Capital Markets Law Journal 2011 Arakcheev 238 52

Islamic money management: a western viewAlexey Arakcheev, Viktoria Baklanova and Joseph Tanega*

1. Introduction

This article provides an overview of Islamic investment principles with an analysis of

three types of liquidity vehicles offered to Shariah-compliant investors. As a point of

departure, the analysis takes as a given the risk management perspective found in the

current practices of conventional money management. This includes the identification

and management of a totality of risks per return in terms of discrete risk categories,

including credit risk, interest rate risk, market risk, liquidity risk, operational risk and

legal risk. These conventional risk categories shall be used as a basis for comparing and

contrasting Islamic liquidity management schemes, including so-called Shariah-compli-

ant money market funds.

In order to show Islamic liquidity management schemes in sharp relief, we first define

the socially responsible investments principles with a special focus on restrictions

imposed by Islamic finance (IF) in Section 2 below. In Section 3, we present a logical

Key points

� This article provides a synoptic analysis of Islamic investment principles within the framework of

socially responsible investing with a focus on the risk attributes in the practice of liquidity

management.

� Three types of collective investment schemes offered to Shariah-compliant investors are examined:

Islamic liquidity funds established under commodity Murabahah, Wakala and Sukuk agreements.

� One of the main results of our analysis is that the Shariah-imposed restrictions reduce the universe of

investable securities and, consequently, give rise to additional risks due to operational complexity and

lack of transparency.

� Furthermore, investment screenings and third-party involvements add to the management cost,

resulting in Islamic liquidity funds being placed in a relatively disadvantaged competitive position in

terms of risk and reward characteristics, which, in turn, make them less attractive to investors.

� In brief, Islamic liquidity management vehicles, including Islamic money market funds would carry

either a higher risk for similar returns or lower returns for a similar level of risks in comparison to

non-Islamic money market funds.

� This conclusion shows the challenges in creating investment products of genuine low risk for a broad

consumerist market.

*Alexey Arakcheev, MCMI, ASIL is a PhD Candidate at the University of Westminster, School of Law. Viktoria Baklanova, CFA,

PRM is a PhD Candidate at the University of Westminster, School of Law. Viktoria Baklanova is currently employed as an analyst

by Fitch Ratings. The views and opinions expressed in this article are those of Ms Baklanova and are not intended to, and do not

represent, the opinions, views or policies of Fitch Ratings or the Fitch Group. Joseph Tanega is a Reader for International Financial

Law at the University of Westminster Law School, and Professor of Regulation & Supervision of Retail Banking at the University of

Bologna, Alma Graduate School.

238 Capital Markets Law Journal, Vol. 6, No. 2

� The Author (2011). Published by Oxford University Press. All rights reserved. For Permissions, please email: [email protected]

doi:10.1093/cmlj/kmq032 Accepted 15 July 2010

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analysis of several liquidity investments schemes organized to meet the IF restrictions,

their major risks and how they may not be entirely manageable or controllable. A

summary of these risks and their relative ranking is offered in Appendix 1. In Section 4,

we pull together the distant threads and theorize how these various categories of risk may

be thought of as Shariah non-compliance risk.

2. Principles of socially responsible investments

Socially responsible investing (SRI) is a concept that integrates ethical values, societal

concern and, sometimes, religious beliefs with investment decisions. The origins of SRI

may date back to the religious Society of Friends (Quakers), when, in 1758, the Quaker

Philadelphia Yearly Meeting prohibited members from participating in the slave trade.1

Currently, increasing demand for SRI is coming from socially active and

religious-affiliated groups, pension fund sponsors, international and supra-national

organizations and individual investors. To meet this demand, more money managers

globally offer investment services with specific SRI mandates. In this article, we focus on

short-term investment vehicles, including money market funds, developed in response to

requirements imposed by principles of Islamic investments.

Principles of Islamic investments

The fundamental principles in Islamic finance ‘have remained unchanged since their

initial development over 1,400 years ago’.2 Also, as the Islamic Investment and Finance

Board of India (IIFB) notes, the ‘Islamic concepts of money and capital, the relationship

between risk and profit, the social responsibilities of financial institutions, etc.’,3 are

explained in detail by Shariah, the Islamic law.4 The Islamic law is derived from two

primary sources—the Holy Qur’an and the Sunnah—and two secondary sources, the Ijma

(consensus of opinion) and the Qiyas (judgment upon juristic analogy).5 Furthermore,

Islam by means of Shariah ‘contains guidance in every sphere of life including [the]

socio-economic fields’.6 Does it mean that Islamic investment as an inalienable part of

Islamic finance is based on a specific philosophy? Undoubtedly, yes. However, how can

we identify this philosophy?

It is generally acknowledged that Islamic economics is based on prohibitions and

encouragements. According to the norms and ethics in the Islamic framework,7 there are

1 5http://www.reference.com/browse/Socialþinvesting4 accessed 4 May 2010.

2 See IFSL Research. Islamic Finance 2010, 7.

3 5http://iifbindia.org/Knowledge%20Centre.html4 accessed 4 May 2010.

4 At the same time, ‘[t]he English term ‘‘Islamic law’’ is ambiguous, translating two Arabic terms, Shariah (the divine law) and

Fiqh (human comprehensions of that law).’ See Frank E Vogel and S Hayes, Islamic Law and Finance: Religion, Risk, and Return

(Arab & Islamic Laws, Brill 2006) 32. Normally, Western scholars when referring to Islamic law mean the Fiqh and not the Shariah.

However, in this article we must be more precise and will mainly use the Shariah as the principal source of law.

5 KM Khan, ‘Juristic Classification of Islamic Law’ (1983) 6 HJIL 23.

6 MT Usmani, ‘An Introduction to Islamic Finance’, Maktaba Ma’ariful Qur’an (Karachi, Pakistan 2007) 16.

7 M Ayub Understanding Islamic Finance (John Wiley & Sons, Ltd 2008) 43.

Alexey Arakcheev, Viktoria Baklanova and Joseph Tanega � Western view of Islamic money management 239

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four basic elements prohibited in Islamic finance and business: Riba8 (interest in

conventional terminology), Gharar9 (ambiguity), Maisir10 and Qimar11 (gambling) and

Haram12 (forbidden goods and immoral activities). Another important element and one

of the Five Pillars of Islam13 is Zakat, the religious tax, to be deducted from wealth, to be

paid to the needy.14 This is ‘a built-in mechanism in Islam for ensuring the redistribution

of wealth and the protection of a fair standard of living for the poor.’15

8 Ibid at 493:

Riba—Literally, an excess or increase. Technically, it means an increase over the principal in a loan transaction, over a debt or

in exchange transactions, accrued to the lender/creditor or a party to exchange without giving an equivalent counter value or

recompense (‘Iwad’) in return to the other party. Riba, meaning prohibited gain, has been explained in the Holy Qur’an by

juxtaposing it against (profit from) sale. It explains that all income and earnings, salaries and wages, remuneration and

profits, usury and interest, rent and hire, etc. can be categorized either as:

� profit from trade and business along with its liability—which is permitted; or

� return on cash or a converted form of cash without bearing liability in terms of the result of deployed cash or capital—which is

prohibited. (47)

9 See M Ayub (n 7) at 488:

Gharar—Literally, uncertainty, hazard, risk relating to major elements of a contract; technically, sale of a thing which is not

present at hand, or the sale of a thing whose consequence or outcome is not known, or a sale in which one does not know

whether it will come to be or not, such as fish in water or a bird in the air. It refers to an element of absolute or excessive

uncertainty in any business or a contract about the subject of contract or its price, or mere speculative risk. It leads to undue

loss to a party and unjustified enrichment of another, which is prohibited. Gambling is a form of Gharar because the gambler

is ignorant of the result of the gamble. Selling goods without allowing the buyer to properly examine the goods is also a kind

of Gharar. Some examples of Gharar are: selling goods that the seller is unable to deliver; selling known or unknown goods

against an unknown price, such as selling the contents of a sealed box without exact information about its contents; selling

goods without proper description; selling goods without specifying the price, such as selling at the ‘going price’.


Maisir—An ancient Arabian game of chance played with arrows without heads and feathering, for stakes of slaughtered and

quartered camels. It refers to all types of hazard and gambling—acquisition of wealth by chance/easily (without paying an

equivalent compensation (‘Iwad’) for it or without working for it, or without undertaking any liability against it).


Qimar—Games of chance—gambling. Technically, it is an arrangement in which possession of a property is contingent upon

the happening of an uncertain event. By implication, this applies to a situation in which there is a loss for one party and a

gain for the other without specifying which party will lose and which will gain.


Haram—Anything prohibited by the Shariah, e.g. forbidden goods, such as pork, pornography and alcoholic beverages.

13 See BBC5http://www.bbc.co.uk/religion/religions/islam/practices/fivepillars.shtml4 accessed 4 May 2010: The Five Pillars of

Islam are the five obligations that every Muslim must satisfy in order to live a good and responsible life according to Islam. The Five

Pillars consist of:

� Shahadah: sincerely reciting the Muslim profession of faith

� Salat: performing ritual prayers in the proper way five times each day

� Zakat: paying an alms (or charity) tax to benefit the poor and the needy

� Sawm: fasting during the month of Ramadan

� Hajj: pilgrimage to Mecca

14 D El-Hawary, W Grais and Z Iqbal, Regulating Islamic Financial Institutions: The Nature of the Regulated. The World Bank

Policy Research Working Paper Series 3227, 2004, 45.

15 A Samad, ‘Performance of Interest-Free Islamic Banks vis-a-vis Interest-Based Conventional Banks of Bahrain’ (2004) 12 (2)

IIUM Journal of Economics and Management 118.

240 Capital Markets Law Journal, 2011, Vol. 6, No. 2

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As Siddiqui (2001) notes, those prohibitions were intended to protect the Islamic

‘economic system, which aims at securing extensive socio-economic justice’16 and,

originally, were not based on economic theory but on the Divine Authority. However, in

essence, the Shariah can be seen as a natural law with its general ethical principles ‘to do

good, avoid evil, cooperate with others in good works’17 directly corresponding with the

first precept of [natural] law enunciated by St Thomas Aquinas: ‘good is to be done and

pursued, and evil is to be avoided’.18 Interestingly, one of the most renowned Islamic

philosophers and scientists, Avicenna (Ibn Sına)19 had highly influenced St Thomas’

thought. Avicenna, in turn, was a follower of the ancient Greek philosophers (Aristotle

and Plato20) and tried to reconcile their writings with the teachings of the Qur’an.21

Meanwhile, as Pelligrino (2001) impartially suggests, the doctrine ‘Do good and avoid

evil is the primum principium of all ethics’,22 and ethics ‘is indeed a practical

philosophy . . . (the philosophy of action and conduct)’.23

It is not widely known, but prohibition of interest and usury initially existed in all

major religions such as Judaism,24 Christianity25 and Hinduism26. As summarized in

Tradition: A Journal of Orthodox Jewish Thought,27 the Pentateuch28 (The five books of

Moses), clearly prohibits one Jew from charging another Jew interest.

16 SH Siddiqui ‘Islamic Banking: True Modes of Financing’ (2001) 109 New Horizon, May–June 1.

17 5http://www.islamicvoice.com/november.98/features.htm4accessed 4 May 2010; The Holy Qur’an says: ‘Let there arise from

among you a band of people who invite to righteousness, and enjoin good and forbid evil’ (3:104).

18 Fathers of the English Dominican Province (trs), St Thomas Aquinas, The Summa Theologica (1947). Q[94],A[2]. Available

online from5http://www.sacred-texts.com/chr/aquinas/summa/index.htm4 accessed 4 May 2010.

19 Avicenna or Abu ’Alı al-Husayn ibn ’Abd Allah ibn Sına in Arabic (980–1037). According to the Encyclopaedia Britannica, ‘He

was particularly noted for his contributions in the fields of Aristotelian philosophy and medicine. He composed the Kitab al-shifa 8(Book of the Cure), a vast philosophical and scientific encyclopaedia, and Al-Qanun fi al-Tibb (The Canon of Medicine), which is

among the most famous books in the history of medicine.’ See5http://www.britannica.com/EBchecked/topic/45755/Avicenna4.

For more detailed explanation, also see5http://muslimheritage.com/features/default.cfm?ArticleID¼4734 accessed 4 May 2010.

20 Far more Aristotelian than Platonic, actually.

21 See JL Esposito (ed), The Islamic World. Past and Present (Oxford University Press 2004) vol 2 13.

22 ED Pellegrino, ‘The Internal Morality of Clinical Medicine: A Paradigm for the Ethics of the Helping and Healing Professions’

(2001) 26 (6) Journal of Medicine and Philosophy 559–79; Cited from R Colgan, Advice to the Young Physician: On the Art of

Medicine (1st edn Springer 2009) 68.

23 PG Horrigan, Introduction to Philosophy (2002). Available online from 5www.paulhorrigan.0catch.com4 accessed 19 May

2010.

24 Judaism is one of the oldest monotheistic religions and was founded over 3500 years ago in the Middle East. According to

information published by The Jewish People Policy Planning Institute, there were around 13.1 million Jewish people in the world in

2007, most residing in the USA and Israel. According to the 2001 census, 267,000 people in the UK said that their religious identity

was Jewish, about 0.5 per cent of the population. For more detailed information see BBC5http://www.bbc.co.uk/religion/religions/

judaism/4 accessed 19 May 2010.

25 Christianity is the world’s biggest religion, with about 2.1 billion followers worldwide. It is based on the teachings of Jesus

Christ who lived in the Holy Land 2,000 years ago. For more detailed information see BBC 5http://www.bbc.co.uk/religion/

religions/christianity/4 accessed 19 May 2010.

26 Hinduism is the religion of the majority of people in India and Nepal. It also exists among significant populations outside of

the sub-continent and has over 900 million adherents worldwide. Unlike most other religions, Hinduism has no single founder, no

single scripture and no commonly agreed set of teachings. In some ways, Hinduism is the oldest living religion in the world, or at

least elements within it stretch back many thousands of years. For more detailed information see BBC 5http://www.bbc.co.uk/

religion/religions/hinduism/4 accessed 19 May 2010.

27 A Journal of Orthodox Jewish Thought is a publication of the Rabbinical Council of America.

28 The word is a Greek adaptation of the Hebrew expression ‘Aamishshah Aumshe ha-Torah’ (five-fifths of the Law) applied to

the books Genesis, Exodus, Leviticus, Numbers and Deuteronomy, and indicating that these five books were to be taken as a whole.

For more information see5http://www.jewishencyclopedia.com/view.jsp?artid¼176&letter¼P4 accessed 10 May 2010.


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This prohibition is explicitly stated in three of the five books. In Exodus, we read: ‘If thou lend money to

any of my people . . . neither shall ye lay upon him interest.’ This is repeated and slightly amplified in

Leviticus: 2 ‘Take no interest of him or increase . . . Thou shalt not give him money upon interest, nor

give him thy victuals for increase.’ And in Deuteronomy, 3 the prohibition against charging interest is

widened and-made all inclusive: ‘Thou shalt not lend upon interest to thy brother, interest of money,

interest of victuals, interest of anything that is lent upon interest.’29

Several Old Testament30 passages forbid the taking of interest:

Deuteronomy 23:19–20: ‘You shall not charge interest on loans to another Israelite, interest on money,

interest on provisions, interest on anything that is lent. On loans to a foreigner you may charge interest,

but on loans to another Israelite you may not charge interest . . . .’

Exodus 22:25: If you lend money to my people, to the poor among you, you shall not deal with them as a

creditor; you shall not exact interest from them.

Also, in the non-canonical Gospel of Thomas31 (V95), [Jesus said], ‘If you have money, do

not lend it at interest, but give [it] to one from whom you will not get it back.’32

Furthermore, as the Institute of Islamic Banking and Insurance (IIBI) notes, ‘[e]ven

the renowned Greek philosopher, Aristotle, condemned acquiring of wealth by the

practice of charging interest on money’:33

Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is

a yield arising out of money itself, not a product of that for which money was provided. Money was

intended to be a means of exchange; interest represents an increase in the money itself. Hence of all ways

of getting wealth, this is the most contrary to nature.34

However, as Fahey (1996) states:

. . . prohibitions of interest slowly but inexorably were cast aside under the pressure exerted by economic

reality and changing theology, and the word usury itself, once applied to all interest, came to be

associated only with interest levels that were clearly excessive and exploitative.35

But what makes the Islamic philosophy different from the underlying principles of the

other religions? The answer is simple and obvious—it is in its everyday practical imple-

mentation. Islam is a relatively young religion36 and, thus, having sufficient fidelity to keep

the basic principles alive. As Presley and Sessions (1994) state, ‘[I]n this respect Islam is

not only a divine service, like Judaism and Christianity, but also involves a code of conduct

which regulates and organises mankind in both spiritual and material life.’37

29 5http://www.traditiononline.org/news/article.cfm?id¼1040824 accessed 10 May 2010.

30 All biblical quotes are as translated in The New Oxford Annotated Bible. Other Old Testament passages dealing with the subject

of interest are Leviticus 25:35–37, Psalms 15:5 and Ezekiel 18:13.

31 Part of the collection of [Coptic] texts discovered in Nag Hammadi in Egypt at the end of 1945, the Gospel of Thomas has a

strong claim to be as old as the gospels in the New Testament5http://www.bardic-press.com/thomas/thomindex.htm4accessed 19

May 2010. The Gospel of Thomas is a collection of traditional Sayings (logoi) of Jesus. See 5http://www.sacred-texts.com/chr/

thomas.htm4 accessed 19 May 2010.

32 Cited from BD Ehrman Lost Scriptures: Books that did not Make it into the New Testament (Oxford University Press 2003) 27.

33 5http://www.islamic-banking.com/prohibition_of_interest.aspx4 accessed 10 May 2010.

34 TA Sinclair (trs) Aristotle, The Politics (Penguin 1962) 46.

35 C Fahey, ‘Churches Came to Terms with Moneylending’ (1996) 14 (5) Dossier: Economic Alternatives Nov/Dec, 215http://

gvanv.com/compass/arch/v1405/fahey.html4 accessed 10 May 2010.

36 5prs.heacademy.ac.uk/publications/Islam.pdf4 accessed 10 May 2010.

37 JR Presley and JG Sessions ‘Islamic Economics: The Emergence of a New Paradigm’ (1994) 104 The Economic Journal May,

585.


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Shariah Supervisory Board

From the practical perspective, Islamic financial institutions in their everyday life are

guided by a legitimate control body known as the Shariah Supervisory Board (SSB),38

which consists of eminent Islamic jurists, scholars and academics.39

According to the IIBI,

the day-to-day application of Shariah by the Shariah Supervisory Boards is two-fold. Firstly, in the

increasingly complex and sophisticated world of modern finance they endeavour to answer the question

on whether or not proposals for new transactions or products conform to the Shariah. Secondly, they act

to a large extent in an investigatory role in reviewing the operations of the financial institution to ensure

that they comply with the Shariah.40

Moreover, as Shaikh Yusuf Talal DeLorenzo, the leading Islamic scholar,41 says ‘[u]nless a

financial product or service can be certified as Shariah compliant by a competent Shariah

supervisory board, that product’s authenticity is dubious.’42

Proponents of the Islamic investment principles maintain that these principles are

based on the ‘social justice, equitability, and fairness as well as practicality of

transaction.’43 Usmani (2007) states, ‘[a]ccording to the Islamic principles, [all] business

transactions can never be separated from the moral objectives of the society’.44 Van

Greuning and Iqbal (2007) note, ‘ . . . the foremost priority of Islam and its teachings on

economics is about ‘‘Justice and Equity’’ ’.45

38 HG Rammal, ‘The Importance of Shariah Supervision in Islamic Financial Institutions’ (2006) 3 (3) Corporate Ownership and

Control 204–8, 205. Available at SSRN5http://ssrn.com/abstract¼14427894 accessed 10 May 2010.

39 There are ‘. . . four types of legal personnel who played fundamental roles in the construction, elaboration and continued

operation of the Shariah. These are the Mufti, Author-jurist, the judge and law professor [scholar].’ See WB Hallaq, An Introduction

to Islamic Law (Cambridge University Press 2009) 8.

40 5http://www.islamic-banking.com/shariah_supervisory_board.aspx4accessed 10 May 2010. The clear definition of the role of

SSB is provided by Usmani in the Introduction to the Compendium:

The function of a Shariah Supervisory Board is of a very delicate nature. On the one hand, they are meant to abide strictly by

Islamic principles, and on the other they have to fulfil the requirements of a constantly emerging needs of the contemporary

marketplace. The task entrusted to the Shariah boards is indeed a difficult one; because when we claim that Islam provides

solutions to the problems of every time and place, we do not mean that Islam has given a specific rule for each and every

minute detail of every transaction.

. . . the sacred sources of the Shariah, the Qur’an and the Sunnah, have provided Muslims with a set of eternal principles, but

their application to the practical situations of each age requires the exercise of ijtihad. This means consultations in which the

individual deliberations of many scholars play a vital role in reaching many firm conclusions. This exercise sometimes brings

different answers from different Shariah Boards with regard to the same question. The Shariah Boards, being comprised of a

number of scholars, decide the matter placed before them after mutual deliberations, which is tantamount to collective

Ijtihad.

Cited from 5http://www.salaam.co.uk/themeofthemonth/november02_index.php?l¼74 accessed 10 May 2010. YT DeLorenzo

(ed), A Compendium of Legal Opinions on the Operations of Islamic Banks: Murabahah, Mudarabah and Musharakah (Institute of

Islamic Banking and Insurance, London, UK 1997).

41 Yusuf Talal DeLorenzo is a well-known and respected Shariah advisor and Islamic scholar. He is currently Chief Shariah

Officer and Board Member at Shariah Capital Inc, USA, Member of The Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI) Shariah Board5http://www.aaoifi.com/sharia-board.html4.

42 5http://www.dinarstandard.com/finance/DeLorenzo012308.htm4.

43 OICU–IOSCO (2004). Islamic Capital Market Fact-Finding Report. Report of The Islamic Capital Market Task Force of the

International Organization of Securities Commissions, 8.5www.iiibf.org/media/ICM-IOSCOFactfindingReport.pdf4.

44 See MT Usmani, (n 6) at 244.

45 H Van Greuning and Z Iqbal, Risk Analysis for Islamic Banks (The World Bank, 2007) 5.


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Key effects of Islamic investment principles

The major criticism of SRI investments, including an application of Islamic investment

principles to a broad portfolio, comes from the proponents of the modern portfolio

theory.46 Application of a negative screen greatly diminishes opportunities for asset

allocations and portfolio diversification. For example, broad restrictions on investments

in fixed-income securities limit Islamic investors in sources of stable income.

The IF screen makes conventional cash management mechanisms, such as bank

deposits with international money centre banks and money market funds, unavailable to

Islamic investors, both institutional and retail. To meet the liquidity management needs

of such investors, including Islamic corporations and Islamic financial institutions, global

money managers have attempted to establish collective investments schemes organized

under the premises of the IF. Section 3 analyses three investment undertakings of that

kind.

3. Islamic liquidity management

On the ground of the strict prohibition of interest payments under Shariah, Islamic

financial institutions cannot accept the conventional liquidity management methods

based on investments in international money market instruments. However, there are a

few Shariah-compliant basic schemes, which can be used for managing liquidity. Each of

the schemes entails additional risks imposed by the IF limitations relative to comparable

vehicles established in the absence of such restrictions.

Islamic liquidity funds established under Murabahah47 agreements

The most widely used mechanism of achieving the risk/return profile comparable with

the profile of a conventional fixed-income instrument is commodity Murabahah. Under

commodity Murabahah, an investor appoints an agent to enter into an initial purchase

and subsequent sale of any commodity, such as metal or oil, with a third party on behalf

of the investor. The sale is arranged at the purchase price of the commodity plus a

mark-up, which is normally tied to an accepted short-term index, such as LIBOR. Details

of the arrangements may vary depending on the underlying commodity, timing of

purchase and sale, institutions involved and settlements.

Collective investment schemes under commodity Murabahah arrangements involving

next-day settlement are designed to offer a daily return comparable with LIBOR and solve

the problem of overnight liquidity for Islamic investors, including both institutional and

46 Modern portfolio theory (MPT) is the theory of investments that tries to maximize the return while minimizing the risk by

choosing different assets. Its basic premise is that the assets in the portfolio cannot be selected individually, but must be considered

relative to each other. MPT maintains that the optimal risk/return profile can only be achieved in a broadly diversified portfolio

5http://capital-flow-watch.net/tag/modern-portfolio-theory/4 accessed 20 May 2010.


Murabahah—Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares

his cost and the profit. This has been adopted by Islamic banks as a mode of financing. As a financing technique, it can

involve a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the

cost.


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retail investors. These types of collective investment schemes are sometimes referred to as

Sharia-compliant money market funds (SCMMF). The investment management process

is typically conducted as follows:

1. A fund organized under commodity Murabahah (MF) enters into a trading

agreement with a commodity seller (CS) to purchase a specified volume of

commodity (V) at the current market price with same day delivery (T0) and same

day settlement (P0).

2. Immediately after arranging to purchase the commodity from a CS, MF enters an

agreement with a commodity purchaser (CP) to sell the same volume V of

commodity for same day delivery (T0), but with next-day settlement (T1).

3. The next-day payment by CP is secured through an escrow agent, ie at T0, CP must

deposit the full amount of payment V� P0 in the escrow agent’s account.

4. At T0, the escrow agent receives cash equal to the amount of the payment [V�P0]

and invests it overnight in high-quality securities such as shares of a conventional

money market fund.

5. At T1, the escrow agent receives the proceeds from the cash invested overnight either

though maturities or through selling the securities. The amount of the proceeds is

equal: P1¼P0 under commodity Murabahah incurs credit risk from its daily

exposure to conventional credit securities through its escrow agent albeit such

exposure is minimal due to the high quality and short maturities of such securities.

Market risk, which encompasses interest rate risk, foreign exchange risk, spread risk,

basis risk, etc., is inherited in the investment process and depends on the general level

of interest rates, interest rate volatility, currency denomination of escrow securities

versus the portfolio’s base currency, presence of hedges and other factors. In the

described process, these risks are sufficiently mitigated by the high quality of such

securities.

6. For example, the escrow securities48 can be shares of the US domiciled money market

funds (MMFs), governed by Rule 2a-7,49 which are managed to maintain a stable

principal value and provide daily liquidity. Let us suppose that the escrow agent

invests the amount V�P0 in shares of US MMFs. The proceeds at T1 will be

P1¼P0�V� (1þD) because US MMFs are managed to a stable share price and do

not normally distribute capital gain/loss. Income on the MMFs’ shares comes only

from the interest collected on the MMF portfolio securities daily.

7. Islamic liquidity funds established under Murabahah agreements conduct commod-

ity settlements on a daily basis. Therefore, the cash accumulated in the escrow

account needs to be reinvested daily. The process of daily reinvestment of the entire

fund’s portfolio entails significant operational risk. Such a fund not only has to have

48 An escrow account is an account established by a third party, typically a fund’s custodian, for the sole purpose of safekeeping

specified securities on behalf of the fund.

49 Rule 2a-7 under the Investment Company Act of 1940, as amended, governs activities of all money market funds organized in

the USA5http://www.sec.gov/rules/final/21837.txt4 accessed 20 May 2010.


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systems and processes to conduct daily subscriptions and redemptions with its own

investors, there also must be processes in place for purchasing and selling the

commodity, monitoring escrow payments and directing the escrow agent to purchase

specific assets. Furthermore, the scheme calls for three additional parties involved in

the liquidity fund management process such as CP, CS and escrow agent. Fees for the

services provided by the additional parties may render the structure economically

unfeasible, especially during a period of low interest rates.

8. The discussed scheme imposes additional liquidity risk on the issuers of escrow

securities. To illustrate, if shares of a US MMF are chosen as escrow securities, daily

redemptions from such a fund would cause it to keep extra daily liquidity. This, in

turn, would make such an MMF more expensive to run, disadvantaging the

remaining shareholders. Therefore, the presence of Islamic liquidity schemes with

daily reinvestment needs among MMF’s shareholders may be viewed as undesirable

from the standpoint of a conventional MMF investor with more predictable, even if

short-term, cash flows.

9. Further, under the amended Rule 2a-7, the US MMF advisors must establish ‘know

your customer’ procedures including a deep understanding of each investor’s

liquidity requirements. Islamic liquidity funds established under commodity

Murabahah acting through the escrow agent may not be transparent enough to

satisfy ‘know your customer’ procedures. At this time, US MMFs are in the process

of reviewing their operations to comply with this amendment and no further

information is available as to how the discussed structure is going to be treated for

the purposes of compliance with this provision. The uncertainty of the treatment can

be viewed as an additional regulatory risk for Islamic liquidity schemes involving

purchasing shares of US MMFs.

10. If the discussed scheme invests in securities other than shares of US MMF, such

securities are likely to be overnight securities to avoid losses due to movements of

interest rates. From the perspective of an issuer of short-term debt, such as a

commercial paper issuer, investors’ preference for daily securities constitutes

additional liquidity risk and exposes the issuer to a greater asset-liability mismatch.

Interim risk assessment

Islamic liquidity funds established under Murabahah agreements expose their investors to

a number of additional risks above and beyond those borne by investors in conventional

MMFs or direct purchasers of short-term debts. The structure established to manage the

commodity exposure is operationally cumbersome and could be expensive to run. The

presence of an escrow agent entails additional operational and regulatory/legal risks.

Accordingly, Islamic liquidity funds established under Murabahah agreements are

unlikely to be viewed as comparable with conventional MMFs or direct investments in

short-term securities in terms of their risk/return characteristics. Investors in


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conventional MMFs can be, in turn, disadvantaged by the presence of Islamic liquidity

schemes in their funds due to the non-transparent nature of their cash flows.

Islamic liquidity funds established under Wakala50 agreements

Under this scheme, the investors’ monies are commingled in a single pool/fund, which

enters into Wakala agreements with a number of Islamic banks to deposit the fund’s

balances on a medium-term basis, normally one year. The deposits are callable. The basic

premise of the scheme is that, although it is marketed as a liquidity management vehicle,

investors are expected to keep their fund investments for a year or longer thus enabling

the fund to collect higher dividends as compared with dividends that could have been

collected by the fund investors individually. In case of unanticipated cash outflows,

deposits can be called prior to maturity, albeit with penalties.

As the fund reaches a critical mass, it is expected that the redemption requests are to be

met with cash coming from new investors. Netted payments in and out of the fund would

reduce the necessity to call bank deposits, thus improving management efficiency and

fund return.

Analysis

The key characteristic of Wakala placement is uncertainty of capital and uncertainty of

return. In general, Islamic financial institutions accepting Wakala placements are rated

within A/BBB, or low investment grade, categories by global credit-rating agencies.51 This

is in contrast with Western financial institutions normally sponsoring liquidity products,

which are typically rated in high investment-grade categories such as AAA/AA. Therefore,

the creation of a high-credit-quality liquidity product similar to those in the Western

capital markets may not be possible.

The secondary market does not exist for Wakala placement. The fund is reliant on the

good will of the bank to break the deposit in order to meet redemptions in excess of

incoming cash flow on any given day. Managing cash-flow volatility through netting cash

inflows and outflows may not be possible until the fund collects sizeable assets under

management. Yet, even then such a vehicle remains susceptible to an asset–liability

mismatch and imposes significant liquidity risk on the remaining investors.


Islamic liquidity funds reliant on Wakala placements with other Islamic financial

institutions incur greater credit risk relative to liquidity management vehicles available to

Western investors due to the generally low credit quality of Islamic financial institutions

participating in the scheme and limited portfolio diversification opportunities.

50 An agency contract, which may include in its terms a fee for the agent. The same contract can also be used to give a power of

attorney to someone to represent another’s interests. See D El-Hawary, W Grais and Z Iqbal, ‘Diversity in the Regulation of Islamic

Financial Institutions’ (2007) 46 The Quarterly Review of Economics and Finance 796.

51 Credit-rating agencies, such as Fitch Ratings (5www.fitchratings.com4), Moody’s Investors Services (5www.moodys.com4)

and Standard and Poor’s (5www.standardandpoors.com4), normally refer to credit ratings of debt securities or issuers of debt

securities as ‘investment grade’ ratings, if the ratings fall into the four highest categories ranging from AAA to BBB. Ratings in

categories from BB to C are referred as ‘below investment grade’ or ‘speculative’ ratings.


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Furthermore, the proposed liquidity management mechanism through cash inflow and

outflow netting is likely to be unreliable, especially during the first years of the fund’s

operations when cash flow patterns are untested.

Islamic liquidity funds investing in global Sukuk52 markets

An investment strategy of such funds is based on Sukuk holdings issued by sovereign,

quasi-sovereign and corporate issuers. Sukuk are Shariah-compliant certificates with

economic characteristics similar to conventional bonds. It should be noted, however, that

a Sukuk is not a debt instrument, but rather represents ownership of a business or real

asset and hence has equity-like characteristics. In 2008, the UK’s economics and finance

ministry HM Treasury53 introduced legislative changes to align the regulatory treatment

of alternative finance investment bonds (AFIBs) with conventional debt securities.54 The

HM Treasury’s amendment Order 2010 to the Financial Services and Markets Act 2000

came into force on 24 February 2010,55 with the objective ‘to ensure that innovative

Figure 1. Cash flows among parties in Islamic liquidity funds established under Wakala

agreements.

52 Plural of the Arabic word Sakk, meaning certificate, reflects participation rights in the underlying assets. The design of the

security is derived from the conventional securitization acquiring assets and issuing financial claims on the assets. See Z Iqbal and

H Tsubota, Emerging Islamic Capital Markets—A Quickening Pace and New Potential. The Euromoney International Debt Capital

Markets Handbook 2006 (The World Bank 2006) 5http://treasury.worldbank.org/cmd/pdf/Euromoney_2006_Handbook_

International_Debt_Capital_Markets.pdf4 accessed 25 May 2010.

53 5http://www.hm-treasury.gov.uk/home.htm4 accessed 25 May 2010.

54 HM Treasury, Consultation on the legislative framework for the regulation of alternative finance investment bonds (sukuk),

(2008).5http://www.hm-treasury.gov.uk/consult_sukuk.htm4 accessed 25 May 2010.

55 Statutory Instruments 2010 No 86. The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order

2010.5www.opsi.gov.uk/si/si2010/pdf/uksi_20100086_en.pdf4 accessed 25 May 2010.


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financial instruments [AFIBs such as Sukuk] are treated in a similar way to existing

financial products with similar economic characteristics.’56

Issuers of Sukuk raise capital from diverse sources and may constitute partial

ownership in an asset (Sukuk Al Ijara), project (Sukuk Al Istisna), business (Sukuk Al

Musharakah), debt (Sukuk Murabahah) or investment (Sukuk Al Istithmar).57 In its basic

form, Sukuk is an asset-backed trust certificate evidencing ownership of an asset or its

usufruct. The Accounting and Auditing Organisation for Islamic Financial Institutions

(AAOIFI) in Articles 2 of Shariah Standard No 17 defines Sukuk as ‘certificates of equal

value representing undivided shares in ownership of tangible assets, usufruct and services

or (in the ownership of) the assets of particular projects or special investment activity,

however, this is true after the receipt of the value of the Sukuk, the closing of the

subscription and employment of funds received for the purpose for which the Sukuk were

issued.’58 The basic Sukuk structure,59 which relies upon establishing a Special Purpose

Vehicle (SPV), is depicted in Figure 2.

The majority of Sukuk are intended to be bought and held, thus making such assets

fairly illiquid investments. A key technique of providing liquidity is a binding promise to

repurchase certain assets, eg in the case of Sukuk Al Ijara, by the issuer. This feature

resembles a put option offered to investors in certain conventional bond structures. There

is also a growing Sukuk secondary market including trading on major European

exchanges.

Figure 2. Basic Sukuk structure.

56 Explanatory Memorandum to The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2010.

5www.opsi.gov.uk/si/si2010/em/uksiem_20100086_en.pdf4 accessed 25 May 2010.

57 See R Wilson, ‘Overview of the Sukuk Market’ in A Thomas and N Adam (eds) Islamic Bonds: Your Guide to Issuing,

Structuring and Investing in Sukuk (Euromoney Institutional Investor PLC 2004).5http://new.euromoneyplc.com/images/covers/

Islamic%20Bonds%20Your%20Guide%20to%20Issuing%20Structuring%20and%20Investing%20in%20Sukuk/

sample%20chSukuk.pdf4 accessed 27 May 2010, and MT Usmani (2008). Sukuk and their Contemporary Applications. AAOIFI

Shari’a Council meeting, Saudi Arabia. 5http://www.iefpedia.com/english/wp-content/uploads/2009/11/Sukuk-and-their-

Contemporary-Applications.pdf4 accessed 27 May 2010.

58 AAOIFI Shariah Standard No 175http://www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf4 accessed 27 May 2010.

59 Adapted from5http://www.practicallaw.com/5-201-19854 accessed 27 May 2010.


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Islamic liquidity funds have income orientation and often explicitly promise to

provide fund investors with returns benchmarked to a specific rate. Such funds can only

invest in those Sukuk whose issuers pay rent, which is usually benchmarked to an interest

rate like LIBOR. Sukuk can be issued in multiple currencies. The fund purchasing Sukuk

in currencies other than the base portfolio currency may have to hedge against

unfavourable interest rate moves.

Analysis

While it is often stated by Islamic financial institutions that Sukuk provides investors with

enhanced return, the market risk incurred by investors is also higher relative to

conventional bonds due to exposure to the change in value of the underlying assets. To

make Sukuk more attractive, Sukuk issuers often have to offer investors a higher rate

relative to a conventional bond of a similar credit quality. Investments in securities with

such equity-like characteristics are normally viewed as inappropriate for Western

liquidity vehicles.

Although the credit quality of each specific portfolio investing in Sukuk may differ, it is

unlikely that such funds will be viewed as having comparable credit quality to

conventional liquidity management vehicles. This is due to a generally lower average

credit rating assigned to Sukuk by global credit-rating agencies relative to conventional

senior unsecured bonds and commercial paper issued by the major financial and

non-financial corporations in the global money markets.

Liquidity risk is significant due to a thin secondary market. Therefore, investors in

Islamic liquidity funds may not be able to achieve a core objective of on-demand liquidity

without substantial loss of value. To mitigate the liquidity risk, such a fund may have to

establish redemption limits, or a defined holding period for each cash flow. Limiting

redemptions from registered mutual funds is unlawful under US securities law;60

however, so-called ‘gating provisions’61 are accepted business practices in other markets,

including European money market funds.


Islamic liquidity funds investing in Sukuk are likely to incur greater market and credit

risks relative to liquidity management vehicles available to Western investors due to the

generally lower credit quality of Sukuk relative to conventional money market

instruments issued by major Western corporations and equity-like characteristics in

certain Sukuk structures.

Liquidity risk can be significant due to a thin secondary market for public Sukuk.

It should be noted that there is no secondary market for private Sukuk.

60 Section 22(e) of the Investment Company Act of 1940 precludes US mutual funds from suspension of redemptions of mutual

fund shares for a period longer than seven days with limited exceptions5http://www.sec.gov/about/laws/ica40.pdf4 accessed 27

May 2010.

61 It is an accepted business practice in offshore money market funds to impose daily redemption limits both in terms of dollar

amount and percentage of shares allowed to be redeemed.


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4. Islamic liquidity funds and Shariah non-compliance risk

According to the State Bank of Pakistan (2008), Shariah non-compliance risk is

‘considered as falling within a higher priority category in relation to other identified risks’

and ‘such compliance requirements must permeate throughout the organisation and

their products and activities.’62 With reference to Islamic Investment Funds particularly,

Usmani (2007) explains:

[t]he term ‘Islamic Investment Fund’ . . . means a joint pool wherein the investors contribute their

surplus money for the purpose of its investment to earn halal profits in strict conformity with the

precepts of Islamic Shariah. Their validity in terms of Shariah will always be subject to two basic

conditions: Firstly, instead of a fixed return tied up with their face value, they must carry a pro-rata

profit actually earned by the Fund. Therefore, neither the principal nor a rate of profit (tied up with the

principal) can be guaranteed. Secondly, the amounts so pooled together must be invested in a business

acceptable to Shariah. It means that not only the channels of investment, but also the terms agreed with

them must conform to the Islamic principles.63

Appling these principles to Islamic liquidity vehicles, including SCMMFs, El-Gamal

(2000) views such financial instruments, in addition to conventional bonds, as ‘forbidden

interest-based instruments.’64 Ayub (2008) points out that ‘Islamic banks deal in goods

and documents and not in money.’65 From the perspective of fundamental principles

of IF, SCMMFs should not exist. This is because, according to Shariah, neither the return

of principal nor yield can be promised. Yet, the very basic premise of majority of

conventional money market funds is safety of principal and on-demand liquidity. These

are attractive attributes that have won investor loyalty globally. Money managers serving

Muslims would like to emulate the global success of MMFs in the Islamic world.

One may see the challenge arising from an attempt to reconcile the need for a basic

financial service of cash and liquidity management with limits on certain investment

practices imposed by Shariah. SCMMFs and other similar liquidity management vehicles

offered to Muslims remain susceptible to Sharia non-compliance risk due their

fundamental incompatibility with the postulates of IF. The creative structures discussed

in Section 3 only serve to multiply various investment risks, reduce transparency and add

operational complexity in an attempt to disguise the true nature of investments.

5. Conclusion

Collective investment schemes, including money market funds, offered to Sharia-

compliant investors who have to follow the basic moral–religious principles, are under

the legal and investment restrictions imposed by both Western law system and Islamic

Law. Investment restrictions reduce the universe of investable securities, while certain

62 State Bank of Pakistan (2008). Risk Management Guidelines for Islamic Banking Institutions. Islamic Banking Department

Circular No 01, 18.

63 See MT Usmani (n 6) at 203.

64 MA El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (Rice University, Houston 2000) 18.

65 See M Ayub (n 7) at 82.


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moral–religious principles raise additional risks66 due to operational complexity and lack

of transparency. Furthermore, investment screenings and third-party involvements add

to the management costs. This results in Islamic liquidity funds being competitively

disadvantaged in terms of their risk/return characteristics, which, in turn, makes them

less attractive for investors.

Additional risks highlighted in Appendix 1 are likely to make such funds less qualified

for the highest credit rating from major credit-rating agencies. At this time, the authors

are not aware of any highly rated SCMMFs.

Appendix 1

Table A1. Relative risk ranking in Islamic liquidity funds

Islamic liquidity funds

established under

Murabahah agreements


established under

Wakala agreements


investing in global

Sukuk markets

Credit risk Low Moderate High

Interest rate risk Low Moderate High

Market risk Low Moderate High

Liquidity risk Moderate High High

Operational risk High High Moderate

Legal risk* High Moderate High

*Perceived degree of controversy under Shariah.

66 For more detailed explanation of additional risks in Islamic Finance see A Arakcheev, ‘Legal Risks in Islamic Finance

Transactions‘ (2010) 3 The Journal of Applied Economy 131–52.


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Capital Markets Law Journal 2011 Arakcheev 238 52

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Transcript of Capital Markets Law Journal 2011 Arakcheev 238 52