Derivatives 2006 - A need to hedge
As Islamic financial markets become increasingly developed, there is a growing need for Shariah-compliant risk management tools. A number of banks are gearing up to meet this need by creating Islamic derivatives and many new products are in the pipeline. Joseph Radford reports.
Demand for Islamic risk management products is set to snowball over the next few years and bankers are rushing to develop effective Islamic derivatives to sate this appetite.
As interest in Islamic finance starts to reach fever pitch, investors and issuers of Shariah-compliant instruments such as Sukuk bonds are increasingly looking for a wide range of tools to help them hedge their positions without breaking Islamic rules.
“Islamic markets need derivative equivalents to be on a par with conventional markets,” said a banker in Kula Lumpur. “A full suite of Islamic risk management tools is something that is missing in Islamic markets at the moment.”
Under Shariah law, market participants are not allowed to take part in transactions that are speculative, that pay interest or are connected to businesses that are un-Islamic, such as casinos or breweries. It is also crucial that transactions are asset-backed because money can only be used as a purchasing tool.
Commodity derivatives-based trades using the Murabaha, or cost-plus technique, and foreign exchange options that use the Arboun approach have so far been the most prevalent Islamic risk management instruments.
But bankers have also been developing tools such as profit-rate swaps and Islamic forward rate agreements, which are designed to offer an Islamic proxy for interest rate swaps and regular forwards. For example, Bank Islam Malaysia and Standard Chartered Bank Malaysia in mid-August closed what was claimed to be the world’s first standalone Islamic forward rate agreement. The deal also used the Murabaha concept, with commodities traded through the London Metals Exchange as the underlying.
There have even been moves to develop Islamic credit derivatives, although these markets are still at a very early stage of development. Islamic credit default swap (CDS) and CDO transactions, which could be based on Islamic underlyings, are likely to take off as Islamic bonds become more popular. “There is a lot of potential for cash secondary Sukuk bonds,” said Steve McMillan, senior managing director for Europe at inter-dealer broker GFI. “Providing the momentum can be sustained in issuance, there will eventually be demand for CDS-type products.”
The development of fully functioning Islamic derivatives markets was recently given a significant helping hand when the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) signed an agreement to develop standard documentation for Shariah-compliant derivatives. IIFM was founded in 2001 by the Saudi Arabia-based Islamic Development Bank with central banks and monetary agencies in Bahrain, Brunei, Indonesia, Malaysia and Sudan to develop Islamic capital markets around the world.
The alliance, which was welcomed by bankers involved in Islamic finance, is expected to come up with an Islamic master agreement by June 2007. “Shariah-compliant derivatives instruments and their documents are the need of the hour for risk management in Islamic financial institutions and they will contribute a great deal to making Islamic finance mainstream,” Ijalal Alvi, IIFM’s Bahrain-based chief executive, said at the time the agreement was signed.
A working group open to members of the two organisations will meet in London with access via conference calls every four to six weeks. The group will focus on creating a general contract that can be tailored to different kinds of Islamic transaction, according to Peter Werner, ISDA policy director. “The aim is to have a generic ISDA master agreement in place to document all types of transaction.”
Bankers have often noted that universal documentation for Islamic risk management tools would give a significant helping hand to market evolution. “This [the potential creation of ISDA Islamic documentation] is great news,” said another Kuala Lumpur-based banker. “Islamic markets need this.”
Although a potential ISDA master agreement for Islamic derivatives is a welcome development, it will not eradicate the problem of differing standards of Shariah compliance between the Middle East and South-East Asia. “Once this [documentation] is developed then it will be available to all jurisdictions and it all depends whether the jurisdiction or its institutions want to adopt the end product,” said Alvi.
Some products deemed Islamic in countries such as Malaysia are not approved by Shariah councils in the Middle East. “There are a lot of issues and grey areas when you talk about Islamic products,” said one of the bankers in Kuala Lumpur.