Securitisation in Islamic and Conventional Financial Systems Finance Essay

In this chapter the basic features of securitisation used in Islamic and Conventional financial system is presented in respect to the structures of bonds and derivatives. Over the years securitisation has developed into a significant financing tool, offering credit to both the public and the private sectors. In particular, we have seen that under the Subprime mortgage crisis the US credit markets relied heavily on the shadow banking system provided by securitisation to satisfy their financing needs.

Don’t waste time! Our writers will create an original "Securitisation in Islamic and Conventional Financial Systems Finance Essay" essay for you

Create order

There are various kinds of products in the financial market used for the purpose of securitisation. The key motivation for the employing the tools of securitisation include cheaper funding, regulatory capital relief, arbitrage and balance sheet considerations. [1] We have discussed in previous chapters that due to the non performance of the loans financial institutions were strapped into liquidity problems. This issue diverted the financial institutions to relay on the bond market to support their financing needs instead of looking for bank loan financing and equity financing for required funds. A bond is kind of a loan or a debt security. In conventional bond structure the issuer of the bond is like debtor and the holder of the bond is like a creditor. The bond issuer owes the holder a debt and pays the holder of the bond fixed interest, until the date of maturity when the principal amount is due. We have discussed in the previous chapters that interest and debt based transaction in there nature lead to inequity and instable economic situations. And their malfunctioning can be termed as a major element attracting the crisis over the years. [2] Bonds are termed as a source of external funding for the issuer to finance his long term financial projects. Bond holders have a creditor stake in the company for a definite term. [3] Sukuk (plural of Sakk), commonly referred to as “Islamic bonds”, are proportional undivided ownership rights in tangible assets, or a pool of assets, or in the assets of a specific project or investment activity. Sukuk are used in Islamic financial sector as alternate of conventional notes. Sukuk have developed as one of the most significant mechanisms for raising finance in the international capital markets used by Islamic financial institutions as an alternative to syndicated financing [4] as a proportionate interest in the well defined pool of specific assets to yield income and capital interest. The funds raised through the issuance of Sukuk are applied to investment in specified and particular assets rather than for general or undetermined purposes. Identifiable assets provide the basis for Islamic bonds. Since the Sukuk are based on the real underlying assets, income from the Sukuk relates to the purpose for which the funding was used. The Sukuk certificate represents a proportionate ownership right over the assets in which the funds are being invested. The ownership rights are transferred, for a fixed period ending with the maturity date of the Sukuk, from the original owner (the originator) to the Sukuk holders. The process of issuing Sukuk involves the following steps: Origination of assets from Shariah compliant assets. Transfer of the assets to a Special Purpose Vehicle (SPV) which issues after packaging them into securities (Sukuk); and Issuing of these securities to investors. The main difference between the both Islamic and conventional bonds is that issuance process of Islamic bonds should be approved by Shariah principles while the issuance process of the conventional bonds only requires the acceptance or approval of securities commission. Conventional bonds are the debt of the issuer while on the other hand Sukuk is the like an undivided ownership share in specific assets. So the owner of the bond has an ownership claim on the specific assets. But in case of conventional bonds it is the creditors’ claims on the borrowing entity and in some cases liens on assets as well. Conventional bondholders do not have any responsibilities for the circumstances of the issuers, while the Sukuk holder has a responsibility for defined duties relating to the underlying assets. Sukuk structures have real assets at their core and their structure is based on assets, equity and it could be debt based as well while the conventional bonds are based by large on loans. And ultimate users of Sukuk bonds are both Islamic and conventional investors but Islamic investors can not use the conventional bonds as their trading is against the principles of Shariah laws. [5] Conventional bonds as we know are the sale of debt, which is prohibited under Islamic financial system.

Derivatives

“A Zero Sum Game of Small Investments with Large Consequences” For many around us “Casino type trading” is and was considered more than a threat to the financial system. This breed of synthetic products was identified as “Financial Weapons of Mass Destruction” [6] and for this indistinguishable rationale Alexander Lamfalussy cautioned against the use of derivatives that enhance instability and increase systematic risks against the backdrop of global markets. [7] In the global economy, flexibility and innovational methodologies of derivatives makes them very dominating among other assets in respect of growth and popularity. [8] Derivatives are useful alternatives for holding the underlying commodity or financial asset. They are being used on a large magnitude in financial markets by individuals (for leveraging or gearing), by institutional investors (for asset allocation strategy), by corporate treasurer (for hedging exposure and for enhancing yields) and by banks /other financial intermediaries (for their strategic risk management features and for hedging etc). [9] As compare to the amount of money needed to buy an actual commodity or financial asset they require a relatively small amount of capital to trade. [10] Derivatives became an enigma due to the development of a complexity over their basic working, purpose and mechanics. They were created to manage risk and enable hedging, but the troubling part is that they are largely used for speculation, against their projected purpose. [11] The current financial crisis is largely blamed on the speculative usage of derivatives. According to OCC only 2.7% of total derivatives are used by end users, (i.e. corporations assumed to hedge their risks); while the remaining 97.3% is used by dealers (OCC 2005) [12] concluding hedgers as minorities while the speculators an obvious majority working in the financial market. The three main users of derivative products are as follows: Hedgers – They use futures to lock in an acceptable margin between their purchase cost and their selling price. Hedgers make purchases and sales in the futures market for the purpose of establishing a known price level for something they later intend to buy/ sell in the cash market to protect themselves against the risk of an unfavourable price change in the interim. [13] Speculators – they trade in derivative market with a higher than average risk in return for a higher than average profit potential especially with respect to anticipating future price movements, in the hope of making quick, large gains. [14] Arbitragers – in the hope of profiting from the price differential, they purchase securities from one market for their immediate resale in the new market. It is basically speculation about the differences in prices of commodities and assets in different markets. Islamic Financial System introduced different contractual structures (described above) in which derivatives can be formulated. But the main principle around which they all are developed is the same as prescribed by Shariah laws i.e. there is a freedom of contract under Islamic Financial System transactions but it should be free of Interest, Uncertainty and Gambling Underlying asset must exist that Must be owned by the party willing to sell and Must be envisaged to be delivered. [15] Islamic derivatives advocate fairness and risk sharing between parties under ethical investment and substance contract. The terms on which transaction will take place should be known, any operation apart from it for example Where time of delivery is not known, or where there is ambiguity in presence of some transactional product or There is excess of inequality, or Delay in delivery of dissimilar products etc these operations are not permitted under IFS. Derivatives issued and formulated under IFS are for sole purpose of hedging as there is no speculation allowed under IFS. These derivatives are risk management structures to manage currency risk in a global trend and yield curve risk movement to determine the cost of the production. Islamic derivatives are new and are subject to new changes and developmental issues. The economic effect of both conventional and Islamic derivatives is the same except that Islamic derivatives can only be used for hedging and covering risk and not for speculation and hence deemed to be more restrictive for the impacts that caused current global crisis. A derivative is a unique value holder; a financial instrument independent from the underlying asset from which it derives its value. It is an independently tradable entity with referable value to its underlying asset. Types of conventional derivatives include; Forwards, Futures, Options and Swaps. Naked Short Sale In order to create hybrid instruments these forms are usually combined together with traditional securities, loans and bonds. The Forward contracts are customised, simplest in form and risk-exposed contracts for future trade which are undertaken between two parties with diametrically opposing needs to complete a transaction at a future date at a price that is determined today. Their prices are determined by negotiation so a party in a better bargaining position may be able to exploit the situation in their favour. This transaction bears a counterparty risk, i.e. the risk to one party for the default of other. The Futures contract is a standardised exchange-traded, daily-settlement contract with respect to contract size, maturity, product quality and place of delivery where physical delivery hardly ever takes place. These contracts carry fair prices which arrive at by the interaction of many buyers and sellers against exploitations. Unlike forwards they manage to avoid a number of problems like multiple coincidences and Counterparty risk, as the exchange or the clearing house itself is the guarantor for each trade by being the buyer to each seller and the seller to each buyer . [16] Exchange minimises its risk of default by ‘Margining’ and ‘Marking to Market’ methods. Under Margin Call each party deposits initial deposits/margins, then the party whose position is losing, pay up as the loss occurs. Marking to market refers to the ‘gain or loss in each contract position’. The above mentioned gain or loss is determined by change in the price of the futures or option contracts at the end of each trading day by adding or subtracting from each account balance. [17] An Option entitles the holder the right (not an obligation) to buy or sell the underlying asset at a predetermined exercise price anytime before maturity against a premium. There are three types of options: A Call Option, A Put Option and a Double Option A Call Option provides the holder a right to buy and a Put Option provides the holder a right to sell the underlying asset at a predetermined price, while a Double Option is a right of the holder, either to buy from or sell to the grantor a specified underlying asset at a predetermined price during a fixed period. [18] In futures and forwards there will be an obligation to exercise the contract, unless the holder reverses his position before maturity. Inactivity will cause him to pay compensation or deliver the commodity, however, for options no such obligation exists at maturity, inactivity will just cause the option contract to expire and the premium paid will be lost. [19] Swap is a multiple of forwards with periodic settlement of contractual agreements, based on a predetermined notional amount of the underlying asset in which two parties agree to exchange payments over a period of time. [20] For instance interest-rate swaps and currency swaps, they control effective management of both balance sheets and risk profiles. [21] In Swap Contracts two parties exchange benefits (cash flows) resulting from a given asset or liability. This is very much like a specialized, time limited barter arrangement. For example, two firms, one with a loan on a fixed interest rate over ten years and the other with a similar loan on a floating interest rate over the same period, may agree to take over each other’s interest obligations, so that the first firm pays the floating rate and the second pays the fixed rate. If one is careful with regards to Interest (Riba) on physical trades, these contracts can be Islamically justified and could be used regularly in the commodities swap markets. Alternatives to conventional derivatives Islamic finance system have developed Islamic derivatives that comply with the rules of Shariah. Their structure uses a combination of different contracts. These instruments may include the following contractual structures; Salam Istasnah, Urbun, Wa’ad Jialah Bai bil-Wafa Bai bil-Istighlal Bai Sarf Murabiha contract Islamic Swap etc A brief summary of the most commonly used Islamic financial derivatives are: Salam is a clearly beneficial transaction to the seller where two parties agree to carry out a sale or purchase of an underlying asset at a predetermined future date and fully cash paid price. So before the performance of transaction on the part of a seller is reached, price is determined at a lower than the prevailing spot price for today. The customized nature of Salam makes it closer to Forward contracts. Thus Salam carries the same problems of forwards like double coincidence and negotiated price but counter party risk is avoided under the transaction as buyer can take guarantee or mortgage as security against default. [22] Note: It is similar to a conventional forward contract with a distinction of full payment in cash to help needy farmers and small businesses with working capital financing, whereas, prohibiting the partial payment as it would signify the use of credit. The subject matter of Salam has to possess defined and clearly specified qualities. If the commodity is destroyed, seller can buy the same from anywhere he wants for the buyer (avoiding the element of ‘Gharar’). Salam contract is used for financing the agricultural sector and by banks to purchase a good and then resale through a parallel Salam. [23] Under Istasnah contract, a buyer contracts with a manufacturer a needed product under specifications upon agreed and fixed price. Unilateral cancellation of the transaction is possible by either party before production begins. Unlike the Salam Contract neither time of delivery or payment in advance is made. Under Urbun, the buyer who intends to buy a certain commodity in the future pays a predetermined amount to the seller as a down- payment. If the buyer purchases the commodity, the down- payment is counted towards the total price for the commodity. If buyer decides not to buy the commodity, the down- payment is forfeited to seller. [24] By virtue of holding equal and opposite option positions on the same strike price, both parties are obliged to honour the terms irrespective of changes in asset value. The sequence of periodic and maturity-matched put-call combines with a zero-cost structure and preserves equitable risk sharing consistent with IFS entrepreneurial investment. Unlike in conventional options, there are no unilateral gains from favourable price movements in the range between the current and the contractually agreed repayment amount. Any deviation of the underlying asset value from the final repayment amount constitutes shared business risk in existing or future assets. [25] Note: urban looks as if it is parallel to an option contract yet there are serious differences between them. As under profit and risk sharing principal both parties are required to bear the risk of the transaction as the seller may not sell and the buyer may forfeit his down-payment consequently putting the burden of risks on one party is strictly prohibited. The purpose of Urbun is to secure future purchase of the commodity, unlike option the total price of the commodity is known to the parties at the time contract is entered into and the client does not need to bet on future price of the commodity. The down payment in the transaction is treated as a guarantee showing a serious intention to buy the commodity and latter as compensation to the seller in case the buyer withdraws from the purchase. This payment is counted towards the total price of the commodity upon purchase. While in an option contract the seller sells his right (in the context of Ikhtiyarat) against his property to buyer for a premium, as he is buying an “Opportunity” from seller to entitlement him to have first right to purchase underlying asset for an agreed price on an agreed term in the future. Waad is a unilateral and legally binding promise and in the context of a classic Murabiha sale resembles a conventional ‘sale and deferred payment’ model. Waad is morally binding and may be enforceable at court, if: (a) If it is a unilateral promise, binding only one of the parties to the Murabiha; and (b) The promise has caused the promisee to incur some liabilities. [26] The Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) has endorsed the extension of the Waad to currency exchange transactions within an Islamic framework . [27] The Wa’ad can be used to structure an FX (i.e. currency) option. In this regard, Shariah distinguishes between the “creation” of an option and the “trading” of an option. The creation of an option for genuine trade hedging purposes is broadly viewed as permissible, as it reduces uncertainty (Gharar) and is therefore regarded as contributing towards the public good (Maslaha). However, the trading of an option without any accompanying purchase or sale of underlying tangibles and undertaken solely with the objective of making a speculative gain is regarded as impermissible as this is looked upon as increasing Gharar. The currency option is conceptually accepted by many scholars and the promisor may be eligible to receive a fee for facilitating the transaction. The cash-flows under an FX option using a Wa’ad emulate the cash-flows under a comparable conventional FX option. [28] Jialah contract is essentially an Istasnah but applicable for services as divergent to a manufactured product. Under Bail bil-Wafa seller sells an asset to a buyer who pledges to sell back the asset to the original owner at a predetermined future date making it a fusion of sale and pledge (the pledge being to sell back to the owner and not to a third party). Note: This transaction is very near to repurchase agreement as the buyer has rights to benefits from ownership of the asset. A repo is equivalent to a cash transaction combined with a forward contract. Except that the resale price and original purchase prices must be the same. Under the transaction of Bai bil-Istighlal the buyer promises to resell at a predetermined future price and to lease the asset to the seller in the interim period. It is a convenient mean to provide short or medium term financing. The bank first purchases the asset and then leases it the customer before finally reselling it to the customer. The Istijrar Contract embedded options that could elicit if an underlying asset’s price exceeds certain bounds. It involves two parties; A buyer which could be a company seeking short term working capital to finance the purchase of a commodity approaches a bank. The bank purchases the commodity at the current price and resells it to the company for payment to be made at a mutually agreed upon date in the future. [29] Islamic banks are increasingly looking for ways in which to hedge their exposures i.e. mismatches between underlying portfolio payments and payments due from an originator, lender or project company in securitisations, loan structures and project financings. [30] This agreement is a customised and privately negotiated hedging tool that confirms to the principles of Islamic finance. It is designed for use with Shari’ah-compliant hedging transactions that use murabaha contracts. This document is prepared to give the industry access to a framework of document which is neutral in terms of treatment to both the trasacting parties and strictly comfirms to Shariah principles and will provide the critical frame work for the growth and evolution of Shariah compliant hedging instrument. Under this agreement two types of transaction can take place; In which the parties agree that they will enter into at a future date or the transactions which one party undertakes pursuant to a wa’ad, to enter into at a future date at the election of the other party. The agreement to enter into such transactions is referred to as a DFT terms agreement. Which will be confirmed by a DFT terms confirmation. Until they are entered into, DFT do not constitute transactions for the purpose of the agreement and are therefore treated differently from concluded transactions (most notably in relation to close-out). However, once entered into, DFT constitute transactions for the purposes of the Agreement. [31] Islamic Profit Rate Swap (IPRS) and the Islamic Cross Currency Swap (ICCS) are most commonly used swaps. IPRS is used to swap or exchange floating payment obligations with fixed payment obligations while ICCS is used to hedge against fluctuations in currency rate (by swapping or exchanging a series of profit payments in one currency for another). The common underlying Islamic contracts used by the banks in Islamic swaps are commodity Murabiha and Waad. Other common uses of Islamic derivatives are for foreign currency exchange purposes. For the purposes of hedging the exchange rate prices, Islamic banks enter into transactions to exchange different currencies at a future date but at a rate decided today. The Islamic contracts that are used to support these transactions are the Waad, commodity Murabiha and also Bay-Mu’ajjal. [32] Shariah-compliant swap transactions are traded bilaterally and combine opposite, maturity matched Murabaha contracts with instantaneous (or periodic) transfer of similar assets and delayed payment of the sales price (inclusive of a premium payment for the use of the asset until the maturity date). The basic structure of a ICCS matches two commodity Murabaha sale contracts that generate offsetting cash flows in opposite currencies with maturities desired by the contracting parties. The following example illustrates the functioning of a ICCS .Consider the case of a Malaysia-based Islamic bank that raises revenue in Malaysian Ringgit but faces payments in US dollars over a certain period of time. To eliminate this foreseeable currency mismatch, the bank could substitute its future outflows in US dollars for outflows in Malaysian Ringgit by entering into a CCS with a US dollar-paying counterparty. Under this contract, the Malaysia-based Islamic bank purchases an amount of commodity A on a Murabaha basis (i.e. against future instalments) denominated in Malaysian Ringgit and sells it forward against payment in US dollars. Simultaneously, a GCC-based Islamic bank buys an amount of commodity B, also under a Murabaha agreement, but denominated in US dollars and sells it forward against payment in Malaysian Ringgit. By combining the two Murabaha contracts, each denominated in a different currency, each party will be able to receive cash flows in the desired currency. Finally, both banks sell their respective commodities in order to recoup their initial expense, where the fair value of each commodity (A and B) should wash out at the prevailing exchange rate. [33] A profit rate swap is best analogised to a conventional interest rate swap. Under the profit rate swap, the parties enter into Murabaha contracts to sell Shariah-compliant assets to each other for immediate delivery but on deferred payment terms. A term Murabaha is used to generate fixed payments (comprising both a cost price and a fixed profit element) and a series of corresponding reverse Murabaha contracts are used to generate the floating leg payments. The cost price element under these Murabaha contracts is fixed but the profit element is floating. This structure, in effect, is not dissimilar to the “parallel loans” structure. It should be noted that a profit rate swap may also be structured as a series of Wa’ad whereby each party undertakes to the other to “swap” relevant fixed and floating rate payments at some particular point of time in the future. Under a conventional interest rate swap the parties agree to exchange periodic fixed and floating payments by reference to a pre-agreed notional amount. As with many conventional derivative products, a conventional interest rate swap, is prohibited Islamic Financial System because of the overarching requirements for a transaction for a number conditions for example, Riba – the receipt and payment of interest (the effective exchange of interest payments being fundamental to an interest rate swap); Gharar – Identifiable object characteristics (“quantity and quality”) of a bona fide trade and/or certainty about delivery results–in order to avoid Gharar. uncertainty in the principal terms of a contract (for example price, quantity or material characteristics of any asset sold and hence under a conventional interest rate swap the agreement to make future payments linked to a floating rate); and Maysir – gambling or speculation in contracts (and accordingly, conventional contracts of insurance and particular futures and options contracts viewed as akin to gambling are prohibited). Price certainty and balance between borrowers (protection buyers) and lenders (protection sellers) Asset ownership and prohibition of both short selling and leverage (under funding) Islamic Financial System arranges the transaction in such a way that the parties gain the benefit of the positive risk sharing and management solutions that derivatives can offer but without breaching the fundamental prohibitions as discussed above (by using reciprocal Murabaha transactions). [34]

Did you like this example?

Having doubts about how to write your paper correctly?

Our editors will help you fix any mistakes and get an A+!

Get started
Leave your email and we will send a sample to you.
Thank you!

We will send an essay sample to you in 2 Hours. If you need help faster you can always use our custom writing service.

Get help with my paper
Sorry, but copying text is forbidden on this website. You can leave an email and we will send it to you.
Didn't find the paper that you were looking for?
We can create an original paper just for you!
What is your topic?
Number of pages
Deadline 0 days left
Get Your Price