market place June 16th, 2008

Innovation is a cornerstone of the financial markets. Without the development of securitization, derivatives, and other complex financial instruments it’s safe to argue that it would be impossible to fuel the growth of the global economy. Since the growing Islamic Finance industry exists as a subset of the global financial system there is always a steady stream of new ideas being proposed and tested by Islamic financial institutions. At the center of this process of testing new ideas are the Shari’ah (Islamic law) supervisors who advise Islamic finance institutions on the Shari’ah compliance of their products and investments.

Yusuf Talal DeLorenzo is currently Chief Shari’ah Officer and Board Member at Shari’ah Capital. He is a well-known and respected Shari’ah advisor and Islamic scholar whose career spans more than 30 years. He serves as a Shari’ah advisor to over 20 global financial entities, including index providers, banks, mutual funds, real estate funds, leasing funds, institutional investors, home finance providers, alternative asset managers and others.
Shaykh Yusuf
Talal DeLorenzo

Shaikh Yusuf is also author of the three volume “Compendium of Legal Opinions on the Operations of Islamic Banks”, the first English reference on the fatawa (religious ruling) issued by Shari’ah boards. Shaikh Yusuf is also a special consultant, appointed by the Asian Development Bank and the Islamic Development Bank in Jeddah to the International Financial Services Board (“IFSB”) on the subject of Sukuk.

He recently delivered a paper questioning the validity of a proposed structure whose purpose is to “wrap a non-Shari’ah compliant underlying into a Shari’ah compliant structure.” The paper is a bold attempt to correct some of the recent attempts to ostensibly make halal (lawful) what is clearly haram (unlawful) by calling for due consideration for both the letter and the spirit of the Shari’ah.

Following is part of the paper’s introduction that lays out the issue [available for download here]:

Recently, a financial stratagem known as “Shariah Conversion Technology” was developed, the purpose of which is to affect a total returns swap or to “Wrap a non-Shariah compliant underlying into a Shariah compliant structure.”

In other words, the objective of the mechanism is to use non-compliant assets and their performance to bring returns into a so-called Shariah-compliant investment or investment portfolio. This point is key to the entire transaction, and for that reason it needs repeating. What the product proposes to accomplish is to bring to the Islamic investor returns from investments that are not compliant with Shariah principles and precepts.

In June of this year, 2007, a pioneering Islamic bank in the Gulf launched a principal protected note that was the first product using this “Shariah Conversion Technology’ to be offered to the investing public. This was followed by another such product, also offered by a Gulf-based Islamic bank. Prior to this, the stratagem was used in structured products offered by multinational banks to institutional investors and the treasuries of Islamic banks and finance houses. All of these products have been approved and certified by Shariah supervisory boards. Not all of these products, however, bring to the Islamic investor returns from investments that are compliant with Shariah.

The questions that such a product immediately bring to mind are: How can Shariah boards approve such returns? Does the circumstance of direct or indirect delivery to the Islamic investor change the ruling? When the Shariah of Islam is understood to differ from other legal systems because it may be characterized as both positive law and morality, is it possible to ignore the moral aspect of a financial transaction like this?

The means of delivery, a wa’d or promise, is widely seen to comply with Shariah norms. Since it is compliant, at least to the letter of the law, some Shariah scholars have approved products that use a wa’d to deliver returns from non-compliant investments. By doing so, however, they have failed to consider the purpose of the transaction, they have failed to consider the movement of the cash and, most importantly, they have failed to consider the ramifications for the industry as a whole.

At a very fundamental level, the reason for these failings is that they have not discerned the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shariah compliant assets as a determinant for returns.

DinarStandard recently spoke to Sh. DeLorenzo about total returns swap, its impact on Islamic finance industry, and the role and responsibility of Shari’ah supervisors today.

DS: What is the difference between abiding by the Shari’ah (as in “Shari’ah compliant) and circumventing it?

YTD: The difference is authenticity. Unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product’s authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.

In matters as complex as modern finance, there is a reason that international standards (such as those set by AAOIFI, the Auditing and Accounting Organization of Islamic Financial Institutions) insist that such decisions must be made by a Shari’ah supervisory board that includes at least three Shari’ah scholars with specialized knowledge of the Islamic laws for transacting, fiqh al mu`amalat, in addition to knowledge of modern business, finance and economics.

DS: Do you believe some people in the industry see both as being compliant?

YTD: Those who attempt to circumvent compliance may perhaps be confused. Only Allah knows whether or not their intentions are sincere. There can be little doubt, however, that their actions are counterproductive and probably of benefit to no one but themselves.

DS: How serious is the problem – of making something haram halal?

YTD: Making the halal haram or the haram halal is the right of the Almighty and the Almighty alone. So, this is no small matter. However, what we have here is a situation in which qualified jurists have performed ijtihad. In other words, the members of the Shari’ah supervisory boards that have approved these swaps (download the paper to read about the “Total Return Swap”) have given due consideration to the matter and the result of their ijtihad is their approval for the swaps and the products that are based on them.

  “…I am certainly hopeful that the market itself will reject these products. That, perhaps more than anything else, will be the most important step in the process of ridding the industry of this problem and others like it.”

My view is that 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. Even so, as qualified scholars, they have a right to their own opinions. My own opinion of such scholars (some of whom have been my colleagues for more than twenty five years) is to say that it is likely that those scholars fell into the trap of literalism. In Urdu there is an expression for literalists… lakeer ka faqeer.

Whatever you call it, it seems to me that when jurists lose sight of the big picture, of the maqasid, of the Islamic financial industry and its meaning for the future of the entire Muslim community then it is possible to explain why they might approve such swaps. I am happy to share with you the knowledge that several of the scholars who first approved these swaps have since reversed their opinions. And I am certainly hopeful that the market itself will reject these products. That, perhaps more than anything else, will be the most important step in the process of ridding the industry of this problem and others like it.

DS: Comment on the morality of finance – isn’t the right attitude “business is business”? How does Islam invest business with morality?

YTD: Business, in the Qur’anic sense of “profitable trade” or tijarat’un rabihah is business that brings blessings to those who conduct it. Obviously, profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari’ah on proper transacting is that Islam accords great importance to the economic welfare of society.

DS: What is your view on how Shari’ah Supervisory Boards function? Is there really any independence if they are retained by financial institutions?

YTD: The concept of collective decision-making, in other words, decisions made by more than one scholar, is especially important. Shari’ah Supervisory Boards (SSBs) function to ensure that decisions are not unilateral, and that difficult issues of finance receive adequate consideration by a number of qualified people. The members of such boards are paid as professionals who, like consultants, offer their opinions to management. Whether those opinions are acceptable to management or not, the consultants will receive their professional fees.

DS: What should be the model for Shari’ah compliance be in the future – uniform/multilateral; uniform/unilateral (government); or heterogeneous/private sector based?

YTD: Personally, I’m a great believer in market forces. Much like the concept of ijma’, I believe that decisions made over time by large majorities of concerned and informed people are good decisions. At the present time, the Islamic financial industry is just beginning. As more professionals join its ranks, the intellectual capital of the industry will grow; and when that happens, I expect that better decisions will be made, better processes will be developed, and the quality of every aspect of the industry will improve. This is what progress is all about.

DS: What has the reaction been to your paper? – By practitioners, other advisors, and the industry as a whole?

YTD: I have had a great deal of positive feed back by colleagues on Shari’ah boards, by lawyers, bankers and by financial professionals all over the world. I will mention Shaikh Taqi Usmani, in particular, who wrote to me to request a copy of the paper and who, after reading it, thanked me for performing what he called “fard kifayah”. Equally as important is that I have heard from investors who feel very strongly about the issue of authenticity; and many are upset that Shari’ah scholars have actually approved such swaps.

DS: In recent weeks we saw reports surface of Mufti Taqi Usmani’s criticism of the sukuk sector. With the sector growing so rapidly within Islamic finance, how has the market reacted to Mufti Taqi’s observations? How did the problem get so bad?

YTD: I must again point to the relative newness of this industry, and of this product, Sukuk, in particular. Sukuk are based on very complex contracts; and nearly every one is different, even if many are based on the same model. For, even when you begin with a single concept on which to base a Sukuk issuance, if the jurisdictions are different, if the size, the tenor, the credit enhancements, in short if all the business and legal aspects are different, then of course the end product is going to be very different.

Then, while AAOIFI has promulgated detailed standards for Sukuk, those standards are applicable at the conceptual level. At the practical level, however, where all the details are, those standards are often subject to interpretation; and that will lead inevitably to differences. So, in a way, it should come as no surprise that there is such divergence. The contribution of Shaikh Taqi is a responsible way of dealing with all of this. In a like manner, I am hopeful that my paper will stimulate further discussion and debate in keeping with the finest traditions of Muslim legal scholarship. Finally, all of us must say: Allah knows best!


Glossary of Arabic Terms:

fatwa: an opinion on matters of Islamic law, often employed by modern Islamic banks as formal certification for a financial product or service.
halal: lawful
haram: unlawful
Shariah: Islamic law
sukuk: Shariah-compliant securities
taqwa: one’s being heedful of the Almighty
wa’d: promise


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