Thursday, April 29, 2010

Tahawwut (hedging): A breakthrough in Islamic finance

Original posted on Arab News (McClatchy-Tribune Information Services via COMTEX):

The launch of the Tahawwut (Hedging) Master Agreement (TMA) earlier in March 2010 by the Bahrain-based International Islamic Financial Market (IIFM) in cooperation with the International Swaps and Derivatives Association, Inc. (ISDA) gives the global Islamic financial industry the ability to trade Shariah-compliant hedging transactions such as profit-rate and currency swaps, which are estimated to represent most of today's Islamic hedging transactions.

While Ijlal Ahmed Alvi, the CEO of IIFM, hails the TMA as "a breakthrough in Islamic finance and risk management, and marks the introduction of the first globally standardized documentation for privately negotiated Islamic hedging products," it may be wise to remember that it remains a financial industry framework document that may be used on a voluntary adoption basis, as almost all standards issued by various relevant international bodies such as IIFM, AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) and the IFSB (Islamic Financial Services Board) in the Islamic finance space.

As such, it is premature to suggest that the Tahawwut Master Agreement "is applicable across all jurisdictions where Islamic finance is practiced" because it would be subject to the vagaries of the legal and political governance process in various jurisdiction.

Voluntary adoption of standards in the financial sector by Muslims countries is very underdeveloped and very often national practice takes precedence over the less well-established international organizations especially in the nascent Islamic finance space. In addition, in markets such as Malaysia, they have developed local Shariah-compliant hedging techniques including profit-rate and currency swaps quite some time ago.

As such, as Dean Naumowicz of the London-based international law firm Norton Rose points out, "parties wishing to transact under the (Tahawwut) Master Agreement will still be required to develop confirmations to document transactions. In addition, where parties intend to enter into designated future transactions, documents (each a DFT Terms Agreement) will need to be developed in order to bind the parties to enter into, and to give a value to, designated future transactions."

Under Shariah principles, the Tahawwut or hedge must be strictly linked to underlying transactions and cannot be a transaction that has the sole purpose of making money from money.

From a Shariah structure point of view, in entering into the Tahawwut Agreement, each party issues an undertaking to enter into a contract in the future for the sale of assets following the designation of an early termination date. The party to whom the relevant index amount is due may exercise the wad (promise) given in its favor and sell pre-agreed assets in exchange for the cost price of such assets and the relevant index amount. If, in breach of the wad it has issued, a party fails to purchase the assets under a Musawama, liquidated damages are determined and payable.

The Tahawwut Master Agreement is also similar in some respects to the 2002 or 1992 ISDA Master Agreement, a conventional hedging framework agreement governing the contractual relationship between the parties, with transactions documented by way of confirmations.

But while ISDA represents participants in the privately negotiated global derivatives industry, with members including most of the world's major institutions that deal in privately negotiated derivatives, as well as many corporates, governmental entities and other end-users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities, IIFM is an organization steeped in the politics of Islamic finance, especially between Bahrain and Malaysia, arguably the two most developed Islamic finance markets in the world.

After two false starts in which the very ethos of the organization was confused and questioned, IIFM under the stewardship of Alvi, reinvented itself emerging with a primary focus on the standardization of Islamic products, documentation and related processes, and better resourced than previously.

The lack of hedging products for managing risks has put many investors and institutions involved in Islamic finance at a disadvantage. The global financial crisis has underscored the importance of sound risk management, primarily related to hedging transactions. Similarly, the lack of standardized documentation has often meant that transactions in the Islamic finance industry were faced with delays in their execution.

The Tahawwut Master Agreement has other potentially wide-reaching implications. According to Azizan Abdul Rahman, director general, Labuan Financial Services Authority (Labuan FSA), the Malaysian offshore regulator, the Tahawwut Master Agreement provides the needed consistency and predictability to ensure deep and liquid international Islamic financial markets and is a testament to the greater convergence in Shariah interpretations in the global industry.

Similarly, industry players such as Afaq Khan, CEO, Standard Chartered Saadiq, stress that the TMA will allow Islamic banks to offer end-to-end solutions to their customers and will allow better treasury risk management tools for Islamic financial institutions

to competitively manage market risks.

According to Norton Rose, the Tahawwut Master Agreement permits "parties to enter into transactions which may be documented immediately (each a transaction) as well as transactions due to occur in the future (designated future transactions). Using transactions and designated future transactions, parties are able to create cash flows similar to the cash flows created in conventional derivatives products."

There are also a number of similarities between the Tahawwut Master Agreement and the 2002 and 1992 ISDA Master Agreements. In fact, some of the provisions in the original Tahawwut Master Agreement had to be amended to bring them more in line with the 2002 and 1992 ISDA Master Agreements.

According to Norton Rose, these include: i) condition precedent -- where the Tahawwut Master Agreement retains the right of a party to withhold payments and deliveries if an event of default or a potential event of default has occurred with respect to the other party; ii) payments in the same currency, due on the same date in respect of the same transaction will automatically be netted with the ability to opt for multiple transaction payment netting; iii) The scope of the set-off provisions in the Tahawwut Master Agreement were amended to allow such amounts to be capable of being set off in a similar way as under the 2002 or 1992 ISDA Master Agreement; iv) the events set out in the Tahawwut Master Agreement are very similar to those contained in the ISDA 2002 Master Agreement, but have been extended to apply to designated future transactions.

IIFM stresses that though the structure of the Tahawwut Master Agreement document is similar to the conventional ISDA Master Agreements, the key mechanisms and provisioning such as early termination events, closeout and netting are developed based on Shariah principles. It is designed to be used between two principal counterparties as a master agreement. Parties understand that no interest shall be payable or receivable and no settlement based on valuation or without tangible assets is allowed. Moreover, the counterparties to the Tahawwut Master Agreement make representations as to the fact that they enter into Shariah-compliant transactions only.

Indeed, according to Alvi, "a record 24 drafts were developed during the industry consultation and Shariah guidance process before ultimately reaching the final version, which is comprehensive as well as practical in terms of usage with no compromise to Shariah principles."

However, another London-based international law firm, K & L Gates, while stressing the Tahawwut Master Agreement as "a step forward in demystifying the Islamic finance and investment market by using an accepted market document as the basis for a new standard," agrees that the agreement's use will need to be monitored on an ongoing basis, and predicts that issues will arise in its application which will need to be carefully considered.

Indeed, Jonathan Lawrence and his colleagues Stephen H. Moller and Anthony R.G. Nolan at K & L Gates stress that a number of clarifications are needed regarding the Tahawwut Master Agreement especially with reference to the caveats as to the Shariah compliance of the agreement, especially in the case of a non-Muslim party in a transaction which may wish to exclude the representation that a party is only obliged to confirm that the transaction is Shariah-compliant as far as it wishes or is required to do so.

There are also disclaimers throughout the Tahawwut Master Agreement that there is no guarantee of Shariah compliance for any amendments or additions to the agreement or related underlying transaction documents.

Another area for potential concern is the election of New York law or English law as the governing secular law for the Tahawwut Master Agreement. Under English law, as several of the cases involving Islamic financial institutions and their clients have shown, it is for each party to satisfy themselves that the substantive terms of the underlying contract comply with Shariah principles. This English court approach prevents parties introducing Shariah principles to avoid the contract they observe.

The Tahawwut Master Agreement also rigorously eliminates provisions for payment of interest. However, according to K & L Gates, it is not clear how the time value of money is addressed in situations contemplated by the agreement where amounts may be deferred. These issues related to the removal of interest will need further examination by parties and in-house counsel to determine whether the economics of a transaction will be distorted on early termination or otherwise.

They also raise points of ambiguity including relating to netting of transactions and Relevant Index Amounts under DFT, since the netting of future transactions is not covered (except in a footnote that contemplates that parties may provide for similar netting in those agreements); the replacement of "transfer" with "redesignation" in the Tahawwut Master Agreement may create ambiguity as to whether "redesignation of rights and obligations" implies the ability of the affected party to change substantive rights in connection with changing the obligor office; the replacement of the definition of close out amount that appears in the 2002 Master Agreement with a very brief definition; the removal of credit-worthiness in determining quotations, which could distort the economics of a transaction on early termination or otherwise; the lack of Shariah board approval for transactions; and basis risk concerns, because it may remain to be seen how the Tahawwut Master Agreement will coexist with other forms to the extent that counterparties may hedge exposure there under by entering into master agreements with differing terms.

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