## 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA)

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### Introduction: context and motivation
- Derivatives provide "vast economic gains from efficient risk management."
- Derivatives facilitate financial intermediation where transaction costs are high, liquidity is poor, and asset supply is limited; they enable diversification and transfer of risk, reduce funding costs, and hedge transaction-specific risks.
- Derivatives are scarce where capital market transactions are governed by Islamic law because many conventional derivatives conflict with shari’ah principles (notably risk-shifting, speculative/unfunded nature).
- Industry response: ISDA and IIFM published the Tahawwut (Hedging) Master Agreement (TMA) in March 2010 as the first standardized documentation for privately negotiated Islamic derivatives to standardize swap-based shari’ah-compliant hedging transactions and improve consistency and predictability of shari’ah-compliant risk management.

### Why conventional derivatives are controversial in Islamic finance
- Core shari’ah objections:
  - Gharar (excessive uncertainty) — state-contingent valuation and unclear object characteristics.
  - Maisir (gambling/speculation) — speculative behavior and risk-seeking divorced from productive activity.
  - Riba (interest) — enrichment from interest or guaranteed predetermined returns rather than profit-sharing from asset performance.
- Shari’ah emphases: transparency, pre-determinability, certainty of profit generation, equitable distributive justice (maslahah), and avoidance of exploitation from ignorance (jahl).
- Many shari’ah scholars now accept hedging of actual exposures as essential for sound risk management and acknowledge opportunity costs from lack of Islamic hedging tools.

### General tenets of shari’ah relevant to derivatives
- Transactions must conform to prohibitory and permissible norms drawn from the qu’ran and the sunnah and aim to serve a public good (maslaha).
- Key contractual requirements bearing on derivative permissibility:
  - Price certainty and balance between protection buyers and protection sellers; price must be definite ex ante (though adjustable for material changes).
  - Identifiable characteristics and certainty about delivery results in quantity and quality; sales generally immediate and absolute to avoid gharar and jahl, with limited exceptions (e.g., salam and istisna’a).
  - Asset ownership and prohibition of leverage (underfunding); reference assets are required to be in the constructive ownership and possession of the creditor (protection seller) at inception to ensure asset-backing and align financial claims with real assets.
- Prohibitions extend to back-to-back trading of the same object at different prices (bay al-inah), trading of debt at prices different from face value (bay dayn bi-dayn), betting/gambling (maisir), and speculative agreements that yield payments without underlying asset transfer.

### Specific concerns about conventional derivatives and market practices
- State-contingent pricing and absence of absolute reference value can create zero-sum payoffs and possible exploitation of less-informed parties.
- Counterparty risk and sale of nonexistent or non-possessed assets conflict with the hadith "sell not what is not with you" and raise ownership/possession problems (qabd).
- Futures and options are often rejected because unfunded or partially funded transactions do not imply legal ownership or possession of the reference asset, undermining guarantee of delivery at maturity.
- Margining and mark-to-market (MTM) practices in futures (interim margin payments and cash settlement) are viewed as problematic because they can imply intertemporal re-pricing and cash-only settlement without underlying asset transfer, resembling prohibited debt sale or bay al-inah.
- Some scholars note that standardized contract specifications, advanced market conduct, and supervisory controls could mitigate certain objections; others permit futures trading of commodities if underlying assets meet shari’ah requirements.

### Market and industry developments; role of the TMA
- Scarcity of shari’ah-compliant derivatives and lack of standardized documentation have delayed transactions and disadvantaged Islamic investors and institutions.
- The TMA (ISDA/IIFM, March 2010) represents a major step toward:
  - Standardizing shari’ah-compliant swap-based hedging transactions.
  - Enhancing transparency, consistency, and predictability of shari’ah-compliant risk management.
- Islamic finance can synthesize instruments with derivative-like features: standard asset-based contracts (e.g., ijara, salam, istisna’a) can be decomposed into contingent claims and used as the basis for shari’ah-compatible hedging solutions; practitioners have also used customized “wrappers” to adapt conventional derivatives.

### Analytical implications and framing for permissible derivatives
- The paper proposes:
  - The existing menu of Islamic instruments is sufficiently rich to deliver some risk management solutions akin to conventional derivatives.
  - Axioms can be articulated to set the stage for permissibility of certain types of derivatives based on asset-backing, possession/ownership at inception, price certitude, avoidance of excessive gharar and maisir, and alignment with the maqasid al-shari’ah (objectives of shari’ah).
- Practical compliance considerations:
  - Design structures that ensure constructive ownership or possession.
  - Ensure immediate payment where required (e.g., salam/istisna’a constraints).
  - Avoid pure cash-settlement-only mechanisms that sever asset transfer.
  - Limit speculative/unfunded constructs.

### Box 1 — The Five Axioms of Shari’ah-compliant Financial Derivatives
- In principle, financial derivatives may be compatible with shari’ah law if they:
  - (i) address genuine hedging demand associated with effective and intended ownership (qabd) in an identifiable asset or venture,
  - (ii) guarantee certainty of payment obligations arising from contingent claims on assets with clearly defined object characteristics,
  - (iii) disavow deferment of contractual obligations (nasi’a) from the actual and direct transfer of a physical asset as the object of an unconditional transaction, except for cases when the doctrine of extreme necessity applies,
  - (iv) contain collateralized payment for the use of risk protection but rule out provisions aimed at generating unilateral gains from interim price changes of the underlying asset beyond the original scope of risk sharing (sharik) among counterparties parties, which favors win-win situations from changes in the value of the reference asset,2 and
  - (v) eschew all prohibited sinful activities (haram), in particular those deemed similar to gambling (maisir) and speculation due to uncertainty (gharar) by means of clearly stated object characteristics and/or delivery results, which mitigate the risk of exploitation from ignorance (jahl).
- Additional requirement:
  - Shari’ah-compliant derivatives must also be employed in keeping with the precept of maintaining an equitable system of distributive justice as a public good (maslahah).

### Implicit derivatives, legacy contracts, and explicit derivatives (classification)
- Implicit derivatives embedded in Islamic contracts:
  - Synthetic loans via sale-repurchase (murabaha), lease contracts (ijara), profit-sharing contracts (musharakah, mudarabah, wakala).
- Legacy derivatives and contested contracts:
  - Examples: salam, bay mu’ajal, bay bithaman ajil (BBA), istisna, arbun, wa’ad, al-shart, kyiyar al-tarwih.
  - Wa’ad: unilateral promise; Fiqh Academy (Kuwait, December 10–15, 1988) found wa’ad in murabaha context morally binding and legally enforceable under certain conditions.
- Explicit derivatives and market innovations:
  - Recent innovations: customized option contracts, commodity hedges, cross-currency swaps, profit rate swaps; explicit derivatives remain few and nascent.
  - Swaps under shari’ah: parties sell assets (usually commodities) to each other for deferred payment rather than exchange interest.

### Box 2 — Islamic Swap Transactions: Cross-Currency Swaps (CCS) and Profit-Rate Swaps (PRS)
- General structure:
  - Murabaha-based swaps combine opposite, maturity-matched murabaha contracts with instantaneous (or periodic) transfer of similar assets to create mutual, fully collateralized payment obligations inclusive of premium for the use of the asset.
  - CCS and PRS are the most prevalent shari’ah-compliant swaps.
- Cross-Currency Swap (CCS):
  - Combines two commodity murabaha sale contracts generating offsetting cash flows in opposite currencies.
  - Example use case: a Malaysia-based Islamic bank substitutes future outflows in U.S. dollars for outflows in Malaysian Ringgit by combining murabaha contracts denominated in each currency.
  - Settlement includes full payment and physical settlement each period.
- Profit-Rate Swap (PRS):
  - Pioneered by Commerce International Merchant Bank (CIMB) of Malaysia in 2005.
  - Based on two commodity murabaha contracts to convert floating-rate payments to fixed-rate payments (and vice versa).
  - Floating leg described as reverse murabaha: commodity market price + floating rate profit portion (e.g., over LIBOR).
- Contested structures:
  - Islamic total return swap (dual wa’ad swapping returns of shari’ah-compliant asset portfolio with designated index/reference investment) is controversial because it could allow access to returns from non-shari’ah-compliant assets.

### Legal, governance, and standardization challenges
- Major governance issues:
  - Lack of consolidated shari’ah rulings and heterogeneous shari’ah board opinions inhibit consistent assessment and adoption.
  - Absence of unified principles and precedent spawns plurality of interpretations and fragmented practices across madh’hab.
- Legal contingencies:
  - Heterogeneous prudential norms and diverse interpretations amplify legal contingencies affecting business conduct and dispute resolution.
  - If a transaction is governed solely by shari’ah law, shari’ah courts could re-qualify the legal nature of a transaction, potentially undermining enforceability.
- Standard-setting initiatives:
  - Organizations involved include AAOIFI, IFSB, GCIBFI, IIRA, and the Fiqh Academy in Jeddah.
  - Industry initiatives: Master Agreement for Treasury Placement (MATP); ISDA/IIFM memorandum (October 2006) leading to the multi-product TMA (March 2010).
  - TMA is a financial industry framework document and does not establish universally binding market rules; adoption subject to national private law practice.

### Box 3 — Key Elements and Distinctions of the TMA
- Overview:
  - Launched March 2010 by IIFM in cooperation with ISDA; designated “Version 1”.
  - Spans all five major schools of shari’ah jurisprudence (pan-madhab).
  - Structure similar to conventional 2002 ISDA Master Agreement and incorporates ISDA technology: flawed asset concept, single agreement concept, close-out mechanism and netting adapted to shari’ah principles.
  - Multi-product: covers murabaha, wa’ad, salam, and arbun-based swap agreements with intention to expand scope.
- Six principal differences from conventional ISDA MA (areas of divergence):
  - (i) the architecture of the agreement;
  - (ii) the close-out mechanism, which includes the net present value of future receipts/payments;
  - (iii) the events of default;
  - (iv) the forum of dispute resolution;
  - (vi) additional representation as to shari’ah compliance; and
  - (vi) the treatment of contractual payments (which exclude payable interest in the TMA).
- Explicit contractual prohibitions and disclaimers:
  - Explicitly states that no interest shall be payable or receivable, and no settlement based on valuation or without tangible assets is allowed.
  - Disclaimers assert no guarantee of shari’ah compliance for any amendments or additions to the agreement or related underlying transaction documents.
- Close-out and designated future transactions:
  - Distinguishes between “concluded transactions” (inception to end of first payment period) and “non-concluded transactions” or “designated future transactions” (remaining maturity term converted into concluded transaction year by year).
  - Close-out of concluded transaction follows 2002 ISDA MA provisions: full amount payable and receivables accelerated and paid out (without discounting).
  - Close-out of designated future transaction(s) uses musawama contracts to crystallize the close-out amount; generates a net amount from offsetting both concluded and designated future contracts.
  - Index level for musawama-based close-out calculated using a similar basis to that used in the conventional 1992 ISDA Master Agreement.
- Events of default, governing law, and representations:
  - Events of default/termination include failure to pay or deliver, breach of agreement, credit support default, breach of contract, and misrepresentation of shari’ah compliance.
  - Cross-default provisions accepted by Islamic scholars.
  - Governing law clause refers exclusively to relevant secular law (New York or English law as a matter of form); parties may elect arbitration.
  - Parties must expressly record intention to enter only into shari’ah-compliant transactions and certify their own due diligence or independent assessment of shari’ah compliance.
- Implementation challenges and ambiguities:
  - Applicability hinges on permissibility under private law in various jurisdictions; national practice may take precedence.
  - Need for confirmations and separate designated future transactions terms agreements.
  - Open issues: net present value concept not recognized in shari’ah law; valuation/time value of money treatment unclear when payments deferred.
  - Election of secular governing law may render shari’ah compliance immaterial to dispute construction absent shari’ah board approval.
  - Replacement of “transfer” with “redesignation” introduces uncertainty about changing substantive rights; removal of creditworthiness in price quotations could distort economics on early termination.
- Musawama notes:
  - In musawama, a bank purchases assets and sells at a mark-up without disclosing profit margin or cost; musawama-based valuation for designated future transactions is pre-agreed and cannot create an objectionable "transaction at an undervalue."

### Key statistics and contextual figures
- Launch date: March 2010.
- Current master agreement designation: “Version 1”.
- Conventional reference agreements cited: 2002 ISDA Master Agreement; 1992 ISDA Master Agreement basis for index calculation.
- Contextual market size: With about US$1 trillion of assets lodged in Islamic financial institutions and capital markets, demand for shari’ah-compliant structured transactions is significant.
- PRS pioneered: Commerce International Merchant Bank (CIMB) of Malaysia in 2005.
- Historical CCS precedent: Standard Chartered arranged the first derivative structure of this kind for Bank Muamalat Malaysia in July 2006.
- Wa’ad Fiqh Academy meeting date cited: December 10–15, 1988.

### Conclusions and policy implications (findings and recommendations)
- Findings:
  - Insufficient or absent asset-linkage and potential for unilateral gains in many derivatives undermine equitable risk sharing and contractual certainty required by shari’ah.
  - Many standard Islamic contracts already embed “implicit derivatives,” guaranteeing definite performance and equitable risk sharing while avoiding interim unilateral gains; these are typically bilaterally negotiated and OTC.
  - Explicit shari’ah-compliant derivatives exist but are limited, customized, and primarily used for currency and interest rate risk management via commodity-based structures and profit rate swaps.
- Policy implications and recommendations:
  - Standardization (e.g., the TMA) could:
    - Establish clarity about rationale for restrictive use and ensure consistent application.
    - Attract a wider range of participants, including conventional participants seeking to expand in Islamic finance.
    - Help establish congruence of derivatives in both conventional and Islamic finance.
  - Widespread adoption of TMA depends on permissibility under private law across jurisdictions and resolution of outstanding legal and valuation ambiguities.
  - As Islamic finance expands internationally, shari’ah-compliant derivatives and other risk management techniques will be increasingly essential to enhance liquidity management, supplement cash markets at lower funding cost, and ensure efficient transmission of funds from savers to investors.

*Source: _wp1263 — 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA), Box 1, Box 2, Box 3 (extracted from the provided content).*

### References .............................................................................................................

### References

### Tables
- 1. Permissible Trading Assets Under Islamic Law ....................................................................8
- 2. Classification Scheme of Derivatives in Islamic Finance ....................................................17

### Figures
- 1. Basic Ijara Contract ..............................................................................................................16
- 2. Murabaha-based Cross-Currency Swap ...............................................................................21
- 3. Murabaha-based Profit Rate Swap .......................................................................................22
- 4. Islamic Total Return Swap (Wa'ad) Arrangement ...............................................................23

### Boxes
- 1. The Five Axioms of Shari’ah-compliant Derivatives ..........................................................13
- 2. Islamic Swap Transactions—Cross-currency and Profit Rate Swaps .................................21

*Source: _wp1263 - References .............................................................................................................*

### 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA) ..........26

### 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA)

### Introduction: context and motivation
- During the recent financial crisis, derivatives were highlighted for their complexity and role in precipitating and propagating the economic fallout, but derivatives also provide "vast economic gains from efficient risk management."
- Derivatives facilitate financial intermediation where transaction costs are high, liquidity is poor, and asset supply is limited; they enable diversification and transfer of risk, reduce funding costs, and hedge transaction-specific risks.
- Derivatives are scarce where capital market transactions are governed by Islamic law because many conventional derivatives conflict with shari’ah principles (notably risk-shifting, speculative/unfunded nature).
- Industry response: after more than three years of negotiations and industry consultations, ISDA and IIFM published the Tahawwut (Hedging) Master Agreement (TMA) in March 2010 as the first standardized documentation for privately negotiated Islamic derivatives, aiming to standardize swap-based shari’ah-compliant hedging transactions and improve consistency and predictability of shari’ah-compliant risk management.

### Why conventional derivatives are controversial in Islamic finance
- Core shari’ah objections:
  - Gharar (excessive uncertainty) — state-contingent valuation and unclear object characteristics.
  - Maisir (gambling/speculation) — speculative behavior and risk-seeking divorced from productive activity.
  - Riba (interest) — enrichment from interest or guaranteed predetermined returns rather than profit-sharing from asset performance.
- Shari’ah emphasizes transparency, pre-determinability, certainty of profit generation, equitable distributive justice (maslahah), and avoidance of exploitation from ignorance (jahl).
- Despite reservations, many shari’ah scholars now accept hedging of actual exposures as essential for sound risk management and acknowledge opportunity costs from lack of Islamic hedging tools.

### General tenets of shari’ah relevant to derivatives
- Transactions must conform to prohibitory and permissible norms drawn from the qu’ran and the sunnah and aim to serve a public good (maslaha).
- Key contractual requirements that bear on derivative permissibility:
  - Price certainty and balance between protection buyers and protection sellers; the price to be paid must be definite ex ante (though adjustable for material changes).
  - Identifiable characteristics and certainty about delivery results in terms of quantity and quality; sales must generally be immediate and absolute to avoid gharar and jahl, with limited exceptions (e.g., salam and istisna’a).
  - Asset ownership and prohibition of leverage (underfunding); reference assets are required to be in the constructive ownership and possession of the creditor (protection seller) at inception to ensure asset-backing and align financial claims with real assets.
- Prohibitions extend to back-to-back trading of the same object at different prices (bay al-inah), trading of debt at prices different from face value (bay dayn bi-dayn), betting/gambling (maisir), and speculative agreements that yield payments without underlying asset transfer.

### Specific concerns about conventional derivatives
- State-contingent pricing and absence of absolute reference value can create zero-sum payoffs and possible exploitation of less-informed parties.
- Counterparty risk and sale of nonexistent or non-possessed assets conflict with the hadith "sell not what is not with you" and raise ownership/possession problems (qabd).
- Futures and options are often rejected because unfunded or partially funded transactions do not imply legal ownership or possession of the reference asset, undermining guarantee of delivery at maturity.
- Margining and mark-to-market (MTM) practices in futures (interim margin payments and cash settlement) are viewed as problematic because they can imply intertemporal re-pricing and cash-only settlement without underlying asset transfer, resembling prohibited debt sale or bay al-inah.
- Some scholars note that standardized contract specifications, advanced market conduct, and supervisory controls could mitigate certain objections; others (e.g., the Sharia Advisory Council of the Securities Commission of Malaysia) permit futures trading of commodities if the underlying asset meets shari’ah requirements.

### Market and industry developments
- Scarcity of shari’ah-compliant derivatives and lack of standardized documentation have delayed transactions and disadvantaged Islamic investors and institutions.
- The TMA (ISDA/IIFM, March 2010) represents a major step toward:
  - Standardizing shari’ah-compliant swap-based hedging transactions.
  - Enhancing transparency, consistency, and predictability of shari’ah-compliant risk management.
- Islamic finance can already synthesize instruments with derivative-like features: standard asset-based contracts (e.g., ijara, salam, istisna’a) can be decomposed into contingent claims and used as the basis for shari’ah-compatible hedging solutions; practitioners have also used customized “wrappers” to adapt conventional derivatives.

### Analytical implications and framing for permissible derivatives
- The paper proposes that:
  - The existing menu of Islamic instruments is sufficiently rich to deliver some risk management solutions akin to conventional derivatives.
  - Axioms can be articulated to set the stage for permissibility of certain types of derivatives based on asset-backing, possession/ownership at inception, price certitude, avoidance of excessive gharar and maisir, and alignment with the maqasid al-shari’ah (objectives of shari’ah).
- Practical compliance considerations include designing structures that ensure constructive ownership or possession, immediate payment where required (e.g., salam/istisna’a constraints), avoidance of pure cash-settlement-only mechanisms that sever asset transfer, and limiting speculative/unfunded constructs.

*Source: _wp1263 - 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA) ..........26*

### Box 1. The Five Axioms of Shari’ah-compliant Financial Derivatives

### Box 1. The Five Axioms of Shari’ah-compliant Financial Derivatives

### Five Axioms
- In principle, financial derivatives may be compatible with shari’ah law if they:
  - (i) address genuine hedging demand associated with effective and intended ownership (qabd) in an identifiable asset or venture,
  - (ii) guarantee certainty of payment obligations arising from contingent claims on assets with clearly defined object characteristics,
  - (iii) disavow deferment of contractual obligations (nasi’a) from the actual and direct transfer of a physical asset as the object of an unconditional transaction, except for cases when the doctrine of extreme necessity applies,
  - (iv) contain collateralized payment for the use of risk protection but rule out provisions aimed at generating unilateral gains from interim price changes of the underlying asset beyond the original scope of risk sharing (sharik) among counterparties parties, which favors win-win situations from changes in the value of the reference asset,2 and
  - (v) eschew all prohibited sinful activities (haram), in particular those deemed similar to gambling (maisir) and speculation due to uncertainty (gharar) by means of clearly stated object characteristics and/or delivery results, which mitigate the risk of exploitation from ignorance (jahl).
- Additional requirement:
  - Shari’ah-compliant derivatives must also be employed in keeping with the precept of maintaining an equitable system of distributive justice as a public good (maslahah).

### Interpretation and Controversies on Options
- Summary of core issues:
  - Options: holders of a call (put) option (“promisees”) acquire from the seller (“promissor”) the right (but not the obligation) to acquire (sell) the underlying asset at a pre-determined price during a specific period of time.
  - Usmani (1999) observation: “according to the principle of the shari’ah, an option is a promise to sell or purchase a thing on a specific price within a specified period. Such a promise in itself is permissible and is normally binding on the promisor [like a wa’ad contract]. However [,] this promise cannot be the subject matter of a sale or purchase. Therefore, the promisor cannot charge the promisee a fee for making such a promise.”
  - Hedging vs. speculation: Bacha (1999) suggests that disqualifying options on grounds of gharar and maisir presumes they are primarily transacted for speculative gains and not genuine hedging.
- Technical notes on option permissibility:
  - Only the time value of an option (independent of the realization of unilateral gains) appears permissible.
  - Interim value changes implying unilateral gains from shared business risk would be shari’ah-compliant only if the option had no intrinsic value at inception for a pre-specified strike price in the future.
  - The inherent leverage in options and their detachment from the reference asset(s) remain controversial.
- Footnoted and scholarly positions:
  - Kamali (2001) finds “there is nothing inherently objectionable in granting an option, exercising it over a period of time or charging a fee for it, and that options trading like other varieties of trade is permissible mubah, and as such, it is simply an extension of the basic liberty that the Qur’an has granted.”
  - Some scholars consider options in violation of Islamic law; the question remains not conclusively answered.

### Implicit Derivatives in Islamic Finance
- Core idea:
  - Main Islamic contracts already contain derivative-like elements; shari’ah-compliant lending establishes contingent (payment) claims via:
    - (i) synthetic loans (debt-based) through sale-repurchase agreements (or back-to-back sales) of borrower- or (third party-)held assets with instantaneous title transfer (e.g., murabaha),
    - (ii) lease contracts (asset-based) through sale-leaseback agreements (operating lease) or leases of third-party-acquired assets with purchase obligation components (financing lease) (e.g., ijara), and
    - (iii) profit-sharing contracts (equity-based) of future assets in the form of partnerships, private equity investments or management contracts (e.g., musharakah, mudarabah and whakala).
- Put-call parity and ijara example:
  - Financing lease (ijara) structure: lender acquires asset at spot price S, entitles borrower to regain ownership at time T by writing a call option -C(E) with constant strike price E (equals the notional future purchase price) in return for rental payments; lender retains right to sell A as a put +P(E).
  - This “creditor-in-possession”-based arrangement with ex ante payoff S - C(E) + P(E) amounts to a conventional loan with present value PV(E).
  - Put-call combination can represent a series of cash-neutral, maturity-matched, risk-free (and periodically extendible) synthetic forward contracts Σ_{t=1}^T [ -C_t(E) + P_t(E) ] over rental payment dates t.
- Practical implications:
  - Both creditor and debtor have incentive to honor contract irrespective of changes in asset value (consistent with prohibition of gharar and maisir).
  - Holding equal and opposite option positions on the same strike price at inception eliminates objectionable zero-sum gains or contractual uncertainty, except in case of counterparty default.
  - Neither creditor nor debtor benefits from asset price fluctuations before maturity; inability to cash in on interim price changes prevents interim unilateral gains.

### Classification and Existing (“Legacy” and “Explicit”) Derivatives
- Table 2 classification (types listed by economic objective):
  - Type categories: Implicit Derivatives / Legacy Derivatives / Explicit Derivatives
  - Forward examples:
    - Implicit: ijara thumma al-bay, murabaha, diminishing equity-musharaka
    - Legacy: salam, bay mu’ajal, bay bithaman ajil (BBA), istisna
    - Explicit: various commodity hedges and “wrappers”
  - Option examples:
    - Implicit: (none listed)
    - Legacy: wa’ad, arbun, al-shart, (kyiyar al-tarwih)
    - Explicit: foreign exchange option contracts
  - Swap examples:
    - Implicit: (none listed)
    - Legacy: tawarruq, al-muqasah
    - Explicit: wa’ad-based swap, profit rate swap, cross-currency swap
- Comments on forwards and counterparty risk:
  - Forward element involves problems of double coincidence and counterparty risk.
  - Forwards require exactly opposite hedging interests coinciding in timing and amount.
  - Absence of centralized clearing and settlement raises high default risk if spot price diverges from forward price before maturity.
  - Legal recourse exists but enforcement can be lengthy, cumbersome and expensive, particularly where commercial law and shari’ah law conflict.
- Legacy derivatives and contested contracts:
  - Salam: deferred delivery sale used mainly in agricultural finance; exempt from seller possession requirement but applies only to commodities.
  - Bay bithaman ajil (BBA): used for long-term financing; lender does not have to disclose profit margin.
  - Istisna: pre-delivery/project finance for yet-nonexistent manufacturing goods with contractual specifications; installment payments possible.
  - Arbun: forfeitable down-payment as an option on conclusion of a sales contract; down-payment deducted from sales price if exercised; valuation differs from call option due to ex ante down payment.
    - Three schools of thought (madh’hab) under Sunni and Shia Islam have declared arbun contracts void.
  - Wa’ad: unilateral promise with option characteristics; Fiqh Academy (Kuwait, December 10–15, 1988) found wa’ad in murabaha context morally binding and legally enforceable if unilaterally binding on one party and the promisee has incurred liabilities.
  - Al-shart and kyiyar al-tarwih: contractual provisions allowing confirmation/cancellation or withdrawal (within three days) under certain conditions; derive economic value from legal recourse.
- Explicit derivatives and market innovations:
  - Explicit derivatives remain few and nascent; main obstacles to shari’ah-compliance of conventional derivatives are:
    - (i) the state-contingent valuation,
    - (ii) the absence of underlying asset transfer and/or pre-existing ownership,
    - (iii) the profitable exchange of the same commodity (possibly with delay in delivery and/or payment) to settle transactions.
  - Recent innovations focus on customized option contracts, commodity hedges, cross-currency swaps and “profit rate swaps”.
  - Swaps structure under shari’ah:
    - Parties sell assets (usually commodities) to each other for deferred payment rather than exchange interest.
    - Cross-currency swaps: exchange commodities in cost-plus sales and settle mutual payment obligations in different currencies per a pre-defined installment schedule.
    - Profit rate swaps: exchange periodic fixed-rate for floating-rate payments; after selling a designated commodity to protection seller, protection buyer receives periodic fixed-rate payments in return for floating rate installments.
  - Use case: corporate in the GCC raising funds in Malaysia could use shari’ah-compliant currency (and profit rate) swap to avoid local currency and interest rate risk.

### Key Implications and Summary Findings
- Insufficient or absent asset-linkage and potential for unilateral gains in many derivatives undermine equitable risk sharing and contractual certainty required by shari’ah.
- Conventional remedies to contractual uncertainties (futures, options) may contravene Islamic principles by implying a zero-sum proposition ex ante and intertemporal debt creation without underlying asset transfer.
- In more developed financial markets with better documentation and enforcement, a more flexible interpretation of some principles that preserves the main moral tenets of Islam might be warranted.
- Many standard Islamic contracts already embed “implicit derivatives,” which guarantee definite performance and equitable risk sharing while avoiding interim unilateral gains; these are typically bilaterally negotiated and OTC.
- Explicit shari’ah-compliant derivatives exist but are limited, customized, and primarily used for currency and interest rate risk management via commodity-based structures and profit rate swaps.

*Source: Box 1. The Five Axioms of Shari’ah-compliant Financial Derivatives (extracted from the provided content).*

### Box 2. Islamic Swap Transactions—Cross-Currency and Profit Rate Swaps

### Box 2. Islamic Swap Transactions—Cross-Currency and Profit Rate Swaps

### Overview
- Shari’ah-compliant swap transactions are traded bilaterally (i.e., non-standardized).
- They combine opposite, maturity-matched murabaha contracts with instantaneous (or periodic) transfer of similar assets to create mutual (and fully collateralized) payment obligations (inclusive of the premium payment for the use of the asset) until the maturity date.
- The two most prevalent contracts are cross-currency swaps (CCS) and profit-rate swaps (PRS), with PRS being the shari’ah-compliant version of interest rate swaps.
- In a murabaha-based swap transaction, both contract parties hold mutually offsetting payment obligations against each other, which mitigates the contingency risk of periodic payments (but does not preclude economic risk from changes in the value of the underlying asset).
- The degree of collateralization of a standard murabaha (cost-plus sale) contract depends on the original ownership of the underlying asset:
  - full recourse if the borrower was the original owner of the asset (sale-repurchase agreement),
  - limited recourse if the seller acquired the asset from a third party (back-to-back sale).

### Cross-Currency Swap (CCS) structure and functioning
- Basic structure: combines two commodity murabaha sale contracts that generate offsetting cash flows in opposite currencies with maturities desired by the contracting parties.
- Historical note: In July 2006, Standard Chartered arranged the first ever derivative structure of this kind for Bank Muamalat Malaysia.
- Illustrated example:
  - A Malaysia-based Islamic bank that raises revenue in Malaysian Ringgit but faces payments in U.S. dollars can enter into a CCS with a U.S. dollar-paying counterparty to substitute future outflows in U.S. dollars for outflows in Malaysian Ringgit.
  - Under the CCS:
    - The Malaysia-based Islamic bank purchases commodity A denominated in Malaysian Ringgit and sells it to a GCC-based Islamic bank on a murabaha basis (against future installments).
    - Simultaneously, the GCC-based bank completes a murabaha agreement for commodity B denominated in U.S. dollars.
  - By combining the two murabaha contracts, each denominated in a different currency, both parties receive cash flows in the desired currency by selling their respective commodities denominated in their local currency.
  - The fair value of each commodity (A and B) should wash out at the prevailing exchange rate.
- Settlement characteristics:
  - The CCS includes full payment and physical settlement each period, with both parties selling their commodities in order to recoup their initial disbursement.

### Profit-Rate Swap (PRS) structure and functioning
- Pioneered by Commerce International Merchant Bank (CIMB) of Malaysia in 2005.
- Purpose: allows financial institutions to manage exposures to fixed and floating rates of return.
- Structure: based on the combination of two commodity murabaha contracts, analogous to the CCS.
- Illustrated example:
  - Risk protection buyer: Islamic bank A (“floating rate payer”) intends to convert payments from floating to fixed rate.
  - Islamic bank A acquires and sells via a murabaha contract commodity A in exchange for a stream of pre-determined, periodic payments from the protection seller, Islamic bank B (“fixed rate payer”), over a specified period of time.
  - Islamic bank B periodically completes a murabaha sale of a commodity in exchange for future installments at the fair value (market) price plus a floating rate profit portion (“cost-plus”) that varies according to changes in some pre-agreed benchmark (e.g., some inter-bank funding rate like the London Interbank Offering Rate (LIBOR)).
  - The floating rate payer purchases commodity B in periodic increments (unlike the fixed rate payer, who receives commodity A in full at inception).
- Payment flows:
  - Fixed periodic payments in US Dollars and fixed periodic payments in MSY Ringgit are possible in CCS illustrations.
  - In PRS illustrations, periodic fixed payments and periodic floating rate payments occur (floating leg described as reverse murabaha: commodity market price + floating rate profit portion (over LIBOR)).

### Contested derivatives and Shari’ah compliance concerns
- Attempts to design other shari’ah-compliant derivatives, such as total return swaps, have been mired in controversy.
- One contested structure: dual wa’ad contract swapping returns of a shari’ah-compliant asset portfolio with those of a designated index or reference investment portfolio that can contain conventional assets (Islamic total return swap).
  - Concern: this structure would allow investors to access returns from assets prohibited under shari’ah principles.
  - DeLorenzo (2007) argues this swap structure does not conform to shari’ah norms because returns from the alternative portfolio are not derived from religiously acceptable activities.
- Note: while some pre-agreed interest rate benchmark is permissible under shari’ah law, it should be distinguished from the use of non-shari’ah-compliant assets as a determinant for returns (DeLorenzo, 2007).

### Legal challenges, governance, and standardization efforts
- Major governance issues:
  - Consistent assessment of shari’ah compliance and generation of commonly binding principles and rules remain a major challenge.
  - Shari’ah rulings (fatwas) and their underlying reasoning are disclosed but not consolidated, inhibiting dissemination, adoption, and cross-fertilization across countries and madh’hab.
  - Absence of unified principles and precedent spawns plurality of interpretations and fragmented opinions of shari’ah boards.
- Legal contingency concerns:
  - Heterogeneous prudential norms and diverse interpretations of shari’ah compliance amplify legal contingencies affecting business conduct.
  - Absence of definite guidance and universal enforcement affects legal integrity in dispute resolution.
  - If a transaction is governed solely by shari’ah law as a matter of form, shari’ah courts could re-qualify the legal nature of a transaction, potentially undermining conventional market conduct and contract enforceability in courts or arbitration.
- Scholastic heterogeneity:
  - Considerable heterogeneity of scholastic opinion about shari’ah compliance of derivatives, reflecting difficulties of reconciling financial innovation with principled interpretation via qiyas, ijtihad, and ijma.
  - General benchmarks for Islamic derivatives are yet to emerge due to divergent market practices, lack of consolidated shari’ah approval process, and legal risk associated with the nonbinding character of precedent in Islamic jurisprudence.
- Standard-setting and industry initiatives:
  - Leading organizations working on regulatory norms: Accounting and Auditing Organization of Islamic Finance Institutions (AAOIFI), Islamic Financial Services Board (IFSB), General Council for Islamic Banking and Finance Institutions (GCIBFI), Islamic International Rating Agency (IIRA), and the Fiqh Academy in Jeddah.
  - These efforts have not addressed various risk management techniques that involve derivatives.
  - Voluntary adoption of standards issued by bodies such as IIFM, AAOIFI, and the IFSB is very underdeveloped, with national practice taking precedence over less well-established international organizations.
  - Examples of industry standardization:
    - Master Agreement for Treasury Placement (MATP) issued recently to contribute to standardization of documentation rules for the shari’ah-compliant commodities market.
    - In October 2006, ISDA and IIFM, in cooperation with ICMA, signed a memorandum of understanding to develop a master agreement protocol for Islamic derivatives, which led to the publication of the multi-product ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA) on swap transactions in March 2010.
      - The TMA is a financial industry framework document and does not establish universally binding market rules.
      - Its adoption remains subject to legal and governance processes determined by national practice as a matter of private law.
      - The TMA is innovative as a pan-madhab agreement spanning all five major schools of Islamic jurisprudence.
    - Precedent: Bank Islam and Bank Muamalat in Malaysia introduced currency and profit rate swaps and had executed a pro-forma derivative master agreement for documentation of Islamic derivatives as early as 2006.
      - In November 2006, Bank Islam Berhad and Bank Muamalat Malaysia Berhad agreed to execute a master agreement for documentation of Islamic derivatives transactions; this initiative was sponsored by the Malaysian Financial Market Association (Persatuan Kewangan Malaysia) with participation from both Islamic and conventional Malaysian banks.

*Source: Box 2. Islamic Swap Transactions—Cross-Currency and Profit Rate Swaps*

### Box 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA)

### Box 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA)

### Overview and purpose
- Launched in March 2010 by the International Islamic Financial Market (IIFM) in cooperation with the International Swaps and Derivatives Association (ISDA).
- Designed to be used between two principal counterparties that make representations as to the fact that they enter into shari’ah-compliant transactions only.
- Spans all five major schools of shari’ah jurisprudence, making pan-madhab, a first in the Islamic derivatives market.
- Current master agreement is designated as “Version 1”.
- Structure similar to the conventional 2002 ISDA Master Agreement (MA) and incorporates three pillars of ISDA technology: the flawed asset concept, the single agreement concept, and the close-out mechanism and netting; key mechanisms (early termination events, close-out, netting) are developed based on shari’ah principles.
- Current version is multi-product, covering murabaha, wa’ad, salam, and arbun-based swap agreements, with intention to expand scope and amend structure to include other transaction and contract types under shari’ah law.

### Key differences from the conventional ISDA MA
- Six principal areas of difference:
  - (i) the architecture of the agreement;
  - (ii) the close-out mechanism, which includes the net present value of future receipts/payments;
  - (iii) the events of default;
  - (iv) the forum of dispute resolution;
  - (vi) additional representation as to shari’ah compliance; and
  - (vi) the treatment of contractual payments (which exclude payable interest in the TMA).
- Explicitly states that no interest shall be payable or receivable, and no settlement based on valuation or without tangible assets is allowed.
- Disclaimers assert there is no guarantee of shari’ah compliance for any amendments or additions to the agreement or related underlying transaction documents.

### Treatment of early termination, concluded vs designated future transactions, and close-out
- Distinguishes between:
  - (i) “concluded transactions” (from inception to the end of the first payment period, e.g., the first year of the contract); and
  - (ii) “non-concluded transactions” or “designated future transactions” (covering the remaining maturity term), which converts into a “concluded transaction” year by year.
- The TMA permits transactions documented immediately as well as transactions due to occur in the future so parties can create cash flows similar to conventional derivatives products.
- Early termination requires a close-out mechanism that contemplates separate confirmations for current transactions and arrangements relating to future transactions, resulting in a parallel (rather than consecutive) mark-to-market (MTM) valuation of the concluded and the designated future contracts.
- Close-out specifics:
  - Close-out of the concluded transaction follows provisions for early termination according to the 2002 ISDA MA; the full amount (and not the net present value) is payable and receivables are to be accelerated and paid out (without discounting).
  - Close-out of designated future transaction(s) uses musawama contracts to crystallize the close-out amount payable.
  - The parallel close-out mechanism generates a net amount from offsetting both the concluded and the designated future contract.
  - Each party issues an undertaking to enter into a contract in the future for the sale of assets at a pre-agreed price following designation of an early termination date.
  - Parties trigger offsetting payments by selling a good or asset to the counterparty at a pre-agreed price calculable using a specified formula to establish a price payable at which shari’ah-compliant assets would be bought and sold.
  - The party to whom a payment is due may exercise the wa’ad (promise) given in its favor and sell pre-agreed assets in exchange for the cost price of such assets and the difference in asset values plus the mark-to-market value of the designated future transaction(s), expressed as an index level.
  - The index level is calculated using a similar basis to that used in the conventional 1992 ISDA Master Agreement.
  - For designated future transaction(s), the non-defaulting party is free to choose the shari’ah-compliant assets that are subject of the musawama contract on a close-out.
  - If one party were insolvent at the time of close-out, or, in breach of the wa’ad it has issued, a party fails to purchase the assets at the net cost of the musawama-based close-out, liquidated damages on the musawama price are determined and payable.

### Events of default, cross-default, and dispute resolution
- Events of default/termination include failure to pay or deliver, breach of agreement, credit support default, breach of contract (e.g., misconduct), and misrepresentation of shari’ah compliance.
- Cross-default provisions accepted by Islamic scholars: any default on another swap will be considered a default on the issue (purpose is to protect a creditor or counterparty from actions favoring another creditor).
- The master agreement includes a governing law clause that refers exclusively to relevant secular law; the agreement follows New York or English law as a matter of form.
- Parties have the ability to elect arbitration as a means to resolve disputes.
- Election of secular governing law acknowledges investor protection concerns as regards re-classification risk by shari’ah courts; violation of shari’ah principles would not preclude legal enforceability of claims under TMA.
- The contractual parties are required to expressly record their intention to enter only into a shari’ah-compliant transaction and represent their satisfaction as to shari’ah compliance by certifying their own due diligence (e.g., based on a copy of the relevant fatwa or documentation of their own internal consideration) or, at least, by confirming their independent assessment with regard to the shari’ah compliance (without reliance on assurances by the other party).
- The governing law provision assumes satisfaction with shari’ah principles was a material pre-condition for entering into the relevant transaction and thus does not impact construction of contractual terms.

### Implementation challenges, ambiguities, and other concerns
- Applicability as a voluntary industry standard hinges on permissibility under private law in various jurisdictions; national practice may take precedence over recommendations by less well-established international organizations.
- Parties must still develop confirmations to document transactions and separate documents (each a designated future transactions terms agreement) would be required to bind parties into and give value to designated future transactions.
- Open issues and ambiguities:
  - The concept of net present value is not recognized in shari’ah law; related valuation/treatment differs from conventional practice.
  - Not clear how the time value of money is assessed when payments may be deferred.
  - Election of secular governing law removes shari’ah principles from legal enforcement under the terms of the TMA because parties are required to ascertain shari’ah compliance outside the contract, rendering shari’ah compliance immaterial to potential dispute resolution (in absence of shari’ah board approval for transactions).
  - The netting of future designated transactions is not covered (except in a footnote that contemplates that parties may provide for similar netting in those agreements).
  - Replacement of the term “transfer” in the conventional MA with “redesignation” of rights and obligations introduces uncertainty about the ability of the affected party to change substantive rights in connection with changing the obligor office.
  - Removal of creditworthiness in determining price quotations could distort the economics of a transaction where there is early termination or otherwise.
- Musawama specifics and valuation notes:
  - In a typical musawama contract, a bank usually purchases assets and holds them until they are sold at a mark-up to the client subject to repayment in installments; as opposed to a murabaha contract, a bank using a musawama contract does not disclose to client either the profit margin or the actual cost of acquiring the assets.
  - Since the valuation and pricing of designated future transactions(s) are agreed at the outset, musawama arrangements cannot create an objectionable “transaction at an undervalue.”
- Despite statements that no interest shall be payable or receivable and no settlement without tangible assets is allowed, several legal contingencies leave room for interpretive uncertainty.

### Key statistics and contextual figures
- Launch date: March 2010.
- Conventional reference agreements and years cited: 2002 ISDA Master Agreement; 1992 ISDA Master Agreement basis for index calculation.
- Current master agreement designation: “Version 1”.
- Contextual market size in conclusion: With about US$1 trillion of assets lodged in Islamic financial institutions and capital markets, demand for shari’ah-compliant structured transactions is significant.

### Conclusions and policy implications
- The TMA represents an important step toward standardization of bilateral hedging arrangements in Islamic finance and is a first step in the right direction for standardizing shari’ah-compliant derivatives documentation.
- Standardization could establish clarity about rationale for restrictive use, ensure consistent application, attract a wider range of participants (including conventional participants seeking to expand their presence in Islamic finance), and help establish congruence of derivatives in both conventional and Islamic finance.
- Widespread adoption of the TMA depends on permissibility under private law across jurisdictions and the resolution of outstanding legal and valuation ambiguities.
- As Islamic finance expands internationally, shari’ah-compliant derivatives and other risk management techniques will be increasingly essential to enhance liquidity management, supplement cash markets at lower funding cost, and ensure efficient transmission of funds from savers to investors.

*Box 3. Key Elements of the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1263.pdf_