In the GCC, Islamic financings that are not provided in a local currency are usually in US dollars. In many cases, such US dollar Islamic financings in the GCC are still being originated using LIBOR as the benchmark rate for profit calculations, despite LIBOR’s discontinuation being increasingly imminent. In this note, we consider the challenges of LIBOR transition for GCC Islamic financiers, and the alternatives to LIBOR that are available for use in Islamic finance transactions, including the forward-looking term SOFR that has recently been formally recommended by the Alternative Reference Rates Committee (ARRC).
LIBOR transition in the GCC
While the transition away from the use of LIBOR towards risk-free rates (RFRs) or other benchmark rates has made great strides in the US, UK and some European markets, it has been somewhat slower in the GCC markets. This can perhaps be explained to a degree by the general understanding in the market that the key tenors of US dollar LIBOR will continue to be published until 30 June 2023. On 5 March 2021, the UK’s Financial Conduct Authority published a statement announcing the dates of the future cessation or loss of representativeness of all 35 LIBOR settings currently published. This confirmed that, while the lesser-used 1 week and 2 month tenors for US dollar LIBOR will cease to be published on 31 December 2021, other US dollar LIBOR tenors (including 1, 3 and 6 months) will continue to be published until 30 June 2023, and some may continue to be published on a non-representative, synthetic basis after that date. However, that mid-2023 backstop date needs to be viewed in the context of other factors – in particular, it should be understood that the ongoing publication of US dollar LIBOR beyond 2021 is primarily to support the transition of legacy US dollar financings to RFRs. US regulators have made clear that they expect banks to cease using US dollar LIBOR on new financings after the end of 2021. Accordingly, it is incumbent upon Islamic financiers in the GCC to ensure that they have a firm grasp of the alternatives to LIBOR and have the documentation and operating systems in place to be able to provide new US dollar financings in the post-LIBOR world.
It is worth noting that there do not appear to be any public plans for any GCC central bank to cease publishing the applicable interbank offered rate for its local currency (for instance, in the UAE, the Emirates Interbank Offered Rate) and we expect that such local interbank offered rates will continue to be used by GCC financial institutions as the benchmark rate for their local currency financings for the time being.
Islamic finance – the complexities of transitioning away from LIBOR
For all financial products that have historically relied on LIBOR, transitioning away from LIBOR is a complex process. But moving beyond LIBOR in Islamic finance raises particular additional difficulties. For example:
- firstly, there is a direct conflict between the requirement for Islamic financings to satisfy the Islamic principle of Gharar (which, in summary, requires certainty in respect of key financial terms at the start of a calculation period) and the way compounded SOFR is calculated (on which see below);
- secondly, there are a greater number of stakeholders involved in Islamic finance decision-making processes when compared with conventional financings. For instance, Shari’a scholars’ guidance and ultimate approval will be needed with regards to any LIBOR alternative to be deployed by GCC financial institutions in respect of each Islamic financing product (for instance, two of the most popular Islamic financing products in the GCC – a Murabaha (i.e. cost plus) financing or an Ijara (i.e. sale and leaseback) financing – might require different approaches); and
- thirdly, certain GCC financial institutions are required to be compliant with current Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards generally (for instance, certain UAE financial institutions are required to be AAOIFI-compliant by the UAE Central Bank). Such GCC financial institutions will need to be comfortable (to the extent possible) that LIBOR alternatives will also be AAOIFI-compliant (please refer to our article, Murabahas and AAOIFI 59, for a summary of some recent complications thrown up by AAOIFI in the context of Murabaha financings).
This all makes transition particularly tricky for Islamic financiers to navigate in comparison with conventional financiers.
Using compounded SOFR in Islamic finance
For most (but not all) conventional finance products in the GCC that have historically used US dollar LIBOR as a benchmark rate, financiers and their customers are transitioning to the use of compounded in arrear SOFR (compounded SOFR), usually with a look-back period of five business days. Interest over an interest period is calculated based on SOFR over a period equal to the interest period but starting and ending five business days earlier than the interest period. This provides sufficient time for parties to run the relevant calculations and provide notifications before each interest payment date (please refer to Dentons LIBOR FAQs for further details). Compounded RFRs have also become the most common alternative to LIBOR in the UK and European markets.
However, compounded SOFR does not sit easily with Islamic finance principles. Because profit based on compounded SOFR is ordinarily calculated at the end of the relevant calculation period rather than the start, this offends the principle of Gharar. Accordingly, if Islamic financiers in the GCC wish to use compounded SOFR, they will need to develop their own bespoke approaches which are satisfactory to Islamic finance market participants and the principles of Islamic finance. We summarise below some approaches that are currently being considered for US dollar Islamic financings in the GCC.
Murabaha financings
For Murabaha financings, there are two alternative “mainstream” approaches when using compounded RFRs: the “Dual Murabaha Approach” and the “Ceiling Murabaha Approach”.
- The Dual Murabaha Approach. This incorporates a unilateral undertaking from the customer to enter into an intra-day spot Murabaha contract at the end of each calculation period (which would be a “deferred payment date” in the context of a Murabaha financing) or close to that date for the financial institution to recover the benchmark component of its profit. The benchmark rate under each such intra-day spot Murabaha contract is calculated using compounded SOFR.
This “Dual Murabaha Approach” uses as its base the post-AAOIFI 59 Murabaha dual Murabaha financing structure (AAOIFI 59 Murabaha Structure) (see our earlier article, Murabahas and AAOIFI 59). Here, the total margin for the tenor of the financing is calculated on day one, added to the principal amount of the financing and then amortised over the tenor of the financing across all interest/calculation periods under a “long” Murabaha contract. This is followed by a series of “short” Murabaha contracts under which the variable benchmark rate is recovered.
In some variations of the AAOIFI 59 Murabaha Structure, the variable benchmark component of the profit is recovered by way of a series of intra-day short Murabaha contracts entered into at the end of each calculation period (as summarised above) using the forward-looking LIBOR rate at the beginning of the calculation period. In other variations, the short Murabaha contracts are entered into at the beginning of each calculation period using the forward-looking LIBOR rate.
In either case, this leads to an unsatisfactory outcome for customers who, in the event of an early payment of the financing, would (as well as not needing to pay the variable benchmark element of the profit under the short Murabaha contract) expect not to need to pay the margin component of the profit rate under the long Murabaha contract after the date of an early payment. Accordingly, a discretionary rebate is included in the finance documents in respect of the margin component of the bank’s profit contained in the long Murabaha contract exercisable in the event that the financing is prepaid. Under the AAOIFI 59 Murabaha Structure (although, in our experience, this has been less common to date), customers would be advised to insist that an undertaking also be granted by the Islamic financier in favour of the customer to enter into a “reverse” intra-day spot Murabaha contract in the event that the Islamic financier did not exercise its discretionary rebate in respect of the post-early payment date margin element of the long Murabaha contract, under which an amount equal to the post-early payment date margin element of the Murabaha contract would become due and payable by the Islamic financier to the customer. Under the settlement deed, the amount due from the Islamic financier to the customer under that reverse spot Murabaha contract would then be set off against the post-early payment date margin due from the customer to the Islamic financier, resulting in no funds being payable by either party in respect of post-early payment date margin. Lastly, following an early payment in full, there would be no requirement on the customer to enter into any further intra-day spot Murabaha contracts for the benchmark amount after the early payment date and, following an early payment in part, the requirement on the customer to enter into any further intra-day spot Murabaha contracts for the benchmark amount would be reduced after the early payment date. As a result, we would expect that customers following the Dual Murabaha Approach would also want this protection embedded in the structure, where possible.
- The Ceiling Murabaha Approach. Under this approach, the parties enter into a single Murabaha contract, calculated on the basis of: (a) the principal; (b) the fixed margin; and (c) a predetermined, notional “ceiling rate” expected to be higher than any benchmark rate calculated using compounded SOFR over the full tenor of the facility. Then, in order to effect an economically similar result at the end of the term of the Murabaha facility or (if earlier) early payment:
- the bank will enter into a unilateral undertaking to enter into a spot Murabaha contract where the aggregate of the profit amounts paid under all Murabaha contracts is more than would have been paid using compounded SOFR, for an amount equal to the difference; and
- the customer will enter into a unilateral undertaking to enter into a spot Murabaha contract where the aggregate of the profit amounts paid under all Murabaha contracts is less than would have been paid using compounded SOFR, for an amount equal to the difference,
with either such Murabaha contract entered into in accordance with the relevant undertaking being effected by way of a spot Murabaha contract.
Under the “Ceiling Murabaha Approach”, the Islamic financier is subject to an additional obligation: keeping a running record of the difference between the amount paid by the customer under the notional “ceiling” rate (referred to above as the benchmark) and the amount that would have been payable by the customer under the Murabaha contract had the amount payable instead been calculated on the basis of compounded SOFR. The customer will have a right to request a copy of those calculations at the end of the financing and request the Islamic financier to exercise a discretionary rebate of the difference between the amounts payable using the two different benchmark rates.
Again, if agreed, the discretionary rebate could be backed up by an undertaking granted by the Islamic financier in favour of the customer to enter into a reverse intra-day spot Murabaha contract in the event that the Islamic financier did not exercise its discretionary rebate in respect of the aggregate difference between the two amounts, under which an amount equal to that difference would become due and payable by the Islamic financier to the customer and, in turn, set off under a settlement deed against the final payment due from the customer on the termination date of the financing, leaving only the balance due from the customer.
However, in all cases under the Ceiling Murabaha Approach, the customer would also grant an additional undertaking in favour of the Islamic financier to enter into an intra-day spot Murabaha contract to cover the situation where the notional “ceiling” rate turned out to be less than the benchmark rate calculated using the Conventional Backward-Looking RFR Approach for any particular intra-day spot Murabaha contract, in which case the Islamic financier could compel the customer to enter into an additional intra-day spot Murabaha contract at some future date to recover the shortfall.
Ijara financings
For Ijaras, there are also two alternative “mainstream” approaches when using compounded RFRs: the “Sub-Period Ijara Approach” and the “Daily Rental Ijara Approach”.
- The Sub-Period Ijara Approach. The calculation period (which would be a “lease period” in the context of an Ijara financing) is split into two parts. For example, a 1 January to 31 March calculation/lease period would be split into two, comprised of the first starting on 1 January and ending five look-back days before the end of the lease period (in this case, we are assuming 25 March) and the second starting on the next day (in this case, we are assuming 26 March) and ending on 31 March. The profit element for the first of each such sub-periods is calculated on an estimated benchmark rate for the whole sub-period (i.e. up to 25 March) using a notional benchmark rate. The profit element for the second of each such sub-periods is calculated by taking the actual compounded SOFR for a period equal to the full lease period (in this case, the three months) ending at the start of the relevant second sub-period, then calculating the difference between that rate and the amount payable in relation to the first sub-period. That difference would then apply for the relevant second sub-period. In both cases, the rental is still paid at the end of the lease period and no payments are made at the end of the first sub-period.
Profit for the remainder of the relevant calculation period during which an early payment is made is dealt with by way of a discretionary rebate only. In the context of an Ijara financing, in contrast to the AAOIFI 59 Murabaha Structure, profit (comprised of the margin and the benchmark amount) is only calculated in respect of each calculation period that has commenced and so the amount of profit subject to the Islamic financier’s voluntary rebate would typically be much smaller than under an equivalent AAOIFI 59 Murabaha Structure paid early at a similar stage due to the Murabaha structuring requirements noted above.
The Daily Rental Ijara Approach. The rental period is daily, and as such the daily rental amount is required to be calculated and notified to the customer on a daily basis by way of a website and, if the customer objects to the daily rate, then the whole rental will end on that day and the bank will be entitled to exercise its rights to require the customer to repurchase the Ijara assets. However, even though the rental period is daily, the actual rental payments are payable on the same dates as they would have been under the traditional Ijara model. Arguably, the beauty of this structure is in its simplicity but its main drawback is the additional administrative burden imposed on the bank in running daily calculations/such a website if not already a common feature of its business.
Using term SOFR in Islamic finance
Discussions have been underway for some time among regulators in different jurisdictions about the possibility of publishing forward-looking term RFRs (term RFRs) as an alternative to compounded or similar backward-looking RFRs. This is particularly important for Islamic finance and other financial products that require interest (or, in the Islamic finance context, profit – being an amount equivalent to interest but structured in a Shari’a-compliant manner) to be known earlier than a few days from when it is due to be paid. Like LIBOR, a term RFR makes it possible to calculate profit in respect of a calculation period at the start of that calculation period and so Gharar is not an issue.
On 29 July 2021, the ARRC formally recommended the CME Group’s forward-looking term SOFR (term SOFR). This provides Islamic financiers with a valuable additional tool to manage the replacement of LIBOR as the benchmark rate for their US dollar financings. Term SOFR is quoted for similar periods (1 month, 3 months and 6 months) as currently quoted for LIBOR and accommodates a term curve.
However, term SOFR does not necessarily provide the same rates as LIBOR: when replacing LIBOR with term SOFR on legacy financings, the ARRC recommends applying a credit adjustment spread set on 5 March 2017, which for 1 month is 11.448 bps, 3 months is 26.161 bps and 6 months is 42.826 bps. This represents the five-year historical median difference between LIBOR and SOFR.
Term SOFR should lend itself quite easily to Islamic financings in much the same way as LIBOR, and we expect this to become a common feature of many US dollar Islamic financings in the GCC going forwards.
Other alternatives to LIBOR for Islamic finance
It is also conceivable that some Islamic financiers in the GCC may turn to calculating profit on a basis completely separate from RFRs in the post-LIBOR world – for instance, by deploying central bank rates or structuring deals on a fixed-rate basis. Such approaches would fit well within the confines of Islamic finance principles, as profit could be determined in advance of the relevant calculation period. However, the extent to which such non-RFR-based approaches are deemed suitable for any particular Islamic finance product, or for Islamic financings more generally, remains to be determined on a case-by-case basis.
Final word
The above is just a brief summary of a small sample of LIBOR alternatives for Islamic finance products. Variations on those alternatives are currently under consideration by Islamic finance participants. Conventional financiers are making great strides with their LIBOR transitions, but for Islamic financiers the terrain understandably remains quite tricky to navigate. Islamic financiers will no doubt continue to push ahead with their current intensive analysis of the wide range of LIBOR alternatives to try to ensure that the Islamic finance products that emerge in the post-LIBOR world continue to remain just as competitive as previous conventional alternatives. Time will tell whether July’s recommendation on term SOFR by the ARRC has dealt the knockout blow to the other contenders vying for the crown of preferred LIBOR alternative for US dollar denominated Islamic financings.
