After 24 drafts and a consultation process lasting three-and-a-half years, the International Swaps and Derivatives Association and the International Islamic Financial Market (IIFM) finally unveiled the sharia-compliant tahawwut (hedging) master agreement for Islamic derivatives on March 1.
The document is based on the 2002 Isda master agreement, but has been adapted to meet the strict demands of Islamic law. For example, it excludes default interest and explicitly states trades must only be entered into for hedging purposes rather than speculation.
The protracted negotiations to draw up the agreement looked to be moving forward in September 2006, when Isda and the IIFM signed a memorandum of understanding and committed to convene regular meetings of a joint working group. But discussions between those drafting the document, sharia scholars and market participants delayed publication.
"A major component of the initiative was working with the sharia panel, which includes many different perspectives from the sharia scholar community, to ensure we addressed their concerns in the drafting and structure of the document. That was a very iterative process that took a lot of time on top of the process we always go through of building consensus among our membership," says Bob Pickel, executive vice-chairman of Isda in New York.
One of the reasons for the lengthy consultation process was the decision to design the master agreement for murabaha transactions - a contract for the sale of goods at a price plus an agreed profit margin. According to Pickel, this decision was taken fairly late in the negotiation process to ensure it would get the widest possible support, which added to the time taken to finalise the agreement.
A major component of the initiative was working with the sharia panel, which includes many different perspectives from the sharia scholar community, to ensure we addressed their concerns in the drafting and structure of the document.
Another thorny issue discussed at length was treatment of close-out netting. In a standard master agreement, close-out netting allows parties to aggregate their exposures and reduce them down to a single payment following a default or other termination event. In an Islamic context, that is more difficult because it needs to fit with the murabaha structure (Risk August 2009, pages 64-65).
The final solution was to split the calculation of the amounts payable on close-out to meet the demands of sharia. There is now one calculation for concluded transactions and another for non-concluded transactions, rather than a single net calculation. The document allows the early termination amount due in respect of concluded transactions to be set off against the amounts due in respect of non-concluded transactions. As part of the mechanism to determine the mark-to-market value of non-concluded transactions, the in-the-money party has the right to require the other party to purchase assets from it at a price equal to their market value plus the mark-to-market value of the non-concluded transactions that have been terminated, according to Allen & Overy.
As Risk went to press, market participants were still digesting the details of the agreement, but the mechanics of close-out netting remained a major concern. "The close-out netting arrangement is the biggest issue for us and proposals in previous versions of the document haven't been workable, because they relied on the entry into a new transaction when there was a default. There are various scenarios in which one could question the enforceability of binding an insolvent party into entering into another commercial transaction," says Hussein Hassan, head of Middle East structuring at Deutsche Bank in Dubai.
Pickel says the close-out netting mechanism in the final document can only be enforced on counterparties in jurisdictions where it is enshrined in national insolvency law. In many Islamic countries, significant changes would need to be made to the law to give legal recognition to the enforceability of close-out netting, he says.