A derivative is a contract that derives its value based on an underlying asset. This underlying asset can be a specific asset, index or a benchmark. Derivative contracts are used for several reasons including risk management and speculation. The use of derivatives for increasing exposure to the underlying asset would be considered to be a speculation on the performance of the underlying asset, as opposed to actually an attempt to offset any undesired volatility of the underlying asset’s performance — ie paying a premium to hedge your exposure (a kind of insurance purchase). The distinction on the use of derivatives is extremely important since speculative derivative transactions offer investment managers and investors an opportunity to increase profit whereas derivatives used for hedging are considered a prudent financial risk management tool.
Derivatives trace their roots back 10,000 years and since the inception of Islamic financial markets and their evolution into a niche sizable market, there is no denying that in order to prudently manage their risk exposures, Islamic financial institutions, similar to their conventional peers, require solutions to manage their credit, rate and foreign exchange risks.
Islamic derivatives are financial instruments used purely for hedging purposes by generating similar economics as a comparable conventional instrument. Islamic hedging products differ in the overall underlying contract structure, as these products employ one of the Shariah compliant concepts of Murabahah, Waad or Musawwamah to achieve the economic result. Finally, a key constraint on derivatives in Islamic institutions is they can only be used to address a risk management framework which arises from engaging in real transactions.
Review of 2020
As per data from the Bank for International Settlements, the global derivative market value at the end of the first half of 2020 was about US$15.5 trillion, with a significant portion of it being interest rate derivatives. MENA continues to be the key Islamic finance jurisdiction with the largest Islamic banks operating in this region and while the overall derivatives market is large, Islamic hedging transactions make up only a minimal portion of this market, with some estimates less than 1%.
However, the volume of Islamic hedging transactions continues to grow as the sophistication of Islamic banks grows. Their need to manage their risk in an appropriate manner is increasing the Islamic hedging product offerings and the volume of transaction. However, challenges continue to remain in the development of this market.
One major hindrance for the growth of the Islamic derivatives market has been the lack of standardization; however, that gap was starting to be bridged when the International Islamic Financial Market developed the Tahawwut Master Agreement along with the International Swaps and Derivatives Association (ISDA). While the adoption of this documentation is increasing, the general market approach to documentation continues to remain fragmented.
Hedging documentation is complex agreements, requiring significant know-how of derivatives and enforceability. Hence, once documentation is negotiated with a client, it is a fairly tedious process to renegotiate. This complexity is enhanced in Islamic institutions that further need to seek approval from their Shariah board.
Preview of 2021
A major consideration going forward for the Islamic finance industry is the benchmark transition. The benchmark transition will be impacting the structure of existing Islamic finance products, not only on hedging but also on financing since it is backward looking, ie the reference rate for the relevant period will not be known until the end of the calculation period. While there are structures that are able to cope with this transition, the extent of the impact needs to be analyzed from an industry perspective and not only at the transactional level.
In the conventional market, the ISDA has implemented a benchmark supplemental protocol to accommodate the London Inter-bank Offered Rate transition. Market participants practicing Islamic hedging will most likely follow a similar approach, but this will require modification and amendment of existing master agreements. These modified master agreements will be renegotiated and reapproved by the Shariah boards. In an industry defragmented on documentation and opinions, this can be a task that is easier debated upon than implemented.
That being said, as Islamic financial institutions are becoming relevant, their know-how and sophistication level is increasing, hence regulators in key Islamic finance jurisdictions are taking steps to standardize both documentation and Shariah opinions and creating centralized Shariah boards, etc. These steps are conducive for the development of the Islamic finance market overall that will further support the development of the use of hedging products.
With the aforementioned backdrop, historical context and advancement in standardization along with foreseeable challenges, it is my humble opinion that while the market remains fragmented, Islamic financial institutions that are able to overcome the inherent challenges of this sector are poised to implement a solid risk management framework that will enable their sustainable growth and continue to be the growth factor of the overall Islamic finance industry.