While on holiday, I bought the book “Too Big To Fail” by Andrew Ross Sorkin. I’m about one-fifth of the way through the book. Really gripping stuff, but I wish I had a better way of remembering the names of the key players. Maybe I should put the profiles of the ensemble cast in an Appendix, along with their photos (haha!).

On Monday I recalled a comment from the first Chapter, and recounted it to one of my colleagues at work. Apparently, sources on Wall Street have it that a group of short-sellers maliciously manipulated Bear Sterns‘s share price and reputation. This eventually resulted in the merger of Bear Sterns with JP Morgan in a stock swap of $2 per share, down from $172 per share a year earlier. The $2 offer was revised to $10 per share, but that is still less than 10% of the $172 high.

I recounted this story to my colleague because she attended a recent two-day seminar conducted by the Centre for Islamic Banking, Finance and Management (CIBFM) on Syariah compliant financial services, and she had briefed me earlier on some of the materials presented during the seminar.

From what we learned, key in determining if a transaction is “Syariah compliant” is whether it adheres to a set of 5 key principles:

1. Avoidance of “Riba” – I think of this as “Usury“. Whether “profit sharing” agreements in murabaha (profit-sharing) transactions really represent “Interest” on debt (where a debt is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits, per the IASB Framework) … ah, that is the topic of a whole separate series of blog posts!
2. Avoidance of “Gharar” – A deceptive sale with uncertain payoffs, benefiting one party at the expense of the other
3. Avoidance of “Maysir” – Games of chance and gambling
4. Avoidance of transactions involving prohibited commodities – all that is “Haram” e.g. Alcohol, drugs, etc.
5. Contracts must have mutual consent, purpose and motive – quite similar to how in common-law systems, the key requirements for the creation of a contract are offer & acceptance, consideration, intention to create legal relations, legal capacity and formalities.

So I was thinking … between running a modern financial services firm and maintaining Syariah compliance … how do we reconcile these two needs? Are they congruent? Are they competing?

More after the break.

Shorting of Bear Stern’s stock

Allegedly, a group of short-sellers worked together as a cabal or a cartel, to spread rumours in the market place that Bear Sterns would not be able to honour its debts. The story goes that the cartel compounded the situation by pulling strings in their own institutions and ensured that their own banks would not trade with Bear Sterns, in effect fulfilling the rumours that they themselves helped to spread.

And they profited from it by buying “naked” Credit Default Swaps (CDS). A CDS is a derivative contract that you take out to insure against a party’s inability to pay their debts. In this case, the cartel bet big that Bear Sterns would not be able to meet their debts. Buying these “naked” CDSs were risky, and in a way, were abusing CDSs to not reduce risk but to actually leverage up and increase risk (but also, reward).

The story then goes to say that as the bank folded, the CDSs were “in the money” and the cartel profited from the CDSs and their normal short selling activities.

Short selling

To understand if short selling is “Syariah compliant”, we can try and fit short selling activities (conventional short selling and naked short selling) into the 5 key principles we learned about above as follows:

1. “Riba” –> Short selling isn’t normally an interest bearing transaction. In substance, short selling is profiting from some one else’s capital loss.
2. “Gharar” –> In the case of the cartel, because they exercised collective bargaining power, could we argue that in the view of the cartel, payoffs were quite likely to happen (> 50% probability chance).
3. “Maysir” –> Again, in the case of the cartel, payoffs were quite likely to happen.
4. Prohibited commodities –> The Bear Sterns stock itself was probably not syariah compliant to begin with. But then again, which global investment banking franchise is also a syariah compliant franchise? For the syariah-compliant investor who wants to tap the risks and rewards in the global investment banking segment, where else can he turn to?
5. Common-law contracts –> Yes, short selling bears all of the key requirements for common-law contracts.

From what the materials we were provided, conventional short selling of securities is not a syariah-compliant transaction, as AAOIFI Shariah Standard on short selling disallows conventional short selling (referring to standards 21, 3/9 and 3/16). The materials then goes to speculate on some syariah-compliant structures that permit short selling.

DISCLAIMER: I am no scholar! But if we try and fit short selling into the 5-point framework above, we seem to get to the answer that under some conditions it is permissible. Yet the training material we were provided shows that conventional short selling is not permissible.

In doing my own research for this blog post, I came across a blog post that presents some alternative structures to create Syariah-compliant short selling structures. One of the key ingredients that is being used is a “Wa’ad” transaction. “Al-wa’ad” is a promise, an undertaking to perform an act. In a way, this acts like 2 options back-to-back. In one structure called a “muwa’adah” or “mu’ahidah” (bilaterial promise), the buyer has a put option and the seller has a call option. Depending on the strike prices and the pricing of the options, when combined these create a synthetic short selling structure.

The Bottom Line

Alone, the 5-point framework above is not enough to determine the Syariah compliance of a transaction. I am still searching for an online resource or a framework that can help me understand Islamic finance better. For example, my key headache with Islamic finance is trying to understand “Riba” and how to reconcile the view of “Usury” with all the things we learn in modern finance like the time value of money.

The bottom line in this one is that there’s still much more reading, understanding and blogging to be done on this topic.

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