ICM04-Islamic Structured Products

7/31/2019 ICM04-Islamic Structured Products

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Islamic Capital Market

ICM04-Islamic Structured Products

Khairuddin ZakariaB.Sc.Eng, MBA, CIFP, RFP


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Outline

What is Structured Product?

What is Islamic Structured Product?

Capital Protection and Structured Products

CASE1: Alternatives Islamic Capital ProtectedProducts

Derivatives and Structured Products CASE2: Alternatives Islamic Derivatives Products

CASE 3-Islamic Structured Products

Challenges for Islamic Structured Products


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What is Structured Product

generally a pre-packaged investment

strategy which is based on derivatives (ie.

options etc) but which features

protection of principal


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What is Structured Product

The two common elements in a Structured Productare: 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, theissuer simply invests in a risk free bond which hassufficient interest to grow to RM10,000 after the 5year period. For example, this bond might costRM8,000 today and after 5 years it will grow toRM10,000. With the leftover funds the issuer invest inspecial derivatives needed to perform whatever theinvestment strategy is.


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What is Islamic StructuredProduct

Generally, it is Structured Product which

is classified as a Shariah-compliant

instrument.

It uses some of below approved

contracts:

Murabahah

Tawarruq

Urbun, etc.


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Capital Protection andStructured 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 Islamicperspective?


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CASE1: Alternatives IslamicCapital Protected Products

Currently the main instruments used to

simulate similar features of conventional

capital protected instruments will involve

below:

Bai Inah

Bai Tawarruq

Waad


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CASE1: Alternatives Islamic CapitalProtected 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


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CASE1: Capital Protection and StructuredProducts: Tawarruq

Bai Tawarruq Similar to Inah with major differences are:

Asset does not return to original seller

Involves more than two parties


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COMPARISONS (Taw vs. Inah)

NO.

DISTINGUISHING

FACTORS AL-INAH

AL-TAWARRUQ

1. Concept

Purchase of acommodity on differedpayment basis and it isthen sold for cash, at aprice lower than the

purchase price, back tothe original seller.

Buying a commodity fora deferred payment andselling it to anotherperson other than initialseller at a lower pricefor immediate payment.

2. PurposeTo facilitate cash andliquidity shortage.

To facilitate cash andliquidity shortage.

3. PartiesTwo parties involve fortwo transactions.

Three parties (at least)involve for two transactions

(at least).

4. Subject MatterReturn back to theoriginal seller.

Transferred andpossessed by third party.

Both Inah and Tawarruq have different level of acceptance

Some consider as valid and some otherwise. Why?


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CASE1: Alternatives Islamic CapitalProtected 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 promiseto purchase.

Sharia issues around promises

Distinction between a promise and a contract

A promise, in general is not binding and, hence, unenforceable in thecourt of law; a contract is binding and enforceable

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

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

Can we write binding promises?

Yes conditional upon the OIC Fiqh Academys resolution: One-side promise,

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

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


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Derivatives and Structured Products

Structured Products Any investment product that falls within the definition of

securities under SCA which provides the holder with aneconomic, 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 investmentstrategy based on derivatives, such as a single security, abasket of securities, options, indices, commodities, debtissuance 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 astructured product.


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Derivatives and StructuredProducts

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


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Derivatives

Derivatives have invoked mixed response from the Shariahscholars whose tendency in holding them as prohibited dueto 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 theseller, negating the hadith 'sell not what is not with you',Sharjah principles require sellers to actually own the referenceasset at the inception of a transaction;

mutual deferment on both sides of the bargain, which reducescontingency risk but turns a derivative contract into a sale ofone debt for another; and

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


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Derivatives:

Forward & Futures

The main issue in the Shariah compliance of a forwardor futures contract is the deferment of both the priceand asset to a future date.

to defer both price and asset to a future date may be abit problematic due to the issue ofgharar. This type ofdeferment is usually allowed as an exception to thegeneral rule when there is a need for such a contract,for example, in the case ofistisna`


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Derivatives:

Forward & Futures

Majma al-Fiqh ruled that to defer both thecounter-values in the trading ofcommodities (forward contract) is notpermissible, but recommended that such

commodity trading follow salam rules inorder to be permissible.

However, in reality, the buyer in a forward

or futures contract does not pay the price ofthe asset at the time of the contract, henceviolates salam rule


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Derivatives:Forward & Futures

The Shariah Advisory Council of theMalaysian Securities Commission (SAC) hasresolved that futures contract on crude

palm oil is permissible.

Later, the SAC also resolved that themechanism for stock index futures contract

does not contradict Shariah principles aslong as the index component is made up ofShariah compliant securities.


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Derivatives:

Forward & Futures

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

Another prominent scholar who does not approve offutures trading is Mufti Taqi Usmani. He argues thatfutures 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 ortheir possession is not intended, and in most cases thetransactions end up with the settlement of the difference inprice only, which is not allowed in the Shariah.


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Options

SAC passed a resolution allowing the use of call warrants, providedthat 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 Islamicjurisprudence as outlined in the haq maliyand hak tomallukprinciples;

haq maliycan be traded if it complies with Islamic principles and

conditions of buying and selling.


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Options

Majma'al Fiqh argued that the subject matter ofconventional options are not mal (property), normanfa'ah (usufruct), nor haq maliy (financialright) that may be recovered/waived, thus, rulingit as not permissible from the Shariah point ofview

Mufti Taqi Usmani was posed with a questionabout a sale of stock attached with put options.He responded that while an option contract whenviewed as a promise is acceptable, charging feesand trading them are not. He also found that asale of stock with a put option to resell the stockto the issuer at a future date is unacceptablesince a pre-condition is placed on the originalsale of stock


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CASE2: Alternatives Islamic DerivativesProducts: Salam

This is similar to the conventional futures contract. However, thebig difference is that, in a salam sale the buyer pays the entireamount in full at the time the contract was initiated. The contractalso stipulates that the payment must be in cash form.

Bai' salam contracts are subject to several conditions, of these theimportant 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 bebased 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 beclearly enumerated in the salam agreement;

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


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CASE2: Alternatives Islamic DerivativesProducts: Urbun

The rationale of financial options resemblesthe concept of urbun in the sense that bothmanage price risks.

Urbun sale refers to a sale contract in whichthe buyer reserves a commodity, pays asmall part of the price and agrees to forfeitthe paid portion of the whole price when

the buyer fails to turn up on a particulardate for taking the goods and payment ofthe remaining price.


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The basic elements that this definitionencompasses 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 abinding offer from the seller while the buyer

is at discretion to accept or reject the offerwithin the period of offer in considerationfor the urbun.


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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 laterdate

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 theassets, but if the client elects not to complete the purchasethey 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 resoldby the financier as agent of the client. The sale proceeds aredistributed to the client net of the outstanding purchase price.

If, on the maturity date, the target price is greater than themarket price, the contract is terminated and the client forfeitsthe deposit.


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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 purchaseprice, in call option, the premium paid is

not part of the purchase price.


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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 thepurchase price

Considered part of the purchaseprice if the contract is later onconfirmed

The option contract is tradable Urbun is financial right, but nottradable, only exercisable by theoption holder.


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Structured Product


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CASE3: Model 1-Islamic Equity-LinkedStructured Investment-i

Client Bank XYZ

Islamic FixedIncome

Equity Asset

Wakalah fi Istithmar


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CASE3: Model 2-Islamic Index RestrictedMudharabah Structured Investment-I

Client Bank

Islamic DebtInstruments

Islamic Index

MudharabahMuqayadah


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CASE3: Model 3-Islamic MudharabahDeposit Structured Investment-I

Client Bank

NIDC

Copper andwheat

Mudharabah

Investment into NIDC

Capital Protected (100%

Return on Investment(if the waad is exercised)

Waad to purchase

Reference Underlying

London Metal Exchange

(LME) Copper spot

Chicago Board of Trade

(CBOT) Whaet spot


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Other Challenges forIslamic 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


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The End

God Knows Best

Thank You

ICM04-Islamic Structured Products

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