Shariah And Swaps (Islamic Finance)

In the Name of Allah, the Merciful and Mercy-Giving

The Total Returns Swap and the

"Shariah Conversion Technology" Stratagem

By Yusuf Talal DeLorenzo

Summary

This study will look at Islamic values in financial decision-making by considering

whether or not Shariah Supervisory Boards will approve any financial product that is

delivered by ostensibly halal means, even if what is delivered by those means, the end

product, is derived from non-compliant investments. This may be characterized as a

quasi-philosophical question about means and ends. Yet, it is one that carries a myriad

of practical implications and far-reaching ramifications for the growing Islamic

financial industry.

This is a case study, and not a theoretical study. The focus of the study is a particular

means or process for the development of products sometimes called "Shariah

Conversion Technology". The reason for writing this paper is to draw the attention of

scholars and industry experts to the importance of making a distinction between

bringing returns from Shariah-compliant investments and bringing returns from non-

Shariah compliant investments. If care is not taken, this "technology" represents a

great danger to modern Islamic Finance. My own reaction to this threat, initially, was

to suggest recourse to sadd al-dhara`i, the instrument in Islamic jurisprudence that

blocks ostensibly legitimate means to illegitimate ends. On closer study, however, I

have concluded that there is no need to resort to this instrument as the matter is simply

one of distinguishing between what is truly lawful, halal, and what is truly unlawful,

haram. In what follows, I will explain exactly what led me to this conclusion, and why

I think it necessary to share my thoughts on the matter.

To date, I have shared this paper with only a handful of scholars and colleagues. In

the coming months, however, Islamic banks and investment houses will look closely

at products based on the "Shariah Conversion Technology" stratagem, and Shariah

boards will be asked to deliberate and opine on the compliance of such products with

the rules of the Shariah. My intention in circulating this paper is to contribute to a

wider and more comprehensive understanding of this particular stratagem. At a time

when Shariah scholars are increasingly being asked to opine on new and exotic

products, I believe that due consideration must be given to not only the literal

structure of products and processes, but also to their consequences for the future of

Islamic Finance.1 In other words, while up until now the Shariah supervisory boards

of modern Islamic financial institutions have focused almost exclusively on the rules

for transacting in compliance with the Shariah, it is now time for them to focus as

well on the higher purposes of Islamic law or the maqasid al-Shari`ah.

1 In an article entitled "The Black Box Syndrome" which I wrote for the April 2007 issue of Islamic

Finance, I wrote: "I would like to see more faith in what true and diligent Shariah compliance actually

means to our industry. I am dismayed by quick fixes and shortcuts which in many cases circumvent the

Shariah. The industry has proved time and again that adherence to the principles of Shariah can be

profitable, and that such adherence does not spell hardship. We have no need of "black boxes" and of

arm's length transactions that miraculously produce results by sacrificing the spirit of the Shariah to the

letter of the law."

Introduction

Recently, a financial stratagem known as "Shariah Conversion Technology" was

developed, the purpose of which is to affect a total returns swap or to "Wrap a non-

Shariah compliant underlying into a Shariah compliant structure."2 In other words, the

objective of the mechanism is to use non-compliant assets and their performance to

bring returns into a so-called Shariah-compliant investment or investment portfolio.

This point is key to the entire transaction, and for that reason it needs repeating. What

the product proposes to accomplish is to bring to the Islamic investor returns from

investments that are not compliant with Shariah principles and precepts. The

questions that such a product immediately bring to mind are: How can Shariah boards

approve such returns? Does the circumstance of direct or indirect delivery to the

Islamic investor change the ruling? When the Shariah of Islam is understood to differ

from other legal systems because it may be characterized as both positive law and

morality3, is it possible to ignore the moral aspect of a financial transaction like this?

The means of delivery, a wa'd or promise, is widely seen to comply with Shariah

norms.