Research

Derivatives and Hedging in Islamic Finance

Introduction

Playing a role in the Islamic finance sector under the headings of structured products, treasury products and risk management, derivatives are financial assets that derive their value from the performance of another underlying entity such as an asset, interest rate or index. Common forms of derivatives include forwards, futures, options and swaps and they are widely used as a means of efficient hedging and for quick and easy access to a market. However, despite their widespread use in the conventional industry they remain a divisive topic in Islamic finance. A consensus of opinion among Shariah scholars regarding the validity of derivatives under the tenets of Islamic finance has yet to be reached, despite the growing volume of regulation assigned to this particular product.

Regulation

In 2007, Bank Negara Malaysia, Malaysia’s central bank, issued the Islamic Derivative Master Agreement (IDMA). This was the first global Islamic regulation regarding Islamic derivatives trading and was introduced by the bank to aid the development of Islamic hedging to mitigate investment risks in the Islamic financial market.

In 2010, the Bahrain-based International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA) joined forces to present the ISDA/IIFM Tahawwut Master Agreement (TMA), based on the common structure of a commodity Murabahah transaction, which was designed to govern the legal and credit relationship between two parties embarking on a bilateral trading relationship involving Shariah compliant hedging transactions.

The impetus for the development of the TMA came in response to a call from the industry for a market benchmark for Shariah compliant hedging transactions and subsequent developments to the agreement have also been market-driven, with a working group established by ISDA to discuss documentation, legal and regulatory issues affecting trading in over-the-counter derivatives transactions with corresponding parties in Islamic jurisdictions.

ISDA collaborated once again with IIFM to issue the ISDA/IIFM Mubadalatul Arbaah (profit rate swap) product standard in March 2012, following on from the TMA and providing an Islamic risk mitigation framework for the industry. In December 2013, IIFM announced the impending issuance of a legal opinion on English law with regards to the implementation of the Tahawwut Master Agreement, as well as further standards and guidelines for Islamic hedging and Islamic liquidity management.

Types of Islamic derivatives

Several common Shariah compliant financing structures are in fact forms of derivatives. For instance, a Salam contract — under which one party makes payment upfront for the delivery of specified goods in the future — is a type of forward agreement. Similarly, a Sukuk issuance that is structured around a Salam contract can also be seen as similar to a structured note with an embedded derivative. Additionally, a number of Islamic derivatives that closely resemble conventional interest rate swaps have been developed such as profit rate swaps and Ijarah rental rate swaps, allowing Islamic institutions to exchange cash flows related to specific assets that have a different basis of calculation. While these agreements require reference to specific assets (which make them distinct from and more complex than conventional swaps) they serve a similar risk management purpose for the parties.

Recent industry initiatives

Kothari Investment Partners plans to introduce a US$100 million Shariah compliant global equities hedge fund targeting ethical investments which is hoped to appeal to a larger investment base including European investors. Said to be the biggest Gulf launch for five years, trades however, will not be signed off by a cleric.

Kenya in March set up a capital markets steering committee that oversees the implementation of the country’s 10-year capital markets master plan targeting areas including financial derivatives, infrastructure finance, asset management, and Islamic finance instruments such as Sukuk.

Abu Dhabi Islamic Bank in January launched an investment product that purchases shares of automobile manufacturers and hedges against losses via the use of financial derivatives with the assurance that investors will be compensated should the investment fail. The structured note carries a maturity of one year and a return of up to 8%, with a minimum subscription of US$30,000.

Progress in the area of Islamic hedging was a topic for the Sixth Islamic Financial Services Board seminar, where the need for establishing international standards governing transactions of Islamic hedging instruments was highlighted with the assertion that standardization would reduce the legal uncertainty within the industry regarding hedging and lend greater legal clarity on the instruments being used. Increased transparency would also lead to more widespread use of best practices in over-the-counter contracts and bring products to market quicker. A call was also made for research into Islamic hedging to aid in the development of innovative and creative instruments.

 

Nabilah Annuar is a Features Editor for Islamic Finance News. This article first appeared in Islamic Finance News (22 April 2015, Volume 12, Issue 16, Page 13). For more information, please visit www.islamicfinancenews.com.

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