Sunday, January 03, 2010

Have we learned nothing? Here come the "Islamic Credit Default Swaps"

Mohammed Khnifer, Islamic Banking Senior Editor at Al-Eqtisadiah and Al-Masrifiah Islamic Banking Magazine, pointed out this new development to me.

In a recent article, it is reported that the end of the year 2009 was punctuated with 10 defaults on "Islamic Sukuk" (otherwise known as poorly designed bonds), and then suggested that the "experts" want Credit Default Swaps to protect investors against the risk of default on Sukuk!! Here's a translated excerpt:
A group of informed experts on the Islamic finance industry called for a "partnership" between Islamic takaful (insurance) industry and Sukuk, toward the end of assisting the latter in providing "protection" for investors against losing their funds that they invested in these Islamic instruments.
Those calls became louder after the recent registration of the Pakistani cement company Maple Leaf as the last company with defaults on its Rupis 8 billion Islamic bonds.
The experts suggested during their interview with "Al-Iqtisadiya" that Takaful companies should find a new insurance instrument for Sukuk, which can protect the Sukuk holders from the risk of default, by providing "partial" compensation in the case of default.
This only months after the conventional CDS industry nearly brought down the entire international financial system.

"Islamic finance" started with a suggestion that the "Islamic economics" philosophy rests on sharing in profits and losses through partnership (i.e. equity) finance. In practice, of course, the industry moved toward debt finance, where the only risk is default risk. Now, they want to insure against credit risk as well, which is of course possible, but defeats the entire purpose.

You see, risk -- like matter -- can neither be created nor destroyed. Sharing in profits and losses provides for continuous risk sharing at moderate magnitudes. Debt financing provides for less frequent but larger losses in cases of default. Debt financing together with credit default swaps provides for very infrequent but catastrophic systemic collapse, which is very unlikely at any point in time, but highly likely to occur sometime within an extended period.

So, the most recent crisis has not taught the participants and experts of today's "Islamic finance" much (I use the quotation marks because they do Islam a great disservice by using it as a brandname to market their grossly inferior and poorly construed products for a profit). Will the customers at least finally see that this is not an infant industry that needs to grow?

12 Comments:

Blogger Muhammad said...

Salam,

Thank you for your post. I hadn’t realised that the innovative 'Islamic' financial engineers had started considering CDS, but I guess it is inevitable that they will ultimately attempt to replicate any conventional financial product. I think this really highlights one of the general issues that you raised in your book, that of the Islamic Finance industry constantly trying just to replicate conventional products, which they actually end up doing very inefficiently. Why would anyone intelligent enough to understand what their effective risk exposure is enter into a substance over form Islamic finance product that synthetically replicates a conventional one in an inefficient way that ends up costing them more money? Of course my implicit assumption here is that this person genuinely wanted to comply with Islamic laws, I will leave his judgement to Allah. Of course you have spoken about this a million times, but I feel that my personal duty as someone with a background in finance and economics is to emphasise point, as our industry really is a joke if it cant understand the form/risk exposure of what ultimately is a very simple contract, to even call these things financial engineering would be laughed at on a conventional trading desk.

I’m sure the argument will be that CDS can be used as a good risk management tool as long as there is some sort of direct link between the amount of the underlying held on your books and the notional amount of the CDS. You don’t have to be a genius to work out that this will also be open to manipulation. I can say with certainty and personal experience that the quants at Goldman will be able to get round any sort of regulation/restriction on trading ability put in front of them in the near future (specifically with regards to new proposed CDS rules), and its always just a matter of time before the techniques filter themselves down through the rest of the street and of course the same is true with the Islamic Finance quants many of whom I am sure learn their trade at the bulge bracket IBs. And if they get what they want I’m sure this will open a very dangerous door, that of speculation in CDS which has the potential to literally bring down companies just through the actions of influential traders.

I completely agree with your analogy about Islamic Finance not being an infant industry that needs to grow/develop. We need to strip down, get rid of our innovations, focus on simple profit loss sharing, and employ being who have a genuine concern for Islamic Finance principles and the bigger picture objective: providing an alternative to those genuinely looking to please Allah in the way they lead their life financially. The infant industry needs to disown its parents and leave home.

5:54 AM  
Blogger heraish said...

In case of default arent the underlying assets supposed to be sold off to pay back the sukuk holders?

2:24 PM  
Blogger heraish said...

http://gulfnews.com/sport/football/mansour-writes-off-man-city-s-debts-1.564319

UEFA the European football association is learning from the recent crises and forcing owners to strengthen football clubs. They are requiring the clubs to have less debt causing the UAE prince and the Russian Jewish Billinionare owner Roman of Chelsea club to convert their debt to equity.

7:02 AM  
Blogger Bro. Kimara said...

Salaam,

I totally agree with Muhammad's posting.

This talk of an 'Islamic' CDS is totally insane. There used to be a time when those guided by the principles of Islam were the ones to guide the Western world out of darkness. Now there are many who are haphazardly following failed 'conventional' innovations with potential 'Islamic' financial tools of mass wealth destruction.

12:13 PM  
Blogger Muhammad Saeed Babar said...

Islamic Finance as the name suggests is finance according to the Law, Rules & Regulations of Allah (SWT) and His Messenger Muhammad (PBUH). It is not just Arabic names of conventional banking products. It is also not just Riba free. It is to accept, surrender or submit to the will of Allah (SWT).

In Islamic teachings, according to the Quran, an insolvent person should be allowed time to be able to pay out his debt. This is recorded in the Quran's second chapter (Sura Al-Baqara), Verse 280, which notes: "If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew."

After clear instructions from Allah (SWT) and His Messenger Muhammad (PBUH), we still want our debt to be secured by Takaful and yet claim to be practicing Islamic Banking & Finance.

10:48 PM  
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