Friday, September 15, 2006

Short Selling and the Travesty of Islamic Finance

I received an email this morning from a young practitioner in the Islamic finance field:

Dear Professor El Gamal

I would like to pick your brains regarding some recent developments In Islamic finance, if I may.

I have just returned from an Islamic Funds conference in Dubai. I was somewhat surprised to find there was a widespread assumption amongst the fund managers speaking that taking short positions was now Islamically acceptable and basically a done deal. Names of Sharia scholars who had accepted it were bandied about

2 questions please.

1. How does it work ? I was told that there was some combination of Murabah + Arboun but no one would tell me exactly how it worked, for obvious proprietary reasons.

2. Is it a done deal Sharia speaking ?

3. If it is a done deal why is everybody not doing it ? Or are they ?

Here is my response:

Dear Mr. ______:

As I have argued repeatedly, every contract can be "Islamized" in the age of financial engineering. That is why the industry's obsession with the Islamicity of contracts, and the identities of jurists-for-hire who certify them, is a disastrous combination.

Every beginner's textbook in financial engineering shows how to synthesize short sales and leveraged buying from forwards. The easiest way to get a forward "Islamically" is with the use of salam, which has an element of short-selling already built-in. The use of `urbun as call option allows you to use call-put parity to do the same and synthesize a forward.

It is a silly game. The distinction between contracts that are "now allowed in Islam" and those that aren't is only a function of who is willing to pay sufficient fees for the rent-a-jurists to certify an engineered product, and how high are the transaction costs of the reengineering.

Those people have made a mockery of Islam.

In my recent book, I have shown in detail how to synthesize a forward from salam and a credit facility characterized as murabaha or tawarruq, depending on preference and cost. From forwards, we can then synthesize everything. That is a theorem. So, why are we wasting everyone's time with those big announcements of "the first ever Islamic this or that"? Because it is the selective prohibition of some modern practices and synthesis of others from medieval contracts that creates rent-seeking Shari`a arbitrage opportunities, and that is -- regrettably -- the nature of Islamic finance as practiced today.

Unfortunately, my interlocutor responded back with this:

Yes the Salam route was discussed but the Murabaha Arboun route was the one alluded to throughout. I will try to find out how it works.

I responded as follows:

Why do you care about the specific mechanics?

Short-selling is short-selling. So do it in the most efficient manner possible, or don't do it at all.

I obviously don't get it.


Blogger Unknown said...

Hello Dr. ElJamal,
Do you know any banks or financial institutions (or even governments) that are looking at the real intentions of islamic finance?

I think your book is a breakthrough in the way to think about islamic finance issues. How do you see the future of this approach? is it prevalent in academic circles yet? is it making it to the real-market yet? what is your vision? and what do you hope for?

2:59 PM  
Blogger Islamic Law, Etc. said...

I don't get it either.
I guess its all part of the Islamic identity politics that people are forced to play or forced into playing because of the ignorance of the masses.
One problem that I see with all of this is the problem of the "Islamic" economy.
The only way you will have a truly 'Islamic' economic policy is through staunch regulation, but that would contradict the concept of the free market which is alluded to in various hadith and is testified to by history.

6:34 PM  
Blogger aburajah said...

One of the reasons is as follows. According to Dr Nasr Abu Zayd there is a perception among many Muslims that whatever is deduced by the ulama is in fact God's law. It should in fact be taken as a human attempt which may be right or may be wrong or maybe suited to a socio economic environment. Their interpertation may not necessarliy be applicable to all times and places.

9:19 PM  
Blogger parvezd said...

Dear Dr El Gamal

I recently completed reading your book and it was certainly an eye opener.

I have always been interested in Islamic Finance (being a Muslim although my education and training is in conventional finance). Most of the Islamic products out there somehow seemed no different than products in conventional finance except for their Arabic names and of course as you rightly said “form over substance”.

The only thing that I somehow found missing in your book with respect to modes of housing finance was the concept of Diminishing Musharika and your take on it.

You also discussed the concept of mutuality and the experience of this experiment in Canada. I am from Canada and I think you are referring to the ISLAMIC CO-OPERATIVE HOUSING CORPORATION LTD. (ICHC) operated by ISNA Canada. I would like to share with you some of my findings of this experiment (not pretty).

They use the concept of Diminishing Musharika (which is no different than a fixed rate mortgage) except that there is some profit/loss sharing (10% of Gain/Loss to ICHC and 90% of the Gain/Loss for the homeowner if the homeowner owns more than 50% share and 20% of Gain/Loss to ICHC and 80% of the Gain/Loss for the homeowner if the homeowner owns less than 50% share) at the time of the sale/last installment or the final payment for the house. There are two additional features of this scheme – first it does not have a fixed term and second it allows for prepayment (in Canada, there is a prepayment penalty on fixed rate mortgages) except in the first year where they charge a penalty.

Also, they tell you that the installments (termed as occupancy charge) would be based on the rental value of the property and it will be different for each individual property. Although the property is jointly owned, ICHC does not share property taxes and or maintenance of the property.

This scheme has been sanctioned by Justice Taqi Usmani as Sharia compliant back in 1988 (although I am sure they did not inform him how they would implement this scheme) and they have a copy of his letter in their annual report.

Now the truth about ICHC (I have several friends who fell into this trap as well as I know one of the officials at ICHC).

- ICHC does not base its occupancy charge on rental values of property. They simply base it on a rate of between 8.25% - 8.5% (whichever percentage yields a round value for the occupancy charge). Consider these rates in the light of low mortgage rates for the last few years

- ICHC has historically paid patronage dividends from a low of 6% to a high of 10% every year since its inception. They are able to pay such high rates of return because they charge so much in the name of interest free housing scheme. I have a very pious friend who fell into this trap in order to avoid riba. Now he has to borrow money from the bank to pay ICHC its occupancy charge.

- ICHC and its employees refuse to discuss/negotiate the method by which they arrive at the occupancy rate. Usually they have a “take it or leave it” attitude.

I feel the bottom line is - until the time Muslims are not willing to exchange reward (return/profit) in this world for a return in the hereafter, any kind of structure (mutuality or otherwise) or scheme (diminishing musharika, ijara etc) will not succeed in meeting the true objectives (substance) of Islamic Finance.

Your thoughts on the above.



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10:26 PM  
Blogger Mohammad said...

I totally agree with Dr elJamal assertion.People are making a mockery out of Islam.They are only hurting themselves.AS everything is based on intention.There is a rule that says when fish stinks dont eat it.In other words Prophet pbuh has said if you have doubts about doing something stay away.
Short selling is Haram and it is very clear.We can go around it and decieve ourselves only.
Just my limited knowledge.
Hope you keep looking for the truth but listen to your heart first always.

11:56 PM  
Blogger ZSK said...

Dear Dr. El-Gamal,

I have some questions relating to Urbun agreements from a Sharia’a perspective. The facts are as follows: Seller and Buyer agree that Buyer pay Seller on Jan 1, a $5 Urbun payment for the option to buy 10 shares of company X on Jan 30 for $500. The Urbun will be credited against the payment to be made on Jan 30. At the time the Seller receives the Urbun, he owns 10 shares of company X. The Seller and the Buyer agree that if the Buyer does not buy the shares on Jan 30, he loses his $5. The Seller and Buyer agree that Buyer’s option cannot be exercised before Jan 30. No other conditions are made.

The questions:

1. Is the contract enforceable under Sharia’a?
2. Does the buyer have the right to come before Jan 30 and demand the Seller to sell the 10 shares for $500?
3. Can the Seller sell some of the shares of Company X on Jan 15, and then buy again on Jan 29 to ensure that he would be able to sell to Buyer?

Please do let me have your thoughts on this.


1:16 PM  
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2:43 AM  
Blogger Sufian said...

Hi ZSK please see my comments below

1. Is the contract enforceable under Sharia’a? YES, I think so, I can not identify any wrong element to be not Shariah compliant.
2. Does the buyer have the right to come before Jan 30 and demand the Seller to sell the 10 shares for $500? of Course no.
3. Can the Seller sell some of the shares of Company X on Jan 15, and then buy again on Jan 29 to ensure that he would be able to sell to Buyer? With some hesitation for the period from 15 to 29 Jan, but I think yes if the seller is certain that he can buy shares beofre 30 Jan.
Many thanks

1:04 PM  

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