LONDON, 10 November 2003 — Islamic finance is moving into its ‘exotics’ phase with the recent launch of two pioneering and arguably controversial funds — one the first Islamic forfaiting fund and the other the first Islamic hedge fund. However, the funds have to be put into perspective. The WestLB-Tricon Forfaiting Fund Limited, a Bermuda-registered exempted, open-ended investment company, which was launched in 2000, issued in October a Shariah-compliant Share Class, enabling investors to subscribe to a fund that will engage as part of its investment strategy in commodity and trade finance. The fund is managed by Tricon Trade Management Ltd., with WestLB AG as the Investment Adviser.

According to London-based international law firm, Norton Rose, which acted for the promoters WestLB AG, the German bank, “the incorporation into the structure of forfaiting asset receivables (conventional discounted forfaiting assets) to satisfy obligations due to the fund through the commodity and trade finance program, is a development that many have been considering, but have not yet been able to achieve.”

Forfaiting is the provision of finance for exporters, where an agent (the forfaiter) accepts a bill of exchange from an overseas customer; he buys the bill at a discount, and collects the payments from the customer in due course. Forfaiting can involve promissory notes, letters of credit (LCs) and other trade finance debt instruments.

In Islamic finance under Shariah principles, trading in debt receivables and the sale of debt (bay-al-dayn) are prohibited, because of the elements of riba (interest) due to the discounting and also due to gharar (uncertainty) in the transaction.

As such, Islamic financial institutions are unable to purchase instruments at a discount. The global pool of forfaiting assets has not previously been integrated into an Islamic product such as this. In fact, Muslim countries such as North African states such as Algeria, Tunisia, and Morocco are a very active market in forfaiting for European and international banks.

The Shariah-compliant share class however should not be read as an Islamic forfaiting fund, but more as a Shariah-compliant attachment to a conventional forfaiting vehicle. It is up to the promoters and Shariah advisories to explain and defend their positions.

Norton Rose associate Mohammed Paracha strongly defends the Shariah compliance of the fund, although it may be a contentious issue. “The involvement of conventional forfaiting assets in an Islamic structure has been achieved with careful legal and Shariah structuring which allowed us to develop an investment fund that not only complies with a rigorous legal analysis but also one that adheres to Shariah principles. We had to be careful in ensuring that the pool of non-Islamic forfaiting assets was not used to directly satisfy the Islamically compliant obligations under the commodity and trade financing arrangements.”

The second fund, the AlFanar US Equity Hedge Fund Ltd. is being billed as the “first Shariah-compliant Hedge Fund” and was launched on Oct. 1 by Saudi Economic Development Company (SEDCO) and its US partner Worms & Co., whose subsidiary Permal Asset Management, is the investment management adviser to the nine-strong AlFanar family of Islamic funds. Once again the Alfanar US Equity Hedge Fund is not a traditional conventional hedge fund product. For a start short-selling, an essential component in hedge funds, under Shariah principles is not allowed, because of riba and gharar elements in the contract.

To sell short is to agree to sell at a future date something (in this case shares) which an investor or institution do not possess, but which they will be able to buy for less before the time comes when they have to sell them.

The fund ostensibly is a Shariah-approved technique to allow a manager to hedge (short) in a portfolio. Long and short strategies are essential tools for some fund managers to help preserve capital during down and volatile equity markets, as in the last two years. During this period, Islamic investors were forced to seek refuge in low-risk low-yield Murabaha instruments.

Also cash management has proved to be less profitable because of the low interest-rate environment in the industrialized countries. Even though Islamic investors do not invest in these interest-rate products, the base rate in London, LIBOR is used as the benchmark even in Islamic finance.

The Alfanar Hedge Fund will also screen out the proscribed instruments under its Shariah compliance screens. Instruments or derivatives from futures contracts, options, swaps, preferred shares, short sales, and other instruments where any of their components involve the payment or receipt of interest, are all omitted from the portfolio because they are prohibited under Islamic law.

As long as the Shariah-compliance is transparent and is subject to scrutiny by peers and independent analysis, and first principles are never compromised, such innovation must be encouraged by the Islamic financial movement, which can ill-afford to be stagnant and static especially in an era of globalization.