Two years after publication of a standard template for Sharia-compliant over-the-counter derivatives, there is little evidence that standardisation is driving a liquid swaps market as some had predicted. There are hopes, however, that the first confirmed product template for profit rate swaps could signal a turnaround.
While some international banks have witnessed increased usage of hedging instruments, the long-awaited Islamic Master Agreement unveiled by the International Islamic Financial Market and International Swaps and Derivatives Association in March 2010 has not yet been widely adopted by Islamic counterparties.
“There hasn’t been a lot of uptake of the Islamic ISDA, partly because of the different Sharia boards, but also because only basic rates and profit rate swaps language has come through. Most active dealers have been using their own documentation for such products and continue to do so,” said a Dubai-based structurer at an international bank.
“Banks that have developed their own Master documents are using those to transfer across the derivatives product suite. Standardisation might help the process in the future as it’s not good to have too much bespoke documentation and sometimes it takes months to prepare, but it’s going to take some time,” he added.
According to Khalid Howladar, senior credit officer for financial institutions and sukuk finance at Moody’s in Dubai, the lack of liquidity is a function of the limited hedging requirements for the majority of domestic banks in the region.
“Currency risk probably remains the main concern, but most Islamic retail banks don’t run a lot of unpegged currency risk as they are primarily involved in domestic lending” he said.
Some international dealers report a general increase in the use of Islamic derivatives, with more sophisticated structures including FX options and structured equity options, as well as a range of commodity-based products.
“The Islamic product suite is quite wide. In rates and FX the Sharia-compliant offering is almost as sophisticated and comprehensive as in conventional markets,” said the structurer.
But the current offering doesn’t appear to address the needs of some internationally focused companies. Bahrain’s Arcapita suffered huge P&L volatility stemming from foreign exchange exposure and paid a heavy price after the private equity company filed for bankruptcy protection earlier this month after failing to agree a restructuring package on a US$1.1bn loan.
The firm posted a gain of US$139m on its FX exposure for the year ending June 2011, compared to a negative US$170m in the preceding 12 months. In the three months to September 2011, that exposure represented a negative US$40m.
According to its income statements, the group used Sharia-compliant forward exchange contracts (Wa’ad) to manage its exposure.
“Foreign exchange risk was a key issue facing Arcapita and it made for a very volatile P&L,” said Moody’s Howladar. “This Bahraini institution had many illiquid overseas investments and was unable to effectively hedge its currency risk given the limited Sharia-compliant instruments at its disposal.”
Template supplement
Last week saw the first significant addition to the Tahawwut (hedging) Master Agreement with launch of a new product standard for profit rate swaps – the most widely used derivative by Islamic firms.
Under the new Mubadalatul Arbaah supplement, companies will be able to hedge their interest rate exposure more efficiently and with greater certainty of approval, allowing them to better manage cash flow risks for a variety of capital market instruments.
“We always assumed that without confirmation templates for products, take-up would be a little slower, but we are now addressing that”, said Peter Werner, Senior Director at ISDA.
“Profit rate swaps are the most relevant hedging instrument for Islamic companies and the template that was published earlier this week provides the format for a cross-currency confirmation template that will follow shortly. A confirmation template for FX forwards will be close behind but that will be based on a different concept and will require greater discussion with Sharia boards. ISDA will shortly also be publishing industry legal opinions on the enforceability of transactions done under the ISDA/IIFM Tahawwut Master Agreement in England, Malaysia and Singapore.”
After capital markets volumes declined across the Middle East in 2009 when Dubai World and its subsidiary Nakheel defaulted on their debt, Sukuk issuance bounced back to hit a record high, exceeding US$30bn in 2011. If that growth continues, it should drive related derivatives activity.
“If you look at Islamic finance as a whole, volumes have been much lower in the past couple of years and only recovered recently,” said Werner. “One of the big misconceptions was that the Middle East would be immune from the financial crisis, but that’s not been the case as the region is very real-estate driven and derivatives activity has subsequently been hit by a general slowdown.”
But for many Islamic companies, derivatives still remain a step too far according to Moody’s Howladar. “In general, derivatives are still seen as speculative and viewed with quite a bit of scepticism among many Islamic banks, so while derivatives are extremely common for conventional FIs, only a portion is for hedging versus pure speculation - which is cleanly and universally prohibited for Islamic FIs.”
“Once you get past the lack of demand for domestic-focused retail banks and then general Sharia-driven scepticism, then a liquid and standardised Islamic swaps makes a lot of sense, but at least in the short to mid-term, I think it will remain a very small market,” he said.