Islamic Capital Market

ICM04-Islamic Structured Products

Khairuddin Zakaria

B.Sc.Eng, MBA, CIFP, RFP

Outline

• What is Structured Product?

• What is Islamic Structured Product?

• Capital Protection and Structured Products– CASE1: Alternatives Islamic Capital Protected

Products

• Derivatives and Structured Products– CASE2: Alternatives Islamic Derivatives Products

• CASE 3-Islamic Structured Products

• Challenges for Islamic Structured Products

What is Structured Product

• generally a pre-packaged investment

strategy which is based on derivatives (ie.

options etc) but which features

protection of principal

What is Structured Product

• The two common elements in a Structured Product are:– 1. A bond product or another element of capital

safeguard.

– 2. An alpha generator – which is any financial instrument (i.e. a stock, currency, etc.)

• For example, an investor invests 10,000 ringgits, the issuer simply invests in a risk free bond which has sufficient interest to grow to RM10,000 after the 5 year period. For example, this bond might cost RM8,000 today and after 5 years it will grow to RM10,000. With the leftover funds the issuer invest in special derivatives needed to perform whatever the investment strategy is.

What is Islamic Structured

Product

• Generally, it is Structured Product which

is classified as a Shariah-compliant

instrument.

• It uses some of below approved

contracts:

– Murabahah

– Tawarruq

– Urbun, etc.

Capital Protection and

Structured Products

• Capital protection is possible in

conventional by finance through such

below investment instruments:

– Fixed income securities such as bonds and

bils, etc.

– Preference shares

• Is this possible to have from Islamic

perspective?

CASE1: Alternatives Islamic

Capital Protected Products

• Currently the main instruments used to

simulate similar features of conventional

capital protected instruments will involve

below:

– Bai Inah

– Bai Tawarruq

– Waad

CASE1: Alternatives Islamic Capital

Protected Products: Inah

• Bai Inah

– Two sales contracts concluded separately

– Underlying asset finds its way back to

original seller

– Difference in payment mode and time

between those two concluded contracts

CASE1: Capital Protection and Structured

Products: Tawarruq

• Bai Tawarruq

– Similar to Inah with major differences are:

• Asset does not return to original seller

• Involves more than two parties

COMPARISONS (Taw vs. ‘Inah)

NO.DISTINGUISHING

FACTORSAL-‘INAH AL-TAWARRUQ

1. Concept

Purchase of a

commodity on differed

payment basis and it is

then sold for cash, at a

price lower than the

purchase price, back to

the original seller.

Buying a commodity for

a deferred payment and

selling it to another

person other than initial

seller at a lower price

for immediate payment.

2. PurposeTo facilitate cash and

liquidity shortage.

To facilitate cash and

liquidity shortage.

3. PartiesTwo parties involve for

two transactions.

Three parties (at least)

involve for two transactions

(at least).

4. Subject MatterReturn back to the

original seller.

Transferred and

possessed by third party.

• Both Inah and Tawarruq have different level of acceptance

• Some consider as valid and some otherwise. Why?

CASE1: Alternatives Islamic Capital

Protected Products: Waad

• Promises are used extensively in Islamic finance but not much acknowledged

– The most widely-used Murabaha contract is, in fact, based on a “promise to purchase”.

• Sharia issues around promises

– Distinction between a „promise‟ and a „contract‟

• A „promise,‟ in general is not binding and, hence, unenforceable in the court of law; a contract is binding and enforceable

• Promises are not contracts, but give rise to contracts after a certain condition as laid in promise is met

– An unenforceable promise does not have an economic value. It has an economic value only if it is binding

– Can we write binding „promises‟?

– Yes… conditional upon the OIC Fiqh Academy‟s resolution:

• One-side promise,

• Binding (takes into account the actual damages and not the opportunity cost of the promisee)

• Promisor is not bound if the lack of performance is beyond his control

Derivatives and Structured Products

• Structured Products– Any investment product that falls within the definition of

“securities” under SCA which provides the holder with an economic, legal or the interest in another asset (“underlying asset”) and derives its values by reference to the price or value of the underlying asset.

– In finance, a structured product, also known as a market-linked product, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps.

– The variety of products just described is demonstrative of the fact that there is no single, uniform definition of a structured product.

Derivatives and Structured

Products

• Derivatives– A derivative is a financial instrument whose

value depends on underlying variables.

– The most common derivatives are • Forward,

• futures,

• options, and

• Swaps

– The main uses of derivatives are:• Hedging risk

• Speculation

• Arbitrage

Derivatives

• Derivatives have invoked mixed response from the Shariahscholars whose tendency in holding them as prohibited due to the violation of basic requirements in contract.

• The general key arguments against the use of derivatives contain the following concerns:– the valuation of derivatives based on the sale of a non-existent

asset or an asset which is not in the possession (qabd) of the seller, negating the hadith 'sell not what is not with you', Sharjah principles require sellers to actually own the reference asset at the inception of a transaction;

– mutual deferment on both sides of the bargain, which reduces contingency risk but turns a derivative contract into a sale of one debt for another; and

– excessive uncertainty or speculation that verges on gambling, resulting in zero-sum payoffs for both sides of the bargain.

Derivatives:

Forward & Futures

• The main issue in the Shariah compliance of a forward or futures contract is the deferment of both the price and asset to a future date.

• to defer both price and asset to a future date may be a bit problematic due to the issue of gharar. This type of deferment is usually allowed as an exception to the general rule when there is a need for such a contract, for example, in the case of istisna`

Derivatives:

Forward & Futures

• Majma„ al-Fiqh ruled that to defer both the counter-values in the trading of commodities (forward contract) is not permissible, but recommended that such commodity trading follow salam rules in order to be permissible.

• However, in reality, the buyer in a forward or futures contract does not pay the price of the asset at the time of the contract, hence violates salam rule

Derivatives:

Forward & Futures

• The Shariah Advisory Council of the Malaysian Securities Commission (SAC) has resolved that futures contract on crude palm oil is permissible.

• Later, the SAC also resolved that the mechanism for stock index futures contract does not contradict Shariah principles as long as the index component is made up of Shariah compliant securities.

Derivatives:

Forward & Futures

• To the contrary, it should be noted here that Majma„ al-Fiqh al Islamiy ruled that index trading is not permissible because the subject matter is not real (khayali) and does not exist.

• Another prominent scholar who does not approve of futures trading is Mufti Taqi Usmani. He argues that futures contracts are invalid because:– it is against the Shariah principle that purchase or sale cannot

be affected for a future date; and

– in most futures transactions delivery of the commodities or their possession is not intended, and in most cases the transactions end up with the settlement of the difference in price only, which is not allowed in the Shariah.

Options

• SAC passed a resolution allowing the use of call warrants, provided that the underlying shares of the warrants in question are Sharjahcompliant.

• The main reasons given for permitting call warrants are:

– it fulfils the features of mal (property) according to Islamic jurisprudence as outlined in the haq maliy and hak tomallukprinciples;

– haq maliy can be traded if it complies with Islamic principles and conditions of buying and selling.

Options

• Majma' al Fiqh argued that the subject matter of conventional options are not mal (property), nor manfa'ah (usufruct), nor haq maliy (financial right) that may be recovered/waived, thus, ruling it as not permissible from the Shariah point of view

• Mufti Taqi Usmani was posed with a question about a sale of stock attached with put options. He responded that while an option contract when viewed as a promise is acceptable, charging fees and trading them are not. He also found that a sale of stock with a put option to resell the stock to the issuer at a future date is unacceptable since a pre-condition is placed on the original sale of stock

CASE2: Alternatives Islamic Derivatives

Products: Salam

• This is similar to the conventional futures contract. However, the big difference is that, in a salam sale the buyer pays the entire amount in full at the time the contract was initiated. The contract also stipulates that the payment must be in cash form.

• Bai' salam contracts are subject to several conditions, of these the important ones are as follows:– full payment by the buyer at the time of effecting the sale;– the underlying asset must be standardisable, easily quantifiable and of

determinate quality;– the salam contract cannot be based on a uniquely identified

underlying asset; this means that the underlying commodity cannot be based on a commodity from a particular farm or field, as by definition such an underlying asset would not be standardisable;

– the quantity, quality, maturity date and place of delivery must be clearly enumerated in the salam agreement;

– the underlying asset or commodity must be available and traded in the markets through the period of contract.

CASE2: Alternatives Islamic Derivatives

Products: Urbun

• The rationale of financial options resembles the concept of urbun in the sense that both manage price risks.

• Urbun sale refers to a sale contract in which the buyer reserves a commodity, pays a small part of the price and agrees to forfeit the paid portion of the whole price when the buyer fails to turn up on a particular date for taking the goods and payment of the remaining price.

CASE2: Alternatives Islamic Derivatives

Products: Urbun

• The basic elements that this definition encompasses are:– urbun takes place after effecting a sole

contract;

– the sold item is defined; and

– the effective date of the urbun must be defined.

• The urbun sale entitles the buyer to gain a binding offer from the seller while the buyer is at discretion to accept or reject the offer within the period of offer in consideration for the urbun.

CASE2: Alternatives Islamic Derivatives

Products: Urbun

• Under an Urbun arrangement, the following happens:– The client contracts to buy assets from a financier for an

agreed price (the target price) for delivery on an agreed later date

– The client makes a partial payment (for example, 20 per cent) of the purchase price immediately by way of a deposit.

– The client is entitled not to complete the purchase of the assets, but if the client elects not to complete the purchase they forfeit the deposit.

– If, on the maturity date, the target price is less than the market price, the assets are purchased by the client and resold by the financier as agent of the client. The sale proceeds are distributed to the client net of the outstanding purchase price.

– If, on the maturity date, the target price is greater than the market price, the contract is terminated and the client forfeits the deposit.

CASE2: Alternatives Islamic Derivatives

Products: Urbun

CASE2: Alternatives Islamic Derivatives

Products: Urbun

• This is similar to the call option where the

option holder is entitled to buy shares or

refrain from doing so against losing the paid

premium.

• However, unlike urban where the premium

paid is considered part of the purchase

price, in call option, the premium paid is

not part of the purchase price.

Option vs Urbun

Option ‘Urbun

It is the right to buy or sell It is only the right to buy

The option premium is not part of the

purchase price

Considered part of the purchase

price if the contract is later on

confirmed

The option contract is tradable ‘Urbun is financial right, but not

tradable, only exercisable by the

option holder.

Structured Product

CASE3: Model 1-Islamic Equity-Linked

Structured Investment-i

Client Bank XYZ

Islamic Fixed

Income

Equity Asset

Wakalah fi Istithmar

CASE3: Model 2-Islamic Index Restricted

Mudharabah Structured Investment-I

Client Bank

Islamic Debt

Instruments

Islamic Index

Mudharabah

Muqayadah

CASE3: Model 3-Islamic Mudharabah

Deposit Structured Investment-I

Client Bank

NIDC

Copper and

wheat

Mudharabah

Investment into NIDC

Capital Protected (100%

Return on Investment

(if the wa’ad is exercised)

Wa’ad to purchase

Reference Underlying

London Metal Exchange

(LME) Copper spot

Chicago Board of Trade

(CBOT) Whaet spot

Other Challenges for

Islamic Structured Products

• Prohibition of guaranteed return on

investment contracts-AAOIFI

• Liquidity and Shariah risk due to different

level of acceptance

• Legal risk due to changing

pronouncement/resolution and untested

case in the court of law

The End

God Knows Best

Thank You