LIBOR’s demise is not only a major issue for
conventional banks, but also for Islamic financiers
across the world. This article provides insight into
how Islamic banks are tackling the challenges
of the discontinuance of LIBOR and some of the
alternatives being considered in the background.
Ever since the Financial Conduct Authority announced
that the London Interbank Offered Rate (LIBOR) is to be
discontinued by December 2021, the question of what a
post-LIBOR world will look like has been a topic of much
discussion among financial institutions, regulators and
in global financial markets more generally.
The impact of the discontinuance of LIBOR is also an
issue for the Islamic finance industry, where LIBOR
is widely used as a benchmarking rate for Islamic
financing arrangements involving USD transactions.
Any proposal as to how Islamic financial arrangements
should be implemented and documented post-LIBOR
has the added complexity of needing to ensure that
any mechanics applied to those financial arrangements
comply with Sharia law principles.
While, in the context of conventional debt, the
regulators and market stakeholders have settled on
LIBOR being replaced by so-called backwards-looking
overnight Risk Free Rates (i.e. the Secured Overnight
Financing Rate (SOFR) for USD transactions and the
Sterling Overnight Index Average (SONIA) for GBP
transactions), this approach is not a viable solution
for the majority of Islamic finance arrangements.
The reason for this lies in the differences between how
LIBOR is calculated as compared to how a Risk Free Rate
is determined. LIBOR is a look-forward term rate which
can therefore be used to calculate interest at the start
of a calculation period, whereas (as mentioned above)
the Risk Free Rates are backwards-looking overnight
rates that, if applied to a calculation period, can only be
determined at the end of that period.
This is problematic for many Islamic financing products
given that, in order for these products to comply with
Sharia law principles, a transaction must be entered
into and pricing must be determined at the start of the relevant period. For example, a murabaha structure
sees a financier provide credit to a customer as part
of an asset sale which involves the financier buying an
asset from a supplier and selling it to the customer on a
deferred payment basis, with pricing determined when
that asset is sold. The immediate sale and transfer of the
asset in question (with a deferred payment obligation) is
key to a murabaha product being Sharia compliant, so
if the pricing was set at a later date, then this would not
be acceptable to Sharia law scholars.
This particular problem was not so long ago
acknowledged by the Working Group of the Bank of
England, who suggested that that in order “to continue
with the current market practice, alternate rates should
be considered for [...] Islamic finance which can pay
variable rates of return so long as the variable element
“ In this context, some
commentators feel that it might
now be the right time for the
Islamic finance industry to move
away from the use of LIBOR
or conventional benchmark
rates and instead establish an
alternative benchmark rate
created by, and suitable for,
Coming up with a new international Islamic rate based
on asset transactions may be seen as a long-term (more
sustainable) alternative. In addition, cutting ties with
a conventional benchmark is likely to be a welcome
change from a strict Sharia law perspective. However,
whether this is feasible in such a short timeframe is
questionable. This is because the establishment of an
international Islamic benchmark rate presents a number
of technical and economic challenges. What would
the agreed methodology and basis of calculation be?
Also, is there currently a sufficient volume of underlying transactions on which an international Islamic rate could
be built? Who would be responsible for determining
such rate? Would that rate be sufficiently robust?
Many questions remain unanswered and the clock is
ticking. Institutions such as the International Islamic
Financial Market (IIFM) and the Accounting and Auditing organization for Islamic Financial Institutions (AAOIFI)
are actively working in the background to come up with
a viable solution. However, Islamic financiers should not
simply wait and see, as action needs to be taken now.
Islamic banks need to be more proactive in examining
their LIBOR exposures, even if that involves breaking
away from conventional benchmarks altogether.