Structured finance at the broader level can be divided into two categories: a) financial products instruments and b) structured solutions for raising financing for projects or business. Both categories find their space in the financial world when the existing product suite available does not fit in to meet the ever-changing market dynamics of an economy. Common examples of structured products may include equity-linked notes, interest/profit-linked notes, bonds/Sukuk-linked notes, commodity-linked notes, index-linked and forex-linked notes. In such products, the return is derived from the underlying security such as equity index, wheat, copper, other metals, minerals or the Sukuk portfolio. The other category may include securitization vehicles for project financing or business acquisitions in mergers and acquisitions and REITs. The basic purpose of structured finance is to identify and package risk in such a way that it can either neutralize or reduce risk embedded in a transaction.
However, in Islamic finance there is still no consensus on the permissibility of structured products that borrow ideas from the conventional financing system. This article attempts to discuss the situation with an out-of-the-box thought process.
Review of 2020
2020 will be remembered in human history because of the COVID-19 pandemic’s devastating impact on economies all around the world in an unprecedented way. All activities and innovation in the financial sector effectively came to a halt; however, even by taking it as an exception the development of structured finance and product development in countries where Islamic finance has its forte have remained far behind unlike countries following the conventional financial system, specifically the developed countries.
There may be two possible reasons for this situation:
i) the concept behind structured finance products and solutions is taken as incompatible with Shariah and hence not considered as an avenue to go about, and
ii) where these are adopted, the products lack a standardized approach and harmonization in principles.
Another factor for their non-permissibility is the use of structured products for speculative purposes though these are also used by businesses to hedge the risk of unfavorable volatility in prices of their input materials, etc. This scenario has restricted hedging options available to businesses in 2020 as well.
Islamic banks in Malaysia, the UAE, Saudi Arabia and the GCC have been offering structured products but they still need to go into it more.
As per credit rating agency Fitch Ratings, more than 30% of Fitch-rated Islamic banks do not use derivatives, and most of the remaining 70% use it in a limited capacity, constraining it to instruments like profit-rate swaps and Islamic currency forward contracts. In countries where Islamic finance has a key presence, the derivatives market in general remains underdeveloped.
In April 2019, the over-the-counter (OTC) interest-rate derivatives turnover (daily average) in the UAE, Malaysia, Saudi Arabia, Indonesia, Turkey and Bahrain combined was only US$3 billion and geographically stood at less than 1% of global OTC interest-rate derivatives turnover, based on BIS data.
Furthermore, with the exception of the UAE, no other GCC country has an exchange-traded derivatives market, although Saudi Arabia had announced its plans to launch one in 2020.
Preview of 2021
2021 will remain overshadowed by the fallout from COVID-19. However, the Islamic finance industry can capitalize on efforts that are being put in place by Bank Negara Malaysia and the International Islamic Financial Market which have joined hands with the International Swaps and Derivatives Association to promote activities.
However, a million dollar question arises: can we play rugby by following football rules? If Islamic finance is different than conventional finance, then how can products and structures that are essentially based on conventional financing principles be adopted to fit in with Islamic principles?
In response, the Islamic finance industry should consider its own game plan. A possible area to focus on is slicing out risk according to each business sector of the economy and packaging products for each sector according to the merits and demerits of each. The principle to structure products can be to take risk according to sector-specific downward and upward business conditions, for example the construction and automobile sectors are cyclical in nature and the profit rate setting benchmarks should be different for them than for stable sectors, instead of having a one-fits-all benchmark.
Structuring products or solutions according to sectors’ unique dynamics would enable the capture of risk in a systematic manner. Hence, Islamic financial institutions can have a portfolio of structured products and solutions for every sector of the economy with the right kind of business participation terms. This approach will promote entrepreneurial business sense at each Islamic financial institution level as their fingers will be right at the pulse of their portfolio businesses.
This is something very similar to the analytical approach at equity investment houses that know their portfolio business like a business partner. As far as the financial investment-related derivatives are concerned, just recall taking indirect exposures in other financial assets prior to the global financial crisis of 2008.
A historical crisis of its own class provides us with many lessons to learn from and to stop insisting to go beyond limits by creating bubbles. The BIS Annual Report of 2014 provides a useful insight about the global financial crisis and financial cycle boom and bust.
The Islamic finance industry should set the rules of its own game rather than unwinding and redeveloping conventional finance products and solutions. It may require reinventing the wheel but the pain has to be taken to fulfill the core purpose of its existence.