One of the biggest challenges facing Shariah compliant asset managers in today’s wealth management industry is not being allowed to sell short. In this article, Najla Al Shirawi takes a look at some Shariah compliant contracts and the practical implications in using them to replicate a conventional short sale.
Short-selling is the process of generating positive returns when the underlying value of the stock falls. The concept is that one person will generally borrow the shares from another, sell them in the market and then buy them back at a favourable price, concluding the process by returning the shares to the original owner. The borrower will thus only gain if the price of the asset decreases. The aim is also to provide investors with a less volatile portfolio through the negatively-correlated returns expected from shorting. It has, therefore, become a crucial conventional instrument in the west, with the aim of enhancing the efficiency and overall integrity of stock markets.
In Shariah law, however, one of the fundamental conditions is that sellers must be in possession of an asset before they sell it. The short-selling transaction is therefore in conflict with one of the precepts of the Quran: “Do not sell what you do not possess.” The concept is essential, since the purpose of the sale contract is to transfer ownership of the asset to the buyer, and the ownership of money to the seller. Any other condition under the sale contract would be considered invalid under Shariah law.
In essence, therefore, a short sale would be prohibited as the sellers do not have ownership of the shares that they want to sell. Nevertheless, this has not stopped scholars and intellectuals continuing to seek Shariah compliant short-selling alternatives.
Early efforts of Islamic markets to find a Shariah compliant alternative to conventional short-selling can be traced back to Malaysia in the 1990s, with attempts to replicate this instrument through an Ijarah-based contract. The underlying mechanics of such a structure meant that instead of borrowing the assets to sell short, they would be leased from the other party. In this scenario, the short-seller pays rental payments to the owner of the stock for the privilege of using the shares. The process ends with the short-seller returning the shares back to the original owner at the end of the lease term.
However, as discussed earlier, the Ijarah-based short sale could be controversial, since the short-seller is only leasing the shares and does not have complete ownership of them. Therefore, although the Ijarah contract provided an easy alternative to short-selling, Malaysia’s central bank, Bank Negara Malaysia, announced in 2009 that it did not accept the shares of companies to be the subject of an Ijarah contract. It would be worth investigating whether this is possible in other jurisdictions.
Another way that could be used to gain the benefits of a short sale, without actually borrowing or lending any shares, is a Salam contract. In this instance, Salam refers to a forward sale in which the amount is fully paid upfront, but with delivery taking place at a specified time in the future. The agreement was originally intended to finance certain assets such as agriculture where initial capital was needed to farm the crops, which would then be supplied to the buyer after harvesting.
The concept could be applied to replicate a conventional short sale by selling shares through a forward sale with the intention of delivering the shares at a future date. However, a major obstacle is that AAOIFI does not recognise shares as part of a Salam contract. There is also a lack of an Islamic standard but nevertheless, whether this extends to hedge funds or discretionary portfolios is still up for debate since some hedge funds currently employ this structure.
An alternative approach to replicating a short sale is through the use of a Waad-based structure, also known as a unilateral promise. In this case, both parties enter into a Waad agreement which does not involve any lending or borrowing, with the seller selling stocks to the agent and promising to buy them back after a certain period. At the same time, the agent will sell the stocks to the short-seller, who will then promise to sell them back to the agent after the same period. The Waad agreement becomes useful as the parties involved promise to engage in the transactions.
However, a possible weakness in this structure is that disagreement exists about whether a Waad can be binding. The short-seller may therefore just abandon his/her promise, especially if the price of the stock increases. This suggests that the only way a
Waad would work in a short-sale environment, would be to make it a Waad Mulzim, in other words, a binding unilateral promise. Nevertheless, the risk can be mitigated through the broker agency – which acts as the middleman and has access to a pool of stocks — and would therefore have the ability to sell back to the original owner if the seller did meet his/her promise to buy back the stocks. The promises can also be structured with a wraparound collateral agreement in a situation where one party fails to deliver.
Another type of instrument that has the potential to replicate conventional short-selling is an Arbun-based structure, which in its fundamental form can be compared to a conventional downpayment. In an Arbun agreement, the seller takes a deposit from the buyer with the understanding that the deposit forms part of the price if the asset is sold; however, it is not to be returned if the sale is not executed. The process starts with an investor purchasing the stocks from a broker, based on an Arbun agreement. The short-seller pays a deposit to the broker in exchange for the shares. The call margin for the broker is also satisfied since the deposit aims to imitate this.
As it is an Arbun contract, the short-seller assumes ownership of the shares, and is now allowed to sell them in the market through his/her broker. The activity nevertheless goes against historical norms where the buyer of the Arbun intends to buy and keep the asset. However, the short-seller knows from the start that there is a large probability that he/she will return the shares back to the broker, thus going against what the original Arbun agreement was designed for.
Bringing theory to practice is not always easy, and implementing the aforementioned points would require considering the practical implications. It would take considerable effort to bring together the Shariah principles with the precepts of conventional markets, requiring new documentation, systems and regulations, and a viable platform which removes uncertainty and guarantees delivery.
However, GCC authorities have been reluctant to authorise shorting and associated derivative products for a variety of reasons, but mostly because of a fear that they contribute to stock price declines. The thinking is that they would be harmful to, and negatively viewed by, local individual investors who are unlikely to employ short-selling as a tactic. Apart from Shariah restrictions, the low liquidity and limited depth and breadth of regional markets have often been cited as reasons why the practice would be inappropriate.
Nevertheless, the structures discussed previously can still be implemented on an over-the- counter basis to serve the needs of those that require them. For example, it is well known that the GCC region is highly correlated to oil prices. It would therefore be useful to have contracts or agreements in place to protect portfolios and banks from a plunge in prices, especially as witnessed during 2015 and the earlier part of this year. In such an instance, two unilateral promises backed with a Murabahah could be used to establish a short forward position on oil. Here, the Murabahah can be used to purchase oil from a commodity dealer and then sell it to another third party, who would enter into a unilateral promise through a Waad agreement with the provider of the Murabahah to sell them oil at a future date for an agreed price.
Simultaneously, the same provider promises to buy oil from the third party at the same price. Finally, on the exchange date, the third party can buy oil from a dealer in order to deliver its promise, and make a profit if the price is lower in the secondary market. Islamic asset managers can also use similar techniques to take advantage of a drop in equity prices.
It is well-researched that shorting strategies can add alpha to a portfolio. An Islamic fund could implement such a strategy through a Salam structure, whereby it sells a stock for a price paid upfront for the stock to be delivered at a later date. However, it soon becomes obvious that such structures face a lot of counterparty, incentive and regulatory risks, and require transparency, integrity and simplicity for them to work.
With the UAE and Qatar being upgraded to emerging market status by the index provider MSCI, and Saudi Arabia opening up further to foreign investors, the region’s markets are now attracting a more sophisticated and global investor base. These investors are likely to be frustrated in the long term if they do not have access to tools which enhance price discovery and support risk management, such tools being common in other markets.
The Capital Market Authority, the Kingdom’s market regulator, has announced plans to implement new regulations by the first half of 2017, which include allowing securities lending and covered short-selling, a first for GCC markets.
The ambition to succeed on this front is therefore still a live topic, and an extremely important and interesting one to follow. We believe in future that the aforementioned subject matter will be very interesting to the asset management industry, as it could evolve managers from being long-only players to offering long-short strategies. This would create an opportunity to widen the array of products on offer, and provide tools to capture returns on the downside and reduce volatility of portfolios.
Najla Al Shirawi is CEO of Securities & Investment Company. SICO provides a select range of investment banking solutions covering brokerage, market making, treasury, equity and fixed income asset management, corporate finance, custody and administration, and research.
This article first appeared in Islamic Finance News (7 September 2016, Volume 13, Issue 36, Page 20-21). For more information, please visit www.islamicfinancenews.com.