1. 1 Islamic Principles of Financial Engineering with Special Reference to Sukuk Instruments Prof. Dr. Munawar Iqbal Former Chief of Research Islamic Banking and Finance IRTI, Islamic Development Bank Group UMP-DIFC SYMPOSIUM Dubai, May 3 2010

2. 2 Definition of Financial Engineering Financial engineering can be defined as ‘the design, development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance’.

3. 3 Need for Financial Engineering in Islamic Finance Until now, the Islamic financial tools have essentially been limited to classical modes developed centuries ago. They were developed to meet the needs of those societies. While they may serve as useful guidelines for contemporary Islamic contracts, there is no reason, whatsoever, to be restricted only to those. Financial markets are becoming more and more sophisticated, and competitive. In order to exploit the fast changing market environment and face increasing competition, financial engineering and innovation is imperative.

4. 4 Scope for Financial Engineering in Islamic Finance Financial needs of both individuals and businesses have changed. Engineers in modern finance have designed several new ways such as mortgages, options, derivatives, hedging, insurance pension plans, credit cards etc., to meet those needs. We must examine what needs are being fulfilled by these instruments. If the needs are genuine (Islamically speaking), then we must either adapt them for our purposes or invent Islamic alternatives for them.

5. 5 Scope for Financial Engineering in Islamic Finance-Cont. In the light of the fast changing financial scene, “a needs approach to financial engineering” is desirable, of course within the known principles of Islamic finance. In this regard, the example of bay‘ salam is very important to remember. In general, it is not allowed to sell anything, which is not in one’s possession. But in case of salam, the Prophet (pbuh) allowed such sale because of “need” of the people, but laid down clear rules to protect the interests of both parties. In this regard, the example of bay‘ salam is very important to remember. In general, it is not allowed to sell anything, which is not in one’s possession. But in case of salam, the Prophet (pbuh) allowed such sale because of “need” of the people, but laid down clear rules to protect the interests of both parties. In the following slides we will attempt to provide necessary tools and principles for FE in modern times. In the following slides we will attempt to provide necessary tools and principles for FE in modern times.

6. 6 Ten Guiding Principles for FE 1.The Doctrine of Maximising Human Welfare 2.The Doctrine of General Permissibility 3. Prohibition of Riba 4. Prohibition of Gharar 5. Prohibition of Gambling 6. Prohibition of Selling Without Having Possession and Two Deals in One 7. No pain no gain (Al- Kharaju Bil-Daman) 8. Permissibility of Hybrid Contracts and Rules Governing them 9. Principle of Relief (Istahsan) 10. The Doctrine of Necessity

7. 7 The Doctrine of Maximising Human Welfare The doctrine of maslahah, (seeking of benefit and repelling of harm) is well-recognized in Fiqh. It is something similar to the principle of utility (securing maximum human happiness). However, Muslim jurists have pointed out that from a technical point of view, maslahah means the securing of the objectives of Shariah rather than maximisation of happiness as seen by human beings. However, the objectives of Shariah, themselves, aim at maximising human welfare in this life as well as the life Hereafter. (The Creator knows what is best for His creations) With this distinction in view, let us call it, “The Doctrine of Maximising Human Welfare”. The doctrine of maslahah, (seeking of benefit and repelling of harm) is well-recognized in Fiqh. It is something similar to the principle of utility (securing maximum human happiness). However, Muslim jurists have pointed out that from a technical point of view, maslahah means the securing of the objectives of Shariah rather than maximisation of happiness as seen by human beings. However, the objectives of Shariah, themselves, aim at maximising human welfare in this life as well as the life Hereafter. (The Creator knows what is best for His creations) With this distinction in view, let us call it, “The Doctrine of Maximising Human Welfare”.

8. 8 The Doctrine of General Permissibility Islamic Ahkam (Commandments) are broadly speaking of two kinds: (1) Ibadat (worshipping) and (2) Muamalat (Dealing among human beings). Islamic Ahkam (Commandments) are broadly speaking of two kinds: (1) Ibadat (worshipping) and (2) Muamalat (Dealing among human beings). The general rule in the field of worshipping is that an act is worship only when permitted by Shariah. On the other hand, in the case of mutual dealings, the general principle is that everything is permitted unless clearly prohibited by the Shariah. I call it “The Doctrine of General Permissibility”. In the Islamic theory of contracts, parties are free to agree on any terms as long as known Islamic rules and principles are not violated. There is an authentic hadith stating: The general rule in the field of worshipping is that an act is worship only when permitted by Shariah. On the other hand, in the case of mutual dealings, the general principle is that everything is permitted unless clearly prohibited by the Shariah. I call it “The Doctrine of General Permissibility”. In the Islamic theory of contracts, parties are free to agree on any terms as long as known Islamic rules and principles are not violated. There is an authentic hadith stating: المسلمون عند شروطهم إلا شرطا حرم حلال أو حلل حراما “Muslims are free to determine the conditions of their contracts unless they make something permissible as forbidden or something forbidden as permissible” “Muslims are free to determine the conditions of their contracts unless they make something permissible as forbidden or something forbidden as permissible”

9. 9 Prohibition of Riba  Riba literally means increase, addition, expansion or growth.  In the Shari’ah, however, the term riba refers to anything (big or small), pecuniary or non- pecuniary, in excess of the principal in a loan that must be paid by the borrower to the lender along with the principal as a condition of the loan or for an extension in its maturity.  In this sense, Riba has the same meaning and import as the contemporary concept of interest in accordance with the consensus of all the fuqaha (jurists).

10. 10 Prohibition of Gharar  Gharar refers to acts and conditions in contracts, the full implications of which are not clearly known to the parties.  In economic parlance it is very close to “Asymmetric Information.”  It has two kinds: gharar yaseer (trivial) and gharar fahish (substantial).  The first kind is tolerated since this may be unavoidable without causing considerable damage to one of the parties while the second is prohibited.

11. 11 Prohibition of Gambling (Maysar)  يا أيها الذين آمنوا إنما الخمر والميسر والأنصاب والأزلام رجس من عمل الشيطان فاجتنبوه لعلكم تفلحون ( سورة المائدة، الآية 90(.  O Ye who believe, Intoxicants and Gambling, (Dedication of ) stones, And (Dedication of) arrows, are an abomination, of Satan’s handiwork: Eschew such (abomination), That ye may prosper.  Gambling involves to transfer of wealth without any value added. It involves that kind of risk which is self-created, is zero-sum game and does not add any value to the national wealth.

12. 12 The following Hadith establishes three more principles: The following Hadith establishes three more principles: قَالَ رَسُولُ اللَّهِ -صلى الله عليه وسلم- « لاَ يَحِلُّ سَلَفٌ وَبَيْعٌ وَلاَ شَرْطَانِ فِى بَيْعٍ وَلاَ رِبْحُ مَا لَمْ تَضْمَنْ وَلاَ بَيْعُ مَا لَيْسَ عِنْدَكَ )أبو داود) قَالَ رَسُولُ اللَّهِ -صلى الله عليه وسلم- « لاَ يَحِلُّ سَلَفٌ وَبَيْعٌ وَلاَ شَرْطَانِ فِى بَيْعٍ وَلاَ رِبْحُ مَا لَمْ تَضْمَنْ وَلاَ بَيْعُ مَا لَيْسَ عِنْدَكَ )أبو داود) 1.Loan and Trade Contracts cannot be combined (more on this later) 2.Two deals cannot be combined into one (more on this later) 3.Right to profit is contingent upon taking responsibility (for loss)

13. 13 Provision for Providing Relief (Istihsan) Istihsan literally means preferring something over the other. Technically, it has been defined in several ways. In essence it refers to departure from a ruling based on previous analogy (qiyas) in a particular situation in favour of another ruling, which brings about ease. Some people have criticized istihsan saying it amounts to moving away from a rule deduced through qiyas toward the personal opinion of a jurist. However, this is not in fact the case. In istihsan, a ruling is preferred to another based on a stronger evidence, usually from texts (nusus), due to consensus (ijma) or to the doctrine of necessity all of which have sound basis in Shariah. Istihsan literally means preferring something over the other. Technically, it has been defined in several ways. In essence it refers to departure from a ruling based on previous analogy (qiyas) in a particular situation in favour of another ruling, which brings about ease. Some people have criticized istihsan saying it amounts to moving away from a rule deduced through qiyas toward the personal opinion of a jurist. However, this is not in fact the case. In istihsan, a ruling is preferred to another based on a stronger evidence, usually from texts (nusus), due to consensus (ijma) or to the doctrine of necessity all of which have sound basis in Shariah.

14. 14 Combining of Contracts While it is possible to modify classical contracts to suit modern conditions, a much broader scope for financial engineering exists in developing new contracts. These contracts could be hybrids of old contracts or may be entirely new. However, in hybrid contracts, there are certain rules that govern ‘Combining of Contracts”. Since almost all of contracts being presently employed involve combining of contracts, it is worthwhile to briefly mention them.

15. 15 Combining of Contracts-Cont In principle, Islamic law should not have any objection to the combination of contracts in view of the Doctrine of General Permissibility. However, some scholars have raised certain objections to certain type of contracts being combined into one. They point out that since all rights and obligations created by contracts bunched together are to be viewed as inseparable obligations, one has to see the end result and apply the Shariah rule to it. What is at dispute is not the validity of combination of contracts in principle. The concern is with the nature and form of such combinations. Scholars draw attention to the qualifying clause in the hadith that is the basis of the Doctrine of General Permissibility. It states that all conditions mutually agreed are acceptable “unless they make something forbidden as permissible or something permissible as forbidden”. Therefore, in order to check the validity of the overall deal emerging from a combination of contracts, certain parameters need be established. In principle, Islamic law should not have any objection to the combination of contracts in view of the Doctrine of General Permissibility. However, some scholars have raised certain objections to certain type of contracts being combined into one. They point out that since all rights and obligations created by contracts bunched together are to be viewed as inseparable obligations, one has to see the end result and apply the Shariah rule to it. What is at dispute is not the validity of combination of contracts in principle. The concern is with the nature and form of such combinations. Scholars draw attention to the qualifying clause in the hadith that is the basis of the Doctrine of General Permissibility. It states that all conditions mutually agreed are acceptable “unless they make something forbidden as permissible or something permissible as forbidden”. Therefore, in order to check the validity of the overall deal emerging from a combination of contracts, certain parameters need be established.

16. 16 Conditions for Combining Contracts 1. The combination must not contradict an explicit text 1. The combination must not contradict an explicit text If there is an explicit text in the primary sources of Islamic law that certain types of contracts cannot be combined, for whatever reason, then any structure that involves such a combination becomes unacceptable. If analysed, the rationale of prohibition can also be found. Some Examples are: If there is an explicit text in the primary sources of Islamic law that certain types of contracts cannot be combined, for whatever reason, then any structure that involves such a combination becomes unacceptable. If analysed, the rationale of prohibition can also be found. Some Examples are: (i) It is prohibited to combine a loan contract with a sales contract. Rationale:If allowed, a lender may advance the loan on an interest-free basis in the loan part of the deal but they can buy something at a cheaper price in the sale part of the deal which amounts to riba. (i) It is prohibited to combine a loan contract with a sales contract. Rationale:If allowed, a lender may advance the loan on an interest-free basis in the loan part of the deal but they can buy something at a cheaper price in the sale part of the deal which amounts to riba. (ii) The Prophet prohibited “two deals in one”. Some scholars take this hadith as a general prohibition of combining contracts. However, actually it implies that if more than one option is offered, one must be chosen before the deal is finalised. Rationale: Such combination amounts to gharar in the combined contract, which is prohibited in business contracts. (ii) The Prophet prohibited “two deals in one”. Some scholars take this hadith as a general prohibition of combining contracts. However, actually it implies that if more than one option is offered, one must be chosen before the deal is finalised. Rationale: Such combination amounts to gharar in the combined contract, which is prohibited in business contracts.

17. 17 2. A product structured on the basis of a combination of contracts should not be intended to circumvent impermissible transactions. Such attempts are called hiyal (legal artifices) and are not generally allowed. For example, the Prophet (PBUH) prohibited bay al-inah, which is a sale and buy-back arrangement. For example, A sells his house to B for a cash price of US$500,000 and simultaneously buys it back from B at a credit price of US$600,000. It is easy to see that the end result is exchange of $500,000 now for US$600,000 later. This is nothing but riba. The “selling” and “buying back” of the house is inconsequential. The recent ‘sukuk debacle’ was a result of similar commitment.

18. 18 3. The Combination must not involve contradictory contracts/conditions Each type of contract has unique legal implications and obligations. Contracts which are mutually contradictory cannot be combined. If the legal consequences do not conflict each other then there is no problem in combining them. For example, a collateral condition supports a loan contract and is hence acceptable. On the other hand, a condition in a marriage contract stipulating that the spouses will live apart, defeats the purpose of the contract and is hence not acceptable. Each type of contract has unique legal implications and obligations. Contracts which are mutually contradictory cannot be combined. If the legal consequences do not conflict each other then there is no problem in combining them. For example, a collateral condition supports a loan contract and is hence acceptable. On the other hand, a condition in a marriage contract stipulating that the spouses will live apart, defeats the purpose of the contract and is hence not acceptable.

19. 19 4.The Combination must not involve contingent contracts The Prophet (PBUH) has prohibited a sale that is circumscribed with a condition (bay wa shart). If the combination is such that the execution of one contract is contingent upon another contract, such combination is not permissible. For example, Zaid saying to Bakar that I sell my house to you provided Omar rents his house to me. The Prophet (PBUH) has prohibited a sale that is circumscribed with a condition (bay wa shart). If the combination is such that the execution of one contract is contingent upon another contract, such combination is not permissible. For example, Zaid saying to Bakar that I sell my house to you provided Omar rents his house to me.

20. 20 The Doctrine of Necessity In very exceptional circumstances, application of a particular command (hukm) may be temporarily suspended. For example, eating carrion is prohibited. However, if someone is facing certain death due to hunger and they have nothing but carrion to eat, the objective of “preserving life” dictates that they are allowed to eat of carrion but only as much as is necessary to sustain life and only until something permissible to eat becomes available. This doctrine is clearly established by Quran [Qur’an 2:173]. However, the same verse lays down three conditions for it to be invoked: (1) The situation is that of iztarar (extreme and unavoidable difficulty); (2) The suspension is temporary and (3) There is firm intention to return to the normal hukm ASAP In very exceptional circumstances, application of a particular command (hukm) may be temporarily suspended. For example, eating carrion is prohibited. However, if someone is facing certain death due to hunger and they have nothing but carrion to eat, the objective of “preserving life” dictates that they are allowed to eat of carrion but only as much as is necessary to sustain life and only until something permissible to eat becomes available. This doctrine is clearly established by Quran [Qur’an 2:173]. However, the same verse lays down three conditions for it to be invoked: (1) The situation is that of iztarar (extreme and unavoidable difficulty); (2) The suspension is temporary and (3) There is firm intention to return to the normal hukm ASAP

21. 21 Five Cs of Islamic Financial Engineering  C ompatibility  C onsciousness  C larity  C apability  C ommitment

22. 22 Compatibility That the deal is fully compatible with the requirements of the Shariah, i.e., does not involve anything declared impermissible by Qur'an, Sunnah or ijma. That the deal is fully compatible with the requirements of the Shariah, i.e., does not involve anything declared impermissible by Qur'an, Sunnah or ijma.

23. 23 Consciousness That the parties should consciously and willingly agree on the conditions of the contract without any compulsion or duress. An implication of this is that any agreement made in the state of unconsciousness (like under the influence of intoxicants or imposed by force) is not valid. That the parties should consciously and willingly agree on the conditions of the contract without any compulsion or duress. An implication of this is that any agreement made in the state of unconsciousness (like under the influence of intoxicants or imposed by force) is not valid.

24. 24 Clarity That the parties are fully aware of all the implications of the conditions laid down in a contract. Any ambiguity (with the exception of gharar yasir) will make the agreement invalid. An implication is to minimize asymmetric information. That the parties are fully aware of all the implications of the conditions laid down in a contract. Any ambiguity (with the exception of gharar yasir) will make the agreement invalid. An implication is to minimize asymmetric information.

25. 25 Capability That the parties are reasonably certain that they are capable of complying with all conditions of the contract. An implication of this is that in general the sale of any goods (or services) which are not owned and possessed by the seller at the time of the contract is not valid. That the parties are reasonably certain that they are capable of complying with all conditions of the contract. An implication of this is that in general the sale of any goods (or services) which are not owned and possessed by the seller at the time of the contract is not valid.

26. 26 Commitment That the parties intend and are committed to respect the terms of a contract both in letter and spirit. An implication of this is that any subterfuge to go around any Shariah condition through linguistic or legal tricks is not allowed. That the parties intend and are committed to respect the terms of a contract both in letter and spirit. An implication of this is that any subterfuge to go around any Shariah condition through linguistic or legal tricks is not allowed.

27. 27 The Case Study of Sukuk Sakk (singular of sukuk) literally means cheque or promissory note for receivable. Technically sukuk refer to financial instruments meant to mobilize resources from the market based on the strength of one’s balance sheet, credentials, track record, goodwill and prospects of the proposed project. They are meant to provide an Islamic alternative to conventional bonds. Sukuk can play a positive role in mobilization of savings on a vast scale. They benefit investors as well as those who have projects to finance that bear the promise of eventually generating sufficient revenue to meet the costs yet leave a surplus. Their proliferation increases the efficiency of the financial system. Also, they are capable of meeting credit needs of government and businesses in a manner that keeps credit supply linked with real assets. Sakk (singular of sukuk) literally means cheque or promissory note for receivable. Technically sukuk refer to financial instruments meant to mobilize resources from the market based on the strength of one’s balance sheet, credentials, track record, goodwill and prospects of the proposed project. They are meant to provide an Islamic alternative to conventional bonds. Sukuk can play a positive role in mobilization of savings on a vast scale. They benefit investors as well as those who have projects to finance that bear the promise of eventually generating sufficient revenue to meet the costs yet leave a surplus. Their proliferation increases the efficiency of the financial system. Also, they are capable of meeting credit needs of government and businesses in a manner that keeps credit supply linked with real assets.

28. 28 Sukuk- Contd Financial engineers have come up with fancy, often confusing, names for various types where ‘engineering’ is more in names than in substance. The basic ideas are quite simple. Sukuk are basically, certificates based on ownership of certain assets (or their usufruct). Generally, these certificates are negotiable in secondary markets. They represent ‘ownership’ in the assets (or usufruct) underlying the issue. Those with variable returns are based on mudarabah or musharakah. More popular are those with pre-determined, fixed incomes like the one based on ijarah, (lease). There are sukuk based on salam or istisna contracts. Also there are hybrid issues whose underlying assets are mixtures of these. Murabahah receivables being debt obligations are not considered fit for sukuk issue. But they have been accepted in such a mixture as long as they are in a minority. Due to this last point, while sukuk offer a usefully potential mechanism for secondary market resource mobilization, they also open the way for sale of debt receivables (as minority share in a general sukuk issue). Since, the sale of debt except at its face value is not generally acceptable by scholars, the use of sukuk where debt receivable are a noticeable proportion, remain suspect from a Shariah point of view. Financial engineers have come up with fancy, often confusing, names for various types where ‘engineering’ is more in names than in substance. The basic ideas are quite simple. Sukuk are basically, certificates based on ownership of certain assets (or their usufruct). Generally, these certificates are negotiable in secondary markets. They represent ‘ownership’ in the assets (or usufruct) underlying the issue. Those with variable returns are based on mudarabah or musharakah. More popular are those with pre-determined, fixed incomes like the one based on ijarah, (lease). There are sukuk based on salam or istisna contracts. Also there are hybrid issues whose underlying assets are mixtures of these. Murabahah receivables being debt obligations are not considered fit for sukuk issue. But they have been accepted in such a mixture as long as they are in a minority. Due to this last point, while sukuk offer a usefully potential mechanism for secondary market resource mobilization, they also open the way for sale of debt receivables (as minority share in a general sukuk issue). Since, the sale of debt except at its face value is not generally acceptable by scholars, the use of sukuk where debt receivable are a noticeable proportion, remain suspect from a Shariah point of view.

29. 29 Sukuk- Contd Even these popular ijara sukuk got a jolt when the chairman of the Shariah Board of AAOIFI, made a remark in November 2007 that about 85 percent of sukuk did not comply with Islamic law because of repurchase agreements. That sent shock waves to the sukuk market around the globe and according to industry experts sukuk issuance dropped to around $14 billion in 2008 as compared to some $50 billion in 2007. Though Standard & Poors estimated in September 2008 that the sukuk market will exceed $100 billion by 2009, even with the latest hiccup, no RELIABLE statistics exist that can confirm that their estimation was fulfilled. Even these popular ijara sukuk got a jolt when the chairman of the Shariah Board of AAOIFI, made a remark in November 2007 that about 85 percent of sukuk did not comply with Islamic law because of repurchase agreements. That sent shock waves to the sukuk market around the globe and according to industry experts sukuk issuance dropped to around $14 billion in 2008 as compared to some $50 billion in 2007. Though Standard & Poors estimated in September 2008 that the sukuk market will exceed $100 billion by 2009, even with the latest hiccup, no RELIABLE statistics exist that can confirm that their estimation was fulfilled.

30. 30 Sukuk- Conclusion ‘Damage control’ efforts have started earnestly, but my own view is that even if the sukuk market witnesses some recovery, it will in the short-run be only due to excess liquidity in the market. Sukuk will remain under clouds for some time and there is a big challenge for financial engineers to come up with new sukuk structures that can reassure investors about their Shariah-compliance. Every challenge is also an opportunity and this one is a trillions-dollars opportunity. Therefore, financial engineers better get to their drawing boards quickly. ‘Damage control’ efforts have started earnestly, but my own view is that even if the sukuk market witnesses some recovery, it will in the short-run be only due to excess liquidity in the market. Sukuk will remain under clouds for some time and there is a big challenge for financial engineers to come up with new sukuk structures that can reassure investors about their Shariah-compliance. Every challenge is also an opportunity and this one is a trillions-dollars opportunity. Therefore, financial engineers better get to their drawing boards quickly.