Although one of the most heavily debated area in the industry, Shariah compliant derivatives are undeniably one of the vital components in Islamic finance. As this niche market grows from strength to strength, it remains the most effective means of addressing risks. NABILAH ANNUAR reports on the developments surrounding Islamic derivatives.
Notable transactions
Landmark projects include: the development of the Saudi Arabian Monetary Agency’s Shariah compliant Derivatives documentation; and the development of Shariah compliant repo transactions and utilizing equity derivatives technology to create portfolio options — all of which were engineered by international law firm, Allen & Overy.
Another noteworthy transaction was J.P. Morgan’s US$40 million collateralized Islamic total return swap with Sukuk as an underlying asset, which was structured by Clifford Chance. The total return swap incorporated both, profit rate and credit default swap features and settlement mechanics as well as Wa’ad and Murabahah structures, and was an unique example of complex cross-sectoral communication.
Dubai-based power cables manufacturer, Ducab, last year worked with Societe Generale to convert over 70% of its copper hedging practices, worth US$700 million annually, to Shariah compliant methods, with an aim to convert the remaining 30% and its aluminium contracts in the future.
Qatar Islamic Bank was one of a consortium of banks to provide funding to Qatar Electricity and Water Company, which signed a US$450 million financing agreement for Qatar’s RAF A2 Desalination Plant. Barwa Bank, Masraf Al Rayan and QIB provided Shariah compliant funding, although the transaction was significant given the fact that the banks also provided Islamic hedging in the form of a commodity-based profit rate swap, which was the first time this had been implemented for a project finance deal in Qatar.
Regulatory landscape
On the conventional side, derivatives are traded over the counter, primarily based on the International Swaps and Derivatives Association (ISDA) master agreements. These agreements are highly standardized, allowing for the instantaneous confirmation of derivatives trades, which are required for purposes of the fast paced derivatives market. The master agreements provide a framework for two parties under which individual derivatives transactions may be entered into. The arrangement incorporates standard provisions that the parties may opt to apply or disregard. The commercial terms of each individual derivatives transaction is thereafter documented by a confirmation exchanged between the parties each time a transaction is entered into.
With similar intentions, ISDA collaborated with Bahrain-based International Islamic Financial Market (IIFM) to issue the Tahawwut Master Agreement (TMA) in 2010. ISDA now aims to issue new templates for Islamic cross-currency swaps as well as templates for FX forwards and at the end of this year. The collaborative effort also includes credit support documentation for Islamic derivatives and exploring the development of Islamic collateral documentation. IIFM is also expected to issue a legal opinion on English Law with regards to the implementation of the Tahawwut Master Agreement, as well as standards and guidelines for Islamic hedging and Islamic liquidity management.
The speculative nature of derivatives are not permissible by Shariah as they involve Gharar, Maysir and often the fact that there is no real trade that occurs. The conjecture in derivatives is done with the intention of generating profit. Therefore the underlying assets in the transaction are not often physically delivered. The problem with the derivative instruments is that due to speculation they are not tied to the real economic activity and this is could cause imbalance in the demand and supply condition of the real economy.
Issues
Derivatives are highly contentious instruments for Shariah scholars. The lack of documentations pertaining to Islamic derivative transactions add adds another predicament to the existing issue. Currently, there is no widely accepted Shariah compliant derivative instrument that is equivalent to its conventional counterpart.
The 2010 Tahawutt Master Agreement developed by ISDA and IIFM which was aimed at addressing this issue was not well accepted by the industry. There is disagreement among scholars regarding its admissibility, which has resulted in a lack of acceptance particularly by Islamic financial institutions in the GCC. When it comes to hedging risk, derivatives are crucial to both companies and Islamic financial institutions alike. Without a standard document supporting Islamic derivative transactions, the industry will be at a disadvantage, with companies availing themselves of Islamic facilities often opting to enter into conventional derivatives to hedge their currency or rate exposure.
Outlook
As the industry develops in size, reach and maturity, industry observers seem cautiously optimistic on Islamic finance derivatives. It remains an opportunistic area of sophisticated Islamic finance products in spite of the differing opinions of its Shariah compliance. As interest in derivatives continue to grow, the research and development of documentation on it will be driven by market demands.