Shariah-Based Exchange-Traded Derivatives (ETD) Platform
Introduction: Global e-Souk (e-Souk) is one of several energy market risk management solutions developed by Global e-Bourse Suites® (www.globale-boursesuites.com). A patent defining e-Souk’s proprietary systems, methods, and instruments has been issued in Singapore and others are pending with the U.S. Patent & Trademark Office (USPTO) and the World Intellectual Property Organization, administrator of the international Patent Cooperation Treaty. e-Souk advances prior art in the ETD field by way of its novel embodiments designed to pass Islamic scholar scrutiny based on the arguments and rationale posited herein.
Background: Many buyers and sellers of crude oil, refined products, and other commodities reside and/or conduct business in countries where Muslims comprise a substantial, if not dominant, part of the population. At present, there are estimated to be over 1.7 billion Muslims amounting to ~ 23% of the global populace, with large shares particularly inhabiting the burgeoning Middle East to East of Suez (ME/ES) market corridor, many of whom strive to abide by Shariah principles.
As noted in published works of International Monetary Fund economist Andreas A. Jobst, the scarcity of Shariah-based instruments needed to hedge market price volatility comes at an inauspicious time for Islamic financial institutions as they strive to manage a $1 trillion (and growing) base of assets lodged in Islamic financial instruments and markets. In light of some recent major increases in Shariah-compliant structured transactions, along with the diversification of Islamic banking activities beyond their original jurisdictions, there has arguably never been an environment as ripe as the present for Islamic principles-based hedging solutions that are attuned to market price volatility risks attendant to underlying assets, particularly ME/ES energy commodities that are vital elements of cross-border trade.
As Islamic finance comes into its own, more emphasis will inevitably be placed on market-based sources of Islamic investment and banking. Recognizing this trend, e-Souk’s Shariah-based ETD was specifically designed as a risk management solution aimed at complementing those sources. Working together, they can enhance liquidity management, supplement cash markets at lower funding costs and facilitate more efficient transmission of funds from savers to investors. But before that can take place, valid objections previously raised by Shariah scholars in the course of challenging the permissibility of conventional ETD under Islamic law must be addressed. To that end, this memorandum describes differences between e-Souk ETD and censured conventional ETD attendant to such institutions as CME Group’s New York Mercantile Exchange (Nymex) and the London-based IntercontinentalExchange (ICE).
Previous Objections Raised by Islamic Scholars: Below is a summary of objections commonly raised by Islamic scholars who oppose the use of conventional ETD, particularly futures and options contracts:
Many conventional futures are valued by reference to the sale of a non-existent asset or an asset not in the possession (qabd) of the seller, which negates the hadith “sell not what is not with you”. Prime examples are cash-settled crude oil futures contracts linked to benchmarks that have been heartily embraced by speculators, particularly those engaged in the practice of high-frequency trading (HFT): West Texas Intermediate (WTI) and North Sea Brent exploited by the Nymex and ICE, respectively. WTI and Brent differ (see below), in many cases substantially, from the diverse crude grades produced and consumed in the ME/ES (e-Souk’s target market):
Point of extraction
Quality specifications (e.g., API gravity, sulfur content, etc.)
Terminal delivery point of sale
Various storage and transportation logistics that come into play prior to the crude oil ultimately arriving at customer destinations.
Leading commodity exchanges, such as Nymex and ICE, do not require protection sellers to actually own their referenced asset at the inception of a conventional futures transaction.
For most futures transactions, delivery of an underlying commodity or its possession is not intended and almost never involves delivery by both parties to the contract. In nearly every case, one or both parties merely reverse the transaction to cash-settle the price difference prior to contract expiration, a process that for all intents and purposes transforms a conventional futures contract into a paper transaction lacking the elements of a genuine sale.
Futures are price-marked to market (MTM) each trading day as part of standardized exchange clearinghouse margin call practices requiring additional funds to be posted by parties “out of the money” and returning excess margin to parties holding unrealized gains. When taken alongside the relatively low margin/high leverage terms typically granted by Nymex and ICE to their trader customers (amounting to ~ 4%-5% of an underlying commodity’s market-adjusted gross notional value), MTM and margin calls are viewed as generic practices which too closely resemble those commonly associated with usury (riba).
Conventional options don’t hedge adverse price movements so much as they remove exposure to the contingency risks (e.g., discretionary non-performance) implied in conventional futures, the value of which is received in exchange for an up-front non-refundable premium payment. But even though the general premise of eliminating such contingency risks may be desirable under Islamic law, the notion of assuring definite performance via mutual deferment in option terms is not because it implies a generic zero-sum (rather than bilateral interest) proposition.
In the last decade or so, leading exchange operators like CME Group and ICE became publicly traded “for-profit” companies. Drifting from their original mission as member-owned, “not-for-profit” entities – maintenance of fair and orderly markets -- they began chasing volume growth opportunities, which ultimately led to HFT overindulgence, inter alia by co-locating servers and allowing communications pipelines to be flooded with arcane quote traffic. Sadly, far too little quote traffic today consists of true bids and offers; rather, it has become inundated with rapid-fire order entries and cancellations serving as the cornerstones of algorithmic HFT machinations. So if ever there was any doubt before, it has now become obvious (certainly within the context of Shariah) that conventional energy-complex ETD exploited by Nymex and ICE involve excessive uncertainty (gharar) or speculation. Verging on gambling (maysir; qimar), with zero-sum pay-offs on both sides of the bargain, such ETD trading violates Islamic tenets of distributive justice and equal risk sharing that are subject to religious restrictions covering the practices of lending and profit-taking and otherwise lack any real economic activity and asset transfer attributes.
Key Attributes of e-Souk’s Sharia-based ETD: Following is a list of attributes that differentiate e-Souk’s Shariah-based ETD from the conventional futures, options, etc. exploited by Nymex, ICE, and their global affiliates.
e-Souk deals exclusively with permitted (halal) commodities, particularly those underlying commerce between and among producers, refiners and users of ME/ES corridor crude oil and refined products, plus those Islamic banks, investors, importers, and exporters that are willing and able to deliver or take delivery. Unique quality and delivery specifications of those commodities serve as key elements essential to the configuration of e-Souk’s interrelated benchmarks, complementary indexes, and ETD.
Each ETD is valued by reference to the sale of an asset actually or constructively possessed by the seller, which can be facilitated by e-Souk’s warehouse receipt system. e-Souk requires protection sellers to actually own their referenced asset at the inception of each transaction.
Rather than emulating WTI@Nymex and Brent@ICE, where aggressive exploitation of their self-denoted “global” benchmarks elicit cash settlements either prior to or at contract expiration, e-Souk instead custom-designed its novel systems and methods to match the bilateral interests of buyers and sellers via EFP -- Exchange of Futures for Physical (delivery) -- contracts.
In each case involving e-Souk ETD, delivery of the underlying commodity or its possession is the prime intent. While under certain circumstances, it may be permissible for one side or the other of a position to be reversed, no positions can be cash-settled at a contract’s expiration unless it is required by e-Souk for legitimate institutional purposes.
Unauthorized speculator interests are regulated and deterred by proprietary network hardware and software controls designed to ensure that only those parties pre-qualified by Sharia scholars will be allowed to access and trade over the e-Souk platform.
All payments and settlements occurring in connection with e-Souk executed contracts will utilize Shariah-qualified escrow accounts, the form, nature, and amount (in terms of % of an underlying commodity’s gross notional value) of which will be sanctioned by Islamic scholars prior to implementation. It is intended that both form and nature will be quite similar to that which is typically employed in the normal course by Islamic financial institutions, rather than emulating standardized MTM and margin account practices employed in the case of conventional ETD.
e-Souk’s ETD is designed to be integrated with dealings of Islamic banks and their customers engaged in Murabaha, Musawama, and Salam-style transactions, as elaborated on below:
We posit that the use of Salam-style EFP contracts, where future date and place of delivery are specified, will generate a Shariah-compliant structure meeting bona fide commercial objectives of producers, refiners, importers, exporters, plus Islamic banks, and investors.
Employing Salam-style EFP parameters, Sellers would agree to deliver crude oil, refined products, or another energy commodity already in their possession to Buyers at a future date in exchange for immediate or briefly deferred (up to 3 days) payment, the amount of which would be determined on the spot over e-Souk’s ETD platform. Only those energy commodities for which quantity (in absolute terms) and quality can be expressly specified would be eligible for trading.
Since no minimum period is required for a Salam contract to be considered valid under Shariah -- with a proviso that it cannot be less than the deferred payment period -- any Salam-style EFP contract could conceivably, if desirable, be aligned with the expiration schedules of conventional energy futures contracts, which would arguably enhance the price discovery process of most e-Souk traders (see more on this subject below).
Prices subject to specified future delivery must be negotiated and executed on the spot (i.e., trade date) by parties linked over e-Souk’s platform. Their price discovery process would logically involve current and forward-looking factors they deem to be inherently significant as of the date of trade. Following are prime examples of such factors:
Spot prices then prevailing throughout the global energy markets
Published futures prices posted at conventional ETD outlets, including but not limited to CME/Nymex and the ICE, as well as (if all works out) Global e-Bourse Suite’s® other novel energy market hedging solution: Global Energy e-Bourse
Anticipated costs of logistics (storage, one or more transportation modes, etc.)
Anticipated changes in production output vis-’a-vis refinery run rates and consumption levels being experienced in the attendant trade region(s)
Anticipated macroeconomic and geopolitical issues
Anticipated influence of biofuels and other emerging renewable energy sources
Anticipated influence of non-commercial (qualified investor-class) traders in terms of their open interest levels
Anticipated movements in the value of the U.S. Dollar, or another similarly influential medium of exchange, which might in turn increase or decrease the relative interests in employing e-Souk’s ETD as instruments of protection against energy commodity inflation relative to other asset classes
In certain cases, with or without the above-noted EFP contracts, Islamic banks and Shariah-approved traders may mutually agree that transactions should involve e-Souk executed wa’ad agreements. Thus, it is contemplated that certain counterparties would hold equal and offsetting positions with maturity-matched put and call combinations -- via some reciprocal zero-cost structure -- intended to preserve the type of equitable risk-sharing arrangements that are consistent with Shariah principles applicable to entrepreneurial investment. In other cases, a wa’ad may be required in the form of a guarantee or mortgage in order to ensure that the commodity seller actually delivers.
Conclusion: It is our sincere goal for Global e-Souk to become a Shariah-based ETD platform sanctioned to effectuate economic justice and transparency while serving the public interest (Maslaha). We believe all of the statements, examples, and illustrations contained in this memorandum substantively demonstrate our commitment to achieving that goal.
Global e-Souk @ Global e-Bourse Suites® (www.globale-boursesuites.com)
Key Matters: Exchange-Traded Derivatives (“ETD”) Platform Designed for Sharia Compliance
Islamic Scholars’ reasons for censuring conventional futures and forward trading contracts:
Short selling in conventional futures trading is contrary to Sharia rulings that the item sold must exist and be owned by the seller at the time of the contract.
Reverse trading in conventional futures markets is contrary to Sharia rulings that the purchaser may not sell the goods purchased until they are in his possession.
In the case of conventional futures and forward contracts, a sale is concluded whereby the delivery of goods and its counter value are postponed. This is construed as exchanging one form of debt (i.e. contract obligation) for another, which is prohibited.
Notwithstanding the above, the protection of wealth is a Sharia maxim; thus, not taking appropriate measures to protect wealth from certain or near certain risks is a violation of logic as well as Sharia teachings.
Issues that must be considered re: the undesirable impact of censure (i.e. lack of action):
If risks cannot be eliminated, they must be reduced through risk management, and this should be done in keeping with the following Islamic legal maxims:
“Severe damage is made to disappear by lighter damage”.
“The smaller of two harms is chosen”
“Damage is to be avoided as far as possible”
From the above, we can surmise that Sharia obliges businesses to take measures to hedge undesirable price volatility risks and that hedging can be considered a prime Sharia rationale – ergo a strong case for qualified forwards or futures contracts.
However, the attendant institutional setting must enforce Islamic ethics and devise the means to prevent usury, gambling, and contractual ambiguity as part of the trading platform.
Solution: Global e-Bourse Suites® Novel Sharia-Based ETD Platform having the following characteristics:
ETD contract’s underlying asset would in each case be comprised of a substantial globally traded halal commodity.
Each side (long or short) of an ETD contract would be expressly specified as:
quantity in absolute terms
compositional quality and logistics in practical terms subject to uniform adjustments for variability within the parameters of novel Benchmark Complex Solutions (explained in more detail below)
future date and point of delivery
ETD Sellers must agree to physically deliver specified commodities owned and in their actual or constructive possession (note: the latter per a suitable warehouse receipts system) at the inception of each transaction. ETD platform operator would prohibit sales of non-existent “paper” assets or assets not in the possession of the Seller. Bottom line: short-selling by speculators interested in reversing ETD positions for cash profits prior to contract expiration would not be allowed.
In each case, physical possession or delivery of an ETD contract’s underlying commodity would be the prime intent of counterparties. While in certain circumstances, it may be permissible for one side or the other of a position to be reversed, no position can be cash-settled as of contract expiration unless required by the ETD platform operator for valid non-recurring institutional reasons.
Although all ETD contracts will specify the future date of delivery, all prices must be negotiated and executed on the spot (i.e., trade date). The objective of this practice is to remove uncertainty as much as practicable while enabling ETD platform users to employ prudent commodity price risk management by assessing the potential impact of both current and forward-looking factors prevailing as of the trade date.
ETD contract orders may be executed by the exchange as part of Islamic-financed transactions employing inter alia Murabaha, Musawama, or Salam whereby the bilateral interests of buyers and sellers are matched based on practical (rather than absolute) “coincidence of wants” – an unprecedented event in forward trading circles.
Payments associated with counterparties’ dealings over the ETD platform would flow through clearinghouse accounts structured similarly to those connected with earnest money maintained under Bai Urban contracts, rather than following standardized daily “margin account” practices mandated by conventional ETD platforms (e.g. IntercontinentalExchange, CME Group, etc.) -- construed by Islamic Scholars (unfavorably) as converting conventional ETD contracts into a sequence of one day forward contracts, which may create market uncertainty and otherwise impact prices in the market.
Benchmark Complex Solutions (BCS):
BCS employs novel (U.S. patent issued; others pending throughout the world) counterparty-friendly methods formulated to practically match ETD orders (offsetting bids and offers) for diverse-yet-similar tradable assets earmarked specifically for physical delivery/receipt, as opposed to restrictive conventional ETD arrangements that match solely on the basis of absolute opposite interests, which in today’s environment forces virtually all contracts to be cash-settled (viewed unfavorably by Islamic scholars). All orders are electronically posted contemporaneously over a centralized platform; thus, BCS can provide superior liquidity, transparency, and overall fairness in price discovery, compared to private over-the-counter platform solutions currently dominating global physically-traded markets.
Following is a recap of key attributes comprising Global e-Bourse Suites’® BCS:
Rather than arbitrarily specify one form of a denoted asset as the benchmark for all forms of that asset, each of our benchmark sets is linked to an exchange-specified plurality of qualifying asset forms.
Quantitative and qualitative properties unique to the plurality of denoted asset forms serve as the basis of a neutral weighted average (WA) benchmark mechanism formulated by the exchange for the entire set.
Traders owning or seeking to own similar-yet-discrete asset forms (each qualified as a component of the exchange-specified set) can offer or bid their respective asset form via standardized Exchange of Futures for Physical Delivery (EFP) contracts linked with an operative WA benchmark formulated by the exchange to cover the entire set of qualifying asset forms, thereby sufficiently satisfying all counterparties in a practical manner.
Each component in the WA benchmark’s plurality has quantitative properties as well as varying qualitative properties that customarily add to or detract from an asset’s intrinsic market value, the net effects of which are reconciled/balanced exchange-wide by proprietary algorithms integral to benchmark-specific sets and complementary differential indexes, each discretely configured for transparent trading in the open market and ultimately co-settled as of the operative EFP contract’s specified physical delivery date.
Complementary forward point differential index contracts are also offered to provide flexibility in dealing with practical aspects inherent to counterparties’ scheduling of physical delivery or receipt of an EFP contract’s underlying assets, the net effects of which are reconciled/balanced exchange-wide by proprietary algorithms integral to benchmark-specific sets, each discretely configured for transparent trading in the open market and ultimately co-settled as of the operative EFP contract’s specified physical delivery date.