because it is One sided Doesn’t involve the use of several synthetic trades Is the only solution simple enough to reduce the costs for the customers to make it commercial viable for him to take “Islamic risk protection”. Jazak Allah khair and thank you for your time.
  • FX & Islamic Finance

    1. 1. FX & ISLAMIC FINANCE PROMOTING LEGITIMATE TRADE, NOT SPECULATION AAOIFI WORLD BANK ANNUAL ISLAMIC BANKING CONFERENCE 2010 SAYD FAROOK, GLOBAL HEAD, ISLAMIC CAPITAL MARKETS 2 DECEMBER 2010
    2. 2. CONCLUSION <ul><li>ISLAMIC FINANCE FAILING TO SERVE COMMON MAN </li></ul><ul><li>Islamic Finance not serving the ‘man on the street’ – only for the rich who can pay a premium. </li></ul><ul><li>Real need by SME and corporates that cannot be ignored – FX risk is a REAL phenomenon! </li></ul><ul><li>DERIVATIVES DISLIKED BUT SOME USEFUL </li></ul><ul><li>Derivatives are disliked around the world for the same reasons they are disliked and disallowed in Islamic law. </li></ul><ul><li>Yet, some vanilla versions may pass the Shari’a non-compliance ‘smell test’, while allowing institutions to meet their real needs </li></ul><ul><li>UNILATERAL PROMISE OFFERS HOPE </li></ul><ul><li>A Unilateral Wa’d seems to offer the best compromise in terms of solutions: </li></ul><ul><ul><li>One sided </li></ul></ul><ul><ul><li>No synthetic trades </li></ul></ul><ul><ul><li>Strong volumes possible </li></ul></ul>
    3. 3. MOST OF THE WORLD’S MUSLIM POPULATION WOULD USE ISLAMIC FINANCE IF GIVEN THE CHANCE World’s Muslim population is concentrated in Asia and MENA however more than 300 million Muslims - one-fifth of world total - live in non-Islamic countries World Muslim Population By Region (Percentage of Total) Source: PEW
    4. 4. YET, ISLAMIC FINANCE HAS YET TO MEET THE NEEDS OF THE MAN ON THE STREET Islamic Finance remains concentrated in the wealthy GCC region and Malaysia Source: Iqbal Khan (HSBC); Definition likely represents penetration of Islamic finance Mainstream Relevance Niche Presence Regulator Engagement Conceptual Exploration
    5. 5. CONCLUSION <ul><li>ISLAMIC FINANCE FAILING TO SERVE THE COMMON MAN </li></ul><ul><li>Islamic Finance not serving the ‘man on the street’ – only for the rich who can pay a premium. </li></ul><ul><li>Real need by SME and corporates that cannot be ignored – FX risk is a REAL phenomenon! </li></ul><ul><li>DERIVATIVES DISLIKED BUT SOME USEFUL </li></ul><ul><li>Derivatives are disliked around the world for the same reasons they are disliked and disallowed in Islamic law. </li></ul><ul><li>Yet, some vanilla versions may pass the Shari’a non-compliance ‘smell test’, while allowing institutions to meet their real needs </li></ul><ul><li>UNILATERAL PROMISE OFFERS HOPE </li></ul><ul><li>A Unilateral Wa’d seems to offer the best compromise in terms of solutions: </li></ul><ul><ul><li>One sided </li></ul></ul><ul><ul><li>No synthetic trades </li></ul></ul><ul><ul><li>Strong volumes possible </li></ul></ul>
    6. 6. DERIVATIVES UTILITY OR WEAPONS OF MASS DESTRUCTION? <ul><li>Artificial leveraging = bai’ al-dayn </li></ul><ul><li>Speculation = gharar/maysir </li></ul><ul><li>No asset link ≠ bai sahih </li></ul>
    7. 7. IMPACT OF DERIVATIVES <ul><li>DERIVATIVES FEATURES </li></ul><ul><li>Sale of leverage: Derivatives issuance causes massive artificial leveraging and therefore artificial economy/bubble </li></ul><ul><li>Speculation: Large percentage of market now dominated by speculation </li></ul><ul><li>No asset linkage: Most have lost link to underlying economic activity or real assets and represent only rights </li></ul><ul><li>IMPACT ON MARKETS </li></ul><ul><li>Effects of small movements (in prices) multiplied exponentially leading to extreme scenarios of wealth destruction </li></ul><ul><li>Trading causes artificial price movements </li></ul><ul><li>Investors do not have recourse to anything real to sell </li></ul>
    8. 8. BUT FORWARDS WERE NOT ALWAYS DOMINATED BY SPECULATORS.. <ul><li>First forward contract traced back to Prophet Yaqub’s (a.s) time (1600 B.C.): Laban promises daughter’s hand in marriage to Jacob. </li></ul><ul><li>Chicago’s ‘to-arrive’ forward grain contracts to lock in prices and avoid price decreases during over-supply seasons. </li></ul>
    9. 9. SO WHAT’S THE UTILITY? ILLUSTRATION <ul><li>Car importer wants to buy 1000 cars from Japan. </li></ul><ul><li>At today’s exchange rates, he can sell them at a decent margin. </li></ul><ul><li>However, he is not sure if this market will remain the same with the financial crisis. </li></ul><ul><li>If the price moves against him, he will loose this margin and might even make a loss. </li></ul><ul><li>TWO IMPORTANT FEATURES HERE: </li></ul><ul><li>Legitimate business purposes </li></ul><ul><li>Need to avoid loss </li></ul>
    10. 10. THE GROWING NEED FOR FX RISK PROTECTION <ul><li>Increasingly, Islamic countries are exposed to international trade/investment. </li></ul><ul><li>A large percentage (45-70%) of these corporations/individuals would prefer Islamic methods of transactions, if given the choice. </li></ul>Foreign currency assets & liabilities of countries with Islamic Finance presence Assets and Liabilities Growth rates of assets
    11. 11. CONCLUSION <ul><li>ISLAMIC FINANCE FAILING TO SERVE THE COMMON MAN </li></ul><ul><li>Islamic Finance not serving the ‘man on the street’ – only for the rich who can pay a premium. </li></ul><ul><li>Real need by SME and corporates that cannot be ignored – FX risk is a REAL phenomenon! </li></ul><ul><li>DERIVATIVES DISLIKED BUT SOME USEFUL </li></ul><ul><li>Derivatives are disliked around the world for the same reasons they are disliked and disallowed in Islamic law. </li></ul><ul><li>Yet, some vanilla versions may pass the Shari’a non-compliance ‘smell test’, while allowing institutions to meet their real needs </li></ul><ul><li>UNILATERAL PROMISE OFFERS HOPE </li></ul><ul><li>A Unilateral Wa’d seems to offer the best compromise in terms of solutions: </li></ul><ul><ul><li>One sided </li></ul></ul><ul><ul><li>No synthetic trades </li></ul></ul><ul><ul><li>Strong volumes possible </li></ul></ul>
    12. 12. OPTIONS FOR CAR IMPORTER? Costlier to customer, process intensive and not conducive to economies of scale, inflates accounts No upfront financing/cash required Bank sells via Murabaha payment local currency and customer sells via murabaha payment foreign currency Back to back Murabaha Inefficient and costly to customer, tawarruq controversial Shari’a compliant in form? Bank finances then exchanges to foreign currency Tawarruq/Commodity Murabaha + Spot conversion ISLAMIC Impermissible to defer either leg of the currency transaction Several multinationals provide such services Contract to exchange currency at a future date Currency Forward Contract Not permissible to sell a financial right Easily bought and sold in financial markets Option/right to purchase currency at specified price Call Option CONVENTIONAL Spare working capital? Easily executed Convert spare capital to foreign currency and hold Spot conversion PHYSICAL HEDGE DISADVANTAGES ADVANTAGES DEFINITION TYPE
    13. 13. OPTIONS FOR CAR IMPORTER? Customer requiring forward FX Bank providing forward FX platform Execute Master Agreement for FX trades (T 0 ) Provide unilateral undertaking to exchange foreign currency at T 90 (T 0 ) 2 1 3 Exchange foreign currency (T 90 ) Binding on customer but not binding on MB to execute. Unilateral Wa’d can never be like a forward as not binding on both parties. Universal Shari’a acceptability of Wa’d even where it is one sided. Easily executed, does not inflate balance sheet, conducive to economies of scale and electronic platforms, no commodity costs. Customer provides one way Wa’d to bank, with obligation on customer to exercise. Bank is not obligated to exercise. Unilateral Wa’d ISLAMIC DISADVANTAGES ADVANTAGES DEFINITION TYPE
    14. 14. RELEVANT FIQH PERSPECTIVES <ul><li>STEP 1: CORE RULES </li></ul><ul><li>Asset must be valuable in Shari’a; Pure Rights cannot be sold or traded </li></ul><ul><li>Only a tangible commodity or usufruct may be bought and sold in Islamic law. Pure rights cannot be bought and sold </li></ul><ul><li>Delivery and Possession </li></ul><ul><li>Hakim ibn Hazam said: “ I asked the Prophet: ‘ O Messenger of God. A man comes to me and asks me to sell him what is not with me. I sell him (what he wants) and then buy the goods for him in the market. ’ The Prophet replied: ‘ Sell not what is not with you’ - Tradition of the Holy Prophet (PBUH) </li></ul><ul><li>Deferred currency transaction </li></ul><ul><li>“ Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, in equal weights, from hand to hand. If these species differ, then sell as you like, as long as it is from hand to hand” </li></ul><ul><li>Mutual deferment of countervalues/ bilateral promises </li></ul><ul><li>“ bay al-kali bil kali” Islamic maxim approved through consensus (ijma) </li></ul><ul><li>STEP 2: LEGITIMATE NEEDS </li></ul><ul><li>Overwhelming need for protection/genuine hedging risk </li></ul><ul><li>“ He has only forbidden you what dies of itself, and blood, and flesh of swine, and that over which any other (name) than (that of) Allah has been invoked; but whoever is driven to necessity, not desiring, nor exceeding the limit, no sin shall be upon him; surely Allah is Forgiving, Merciful.” Holy Qur’an, 2:173 </li></ul><ul><li>Critical to define types of permissible risk protection </li></ul><ul><li>Cannot remove risk altogether such as ownership risk or investment risk, since there can be no profit without the assumption of risk , BUT can take steps to mitigate such risks. Permissible risks include: </li></ul><ul><li>Currency Risk </li></ul><ul><li>Profit Rate Risk </li></ul><ul><li>Commodity Risk </li></ul><ul><li>Counterparty Risk </li></ul><ul><li>STEP 3: SHAR’IA COMPLIANT FORM / STRUCTURE </li></ul><ul><li>The structure MUST conform to Shari’a compliance requirements: </li></ul><ul><li>Real trade or investment based instrument, i.e. Musawama or Murabaha </li></ul><ul><li>Avoidance of any implicit or explicit application of interest i.e. penalties etc </li></ul><ul><li>Avoidance of any ambiguity in determination of termination amount and close out netting </li></ul><ul><li>Promises should not be bilateral or unilateral promises must not result in a bilateral contract (where applicable) </li></ul><ul><li>Wa’d </li></ul><ul><li>Wa’d </li></ul><ul><li>Wa’d </li></ul>
    15. 15. RELEVANT FIQH PERSPECTIVES ON WA’D <ul><li>For damages in reliance of a Wa’d to be claimed in a court of law, the following conditions must be fulfilled: </li></ul><ul><li>Only a one-sided/unilateral promise </li></ul><ul><li>The promisee must incur some liabilities/expenses in reliance </li></ul><ul><li>Non-performance must be due to negligence or fraudulent misconduct, not normal causes </li></ul>
    16. 16. REVISITING THE IMPACT OF DERIVATIVES <ul><li>UNILATERAL WA’D </li></ul><ul><li>No secondary market and no artificial bubble possible: Wa’d (Right) cannot be sold in secondary markets once promised and promisor must execute. </li></ul><ul><li>Speculative trades not permissible: Speculative needs cannot be entertained by banks according to Shari’a </li></ul><ul><li>Subject matter of Wa’d must be legitimate asset (commodities, currencies, physical assets): Since no secondary market, always linked to asset based hedging requirements. </li></ul><ul><li>DERIVATIVES FEATURES </li></ul><ul><li>Sale of leverage: Derivatives issuance causes massive artificial leveraging and therefore artificial economy/bubble </li></ul><ul><li>Speculation: Large percentage of market now dominated by speculation </li></ul><ul><li>No asset linkage: Most have lost link to underlying economic activity or real assets and represent only rights </li></ul>FX UNILATERAL WA’D THE ONLY PRACTICAL SOLUTION FOR LEGITIMATE NEEDS
    17. 17. CONCLUSION <ul><li>ISLAMIC FINANCE FAILING TO SERVE THE COMMON MAN </li></ul><ul><li>Islamic Finance not serving the ‘man on the street’ – only for the rich who can pay a premium. </li></ul><ul><li>Real need by SME and corporates that cannot be ignored – FX risk is a REAL phenomenon! </li></ul><ul><li>DERIVATIVES DISLIKED BUT SOME USEFUL </li></ul><ul><li>Derivatives are disliked around the world for the same reasons they are disliked and disallowed in Islamic law. </li></ul><ul><li>Yet, some vanilla versions may pass the Shari’a non-compliance ‘smell test’, while allowing institutions to meet their real needs </li></ul><ul><li>UNILATERAL PROMISE OFFERS HOPE </li></ul><ul><li>A Unilateral Wa’d seems to offer the best compromise in terms of solutions: </li></ul><ul><ul><li>One sided </li></ul></ul><ul><ul><li>No synthetic trades </li></ul></ul><ul><ul><li>Strong volumes possible </li></ul></ul>

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