Sharia strictly prohibits any form of speculating or gambling, which is called 'maisir'. As a result, Islamic financial institutions cannot be involved in contracts where the transactions depend on uncertain events in the future. The rules of Islamic finance also ban participation in contracts with excessive risk or uncertainty. This is to say, that the rules of Islamic finance endorse contracts with near complete certainty on day-one. This is a challenge as backward looking rates mean overnight rates are compounded in arrears, so the borrower does not know with certainty what profit payment is to be paid until shortly before the end of that period. This lack of visibility leads to uncertainty on the terms of the financial product, which violate the Sharia principle of 'gharar' (uncertainty).
More specifically, backward-looking risk free rates are not workable in every Islamic finance contract. In Islamic debt and rental contracts such as Murabaha and Ijarah, the profit amount and/or rental needs to be fixed and agreed in absolute terms at the inception of the contract, and the volatility in the profit or rental rate invokes 'gharar' (uncertainty). Therefore, even if the parties agree to incorporate a differential in the contract (i.e. the anticipated profit or rental rate against the actual profit or rental rate). This may also have Sharia complications due to the presence of an intention to vary rates at the inception stage.
US dollar transactions are fairly common in Islamic finance. There is widespread misconception that the key tenors of US dollar LIBOR will continue until the end of June 2023. However, it is been stated that the 1-week and 2-month LIBOR rate will cease to be published from 31 December 2021; whereas, the 1, 3 and 6 month LIBOR may continue till June 2023. A number of Islamic finance transactions are based on 1, 3 and 6-month profit/rent period payment so there is some time available for a significant portion of the market to adapt. That being said, it is also worth noting that regulators around the world expect new financings to not be based on US dollar LIBOR after 2021. Due to this, it is imperative that banks and financial institutions familiarise themselves with the intricacies of using the increasingly popular compounded SOFR rates and how these rates work with Islamic finance transactions.
In the case of Murabaha transactions, the two popular methods are referred to as the 'Dual Murabaha Approach' and the 'Ceiling Murabaha Approach'. Under the Dual Murabaha Approach, the margin for the term of the financing is calculated at the inception and amortised across the interest period by the execution of a long-term Murabaha contract. In addition, a series of short-term Murabaha contracts are also executed to recover the variable benchmark rate. However, this becomes complicated in instances where the borrower makes a prepayment.
Alternatively, in the case of the 'Ceiling Murabaha Approach', parties enter into a single Murabaha contract based on a rate higher than the anticipated benchmark rate using compounded SOFR for the full term. Therefore, to adjust for the variable interest rates or prepayments, both: (i) the bank is required to execute an undertaking in favour of the borrower to enter into a spot Murabaha contract for the rebate of the excess profit amount (than the compounded SOFR over term); and (ii) the borrower is required to execute an undertaking in favour of the bank to enter into a spot Murabaha contract for the additional profit amount (in case the ceiling rate is less than the compounded SOFR rate).
In the case of Ijarah transactions, the two popular methods are referred to as the 'Sub-Period Ijara Approach' and the 'Daily Rental Ijara Approach'. Under the Sub-Period Ijara Approach, the lease period is split into two parts whereby the first profit payment period is usually the "x minus five days" (whereby x is equal to the complete profit payment period), for which a notional rate is adapted; and for the remaining five days, the rate is calculated by taking the actual compounded SOFR rate for the full profit payment period and adjusted for the notional profit calculated on the notional benchmark rate.
Under the Daily Rental Ijara Approach, a daily rental amount is calculated based on a daily rental rate. While this seems relatively straightforward, this imposes a daily administrative hassle on the parties for running daily calculations.
Despite the various calculation methodologies discussed above, Islamic banks and financiers continue to work together with Sharia scholars to consider other alternatives. While alternatives to LIBOR may not necessarily be complicated for conventional modes of financing, they remain tricky for Islamic modes of financing. It remains to be seen whether Islamic banks and financial institutions adopt backward looking compounded SOFR rates or adopt to a more traditional backward looking rate in the future.
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To find out more about LIBOR, please read our additional resources:
- Countdown to LIBOR: FAQs
- LIBOR: The introduction of forward-looking SOFR
- Greenwashing: The LIBOR and ESG correlation
- The transition away from LIBOR: A project management toolkit
- Implications of LIBOR cessation for legacy LMA-based loan documentation