The Shariah Dynamics of Total Return Swap

A credit derivative is a privately negotiated contract, the value of which is derived from the credit risk of a bond, a bank loan, or some other credit instrument. Market participants can use credit derivatives to separate default risk from other forms of risk, such as currency risk or interest rate risk. The value of a credit derivative is linked to the change in credit quality of some underlying fixed-income security, usually a bond, a note, or a bank loan. Credit derivatives include total return swaps (TRS). Although this is a less common type of credit derivative, it is an important off-balance sheet tool, particularly for hedge funds and for banks seeking additional fee income.

What is a Total Return Swap?

A Total Return Swap is a financial derivative which requires one party to make set rate payments in order to receive payments based on the performance of a certain asset, index, bond etc. The reference assets can be indices, bonds (emerging market, sovereign, bank debt, mortgage-backed securities, corporate), loans (term or revolver), equities, real estate receivables, lease receivables, or commodities.

Essentially, it allows an investor to gain exposure to a class of asset without having to own the asset, merely paying someone else a fixed rate to hold the asset. The objective of a TRS is to transfer the total economic exposure (market and credit risk) of the reference asset without having to purchase or sell it. A TRS allows an investor to enjoy all of the cash flow benefits of a security without actually owning the security. The investor receives the total rate of return.

How does it work?

In order to purchase the reference asset, the TRP must borrow capital. The dealer will raise cash from the capital market at a funding cost (usually linked to the inter-bank offered rate) and this cash will flow right out again to purchase the reference asset. The asset provides both interest income and capital gains or losses, depending on its price fluctuations. A TRS has two payment legs between the payer (TRP) and receiver (TRR); the reference asset or a basket of assets exists on the “total return leg” and the interest payment, linked to the inter-bank offered rate, exists on the “funding leg”. The cash flow payment stream exists on the funding leg. The Return Leg is generally made up of two components: cash flows and capital appreciation of the reference asset(s). The Funding Leg also has two components: floating coupons based on LIBOR +/- a spread and payments to offset any capital depreciation of the reference asset(s). On the “total return leg”, the payer has a long position in the reference asset, holding it on its balance sheet, so it buys protection on the asset and agrees to pay the receiver all the future returns of the reference asset plus any appreciation in its value. In exchange, on the “funding leg”, the receiver seeks exposure to the returns of the reference asset or basket of assets, but does not want to acquire or hold in its balance sheet. The receiver will sell protection on the reference asset by taking a synthetic long position in the asset, agreeing to make regular floating cash flow payments to the payer (inter-bank offered rate +/- a spread) including any depreciation in the value of the asset and compensation for any default losses.

Some of the users of a TRS state that the advantages of a TRS include leverage, operational efficiency and are flexible. Disadvantages include investment return risk and counterparty risk.

Shariah Non-Compliant Issues

The paper identifies multiple Shariah non-compliant issues in TRS including Riba, Qimar like activity, separating risk and reward, Gharar and the trading of an impermissible subject matter. TRS have an element of Riba in the contracts. A Total Return Swap exchanges two streams of cash flows. A total return leg that pays cash flows corresponding to the total return on the period of a specified asset (including any capital appreciation/depreciation and interest/coupon payments). Gambling refers to a contract in which payment and staking of wealth from one of the parties to the contract is definite whereas the liability/payment of the other party to the contract is indefinite and contingent upon chance. One party will definitely win at the expense of another’s loss.

Another element in TRS which makes it impermissible from the Shariah perspective is the aspect of Gharar or uncertainty. Gharar or uncertainty in commercial transactions has been prohibited by the Shariah and thus commercial transactions, in which an essential element of the transaction remains uncertain and could thus be the cause of dispute in the future, are rendered impermissible transactions by the Shariah. In a TRS as a return from the underlying asset is uncertain. Likewise, the quantum and amount is uncertain and not fixed.

Risk is not a tradable commodity or an act in itself contributing to the value of output. Thus, the Prophet clearly prohibited trading and exchanging risk. In prohibiting Gharar, the Shariah has also prohibited the trading of risks, and thereby, prohibiting derivative instruments designed to transfer risk from one party to another. Therefore, a TRS is non-compliant as it entails the transfer of economic exposure and risk in lieu of cash flow.

Shariah Alternative to TRS

Under Shariah, a similar economic profile can be generated by using a double wa’ad structure. Under this structure, an SPV issuer issues certificates to investors in return for the issue price. The Issuer then uses the issue price to acquire a pool of Shariah-compliant assets from the market. These Shariah-compliant assets could, for example, be shares listed on the Dow Jones Islamic Market Indexes (DJIMI). The investors gain exposure to an underlying index or assets based on two mutually exclusive Wa’ad between the Issuer and the Bank. Under one Wa’ad, the Issuer promises to sell the Shariah-compliant assets to the Bank at a particular price, while under the other wa’ad, the Bank promises to buy the Shariah-compliant Assets from the Issuer at the Wa’ad Sale Price (step 6). Out of these two Wa’ads, only one shall ever be enforced.