SHORT-SELLING REPLICATION IN ISLAMIC FINANCE: INNOVATION AND DEBATE IN MALAYSIA AND BEYOND

Calder, Ryan

The short-selling of stocks has long been considered impossible in Islamic finance. This chapter begins by reviewing why. It then moves on to the search to develop Islamic alternatives to conventional short-selling. Several systems have recently come on the market that aim to replicate short-selling in Shariah-compliant ways. This includes one being developed by Bursa Malaysia and the Malaysia Securities Commission that replicates stock borrowing and lending using Waʿd (unilateral promise). Other industry players have endorsed shortsale replication systems that use the Salam contract, the Arbun contract, or Waʿd in a different way. Hedge funds and other institutional investors seeking to be Shariah-compliant are keen to adopt an Islamic alternative to short-selling, but each method has advantages and disadvantages, with its proponents and detractors. This chapter guides the reader through different structures Islamic institutions are using to replicate short-selling, the state of the nascent market for short-sale replication, and the outlook for the future.

b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 277 3rd Reading 14 SHORT-SELLING REPLICATION IN ISLAMIC FINANCE: INNOVATION AND DEBATE IN MALAYSIA AND BEYOND Ryan Calder,1,2 Introduction The short-selling of stocks has long been considered impossible in Islamic finance. This chapter begins by reviewing why. It then moves on to the search to develop Islamic alternatives to conventional short-selling. Several systems have recently come on the market that aim to replicate short-selling in Shariah-compliant ways. This includes one being developed by Bursa Malaysia and the Malaysia Securities 1 Please address correspondence to Ryan Calder at rcalder@berkeley.edu. I thank the following people for their time, advice, and support: Maia Sieverding, Dato Dr. Nik Norzrul Thani, Dr. Aida Othman, Dr. Megat Hizaini Hassan, Zalina Ahmad Ramli, Dr. Angelo Venardos, Juliet Lee, Asharul Huzairi Mohd. Mansor, Prof. Dr. Engku Rabiah Adawiah Engku Ali, Roslan Abdul Razak, Prof. Dr. Mohammad Hashim Kamali, Dr. Mercy Kuo, Dr. Md. Nurdin Ngadimon, Zainol bin Ali, Bindesh P. Shah, and the staff of the IBFIM Knowledge Management Centre in Kuala Lumpur. All errors are mine alone. 2 277 b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 278 3rd Reading Ryan Calder 278 Commission that replicates stock borrowing and lending using Wad (unilateral promise). Other industry players have endorsed shortsale replication systems that use the Salam contract, the Arbun contract, or Wad in a different way. Hedge funds and other institutional investors seeking to be Shariah-compliant are keen to adopt an Islamic alternative to short-selling, but each method has advantages and disadvantages, with its proponents and detractors. This chapter guides the reader through different structures Islamic institutions are using to replicate short-selling, the state of the nascent market for short-sale replication, and the outlook for the future. What Is Short-Selling? Investors engage in short-selling in order to turn a profit from a decline in the price of a security. In a conventional short sale, an investor (with the help of a prime broker) will borrow a security from someone else, sell it immediately, wait until the price of the security goes down, buy the security back from the market, and then return it to the lender. This allows the investor to earn a profit on the security’s decline in price. United States law defines a short sale as the “sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller” (United States C.F.R. 2009). Short-selling, also known as “shorting” or “going short”, is thus the opposite of “going long”, which is simply the act of buying and holding a security in the expectation that its price will increase. Who Engages in Short-Selling, and Why? People engage in short-selling for various reasons. Some people shortsell a security because they expect its price to fall. The simplest reasons b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 279 3rd Reading Short-Selling Replication in Islamic Finance 279 to expect a price drop are because a company appears overvalued or market conditions are worsening. Alternatively, investors may expect a share-price decline because they anticipate imminent merger or acquisition activity. This leads them to use short-selling in a practice known as merger arbitrage (“merge-arb” for short). In merger arbitrage, an arbitrageur will buy the target company’s stock after the terms of an acquisition are announced in the assumption that it will rise when the acquisition is completed. The arbitrageur simultaneously shorts the acquirer’s stock, which he expects to fall because the acquirer will issue its own shares to exchange for the target’s shares, diluting the acquirer’s shares. However, betting against one company’s securities is often not the rationale behind short-selling. A large portion of short-sellers are in fact employing strategies not predicated on a particular outlook for the company whose securities they are shorting (Clunie and Ying 2006:6). Instead, they seek to take advantage of relative movements between different securities. For example, in a market-neutral strategy, a portfolio manager takes both long and short positions on securities expected to behave similarly so as to reduce the volatility in his or her portfolio while exploiting market inefficiencies. In convertible arbitrage, a buyer of convertible bonds hedges his position by shorting the underlying security. In index arbitrage, a trader might buy the index while shorting the individual stocks that compose it, again exploiting minor market inefficiencies. Likewise, an investor practicing index futures arbitrage or index options arbitrage might go long in index futures or index options respectively while shorting the individual stocks that make up the index — a strategy driven by deviations in futures and options prices from their theoretical values (Fung and Fung 1997; Lo and MacKinlay 2001:347–368). These types of approaches are usually not based on the expectation that one particular stock is overvalued; they instead seek to take advantage of exposure to the price b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 280 3rd Reading Ryan Calder 280 movements of related securities. Hedge funds are avid practitioners of such strategies. Problems with Conventional Short-Selling as Viewed from the Islamic Perspective People have long maintained that the short-selling of stocks is unacceptable in Islamic finance (Khan 1983:95; Zaky 1992:81; Zaher and M. Kabir Hassan 2001:191; Archer and Karim 2002:22; Al-Alwani 2005:151; Venardos 2006:43; Iqbal and Mirakhor 2007:176; Ayub 2007:75; Schoon 2009:23–28). Those who argue that Islamic finance is fundamentally more conservative than conventional finance often cite the ban on short-selling as an example of this guarded approach. So why is the short-selling of stocks Haram? Here, I review some of the Islamic objections to conventional short-selling. Selling an Item Without Owning It First, many Shariah scholars frown on selling an item before it is owned. One of the most frequently cited Ahad ith3 in Islamic commercial jurisprudence (Fiqh Al-muamalat) reads: Lā tabi c mā laysa cindaka “Do not sell what is not with you” or “Do not sell what you do not have” or “Do not sell what you do not own” (depending on translation). This Hadith would seem to make a prima facie case against shortselling, since a short-seller sells a security that she has borrowed but does not own. 3 Ahadith is the plural of Hadith. b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 281 3rd Reading Short-Selling Replication in Islamic Finance 281 Case closed? It depends whom you ask. Mohammad Hashim Kamali, for example, has noted (in a context unrelated to shortselling4) that issues have been raised regarding this Hadith (Kamali 2000:110–116). There may be weakness in its authenticity: it appears in the collections of Abu Daud and Al-Tirmidhi, but not in those of Al-Bukhari and Muslim Ibn Al-Hajjaj (ibid.: 110). Even scholars who acknowledge the Hadith as authentic disagree as to its exact chain of transmission (Isnad) (ibid.: 110, 111). Moreover, Kamali asserts that there is “room for interpretation regarding the precise legal value” of this Hadith: he feels it may not be entirely clear “whether it conveys a total ban (Tahrim), or abomination (Karahiyyah), or even mere guidance and advice of no legal import” (ibid.: 111). Let us assume, however, that we accept this Hadith as both authentic and binding. The issue of interpretation then arises: What exactly does this Hadith mean? Fuqaha (scholars of Islamic jurisprudence) have debated this for centuries. The Arabic preposition inda, which appears in this Hadith, is one of the sources of ambiguity. One of the most common words in the Arabic language, inda can refer in different contexts to “having” in the most general sense, or to ownership, or possession, or access, or proximity in time or place.5 As a result, scholars have disagreed for centuries about what exactly this Hadith prohibits. Its simplest interpretation, adopted by many fuqaha past and present, is that a seller must own an item outright when she sells it.6 Along the same lines, the Shariah board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) 4 It is important to note that Kamali’s discussion of this Hadith was part of a book arguing that commodity futures and commodity options should be considered Halal, and was not part of a discussion about the short-selling of securities. Kamali does not discuss the short-selling of securities in the book. 5 Karin C. Ryding summarises the meanings of inda in her excellent book A Reference Grammar of Modern Standard Arabic (Ryding 2005:399, 400). She also notes that inda is actually not a true Arabic preposition but rather a “semi-preposition”. 6 For a good summary of the positions of classical scholars from different schools of jurisprudence on this question, see Al-Islambuli (2005). b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 282 3rd Reading 282 Ryan Calder has ruled explicitly that “it is not permitted to sell shares that the seller does not own”, adding that “the promise of a broker to lend these at the time of delivery is of no consequence”. AAOIFI’s rationale is that “the sale of something that is not within the liability of the seller nor in his ownership” is “prohibited according to the Shari’a” (AAOIFI 2007b:390). However, other Fuqaha have taken a more liberal stance, arguing that certain types of objects may be sold before ownership is established. Imam Al-Shafii (150 A.H.–204 A.H./767 C.E.–820 C.E.), who founded the Shafii madhhab (school of jurisprudence) that is dominant today in Southeast Asia, maintained that “one may sell what is not with one provided that it is not a specific object, for the delivery of a specific object cannot be guaranteed if the seller does not own it” (Al-Shafii 1940:337; in Kamali 2000:113). Following this line of reasoning, it would be unacceptable to sell a house or a piece of land without owning it, because those are unique objects with highly specific attributes; but it might be acceptable to sell a unit of a highly fungible commodity, such as a bushel of a particular kind of wheat, that could be replaced with an identical quantity of the same good to facilitate future delivery. Ibn Taymiyah (661 A.H.–728 A.H./1263 C.E.–1328 C.E.) and Ibn Qayyim Al-Jawziyah (691 A.H.–751 A.H./1292 C.E.–1350 C.E.), both of the Hanbali school, also take a liberal perspective on this question, though a slightly different one. They argue that this Hadith prohibits “the sale of what is not present and which the seller is unable to deliver” (Kamali 2000:113, 114). Like Imam Al-Shafii, they emphasise the ability of the seller to say confidently that she will be able to present the item at the agreed future date of delivery.7 7 Following the perspective of Ibn Taymiyah and Ibn Qayyim Al-Jawziyah, the Salam contract — which many jurists view as an exception to the rule that “one may not sell what one does not have” — is in fact not an exception, but rather an extension of the same underlying logic: that of seeking to ensure that the seller will be able to present the good as promised at the agreed future date of delivery. (I thank Prof. Dr. Engku Rabiah Adawiah Engku Ali for bringing this to my attention.) b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 283 3rd Reading Short-Selling Replication in Islamic Finance 283 The upshot is that one might find it acceptable to sell shares without owning them depending on (a) which schools of jurisprudence one adheres to and which jurists’ opinions one finds most compelling, (b) whether one considers shares to be fungible commodities, and (c) whether the sale of shares without owning them does not run afoul of other injunctions, such as the ban on dealing in Riba (this would clearly contravene the sale of shares in conventional banks, for example). Stock Borrowing and Lending (SBL) Aside from the issue of selling something that one does not own, the short-selling of stocks as practiced in conventional finance is potentially problematic for a second reason: many Shariah scholars consider it impermissible to borrow and lend shares. Different scholars take different views on what kind of good may be the subject of a loan contract. Many jurists feel that “a loan contract can be validly concluded with regard to every property on which Salam is valid” (although some scholars, especially from the H . anafi Madhhab, take a more restrictive view) (Dusuki 2008:206). A Salam contract, or forward-sale contract, is one in which a buyer pays in full now for a product that the seller will deliver to him later. In the case of Salam, there is scholarly consensus that the goods need not be in the seller’s possession, or even in existence at all, to be the subject of a sale. This makes sense when one considers that traditionally, Salam sales often financed agriculture, as when a farmer required capital to purchase seeds or other inputs in advance of planting and harvesting (Cuno 2006; Doumani 2006). There are specific conditions as to how a Salam may be transacted — including the types of goods that may be traded with it. Scholars agree that goods can only be the subject of a Salam sale if they can be “precisely determined in terms of quality and quantity”, yet “not particularised to a specific unit” (Ayub 2007:244; see also b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 284 3rd Reading 284 Ryan Calder Thomas et al. 2005:94). For example, a specified type, quality, and quantity of corn may be the subject of Salam (and may therefore be the subject of a loan contract), but a particular ear of corn may not. Such rules aim to eliminate uncertainty (Gharar) as to: (a) exactly what was lent, (b) whether equivalent goods will be available on the market at the time of delivery in the event that the borrower cannot produce the goods himself, and (c) whether the delivered goods are precisely equivalent to what was promised. As technologies and economies of production have evolved through history, the kinds of goods that scholars have considered sufficiently standardised to serve as the subject of a Salam sale have changed. During the classical age of Islamic jurisprudence (1st–7th centuries A.H./7th–13th centuries C.E.), jurists debated whether items as diverse as cane, bread, honey, cheese, precious stones, musk, carpets, perfumes, shoes, bowls, fish, leopards, and even trained dogs were sufficiently standardised to be the subject matter of Salam (Ayub 2007:244). On occasion, scholars even argued that one kind of wheat was “Salam-able” but another not: Jurists ruled that Iraq wheat, Khorasan wheat, or Ferghana wheat could be sold through Salam because they came from regions that regularly produced wheat in sufficient quantities to supply markets reliably; but they averred that the wheat of Herat, which came only from that one city, could not be the subject of a Salam sale because it was not produced in sufficient quantity to ensure guaranteed circulation (Johansen 2006). Today, however, mass production and the technologies of modern markets have made it easier to specify the characteristics of standardised goods with great certainty and to predict reliably that they will be available at a future date. Commodities of many types are accepted with a high degree of consensus as the subject of valid Salam contracts today. Indeed, the AAOIFI’s standard for acceptable subject matter (Al-Muslam Fihi) of Salam includes not only “fungible goods (such as wheat and other cereals)”, but “also … items of material value (such as livestock)” (AAOIFI 2007a:165), and even “the general b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 285 3rd Reading Short-Selling Replication in Islamic Finance 285 usufruct of a particular asset, such as … having the use of an aircraft or a ship for certain period”. Nevertheless, the AAOIFI still rules out Salam on “anything for which the seller may not be held responsible, like land, buildings, or trees” and on “articles whose values change according to subjective assessment, like jewellery and antiques” (AAOIFI 2007a:165). Thus while the items that are “Salamable” have changed through history, the principles underlying their permissibility or impermissibility have remained static. We now return to our original question: Can stocks be the subject of a loan contract? Some scholars argue yes, contending that different shares8 in a corporation are fungible goods — that is, goods with homogeneous (Mithl i) properties that make them freely exchangeable or replaceable (Dusuki 2008:206,207). This means they can be the subject matter of a Salam contract, and therefore of a loan contract as well. Others say no. This includes the AAOIFI Shariah board, whose ruling focuses less on whether different shares are fungible items and more on the equivalence of shares compared over time — that is, whether a share in a company today can be considered equivalent to a share in the same company tomorrow. In ruling that it is impermissible to lend shares, the AAOIFI’s Shariah board states: The basis for the impermissibility of lending the shares of corporations is that the share at the time of repayment — in consideration of what it represents — does not represent the same thing that it did at the time of lending due to the constant change in the assets of the corporation. (AAOIFI 2007b:390) In the end, we face the question of just what a share of a corporation is. Is one share in a corporation fungible with another? And is a share 8 By “different shares”, I refer to shares of the same type, but merely with, say, different serial numbers. I am not referring to different types of common stock, or of common stock versus preferred stock, etc. b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 286 3rd Reading 286 Ryan Calder in January equivalent to a share in June? The ontology of shares is at issue here: do we conceive of a share as something uniform, standardised, fungible, and existing in the abstract universe of a traded market — in short, first and foremost as a financial security? Or do we conceive of it as a unique bundle of contractual rights that vest the shareholder with the ability to make decisions affecting a concrete, complex, and dynamic business operation with real assets and real employees — in other words, as a participatory ownership stake? “Western” securities law is generally untroubled by the Janus-faced nature of shares, but Islamic commercial jurisprudence must grapple with it. Ontological dilemmas aside, however, the reality on the ground is that a large and relatively stable majority of prominent Shariah scholars active in Islamic finance today find stock lending — as practiced in conventional finance — to be problematic. For the time being, this makes its commercial adoption by Islamic financial institutions untenable. Entanglement with Ribaa A third potential problem with conventional short-selling as viewed from the Islamic perspective is that interest typically gets involved in the process. In a conventional short sale, when an investor borrows stock and then sells it, he or she must leave the full market value of the sold stock in a margin account with his or her broker, plus an additional margin requirement (under United States law, this is initially at least 50% of the short-sale value). The brokerage house will then use the money in this account to earn interest for itself. (Of course, if the brokerage house were willing to invest the money in the margin account in a Shar iah-compliant way — e.g., by investing in Murabahah instead of in interest-bearing instruments — this problem could be avoided.) b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 287 3rd Reading Short-Selling Replication in Islamic Finance 287 Form versus Substance A fourth potential problem with short-selling — whether conventional short-selling or any system that claims to replicate or approximate it in a Shar iah-compliant way — is the meta-issue of “form versus substance”. A few observers of Islamic finance argue that some, if not all, of the Islamic-finance industry’s operations today are misguided because they simply reflect adherence to the letter of Islamic law at the expense of fulfilling its spirit (El-Gamal 2006a; see also Habil 2007 for a discussion of the tension within Islamic finance on this topic). Mahmoud El-Gamal is an ardent expositor of this view, and he sees efforts to replicate short-selling as an example of what is wrong with Islamic finance today. In his view, Islam prohibits short-selling — not merely in form, but in substance. El-Gamal argues that while it may be easy to synthesise short sales from “Islamic” instruments, doing so makes “a mockery of Islam”. He writes: Every contract can be ‘Islamized’ in the age of financial engineering [italics original]… 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 renta-jurists to certify an engineered product, and how high are the transaction costs of the reengineering. (El-Gamal 2006b) Not surprisingly, El-Gamal’s views raise the ire of many practitioners and Shariah scholars involved in the Islamic-finance industry. But while they may bristle at El-Gamal’s strident language, they remain cognizant of the broader issue of form versus substance, which is the core of many legal debates — not only in Shar iah and Fiqh, but in the history of Western law as well (Kennedy 1976). Those in the industry have several responses to the argument that much of Islamic finance is founded on mere mechanical adherence to the letter of the law. Some assert that Islamic finance is a b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 288 3rd Reading Ryan Calder 288 work in progress, and that taking imperfect steps in the direction of a holistic Islamic financial system is better than nothing. Others argue that Islamic financial institutions must offer products and services — like replicated short-selling — comparable to those their conventional counterparts offer, or else they will lose all but their most loyal customers. That, they argue, would render Islamic financial institutions unprofitable and bring the project of Islamic finance grinding to a halt. Still others contend that replicating short-selling is acceptable because that which Islam does not prohibit is permitted, and that Shariah is intended to make life easier, not to bring hardship. Still others contend that short-selling brings benefit to society by smoothing out speculative asset-price increases and imparting useful price information to the market. Efforts to Construct a Shar iah-Compliant Short Sale So far, I have reviewed the many arguments made against allowing conventional short-selling in Islamic finance. Indeed, the vast majority of Shariah scholars interested in Islamic finance today consider conventional short-selling to be Haram. The Market for An Islamic Alternative to Short-Selling: Islamic Hedge Funds and Islamic ETFs However, demand for an Islamic alternative has grown in recent years, driven by the prospect of Islamic hedge funds and Islamic exchange-traded funds (ETFs). Why do hedge funds and ETFs need to short-sell? Hedge funds frequently engage in short-selling as part of long-short strategies and other market-neutral strategies. As hedge funds have become heavyweights of the conventional financial universe — with total global hedge-fund assets under management tripling between 2000 and 2007, reaching US$1.7 trillion by mid-2007 b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 289 3rd Reading Short-Selling Replication in Islamic Finance 289 (Farrell et al. 2007:24) — Islamic-finance practitioners and investors have begun to envision Islamic hedge funds. Since 2006, a handful have launched. Islamic ETFs are proliferating as well: financial institutions from around the world have listed them on stock exchanges in Kuala Lumpur, Singapore, London, Zurich, Istanbul, and Abu Dhabi, with more sites on the way (Abu Bakar 2008). Islamic ETFs are keen to find an Islamic alternative to short-selling because conventional ETFs rely on short selling as an integral part of the creation and redemption of ETF creation units and shares (since the original stock shares deposited in a trust to form the ETF’s underlying asset base are borrowed shares). History of Efforts to Construct a Shar iah-Compliant Short Sale The history of efforts to implement Shar iah-compliant shorting has been a back-and-forth one. At the end of 1995, Malaysia first introduced conventional regulated9 short-selling using securities borrowing and lending (SBL). Shortly thereafter, the Malaysia Securities Commission began exploring Shar iah-compliant means of shorting. Through the mid-1990s, it worked with Shar iah scholars to develop an alternative based on Ijara (lease), which I discuss further below. Just as the Malaysia Securities Commission had come close to finalising its Ijara-based platform, however, the Asian financial 9 “Regulated” means, among other things, that “naked” short selling is not allowed. A naked short sale is one in which the short-seller, before having borrowed the security or perhaps even ascertaining for sure that he can borrow it, commits to selling it. (The opposite of a naked short sale is a “covered” short sale — one in which the short-seller has already secured access to the security when he commits to selling it.) Most national regulatory authorities prohibit naked short-selling, although many — including for some years the U.S. Securities and Exchange Commission (SEC) — have had difficulty enforcing the ban in practice (Bris et al. 2004). In addition to prohibiting naked short sales, the Malaysia Securities Commission also imposes other regulatory requirements on short sales, such as limiting short-selling to specified stocks that meet liquidity requirements. b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 290 3rd Reading 290 Ryan Calder crisis struck. Facing a volatile stock market and capital flight, the government of Prime Minister Mahathir Mohamad suspended all short-selling at the end of 1997. Nevertheless, the Securities Commission’s Shariah board officially endorsed an Ijara-based form of SBL in March 1998, despite the fact that it would not be implemented because all forms of SBL had been banned. Through the 2000s, Islamic finance boomed worldwide. Innovation proceeded apace as high oil prices and economic growth channeled capital to Muslims in the Gulf, Southeast Asia, and elsewhere. Liberalising national financial markets and the emergence of an international Islamic-finance infrastructure also bolstered double-digit annual increases in Shar iah-compliant assets (Warde 2010). Inspired by the success of conventional hedge funds and undaunted by the fact that many Shar iah scholars frowned on the idea, a few people began envisioning Islamic hedge funds. In 2001, hedge-fund manager Eric Meyer met in the United States with Shar iah scholar Shaykh Yusuf Talal DeLorenzo and discussed the possibility of an Islamic hedge fund. Out of this conversation emerged Shariah Capital, a company of which Meyer is CEO and DeLorenzo is chief Shar iah officer and an executive director. Shariah Capital provides technologies and advisory services to support hedge funds and other financial institutions seeking to be Shar iah-compliant. In 2008, Shariah Capital, together with prime broker Barclays Capital, launched the Al Safi Trust Platform for hedge funds. Adopted the same year by several Dubai-based funds, the Al Safi platform employs an Arbun-based short-selling structure that Shaykh DeLorenzo has endorsed. At the same time, other players have also been targeting the market for Islamic hedge funds. Fimat, the prime-brokerage arm of France’s Société Générale, launched some of the earliest Islamic hedge funds at the end of 2006, employing a Salam-based short-selling structure (Hedgeweek 2008). And in 2009, Amiri Capital introduced a short-selling replication mechanism based on Wad as part of a push to establish b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 291 3rd Reading Short-Selling Replication in Islamic Finance 291 Shar iah-compliant long-short equity funds and prime-brokerage services. Meanwhile, the issue of short-selling had arisen yet again in Malaysia. In March 2006, the country’s Securities Commission reintroduced conventional short-selling after a hiatus of more than eight years. Shortly thereafter, Bursa Malaysia (formerly the Kuala Lumpur Stock Exchange) began developing a Wad-based shortselling platform with the support of the Securities Commission and the approval of the Securities Commission’s Shariah board, led by Aznan Hasan. Demand from Islamic ETFs was the strongest motivation, although Islamic hedge funds were an important driver as well. As of 2009, this platform is under development, with Bursa Malaysia chief executive Yusli Mohamed Yusoff publicly endorsing the project to the press (Liau 2009). Based on this brief but eventful history of the “Islamic short sale”, we can make two observations. First, it is clear that demand has been strong enough to elicit a number of very different approaches from industry players. Each has advantages and disadvantages relative to the others, as I discuss below. Second, it is worth noting that the impetus behind innovation differs in different parts of the world. While Islamic hedge funds have been driving short-selling innovation in the Gulf market, which has a high concentration of ultra-high-net-worth Islamic investors, Islamic ETFs have been the driver in Malaysia, where there are fewer ultra-high-net-worth investors but a solid and growing base of increasingly sophisticated small and medium-sized Islamic investors as well as a national government and regulatory authority committed to shepherding a robust Islamic financial architecture into being (Thani and Hassan 2009). Attempts to Construct a Shar iah-Compliant Short Sale There are a number of ways to replicate a short sale with instruments already being used in the Islamic-finance industry. After b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 292 3rd Reading 292 Ryan Calder reviewing how a conventional short sale works, this section describes potential and existing alternatives and evaluates advantages and disadvantages of each. Conventional Short Sale First, let us review how a conventional short sale works. (For simplicity’s sake, the examples below leave out brokerage fees and other ancillary expenses.) Assume a hypothetical investor named Sharif wants to short-sell 100 shares of stock in XYZ Company. He currently owns no XYZ stock. Leila, another hypothetical investor, owns the stock. Leila, through a prime broker, lends 100 shares of XYZ stock to Sharif. Sharif immediately sells the stock, which is currently trading at RM40, receiving RM4,000 for the sale. Two weeks later, after XYZ has fallen to RM35 per share, he buys back 100 shares from the market and returns them to Leila, realising a profit of RM500. Ijara-Based Structure As early as the mid-1990s, the Malaysia Securities Commission looked to Ijaara (Islamic lease10) as the basis for a Shar iah-compliant alternative to conventional SBL. The mechanics of an Ijara-based short sale are simple: instead of Sharif borrowing a stock from Leila, he leases it from her. Sharif’s rental payments to Leila compensate her for the privilege of using her stock. Just as in conventional SBL, Sharif returns the stock to Leila at the end of the lease term. 10 More specifically, Ijara is the hiring or renting of an asset, a commodity, or labor to benefit from its usufruct (Ayub 2007:279). Ijara can also be thought of as a contract to purchase the usufruct that derives, over a specified period of time, from the asset, commodity, or labor (Abu Ghuddah n.d.). b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 293 3rd Reading Short-Selling Replication in Islamic Finance 293 The advantage of an Ijara-based short-sale system is that from a mechanical standpoint, it works just like conventional SBL. This makes it relatively easy to adapt an existing conventional SBL system into an Ijara-based one. The stark disadvantage, however, is that Ijara-based short selling is very controversial from a Shar iah perspective. At least two points of controversy arise. First, many scholars disapprove of the idea that Sharif may sell to a third party the stock that he is leasing from Leila. One of the defining characteristics of an Ijara is that “the leasing agency [in our case, Leila] must own the leased object for the duration of the lease” (Iqbal and Mirakhor 2007:84). As we have seen earlier, it is highly problematic to sell an asset owned by someone else. Moreover, “the Ijara contract is intended for utilization of the asset and not for consumption of the asset” (ibid.:85). Second, many jurists frown on allowing a financial asset to be the subject of an Ijara contract. Property and capital assets that can be utilised without being consumed — such as land, machinery, and houses — are common subjects of Ijara. The labor of, say, a doctor or a carpenter may also be the subject of Ijara (Ayub 2007:280). However, leasing “financial and monetary” assets raises eyebrows. Nevertheless, the Malaysia Securities Commission’s Shariah Advisory Council (SAC) approved Ijara on stocks in 1998 as a basis for the implementation of SBL. The SAC justified this through the principle of Istihsan (application of discretion in a legal decision) based on Maslahah (that which serves welfare) (Securities Commission Malaysia 2007:74). It argued that an exception should be made to allow the lessee (“Sharif”) to sell the leased shares to a third party without nullifying the Ijara contract because this was not only beneficial to the original shareholder (“Leila”) but also because it could “provide liquidity to the share market”. In other words, making an exception to the normal rules of Ijara was acceptable because the outcome was good for the market. Critics argued that turning thus to Istihsan and Maslahah established a slippery slope. If selling leased stocks was acceptable because b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 294 3rd Reading 294 Ryan Calder it provided market liquidity, what else might be justified in the name of market liquidity? Ironically, this debate remained essentially a legal and philosophical one, because SBL using Ijara never gained traction. Between 1997 and 2006, all SBL was suspended in Malaysia anyway. After 2006, regulated short-selling with SBL resumed, but Bursa Malaysia and the Malaysia Securities Commission began development of the Wad-based short-selling system shortly thereafter. The Ijara short-selling question faded into the background. For its part, Bank Negara Malaysia, the central bank, stated in 2009 in a draft of its Shariah parameters that shares of a company may not be the subject of Ijara (Bank Negara Malaysia 2009:9, Item 34). Salam-Based Structure The Salam sale, or Bay Al-Salam, is a forward sale. The basic concept of a Salam is to pay now and take delivery later. The buyer is required to pay in full at the time the contract is established.11 At that time, the buyer and seller also fix the terms of delivery, such as the quantity and quality of goods, the mode of delivery, and the date of delivery. As discussed above, Salam is only applicable to certain goods, and has a long history of being used to finance agriculture as well as the production of other items — such as textiles (Cuno 2006; Doumani 2006) — in which it is useful to provide capital up front before production has occurred. Earlier, I noted that Shariah scholars disagree about whether a share of a company may be the subject of a Salam contract. If one 11 Some Shariah scholars consider it permissible, in some cases, to allow the buyer a brief window of time after the agreement of a Salam contract in which to pay the seller. AAOIFI, for example, writes: “The capital in a salam contract must be paid immediately at the place where the contract is concluded. However, as an exception to this ruling, payment may be delayed for two or three days at most” (AAOIFI 2007a:165). b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 295 3rd Reading Short-Selling Replication in Islamic Finance 295 does assume that a Salam sale on a share is valid, then it is easy to use Salam to approximate a short sale. The most basic Salam-based alternative is even simpler than the conventional version in that no lending or borrowing takes place. Our hypothetical short-seller Sharif simply enters into a Salam contract to sell 100 shares of XYZ stock to Leila for future delivery. Leila gives Sharif RM4,000 today, paying the current market price of RM40 per share. Sharif agrees to deliver the 100 shares to Leila in two weeks. In two weeks, the price has fallen to RM35 per share. Sharif buys 100 shares of XYZ from the market and gives them to Leila. He realises a profit of RM500. One advantage of a Salam-based alternative to conventional short-selling is that no securities borrowing and lending (SBL) is involved. If a streamlined Salam-based system were developed for matching stock users and stock suppliers, this could potentially give Salam-based shorting a technical advantage over SBL. At the moment, no such system has appeared on the market, but it is not impossible to envision. However, Salam-based shorting seems unlikely to enjoy a significant Shariah-compliance advantage over SBL. This is because, as discussed earlier, those scholars who consider stocks to be “Salam-able” are also likely to consider stocks valid for lending, while those who do not consider stocks to be Salam-able will probably not consider stocks valid for lending. Salam-based shorting has at least two major disadvantages relative to other Shar iah-compliant possibilities for replicating short-selling. First, as discussed, many scholars — including the members of AAOIFI’s Shariah board — do not accept stocks as the basis of a Salam contract. However, some scholars do, such as the Shariah Advisory Council of the Malaysia Securities Commission (Securities Commission Malaysia 2009).12 Yet even aside from the Shariah-compliance question, 12 The Shariah Advisory Council (SAC) of the Malaysia Securities Commission ruled that trading shares under the Salam contract is permissible as long as: (a) the shares are not considered to be too specific (Muayyan) an item; (b) the category, type, and amount of the shares can be determined; and (c) the shares’ date of delivery can be ascertained. (Securities Commission Malaysia 2009:2). b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 296 3rd Reading 296 Ryan Calder there is a major practical obstacle to widespread Salam-based shorting, especially in stock exchanges. Note that in the example above, Leila (the stock supplier) had to pay Sharif (the short-seller) up front at the time the Salam contract was agreed. This is very different from a conventional short sale, in which Leila pays Sharif nothing. Even if one were somehow to avoid requiring a cash outlay by Leila, such as by having Leila enter into a simultaneous Salam with some middleman (e.g., a broker), the fact remains that someone (e.g., the broker) must pay Sharif RM4,00013 up front when the Salam is written. While this does not necessarily rule out a Salam-based alternative to conventional short-selling, it might pose a challenge to its widespread adoption on stock exchanges. Market participants may not be used to such a model, and existing IT systems and regulatory frameworks might have trouble adapting to it. Nevertheless, financial institutions have found ways to offer Salam-based short-selling. Newedge (formerly Fimat), a joint venture between French banking giants Société Générale and Calyon, launched a platform for Shar iah-compliant hedge funds in 2005 incorporating Salam-based short-selling. A number of hedge funds based in Europe and the United States have signed up to use the platform. Newedge’s global head of prime brokerage maintained that “although different solutions seem more acceptable for different regions, many Saudi scholars prefer the Salam contract for equities” (Davidson 2008). Permal has also managed a long/short Islamic hedge fund called Alfanar employing a Salam-based shortselling system. (It is important to note that Newedge and other 13 In actuality, Leila (or the broker) would probably end up paying Sharif less than the full market value of RM4,000. When a Salam contract is written on a commodity (e.g., wheat), the Salam sales price is typically lower than the spot price for the same commodity because the seller (Sharif) receives payment up front but does not have to deliver until later. In the case of a Salam on stocks, this discount could serve as compensation to the stock supplier (i.e., Leila and/or her broker), akin to the fees that stock lenders receive in conventional short-selling. b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 297 3rd Reading Short-Selling Replication in Islamic Finance 297 institutions offering Salam-based short selling may or may not use the structure described above.) Wad-Based Structures At least two industry players have proposed structures that aim to replicate short-selling by using Wad (unilateral promise). The first is London-based Amiri Capital, which is launching the Amiri Equity Alternative Strategies Fund (AEAS), an Islamic fund of long-short equity fund managers. Newedge Group is the fund’s prime broker, and Dar Al Istithmar its Shariah advisor. The Dar Al Isithmar Shariah board, which approved the AEAS Fund, includes Sheikh Hussain Hamid Hassan (chair), Ali Al Qaradaghi, Abdul Sattar Abu Ghuddah, Daud Bakar, and Aznan Hasan. The AEAS Fund’s short-sale replication mechanism involves two parties — AEAS and some counterparty — each entering into a Wad with the other to buy or sell stock in the event that the stock price moves in one direction or the other. Only one of the promised transactions will be exercised, since the price will either go up or down relative to the starting price, but not both. The mechanism is thus analogous to what conventional financiers call a synthetic short sale: buying a put option and writing (i.e., selling) a call option. Meanwhile, Bursa Malaysia (the Malaysian stock exchange), with the oversight of the Malaysia Securities Commission, is developing (as of late 2009) a different mechanism to replicate short-selling using Wad. Although the initial impetus for development was demand from Islamic ETFs, the system may attract Islamic hedge funds as well. There are two cornerstones of the system. The first cornerstone is that no lending and borrowing will take place. Instead, the “supplier” of stock (comparable to the stock lender in the conventional scenario) will actually sell the stock to a central facilitation agency b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 298 3rd Reading 298 Ryan Calder (CFA), which will then sell it on to the “user” of the stock (who is comparable to the “borrower” in the conventional scenario). Later, the user will sell the stock back to the CFA, which will then sell it back to the supplier. The Wad agreements serve to ensure that the user will sell the stock back to the CFA, and that the supplier will then buy the stock back from the CFA at prices and terms specified in advance. The second cornerstone of the Bursa Malaysia system is that the Bursa itself will act as the CFA, and thus the counterparty, for all transactions. It will establish and manage the constantly changing database of the pool of stocks that suppliers are willing to offer, and then will operate a real-time bid-ask system to match these with the stocks that users request. Let us revisit our hypothetical scenario. Sharif wants to short 100 shares of XYZ stock, which currently trades at RM40 per share. He puts in an electronic request to Bursa Malaysia’s CFA system, which scans its database of potential suppliers and locates Leila, who is willing to supply 100 shares of XYZ. The CFA confirms the deal, automatically establishes the necessary Wad agreements, and begins executing the trade. First, Leila sells 100 shares to the CFA (Bay 1).14 Delivery is immediate, but settlement is deferred, with the CFA paying Leila in monthly installments.15 Next, the CFA sells the 100 shares on to Sharif (Bay 2). Again, delivery is immediate, but settlement is deferred into monthly payments. Both Bay 1 and Bay 2 are true sales that transfer ownership.16 They are both executed at the price of 14 Bay means “sale” in Arabic. These monthly installments are not equal monthly installments. Rather, they fluctuate based on the changing value of the stock’s market price. Also, they depend on the maximum period over which the user may use the stock, which will be determined in advance by Bursa Malaysia and may be in the range of 18 months, 24 months, or some comparable period. 16 In this sense, the Wad-based short sale is somewhat similar to a conventional repo (repurchase) agreement, in which a (usually fixed-income) security serves as collateral for a cash loan, with the security actually changing ownership rather than simply being lent. 15 b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 299 3rd Reading Short-Selling Replication in Islamic Finance 299 RM40 per share, but in Bay 1, the CFA pays Leila a pre-determined markup (x%) that is distributed across the installments to compensate her for making shares available; and in Bay 2, Sharif pays the CFA a slightly higher markup (x% + ε%). The CFA retains the difference (ε%) as compensation for running the system. Sharif then sells the shares on the market for RM40 per share. All of the above happens virtually instantaneously. Two weeks later, assume XYZ shares are trading at RM35. Sharif decides to cover his short position. He buys 100 shares of XYZ stock back from the market and notifies the CFA. As Wad 1 requires him to do, Sharif now sells the 100 shares back to the CFA at the price of RM40. As Wad 2 requires her to do, Leila now buys the 100 shares back from CFA, also at RM40. The transaction is complete. An advantage of a Wad-based system is that while it does not involve stock borrowing and lending, it operates in a way similar enough to conventional SBL that it can be adapted from a conventional SBL system, as Bursa Malaysia is doing. Pricing under the Wad-based system at Bursa Malaysia, for example, will likely be the same as pricing for the conventional short-selling system. One possible disadvantage is that not everyone agrees whether a Wad can be binding. In the Bursa Malaysia system, each Wad is a Wad Mulzim (binding unilateral promise): Wad 1 is Sharif’s promise to sell XYZ shares back to the CFA when he is done with his short sale, and Wad 2 is Leila’s promise to buy the shares from the CFA when the CFA wants to sell them back to her. There are three main perspectives in the debate over whether Wad can be binding: • The “non-binding view”: Fulfillment of a unilateral promise, though commendable, is neither mandatory (Wajib) nor legally enforceable. Classical jurists endorsing this view include Imām Abu Hanifah (founder of the Hanifi school of jurisprudence), Imam Al-Shafii (founder of the Shafii school of jurisprudence), Imam Ahmad Ibn Hanbal (founder of the Hanbal school of b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 300 3rd Reading 300 • • Ryan Calder jurisprudence), and several Maliki jurists (Uberoi et al. 2009a:1). A number of contemporary jurists echo this view; see Saudi scholar Rafic Yunus Al-Masri’s clear exposition of it (Al-Masri 2002). The “binding view”: Fulfillment of a unilateral promise is mandatory (Wajib) and incurs both moral and legal obligation, making it enforceable in court. This was the view of only a minority of classical jurists, but among their number were notable figures such as Samrah bin Jundab (a Companion of the Prophet), Umar Ibn Abd Al-Aziz (one of the most respected Umayyad caliphs), Hasan Al-Basri, Imam Bukhari (compiler of one of the great Hadith collections), and Ibn Arabi (the great medieval Iberian polymath). The “conditionally binding view”: Although not normally binding, a unilateral promise becomes binding and potentially enforceable in court if it has caused the promisee to incur liabilities. The Islamic Fiqh Academy issued a Fatwa taking this position in December 1998, and many of the Fuqaha most prominent in the Islamic finance community today endorse this stance (Uberoi et al. 2009b). The direction this debate takes will have a major impact on innovation strategies in Islamic finance. The binding view and the conditionally binding view make the Wad-based short sale possible, but the non-binding view rules it out. Beyond just short-selling, the question of whether Wad can be binding has generated much discussion as Islamic financial institutions increasingly employ Wad as a structuring tool — in Murabahah products, Musharakah Mutanaqisah (diminishing partnership), Sukuk, cross-currency swaps, and Islamic derivatives. In one usage that garnered attention in Islamic finance circles, Deutsche Bank used Wad in 2007 to construct what is in effect a total return swap: clients invest in liquid Shar iah-compliant assets whose returns are swapped for the returns on non-Shar iah-compliant assets such as a hedge fund. The Shar iah board that approved the structure was a b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 301 3rd Reading Short-Selling Replication in Islamic Finance 301 Who’s Who of Islamic-finance luminaries: Hussain Hamed Hassan (chair), Ali Al Qaradaghi, Abdul Sattar Abu Ghuddah, Mohamed Elgari, and Daud Bakar. However, another prominent Shariah scholar, Shaykh Yusuf Talal DeLorenzo, directly questioned the product’s authenticity in a public paper, arguing that while Wad itself may be “widely seen to comply with Shariah norms,” “products that use a Wad to deliver returns from non-compliant investments” are unacceptable (DeLorenzo 2007). It is clear that the various uses of Wad continue to foster debate. Although it is too early to say definitively how this debate will play out and whether Wad Mulzim (binding unilateral promise) will gain complete acceptance across the world of Islamic finance, the fact that Bursa Malaysia received no major Shariah-related objections from the international Shariah scholars at a 2008 International Islamic Capital Market Forum in Kuala Lumpur where it presented its plans to develop the Wad-based short sale is anecdotal evidence that the Islamic finance community may be heading toward acceptance. Arbun-Based Structure In addition to Salam and Wad, the Arbun (down payment, also known as “earnest money”) sale is also being used to structure Islamic alternatives to short-selling. In an Arbun sale, a buyer makes a down payment when a sale is agreed, and is committed to pay the remainder later if and when he decides to take the goods. If the buyer decides not to take the goods, then he forfeits the down payment and must return the goods. In this regard, Arbun is similar to a conventional option contract. (See Billah 2003:72–83 for a discussion of the contract and the positions taken on it through history by jurists and schools of jurisprudence.) In 2008, Shariah Capital, together with prime broker Barclays Capital, launched the Al Safi platform for hedge funds. Al Safi employs an Arbun-based short-selling structure that Shariah b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 302 3rd Reading 302 Ryan Calder Capital’s chief Shariah officer Shaykh Yusuf Talal DeLorenzo has endorsed. Shaykh DeLorenzo explains Shariah Capital’s “Arboon Short Sale” in a white paper entitled “A Shariah Compliant Alternative to Selling Short with Borrowed Securities” (DeLorenzo 2008). Based on Shaykh DeLorenzo’s explanation, it appears that in the Arboon Short Sale, the prime broker agrees to sell stock to the short-seller (an investment manager) at the quoted market price. The shortseller makes a down payment to the prime broker that is equal to the margin-account deposit that would have been made in a conventional short sale. As stipulated in a “Master Securities Arboon Sale Agreement”, this down payment transfers ownership of the stocks to the short-seller. Now that he has ownership, the short-seller sells the stocks (through the prime broker) to some third party in the market at the market price. Then, at some time in the future, the short-seller decides to close out the transaction. He buys back the required number of shares from the market (again through his prime broker) and then returns them to the prime broker, who retains the down payment. Since the specifics of Shariah Capital’s Shar iah-compliant short sale are not public and are based on a proprietary model, its mechanics may well differ from the theoretical Arbun-based structure outlined above. Indeed, the devil is often in the details when it comes to developing a Shar iah-compliant short-sale alternative, particularly because of the challenge of simultaneously meeting Shariah requirements and government regulatory requirements. Shariah Capital CEO Eric Meyer has commented that while achieving Shariah compliance required “a great deal of intellectual capital”, “the most demanding part” of bringing the Arboon Sale to market “was reconciling Shariah principles and precepts with the realities of U.S. Securities and Exchange Commission regulations that are based on the Securities Act of 1934 and the Investment Company Act of 1940” (Meyer 2006). b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 303 3rd Reading Short-Selling Replication in Islamic Finance 303 In general, an advantage of Arbun-based short-selling is that its mechanics are similar to those of a conventional short sale. For example, a parallel exists (albeit not an exact one) between the down payment in an Arbun sale and the margin deposit in a conventional short sale. And unlike in a Salam-based structure, the stocks in an Arbun-based structure can move in the same way as in a conventional short sale: first from the prime broker to the shortseller, then on to the market, and then from the market back to the short-seller and to the prime broker. These similarities may make an Arbun-based structure easier to understand for both clients and service providers and may render it more adaptable to the platforms that prime brokers already use for short sales. Yet like the other structures discussed, Arbun-based short-selling may be potentially controversial from a Shariah perspective — depending whom you ask. Classical Fiqh is particularly critical of the Arbun sale. Through the history of jurisprudence, most scholars from the Maliki, Hanaf i, and Shafıi schools have held that Arbun is invalid. They refer to a Hadith included in Al-Muwatta’, the monumental Hadith collection of Maliki school founder Imam Malik bin Anas, that reads c Rasūl allāh s.allá allāhu calayhi wa-sallam nahá can bay al-curbān The Messenger of God, peace be upon him, forbade curban17 sale (Malik Ibn Anas 1986). Different scholars have taken different approaches to this Hadith, which is also recorded in the Sunan of Abu Daud and the Sunan of Ibn Majah, two of the other Hadith collections considered most important by Sunni Muslims (Abu Daud Sulayman Ibn Al-Ash’ath AlSijistani 1996; Ibn Majah 1998). Some have questioned its 17 Urban, Arban, and Urbun are different Arabic spellings of the same word. b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 304 3rd Reading 304 Ryan Calder authenticity. A minority of classical scholars — largely Hanbalis, including Hanbali school founder Imam Ahmad Ibn Hanbal — have relied on a conflicting report saying that Umar bin al-Khattab (one of the Prophet’s companions and the most powerful of the four Rashidun caliphs) himself practiced Arbun sale, and that Umar’s son validated it (Kamali 2000:201). However, the historicity of that account has been questioned too. In the face of conflicting historiographies, some prominent contemporary Fuqaha argue that Arbun sale should be accepted because they feel it can benefit people in the modern era. Among them is Yūsuf Al-Qaradawi, who asserts that the best course is to apply reason to present circumstances and permit Arbun so as to remove hardship and bring benefit to people (Kamali 2000:202; Al-Amine 2008:239). Another is Mustafá Al-Zarqa’, who stresses the utility of Arbun to modern commerce (Al-Amine 2008:239). Modern scholars and financial institutions have responded to some classical objections. One criticism of Arbun over the centuries has been that it may harbour Gharar (uncertainty) if it includes no time limit for contract cancellation. The Islamic Fiqh Academy addressed this issue by stipulating that every Arbun contract include a time limit for cancellation (Majis Majma Al-Fiqh Al-Islami AlDuwali 1993) — a possibility that some classical Hanbali jurists raised (El-Gamal 2006a:91). The Fiqh Academy’s decision has lent Arbun credibility. Indeed, Shaykh DeLorenzo cites the Fiqh Academy’s 1993 decision accepting the use of Arbun by “modern Islamic banks and investment houses” (DeLorenzo 2008). However, some object that Arbun still contains Gharar because the seller does not know whether the buyer will conclude the sale (El-Gamal 2006a:91) — a questioning of the Shariah validity of the option concept itself. Another potential issue with using Arbun to replicate a short sale as described above is that it is not in accord with the traditional usage of Arbun as a down payment. In the theoretical Arbun-based short sale above, if the short-seller is actually planning to complete b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 305 3rd Reading Short-Selling Replication in Islamic Finance 305 the short sale, then he knows in advance that he will not be “keeping” the stocks on which he has made a down payment. He knows from the beginning that he will be returning them to the prime broker, forfeiting his deposit as the cost of making a short sale. He does not enter into the Arbun thinking that he probably — or even maybe — will later complete the transaction and buy the goods in full after making his initial down payment, but rather enters the contract knowing in advance that he will not accept the goods. Conclusion Efforts to develop Shar iah-compliant short-selling alternatives are part of an ongoing wave of innovation in the Islamic finance industry that gained pace in the mid-2000s. This innovation wave, which we might call the “post-sukuk” wave, has had multiple causes: high oil prices, deregulation, the internationalization of finance, the evolution of more robust national and international standard-setting frameworks for Islamic finance, and an increase in the number of scholars versed in both fiqh and finance (Kahf 2004; Warde 2010). In addition to short-selling alternatives, it has encompassed efforts to develop Islamic derivatives and hedging techniques (e.g., profitrate swaps, Islamic currency swaps and forwards, Islamic options), new types of Shar iah-compliant securities (e.g., securities referenced to commodities, equities, funds, and baskets), Islamic credit cards, Islamic mortgages, and novel project-finance and trade-finance structures — to name a few. What is the Status of the Market? For the moment, the market for Shar iah-compliant alternatives to short-selling is nascent but growing fast. As this chapter has discussed, several offerings are available. Most target Islamic hedge funds as b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 306 3rd Reading 306 Ryan Calder their primary client base: these offerings include Amiri Capital’s Wad-based structure, Newedge’s Salam-based structure, and Shariah Capital’s Arbun-based structure. Meanwhile, Bursa Malaysia, the Malaysian stock exchange, is targeting Islamic ETFs using a Wadbased structure incorporated into the workings of the exchange itself. Thus the fledgling market for short-sale replication is somewhat bifurcated by both client base and geography. On one side are the players targeting Islamic hedge funds. They are based in the United Kingdom (Amiri Capital), continental Europe (Newedge), and the United States (Shariah Capital). Their clients are primarily headquartered (though not necessarily domiciled) in the United States and the United Kingdom, for that is where the majority of Islamic hedge funds are based at the moment. These funds’ investors reside largely in the GCC, although some come from Southeast Asia and elsewhere in the Islamic world. Meanwhile, on the other side of the market for short-sale replication is Bursa Malaysia, the lone exchange-based contender, which will target Islamic ETFs in particular. What should Potential Customers Keep in Mind? Investors and fund managers choosing a short-selling platform must realise that their options are not mere variations on a single theme, as competing financial products often are, but that they differ in structurally fundamental ways. Even though all have been developed with the oversight and active involvement of some of the world’s most prominent Shariah scholars, not all will necessarily be popular with every Shariah expert. That said, it would be difficult to argue that one of the structures described above is clearly more universally accepted than the others; differences of opinion arise on a productby-product, scholar-by-scholar, and Madhhab-by-Madhhab basis. Therefore, investors and fund managers should take the time to b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 307 3rd Reading Short-Selling Replication in Islamic Finance 307 understand each structure well and consider whose opinions — past and present — are most important to them. Beyond Shariah considerations, investors and fund managers should evaluate which options are best suited to the legal enviroment in which they do business. Developers of Shar iah-compliant platforms to replicate short-selling attest that while the basic structures they employ — as shown above — may be simple, harmonising Shariah requirements with securities law adds tremendous complexity. It is therefore critical that investors and fund managers “do their homework” to make sure the platform they choose will function properly in the jurisdictions in which they are domiciled and do business. In particular, investors and fund managers should explore what contingencies are built into the platform for unexpected mishaps. Platforms replicating short-selling, like other complex legal structures, prove their mettle under extreme or unusual market conditions. Aware of this, platform developers expend great effort ensuring that they have Shar iah-compliant, legally sound structures to deal with infrequent but potentially critical situations. Amiri Capital, for example, spent an entire year of its two-and-a-half-year product-development process developing a netting structure for its short-sale replication mechanism that could complete the physical transfer of assets required by Shariah even in the event that one of the counterparties to the transaction went bankrupt (Shah 2009). Other players likewise incorporate contingency plans for unlikely events into their platforms. Where is the Market Headed? Prognosticating about finance is treacherous. Nevertheless, I hazard some thoughts about the future of Shar iah-compliant alternatives to short selling. First, the broad trend among Shariah scholars toward gradual acceptance of techniques to replicate short selling is more likely to continue than not. None of the replication techniques b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 308 3rd Reading 308 Ryan Calder I have discussed has the acceptance of every Shariah scholar, but this has not kept replicated short-selling from going from being a pipe dream to being increasingly accepted in half a decade. This is due in part to providers’ efforts to integrate leading scholars into their product-development processes. But is also due to an increase in the visibility of Islamic finance and a proliferation of training and certification programs in the past few years. This trends have made Shariah scholars in general more familiar and more comfortable with complex financial transactions and instruments. In other words, as the intellectual enterprises of fiqh and financial structuring have spent more time brewing together in the cauldrons of Islamic financial institutions, new techniques like Islamic short-sale replication have bubbled to the surface. A second and contrasting point, however, is that a ruling against short-sale replication by one or two leading Shariah scholars could dampen the market’s prospects considerably. In 2007, Sheikh Taqi Usmani presented a paper at the meeting of the AAOIFI Shariah council that suggested the structures employed by about 85 percent of Sukuk are un-Islamic (Usmani 2007). This threw the sukuk industry into turmoil and sent prices tumbling. The possibility exists that a prominent jurist could rule similarly against some of the short-sale replication techniques discussed above, or even against the idea of Shar iah-compliant short-sale replication tout court. Yet while that may sound like a nightmare scenario to providers of short-sale replication, such an event could prove beneficial in the long run. Nothing would focus more energy and attention on developing novel structures, and on improving existing ones, than an unexpected jolt to the business of short-sale replication. Third, the vitality of the market for replicated short-selling will depend on macroeconomic health in the GCC and Southeast Asia. In the GCC, the global financial crisis that began in 2008 popped speculative bubbles in property and equity markets. The capital pouring into Islamic investment vehicles, including the nascent Islamic hedge-fund sector, slowed to a trickle. If global recovery from the b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 309 3rd Reading Short-Selling Replication in Islamic Finance 309 present crisis is robust and global oil demand is sustained in the medium term, GCC investors are likely to regain confidence and feel warmer about Islamic hedge funds. That would strengthen demand for Shar iah-compliant short-sale alternatives. In Southeast Asia — which has not been struck as hard by the global crisis as North America, Europe, and the Gulf — sustained stable growth over the 2010–2015 horizon is also the formula most likely to attract investors to Islamic hedge funds and Islamic ETFs. Moreover, unless Southeast Asia experiences an economic meltdown worse than the 1997–1998 crisis, governments are unlikely to halt short-selling (Islamic or otherwise) the way Prime Minister Mahathir Mohamad’s administration did in Malaysia in 1997. In Malaysia in particular, the state now views Islamic finance as a lever of economic growth and has been an enthusiastic champion of Islamic-finance infrastructure and innovation (Muhyiddin 2009), making another government “crackdown” on conventional shortselling or replicated short-selling unlikely. Fourth, while it is possible that the market for Islamic short-selling alternatives could converge toward a single standardised structure, convergence appears unlikely in the short or medium term. Competitors’ claims aside, there is no single replication structure that is clearly superior to the others along one dimension or other, whether that be Shariah compliance, regulatory harmonisation, tax considerations, or economic efficiency. This contrasts with the case of Sukuk, for example, in which some structures — like Sukuk Al-Ijara — are frequently described as more “orthodox” and less controversial than others. The fact that short-selling can be replicated in a number of different ways also suggests that the market for it will continue to grow. Replicating short-selling using Islamic contracts and instruments is not difficult from a theoretical perspective (see, for example, Hassan and Lewis 2007:90–95). The challenge stems from the need to harmonise Shariah with regulatory requirements, tax considerations, and legal contingency plans. Seeing multiple avenues open in front b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 310 3rd Reading 310 Ryan Calder of them, new competitors are likely to continue bringing new structures onto the market in the next decade as the Islamic finance industry grows. Meanwhile, as new players enter, existing players will expand their offerings into new markets. Bursa Malaysia, for example, will be well positioned to offer its exchange-based short-sale replication system to other stock exchanges if the system succeeds in Kuala Lumpur. (In this regard, Bursa Malaysia will enjoy an advantage relative to other exchanges that would seek to develop their own in-house Islamic short-sale replication system because it has benefited from strong government support and significant coordination among Bursa Malaysia, Securities Commission Malaysia, and the central bank, Bank Negara Malaysia.) In short, innovation in this field is just beginning, and Islamic short-selling alternatives will likely become more widespread in the next decade. Is All This a Good Thing? The question may long remain, however, whether Islamic short-sale replication is in line with Maqasid Al-Shar iah — the objectives of Islamic law. It is one thing to say that a technique used to replicate short-selling complies with the letter of Islamic commercial law (Fiqh Al-Muamalat), but it is another thing to show that the benefits (Masalih) it engenders outweigh the evils (Mafasid). The hope is that complying with the letter of the law — however interpreted — does indeed lead to social good and to outcomes consonant with Maqasid Al-Shariah. However, when the letter of the law comes to us via juristic interpretations formulated in the classical age of Islamic jurisprudence but the substantive impact of financial instruments is felt in a twenty-first-century economy, the possibility arises that adherence with the letter of the law and with its spirit may not necessarily guarantee each other. In a globalised economic system founded on complex and intertwined financial markets behaving in b839_Chapter-14.qxd 1/28/2010 9:36 AM Page 311 3rd Reading Short-Selling Replication in Islamic Finance 311 unpredictable ways, it may be rash to assume that adhering to classical juristic rules insures us against the deleterious effects that even “Shar iah-compliant” financial structures could have, whether at the individual level or the systemic. Ultimately, we may have to wait and see what kinds of effects Islamic short-sale replication has. The history of conventional shortselling is instructive here. On one hand, short-sellers have been vilified for centuries as vultures who undermine market confidence, being blamed as early as the 17th century for financial crises (De Marchi and Harrison 1994; Ferguson 2008). On the other hand, many economists insist that short-sellers provide information that helps smooth out markets, acting as one of the few safety valves to relieve upward price pressure driven by “irrational exuberance” during speculative asset bubbles (see, inter alia, Figlewski 1981; Jones and Lamont 2002). What about Islamic short-sale alternatives? Do they have positive, neutral, or negative effects on the individuals that use them and the markets and societies in which they are used? What criteria should be used to evaluate them? 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Short-selling replication in Islamic finance: Innovation and debate in Malaysia and beyond

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