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success of al safi Prime broker agreement is key to Shariah-compliant short selling A long/short hedge fund strategy is the plain vanilla of the industry. Finding a Shariah-compliant way to achieve the same strategy is at the heart of the Al Safi hedge fund platform. Finding a workable solution was a complex task. Short selling is not new. It dates from 1609 when Dutch trader Isaac Le Maire performed the first short. His outrageous act led to the first stock exchange regulations: a ban on short selling, revoked in 1611. Today short selling is one of the most popular techniques used by hedge funds to protect and, hopefully, increase their investors’ money. The majority of shorting is a way to ‘hedge’ a long position on a particular stock. The idea is that a short seller can profit from a stock price going down by borrowing a security and selling it, expecting it will be cheaper to repurchase at some point in the future. When the seller believes the time is right, or when the lender recalls the shares, the seller buys back the shares and returns them to the lender. Short sellers borrow from brokers, who in turn borrow the shares from investors holding the shares ‘long’ (for a number of years). A short seller takes a fundamentally negative view on a stock, selling high and buying low. The technique helps balance the market. Short sellers target overpriced stocks or markets. Hedge fund managers use shorting as a way to protect (or hedge) other long positions. Under Shariah law, however, this practice is not permitted. Finding a way to replicate the hedging principle used by the majority of hedge funds was one of the main challenges to establishing the Al Safi platform and other attempts in the past to make hedge funds Shariah compliant. The conventional methods for hedging, and in particular shorting, are not acceptable in Shariah finance. However, scholars and experts have come to a consensus view that it is possible in theory to use classical transactional models like salam and arboon to provide investment managers with effective tools for hedging and managing risk, including an ability to profit from falling share prices. Fatwa key to approval Formal approval and certification by means of a fatwa of Shariah compliant short sale methodology is key to the Shariah compliant short sale alternative. A fatwa has been issued for the Al Safi platform and its various solutions, including the arboon short sale, by a Shariah supervisory board of internationally renowned scholars. The process used by the hedge funds on the Al Safi platform establishes ownership before the sale of the asset to the market. When an Al Safi hedge fund wants to short a stock, the trader puts an order through Barclays Capital Prime Brokerage. The difference is that on Al Safi the broker facilitates the transaction as a purchase and not as a loan. The solution uses an arboon sale, rooted in classical Islamic law. This is when a seller takes an arboon or ‘earnest’ money, a non-refundable down payment or deposit paid by the buyer to the seller when the sale is concluded, with the provision that the contract is completed within a set period of time. Although both the salam and arboon models have been approved by Shariah supervisory boards around the world and are routinely used by Islamic and multinational banks with Islamic clients, only the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) and the US Securities and Exchange Commission (SEC) have found the arboon model suitable for use. The arboon short sale replicates a conventional short sale without the borrowing-to-sell method of shorting used by conventional prime brokerages for hedge funds. A complex transactional process using arboon short sale is needed to achieve the same economic result (and profit) as a conventional short sale. Different Shariah, regulatory, legal and commercial elements are involved and the legal documentation is extensive. No matter how willing a hedge fund manager may be to comply with the investment guidelines specified by a Shariah supervisory board, it would not be enough. This is because a hedge fund manager does not control the short sale process but depends on the prime broker. Prime broker role Only a prime broker can provide the complicated series of services required for Shariah compliant short sale transactions or has the contracts that satisfy legal, regulatory, exchange and prime broker credit and balance sheet requirements. In a Shariah compliant arboon short sale, stocks are bought using an arboon contract. The investor (hedge fund) takes ownership of the stocks. The fund does not borrow the stocks as in a conventional short sale. The arboon short sale uses a similar agreement to ensure the investor’s ownership of whatever stocks are later sold into the market. The prime broker (in this case Barclays Capital Prime Brokerage) agrees to sell stock to the investment manager at the quoted (and agreed) market price. The investment manager makes an arboon down payment and assumes ownership of the stocks. The arboon short sale equivalent is structured with a specified “date of ultimate settlement of the purchase and sale”, at which time the unpaid portion of the purchase price has to be paid (the closing date). This complies with the condition stipulated by the Fiqh Academy (OIC), an international body of Shariah compliant scholars, that a time period for payment of the remaining purchase price must be stated. If the investment manager decides not to complete the sale, he returns the shares and forfeits the arboon earnest money. Once the investment manager has made a down payment equal to a margin account deposit, it is possible to arrange through the prime broker to sell the stocks bought by means of the arboon short sale to a third party at the market price when the sale is concluded. In order to close out the transaction in the arboon short sale, the investment manager instructs the prime broker to purchase the required number of stocks from the market at the market price. Using these securities the investment manager ends the arboon and the prime broker retains the earnest money. The same process is used in a conventional short sale. The arboon short sale solution for hedge funds goes beyond the usual development of a financial product because Shariah compliance requires more than structuring and monitoring a fund to ensure compliance of the hedging strategy and the securities held in the investment portfolio by means of screening, investment guidelines, and oversight by a qualified Shariah supervisory board. For hedge funds the arboon short sale requires fundamental changes to the way trades are processed. The contracts underlying the exchange of securities must comply with Shariah rules. Without these modified legal documents, no short sale solution, however sound its Shariah methodology, can be considered Shariah compliant. n 12 | Access to Islamic Hedge Funds Supplement | November 2008 www.hedgefundsreview.com
dubai multi commodities centre Al Safi is strategic step for Dubai financial services growth A strategic initiative of the Dubai government created the Dubai Multi Commodities Centre tasked with making Dubai a global commodity hub. Established with the objective of delivering world-class and specialised market solutions to the commodities industry, the Dubai Multi Commodities Centre (DMCC) also is providing industry-specific market infrastructure and a full range of facilities for the gold and precious metals, diamonds and coloured stones, energy and other commodities industries. Rated ‘A’ by Standard & Poor’s, DMCC is a free zone authority offering tax incentives and other services to encourage investment in the region and to promote trade. “We have to make history and approach the future with steady steps – not wait for the future to come to us,” said His Highness General Sheikh Mohammed bin Rashid Al Maktoum, vice president and prime minister of the UAE and ruler of Dubai at the launch of DMCC. Strategically located at the crossroads of Europe and Asia and with access to large emerging markets, Dubai has ambitions to become an international financial centre, leveraging its considerable expertise and importance within the commodity sector. It is the first dedicated commodities centre in the time zone between Europe and the Far East. Dubai’s financial centre ambitions encompass the Gulf states, African countries, the Levant, the Caspian and the former Soviet Union, as well as the Indian subcontinent. With a total population of 1.8 billion, this region’s combined economy totals $1.5 trillion in terms of GDP and is growing at a rate of over 5% a year. Dubai clearly is positioning itself as the business hub of the region. Part of this strategic initiative is DMCC’s development and management of a range of Shariah compliant investment products focused on commodities through a joint venture initiative between Dubai Commodity Asset Management (DCAM), a wholly owned division of DMCC and publicly traded Shariah Capital, Inc. The joint venture, Dubai Shariah Asset Management (DSAM), is owned 51% by DCAM and 49% by Shariah Capital. DSAM offers Islamic investors exposure to a range of commodity companies, including those engaged in gold mining, oil and gas, alternative energy, global natural resources and agriculture through some of the world’s most experienced commodity equity hedge fund managers. With the seeding of its fourth manager, DSAM provides access both to individual strategies and to an equally weighted, fund of fund solution comprising all DSAM managers. This fund of funds is ideal for Islamic investors who want an allocation in this asset sector without the complication of choosing one commodity exposure over another. “Financial engineers have misallocated capital. Investing in commodity stocks in a non-leveraged, Shariah manner would return capital investments to the principles of economic growth and development rather than trading for its own sake,” said Mohammad Jamjoum, DSAM general manager, on the launch of the venture. Access to the individual commodity-linked hedge fund strategies www.hedgefundsreview.com November 2008 | Access to Islamic Hedge Funds Supplement | 13
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