The phase-out of the London Inter-Bank Offered Rate (LIBOR) as a benchmark interest rate has been complicated for banks around the world, but particularly in Islamic finance markets.
Publication of LIBOR rates stopped at the end of 2021, apart from a few tenors of dollar LIBOR that will run until mid-2023. Supervisory guidance from regulatory bodies in the US and the UK called for no new LIBOR contracts after 2021, to facilitate the transition.
Rates such as the Secured Overnight Financing Rate (SOFR) and Sterling Overnight Index Average (SONIA) were brought in to replace the previous benchmark. Unlike LIBOR, these are backward-looking risk-free rates (RFRs), based on past transactions rather than estimates of future borrowing costs.
For banks in general, the move to RFRs poses operational and legal risks, as bank processes and systems have been built to quote interest rates payable at the end of a borrowing period upfront. This has led to, among other things, a lack of clarity on how to account for derivatives, hedging and futures instruments.
Islamic finance institutions (as well as parties looking to structure and raise funding through Islamic finance products), however, face an additional and unique complication: They have to unpack the implications of RFRs in the context of Sharia principles, which require upfront certainty on all key financing terms, including pricing.
Certainty is the challenge
The principle of gharar — uncertainty or speculation — essentially requires Islamic financing instruments to specify each counterparty’s commitments on pricing, delivery and timing in advance. For example, both murabaha (cost-plus financing, where seller and buyer agree on the cost and mark-up of an asset in advance with payment due and made on a deferred basis) and ijarah (where an asset is leased by one party to another at a pre-agreed rental rate) must have cost certainty built in from the outset to meet Sharia requirements.
Forward-looking rates like LIBOR addressed these requirements but RFRs cannot, by their nature, do the same and amounts payable can only be finalized a few days before the due date for payment.
Consensus on how to tackle this issue has been slow to build, with institutions unsure about how to proceed and regulators applying varying degrees of pressure to move away from LIBOR across various jurisdictions.
The absence of a forward-looking rate to replace LIBOR/consensus in the application of back-looking RFRs for the Islamic finance market will have a clear knock-on effect.
For example, until there is a market consensus on approach, putting together Sharia-compliant floating rate structures will be more complex and have potential additional risk factors to the structures such that Islamic finance institutions will have to work that much harder to build confidence that they are on a level playing field with mainstream conventional banks, as well as distancing the economic goals and outcomes of Islamic finance products from their conventional counterparts.
In addition, unless structured appropriately, facilities that combine Islamic and non-Islamic financing could be commercially unviable because of discrepancies between the floating rates assigned to different tiers of capital in the structure. For example in the area of project finance, large scale projects in the Middle East and in some Asian markets typically feature dual financing from conventional and Islamic sources and it is unclear how this will work going forward if there is no consistent approach across both sources.
With LIBOR now, for practical purposes, discontinued, the US SOFR rate has become the default in key Islamic finance markets in the Middle East and Asia, which are predominantly dollar-denominated. Islamic banks have, leading up to the discontinuation, also taken steps to cover off LIBOR transition risk with the inclusion of fallback terms in documents, outlining what rate should be applied when LIBOR is discontinued but in most cases these terms were an agreement to agree what the new rates would be when the time came.
These are positive moves, but the challenge of settling on an agreed-upon forward-looking rate to replace LIBOR remains unresolved. A forward-looking SOFR term rate was only introduced in June 2021 and transaction volumes are still relatively thin. Volumes will need to build before market participants can price a SOFR term rate with confidence. And, while the term rate for SOFR is a good alternative for a wholly Islamic transaction, the potential mismatch between multi tranche transactions which are incorporating both a term SOFR rate for Islamic tranche and a non-term SOFR rate for a conventional tranche is likely to prove difficult to provide pricing parity and effective. Equally the lack of available Term-SOFR day-one hedging is currently proving to be an obstacle in the medium to long term Sharia compliant dollar markets which are in non-USD “home” jurisdictions.
The development lag in this space can be seen in particular in the international Islamic capital markets, arising largely as a function of commercial realities. To date, most US dollar cross-border sukuk (Islamic finance trust certificates ) issued have been (and continue to be) fixed rather than floating rate instruments and, practically speaking, minimally affected by changes to floating interest rate calculation methodologies. Further, while many sukuk issuance programs accommodate both fixed and floating rate options and have provisions built in that contemplate changes to reference rates, such provisions have not tended to be particularly prescriptive or consistently applied, nor have they sought to reconcile the application of alternate reference rates (which may include RFRs) with the mechanics of the relevant Islamic structures that underlie such sukuk. With the complete cessation of LIBOR, however, this “middle ground” approach in the Islamic capital markets will not be tenable for much longer. Indeed, we have already seen examples of RFRs being applied to sukuk such as the US$400 million SOFR-linked sukuk issued in April 2021 by the Islamic Development Bank (as obligor), although this very much represents the exception rather than the norm in the current market.
Islamic finance deals relying on RFRs have proved to be, and remain, more challenging to structure in comparison to forward-looking rate counterparts, and often rely on complex mechanisms, such as rebates, to achieve structural Sharia compliance.
The lack of standardization across Islamic finance markets further complicates the process.
The development of forward-looking term rates derived from RFRs will be crucial to remove friction and wean existing Islamic finance portfolios and new deals off LIBOR.
Additionally, while SOFR and the SOFR term rate appear to be the leading candidates to take over from LIBOR, RFRs such as the Indonesian Overnight Index Average and Turkish Lira Overnight Reference Rate — which have been published since 2018 and 2019, respectively — may be the preferred RFRs in some jurisdictions. LIBOR transition could also provide the impetus for the market to develop its own set of metrics specifically for Islamic finance, rather than tethering to interest rate benchmarks. In the UAE there has been some talk over a few years about the introduction of an Islamic finance market alternative IBOR but speaking to various financial institutions and their Sharia advisory teams, this seems to be of academic interest rather than a serious commercial alternative at this stage.
Islamic finance is making headway as it decouples from LIBOR, but there is still work to be done and until the market reaches consensus on the new alternative rates, we expect to see various structuring methodologies emerge. The key for the industry will be to formulate a homogenous response (and potentially product-specific responses) quickly and implement those alternatives on a standardized basis in order to ensure that footing in the markets is not lost.