In 2017, the United Kingdom Financial Conduct Authority (FCA)
announced that the London Interbank Offered Rate (LIBOR) will cease
to exist by the end of 2021. The scarcity of underlying
transactions based on LIBOR has made the benchmark rate potentially
inaccurate to reflect market conditions and unsustainable.
Therefore, all existing contracts benchmarked to LIBOR have to be
transitioned to an alternative benchmark rate before the end of
2021. Following this development, the global financial market has
agreed for Risk Free Rate (RFR) to be the alternative benchmark
rate for LIBOR as it is transaction-based and more reflective of
market conditions.
The above gave rise to three potential Shariah issues, namely:
i. Whether the use of the compounded setting in-arrears (CSIA) method to derive the term rate for profit component in sale-based (e.g. Murabahah / Tawarruq) and rental-based (e.g. Ijarah) transactions complies with Shariah requirements?
ii. Whether the use of the backward-looking methodology in sale-based and rental-based contracts trigger uncertainty (gharar) issue given that the periodic payment amount can only be determined on or near the payment date?
iii. Whether it is appropriate to invoke the deemed consent mechanism to signify customers' consent on the incorporation of fallback provision in the contract's terms and conditions in facilitating the transition to an alternative benchmark rate?
The Shariah Advisory Council of Bank Negara Malaysia (SAC) in
its 210th SAC meeting on 23 December
2020 ruled that the adoption of risk-free rate
(RFR) as an alternative benchmark rate to LIBOR or as a fallback
benchmark replacement rate after the permanent cessation of LIBOR
is permissible based on the following justifications:
1. The compounding methodology is merely a computational method to derive the term rate from overnight RFR which will be used in the profit component of Shariah-compliant transactions and this does not affect compliance of the transactions with Shariah requirements.
The compounding method for RFR also does not cause additional charges being imposed on the accrued profit, as commonly practised in the market for late payment incidences in conventional financial transactions.
2. Uncertainty (gharar) from the adoption of average RFR or backward-looking term rate at the point of payment is mitigated via proper determination and disclosure of the ceiling price and formula to derive the periodic payment amount to the customer at the inception of the contract.
For sale-based (Murabahah / Tawarruq) financial
instruments with variable rate, the selling price is concluded
based on the ceiling profit rate (CPR). Under this mechanism, the
ceiling profit rate and the formula to calculate the effective
profit rate (EPR) are made known to the contracting parties and
agreed upfront.Therefore, the issue of uncertainty does not arise
as it is mitigated by the existence and disclosure of the CPR and
formula to determine the EPR.
As for rental-based (ijarah) financial instruments with
variable rate, the formula to calculate the periodic rental payment
is made known to the contracting parties and agreed upfront.
Therefore, the issue of uncertainty does not arise as it is
mitigated by the existence and disclosure of the formula to
calculate the periodic rental payment.
3. In transitioning to the alternative RFR, the SAC has agreed to empower the respective financial institutions' Shariah Committee to determine the appropriateness of invoking the deemed consent mechanism to signify customers' consent on the incorporation of the fallback provision in the contract's terms and conditions.
This ruling by the SAC was published on Bank Negara Malaysia's website on 22 March 2021 and came into effect immediately upon such publication. The ruling applies to the following Islamic Financial Institutions:
a. licensed persons under the Islamic Financial Services Act 2013;
b. licensed banks and licensed investment banks approved under the Financial Services Act 2013 to carry on Islamic banking business; and
c. prescribed institutions approved under the Development Financial Institutions Act 2002 to carry on Islamic financial business.
Comments
The current use of LIBOR is in line with Shariah principles as it
a forward-looking rate, which enables the profit mark to be
calculated at the start of the contract. However, with RFRs, the
key challenge for Islamic financing transactions is their current
backward-looking nature, given the rates are overnight. Their
overnight nature means overnight rates must be compounded in
arrears over the actual period, thus in the case of financial
instruments with variable rates, the borrower will not know for
certain the profit payment amount until shortly before the end of
the period. However, with the provision of formulas to calculate
EPRs (for Murabahah / Tawarruq) and periodic rental
payments (for Ijarah), it circumvents the issue of
uncertainty and ensures that there is no impact on the
Shariah-compliance of these transactions.
Whiles the issue of compliance may have been addressed, it is to
be noted that LIBOR is widely used as a benchmark to determine the
profit rates for Shariah-compliant derivatives (tahawwut)
such as profit rate swaps and currency forward contracts and its
discontinuance may potentially lead to significant changes in the
pricing and valuation of these products.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.