The Shariah compliant derivatives market continued to grow during 2016. YUSUF BATTIWALA feels 2017 will be a crucial year for the market. Among the challenges facing the industry are regulatory changes implemented in the wake of the global financial crisis which require certain market participants to put in place margin arrangements for uncleared over-the-counter (OTC) derivatives transactions.
We saw increased standardization of products in 2016 with the publication of template documentation for Shariah compliant foreign exchange (FX) forwards by International Swaps and Derivatives Association (ISDA) and International Islamic Financial Market (IIFM). With the squeeze on liquidity in the Middle East, 2016 witnessed increased appetite for derivatives-based financing transactions including Shariah compliant repo and total return swap transactions.
Review of 2016
Further standardization of Shariah compliant derivatives documentation took place in 2016. ISDA and IIFM published template documentation for Shariah compliant FX forwards. The documentation is intended to work in conjunction with the ISDA/IIFM Tahawwut Master Agreement (the TMA), the industry standard Shariah compliant derivatives master agreement. Although we saw an increased uptake and use of the TMA in 2016, the market’s approach to documentation remains fragmented, with a number of institutions continuing to use bespoke documentation which inevitably results in increased negotiations and a greater lead time for the execution of deals.
Profit rate swaps and FX forwards provide the core of the Shariah compliant derivatives market, but there was renewed focus on more structured transactions such as structured FX options and commodity derivatives.
2016 was a particularly busy year for the Shariah compliant repo and total return swap market. The lack of liquidity in the Middle East in particular saw Islamic institutions looking for ways to utilize their assets to seek funding. Despite the publication by IIFM of standard collateralized Murabahah documentation, the market continued to use bespoke documentation given the need for a title transfer arrangement underpinning the structure as opposed to a security arrangement which the IIFM documentation provides for.
Preview of 2017
With regulatory changes coming into effect in March 2017 in the US, Europe and elsewhere, a number of market participants will be required to put in place margin arrangements for uncleared OTC derivatives transactions. In anticipation of this, ISDA and IIFM are working on developing market standard Shariah compliant collateral documentation. However, coming up with a universally acceptable structure is a challenge and it remains to be seen how institutions will put into effect their collateral arrangements given the issues with the enforceability of netting and set-off (which Shariah compliant derivatives documentation are premised on) in a number of Middle Eastern and other jurisdictions. One solution to address this issue has been for Middle East-based institutions to set up SPVs in netting-friendly jurisdictions such that US and European institutions can transact with such entities with certainty as to the enforceability of the netting and collateral arrangements underpinning their derivatives transactions.
We expect to see continued appetite for Shariah compliant funding solutions in 2017 and expect an increase in Shariah compliant repo and total return swap transactions. Development of market standard documentation which provides for a title transfer arrangement would be a welcome development for market participants.
2016 witnessed the further development of the Shariah compliant derivatives market with a wide variety of transactions being entered into and the further standardization of certain products. 2017 is likely to prove a challenging year for the market as it accommodates margin rules for uncleared OTC derivatives transactions. The lack of a favorable legal regime in a number of jurisdictions with an active Islamic finance market is likely to be a hurdle although the hope is that recent legal and regulatory reforms in such jurisdictions are accelerated to allow for legally enforceable collateral arrangements to be put in place.
Yusuf Battiwala is a senior associate in the derivatives and structured finance group at Allen & Overy. He can be contacted at [email protected].