On 27 December 2023, The International Islamic Financial Market's Shari'ah board announced it had reaffirmed the mechanism for the close-out netting amount following an early termination in the ISDA/IIFM Tahawwut Master Agreement (the TMA).
The purpose of this article is to briefly explore the TMA, how close-out netting operates under the TMA and the outlook for the TMA.
What is the Tahawwut Master Agreement?
The TMA was developed by the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) and published in 2010.
The TMA is a bilateral framework agreement for Shari'ah-compliant derivative transactions. It is similar to the 1992 or 2002 ISDA Master Agreements in that it sets out the main terms for the relationship between the parties.
How is the TMA structured?
The TMA is structured in a similar way to the ISDA Master Agreement. The TMA is a framework agreement which sets out the main terms governing the relationship between the parties. It is tailored by a Schedule that sets out various elections that the parties wish to adopt. Then, when a derivative transaction is to be entered into, the key terms for that trade is set out in a supplemental Confirmation. The TMA, Schedule and any Confirmations all form one single agreement.
The main terms in the TMA are as follows:
- a provision confirming that the payment obligations between the parties set out in the relevant Confirmation will be complied with;
- payment netting provisions, including payment netting in the same currency and transaction and two or more transactions;
- representations, which are generally in a similar form to those in the ISDA Master Agreement;
- events of default and termination events, which are generally similar to those in the ISDA Master Agreement (i.e. events of default are largely fault based events and termination events are largely non-fault based events);
- early termination provisions (on which, see below).
The TMA is supplemented by a Schedule, which is in a similar form to the ISDA Master Agreement Schedule. It sets out a series of elections which the parties can elect in respect of their agreement, including in relation to termination provisions, tax representations, conditions precedents and subsequent and other key, specific or bespoke terms.
The TMA contemplates transactions to be entered into immediately (known as 'Transactions') and transactions which will be entered into in the future (known as 'Designated Future Transactions'). When a transaction is entered into, the parties enter into a supplemental Confirmation, which is deemed to form part of the TMA.
What can the TMA be used for?
The TMA is intended for use in governing hedging derivative transactions. That is to say, it is not intended to be used for speculative derivative trades, which is prohibited under Shari'ah principles.
How do the termination provisions operate?
Arguably, the most important provision in the TMA is the section that addresses how the TMA – and any transactions under the TMA – can be terminated and the consequences of that termination.
The early termination provision sets out the rights of the relevant party to terminate following an event of default or termination event, and which party may designate an early termination date. If an event of default has occurred, the non-defaulting party is entitled to designate an early termination date. If a termination event has occurred, then this will be identified with respect to the relevant termination event that has arisen.
How are the termination amounts determined?
Following early termination, each outstanding transaction is terminated and replaced with an amount owed from one party to the other.
One of the key elements in the TMA is how to determine the amounts owed in respect of each transaction following termination. Owing to the nature of the way in which transactions are effected under the TMA, a valuation cascade is set out to establish how to value the terminated transactions. It is contemplated that the transactions will have either been effected by way of commodity Murabaha transactions or Wa'ads.
If the transactions relate to commodity Murabaha transactions, the underlying commodities for which have not been delivered or the purchase price for which is not yet payable, then the transaction is terminated and the purchase price accelerated. This results in an amount due.
If the transactions relate to Wa'ads which have not yet been exercised, the Market Quotation methodology used in the 1992 ISDA Master Agreement is to be used to establish the mark-to-market value. Quotations from four leading dealers will need to be obtained to work out the amount owed.
These amounts are then netted off against each other, leaving a single net sum owing. The mechanics for effecting the payment are by way of a Musawama transaction, which involves the party owing money to the other party committing to purchase commodities from the other party for an amount equal to the cost price of the commodities plus the relevant termination payment.
What is the outlook for the TMA?
We are seeing the TMA being further adopted by market participants in GCC, Malaysia and the UK and we expect this to continue, particularly given the current volatile interest rate environment. If you have any questions, please contact us.
