Ruling of Bank Negara's Shariah Advisory Council on the Adoption of Risk-Free Rate

In 2017, the United Kingdom Financial Conduct Authority (FCA) announced that the London Interbank Offered Rate (LIBOR) will cease to exist by the end of 2021. The scarcity of underlying transactions based on LIBOR has made the benchmark rate potentially inaccurate to reflect market conditions and unsustainable. Therefore, all existing contracts benchmarked to LIBOR have to be transitioned to an alternative benchmark rate before the end of 2021. Following this development, the global financial market has agreed for Risk Free Rate (RFR) to be the alternative benchmark rate for LIBOR as it is transaction-based and more reflective of market conditions.
 
The above gave rise to three potential Shariah issues, namely:
 
  1. Whether the use of the compounded setting in-arrears (CSIA) method to derive the term rate for profit component in sale-based (e.g. Murabahah / Tawarruq) and rental-based (e.g. Ijarah) transactions complies with Shariah requirements?
  1. Whether the use of the backward-looking methodology in sale-based and rental-based contracts trigger uncertainty (gharar) issue given that the periodic payment amount can only be determined on or near the payment date?
  1. Whether it is appropriate to invoke the deemed consent mechanism to signify customers’ consent on the incorporation of fallback provision in the contract’s terms and conditions in facilitating the transition to an alternative benchmark rate?
The Shariah Advisory Council of Bank Negara Malaysia (SAC) in its 210th SAC meeting on 23 December 2020 ruled that the adoption of risk-free rate (RFR) as an alternative benchmark rate to LIBOR or as a fallback benchmark replacement rate after the permanent cessation of LIBOR is permissible based on the following justifications:
 
  1. The compounding methodology is merely a computational method to derive the term rate from overnight RFR which will be used in the profit component of Shariah-compliant transactions and this does not affect compliance of the transactions with Shariah requirements.
 
The compounding method for RFR also does not cause additional charges being imposed on the accrued profit, as commonly practised in the market for late payment incidences in conventional financial transactions.
 
  1. Uncertainty (gharar) from the adoption of average RFR or backward-looking term rate at the point of payment is mitigated via proper determination and disclosure of the ceiling price and formula to derive the periodic payment amount to the customer at the inception of the contract.
 
For sale-based (Murabahah / Tawarruq) financial instruments with variable rate, the selling price is concluded based on the ceiling profit rate (CPR). Under this mechanism, the ceiling profit rate and the formula to calculate the effective profit rate (EPR) are made known to the contracting parties and agreed upfront.Therefore, the issue of uncertainty does not arise as it is mitigated by the existence and disclosure of the CPR and formula to determine the EPR.

As for rental-based (ijarah) financial instruments with variable rate, the formula to calculate the periodic rental payment is made known to the contracting parties and agreed upfront. Therefore, the issue of uncertainty does not arise as it is mitigated by the existence and disclosure of the formula to calculate the periodic rental payment.
 
  1. In transitioning to the alternative RFR, the SAC has agreed to empower the respective financial institutions’ Shariah Committee to determine the appropriateness of invoking the deemed consent mechanism to signify customers’ consent on the incorporation of the fallback provision in the contract’s terms and conditions.
This ruling by the SAC was published on Bank Negara Malaysia’s website on 22 March 2021 and came into effect immediately upon such publication. The ruling applies to the following Islamic Financial Institutions:
 
  1. licensed persons under the Islamic Financial Services Act 2013;
  1. licensed banks and licensed investment banks approved under the Financial Services Act 2013 to carry on Islamic banking business; and
  1. prescribed institutions approved under the Development Financial Institutions Act 2002 to carry on Islamic financial business.
Comments
 
The current use of LIBOR is in line with Shariah principles as it a forward-looking rate, which enables the profit mark to be calculated at the start of the contract. However, with RFRs, the key challenge for Islamic financing transactions is their current backward-looking nature, given the rates are overnight. Their overnight nature means overnight rates must be compounded in arrears over the actual period, thus in the case of financial instruments with variable rates, the borrower will not know for certain the profit payment amount until shortly before the end of the period. However, with the provision of formulas to calculate EPRs (for Murabahah / Tawarruq) and periodic rental payments (for Ijarah), it circumvents the issue of uncertainty and ensures that there is no impact on the Shariah-compliance of these transactions.
 
Whiles the issue of compliance may have been addressed, it is to be noted that LIBOR is widely used as a benchmark to determine the profit rates for Shariah-compliant derivatives (tahawwut) such as profit rate swaps and currency forward contracts and its discontinuance may potentially lead to significant changes in the pricing and valuation of these products.
 
This article was written by Sharifah Shafika Alsagoff (Partner) and Hafidah Aman Hashim (Partner) of the Banking and Finance Practice Group of Skrine.