Original question: It is to my understanding that most US REITS including SC ones in SPRE engage in risk-hedging via interest rate swaps. Also that swap contracts are in of itself not SC. Will the shariah-compliance of SPRE holdings be challenged if profits from these swaps exceed the 5% threshold?
Answer for question #155 #
Risk management is a principle encouraged by Shariah. Surah Yusuf highlights the value of planning for future risks:
“[Joseph] said, ‘You will plant for seven years consecutively; and what you harvest, leave in its spikes, except for a little from which you will eat. Then will come after that seven difficult [years], which will consume what you saved for them, except for a little from which you will store. Then will come after that a year in which the people will be given rain, and in which they will press [olives and grapes]'” (Qur’an, 12:47-49).
Moreover, risk management strategies are an integral part of the higher objectives of Shariah, specifically in the principle of Hifdh al-Mal (preservation of wealth). Seikh Ibn Bayyah elaborated in his work that Hifdh al-Mal includes concepts such as Husn al-Tadbir (prudent management) and al-Iddikhar (saving) (Maqasid al-Mu’amalat wa Marsad al-Waqi’at, p. 78).
Principles of Using Hedging Instruments #
While Shariah encourages risk management, the derivatives used in Islamic finance must adhere to key principles, such as:
- Absence of riba (usury).
- Avoidance of gharar (excessive ambiguity and speculation).
- Exclusion of maysir/qimar (gambling).
Understanding Interest Rate Swaps #
An interest rate swap (or profit-rate swap in the shariah-compliant structure) is a type of forward contract in which one stream of future interest payments is exchanged for another, based on a specified principal amount. These swaps typically involve exchanging a fixed interest rate for a floating rate, or vice versa, to either reduce exposure to interest rate fluctuations or secure a marginally lower interest rate than would have been possible without the swap.
For instance, if a REIT entered into swap contracts when the SOFR index was 0.75% and the rate later rose above 2.25%, the REIT would benefit from receiving payments linked to these higher rates, protecting against increased interest costs.
Shariah Stance on Derivatives #
A core principle in Islamic finance is that profits should be earned through legitimate trade and risk-taking. Conventional hedging products often don’t comply with Shariah because they involve profits without ownership or direct risk exposure in the asset itself. This disconnect can lead to non-compliance since such arrangements frequently involve elements of riba, gharar, or maysir.
Due to these issues, Islamic finance has developed Shariah-compliant alternatives that utilize wa’d (promise) structures instead of traditional derivatives. Wa’d allows a binding obligation to be created for future transactions in a manner that aligns with Islamic principles.
Wa’d-Based Structures in Islamic Finance #
Wa’d-based (promise to transact) structures enable Islamic financial institutions to offer hedging tools that comply with Shariah guidelines. In these structures, one party makes a unilateral promise to enter into a specific transaction in the future under certain conditions. This promise binds the promisor, but it leaves the promisee with the option to either proceed or not.
For example, in an Islamic profit rate swap using wa’d, two parties might agree to a series of commodity murabaha transactions in the future. These transactions replicate the cash flows of conventional interest rate swaps but do so without involving direct interest payments.
These structures aim to provide similar economic benefits to conventional derivatives while avoiding interest-based transactions, reducing uncertainty, and often involving tangible assets in line with Shariah requirements.
Shariah Compliance of Conventional Interest Rate Swaps #
Interest rate swaps inherently involve riba (usury), which is unlawful in Shariah. According to AAOIFI’s (Accounting and Auditing Organization for Islamic Financial Institutions) Shariah standards:
- “Currency swaps that are concluded on the basis of riba are not permissible. This is because the process involves interest-based securities being set-off against interest-based securities.” (Shariah Standard 4).
- Capital protection through non-Shariah-compliant contracts like swaps is not allowed (Shariah Standard 45).
As a result, most scholars deem interest rate swaps and similar conventional derivatives incompatible with Shariah principles.
Regulatory Guidance on Islamic Derivatives #
The Securities Commission of Malaysia’s guidelines allow Islamic REITs to use derivatives strictly for hedging purposes, and only when Islamic derivatives are unavailable. Conventional derivatives may be used in these instances, but they require prior approval from a Shariah adviser (Guidelines on Islamic Capital Market Products and Services: 33.15).
This flexible approach is particularly relevant in markets with limited Islamic finance options, permitting a conditional use of conventional derivatives under Shariah oversight.
Implications for Shariah Compliance #
The use of conventional derivatives must be carefully supervised by a Shariah advisory board. Temporary Shariah compliance may be granted in certain circumstances, such as when a REIT is transitioning to Shariah-compliant alternatives or managing assets critical to the public, like hospitals or schools.
In some jurisdictions, REITs may be legally required to implement specific risk management strategies. If Shariah-compliant options are not recognized by regulators, this could create a scenario where the use of conventional derivatives becomes necessary to meet these legal obligations.
This approach aligns with Islamic legal maxims:
- الحاجة العامة تنزل منزلة الضرورة الخاصة (“A general need may be treated as a specific necessity”)
This maxim outlines that in particular situations where a necessity is acknowledged, a temporary exception may be allowed to address that specific necessity.
- إذا ضاق الأمر اتسع (“When a matter becomes constricted, it becomes relaxed”)
This maxim reflects the flexibility and taysiir (facilitation of ease) within Shariah, where a person’s context and circumstances are taken into consideration for exceptional rulings.
This refined addition clarifies that regulatory requirements may necessitate the use of conventional derivatives if Shariah-compliant options are not available, aligning this practice with established Islamic legal principles
Conclusion #
Determining the Shariah compliance of any REIT or fund ultimately requires the expertise of its Shariah advisor. While non-compliant derivatives like interest rate swaps generally undermine Shariah principles, specific conditions may justify their temporary use under strict limitations. Any profits from these instruments must undergo purification, and the ultimate goal should always be to shift towards fully Shariah-compliant solutions as soon as feasibly possible.
Given that SPRE is a Shariah-compliant REIT, it is likely that they are using a profit-rate swap structure rather than a conventional interest-rate swap. Profit-rate swaps are designed to align with Shariah principles, avoiding elements of riba and ensuring compliance with Islamic guidelines. This approach reinforces SPRE’s commitment to maintaining its Shariah-compliant status.
Nonetheless, it is essential to consult the specific Shariah advisory stance of the product or fund in question to fully understand its compliance status. Each scenario may present unique challenges, and a qualified Shariah advisor’s guidance is crucial for ensuring that financial strategies align with Islamic principles.
Wallahu A’lam (Allah knows best).
References: #
- Abdullahi, I. B., & Asmak, A. R. (2015). Risk Management in Islamic Finance: An Analysis from Objectives of Shari’ah Perspective. International Journal of Business, Economics and Law, 8(4), 88–96. https://www.ijbel.com/wp-content/uploads/2015/09/RISK-MANAGEMENT-IN-ISLAMIC-FINANCE-AN-ANALYSIS-FROM-OBJECTIVES-OF-SHARI%E2%80%99AH-PERSPECTIVE.pdf
- Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). (n.d.). Shariah Standards.
- Bank Negara Malaysia. (2010). Shariah Resolutions in Islamic Finance (2nd ed.). https://www.bnm.gov.my/documents/20124/9198675/shariah_resolutions_2nd_edition_EN.pdf
- Bin Bayyah, A. A. (2019). Maqasid al-Mu’amalat wa Marsad al-Waqi’at [The Objectives of Transactions and the Realities of Affairs]. https://binbayyah.net/arabic/wp-content/uploads/2019/01/%D9%85%D9%82%D8%A7%D8%B5%D8%AF-%D8%A7%D9%84%D9%85%D8%B9%D8%A7%D9%85%D9%84%D8%A7%D8%AA.pdf
- Blue Vault Partners. (2023). How Interest Rate Caps and Swaps Are Used by Non-Traded REITs. https://bluevaultpartners.com/how-interest-rate-caps-and-swaps-are-used-by-non-traded-reits/
- Clifford Chance. (2013). Introduction to Islamic Financial Risk Management Products. https://financialmarketstoolkit.cliffordchance.com/content/dam/cliffordchance/briefings/2013/08/introduction-to-islamic-financial-risk-management-products.pdf
- International Islamic Fiqh Academy (IIFA). (2020). Fatwa on Derivatives and Hedging in Islamic Finance. https://iifa-aifi.org/en/33165.html
- Islamic Banking and Finance Training and Research Academy (IBTRA). (2010). Shariah Compliance and Derivatives in Islamic Finance. Journal of Islamic Economics, Banking and Finance, 7(1). https://ibtra.com/pdf/journal/v7_n1_article3.pdf
- Maybank Islamic. (n.d.). Derivatives in Islamic Finance: Issues and Challenges. https://www.maybank2u.com.my/iwov-resources/islamic-my/document/my/en/islamic/scoe/knowledge-centre/research-paper/Derivatives_in_IF.pdf
- Securities Commission Malaysia. (n.d.). Islamic Capital Market—Shariah Governance. https://www.sc.com.my/api/documentms/download.ashx?id=7279989d-00f8-4ebc-8c18-fbf6c260ab1a
FAQ #8: Is options trading in line with Islam, considering down-payment comparisons?
