Huge strides have been made over the past 20 years in Islamic finance, so that something which was once small scale and barely known outside specialist circles is now a globally recognised sector of the financial markets.
Derivatives have lagged behind Islamic banking and bond issuance – and they remain controversial. Some Islamic financial players believe derivatives will never be compatible with Shari’ah law.
But the swelling interest in Islamic hedging structures and the wide variety of initiatives being worked on suggest the opposite – that an Islamic derivatives market is emerging that will eventually offer an extensive range of services.
The world of Islamic derivatives is arcane and fragmented – nobody contacted by FOW was able to give an indication of the size of the market.
But most participants agree that there is noticeable growth every year, which, although disrupted by the financial crisis, looks set to continue when the economy recovers.
Getting to grips with Islamic principles
So how can a derivative be Shari’ah-compliant? Shari’ah law prohibits usury or excess interest (riba), unnecessary uncertainty (gharar) and speculation (maysir). This poses obvious problems when it comes to structuring derivatives.
Trading of debt is also prohibited. “One of the reasons for not making money from money is that it may lead to hoarding, which does not advance the economy,” says one market participant.
There are other rules – the underlying assets need to be halal, so cannot be based on products such as alcohol, weapons, gambling or pork. Even when derivatives are structured in such a way that they manage to comply with the rules, some scholars still refuse to accept them.
Imran Mufti, a senior lawyer in the Dubai office of the English law firm Lovells, lays out the problems inherent in creating Islamic derivatives. “You can’t sell what you don’t own,” he says. “There are very limited exceptions as to where that’s allowed. There has to be a real economy behind it all rather than notional evaluations.”
Some Islamic financiers and investors will not accept that derivatives can ever be Shari’ah-compliant, and bankers say some of them may never change that view.
But products that perform similar functions to derivatives exist. This is because there are several schools of thought which take different views on Shari’ah law.
The broadest divide is between Sunni and Shia scholars, but within these groups there is further variety. This means that a financial instrument can be accepted by some scholars but rejected by others. “Because it’s a comparatively fluid intellectual space, you have differences of opinion,” says Mufti.
Suspicion of motives
One of the main problems lies with the way derivatives are used. There is nothing wrong from an Islamic point of view with taking a business risk or making a profit – Islamic finance is based on the sharing of risks and rewards.
From this point of view, an Islamic business might seek to mitigate risk by hedging with derivatives. But many investors are wary of moving into derivatives because they are so often used speculatively.
The ideological divide has created a geographical variation in Islamic finance. Malaysia is generally viewed as less restrictive and has emerged as an important hub of Shari’ah-compliant finance, often pioneering new ideas. The Middle Eastern market can be more conservative and stringent in its requirements. But there is considerable overlap.
Many international institutions working on Shari’ah products tend to go for cautious structures, so that their products have a wider appeal.
“The biggest job is to convince scholars that there is a real need for [derivatives],” says Farrukh Raza, managing director of Islamic Finance Advisory and Assurance Services (IFAAS), a consultancy based in the UK.
The legitimacy of any Islamic financial product must be decided by a board of Shari’ah scholars. Banks and other institutions either have in-house scholars who can give such approvals, or they bring in scholars periodically to approve or reject their products.
The scholars perform two principal tasks – ruling on products that the bank has devised itself, and doing the same for third party products.
The vast majority of Islamic products that replicate derivatives are traded over the counter, using either a specialist Islamic bank or the Islamic arm of a standard bank. For example, HSBC has an Islamic branch known as HSBC Amanah. The Islamic derivatives business is run by the derivatives desk but with separate back office procedures.
HSBC’s Shari’ah scholars meet regularly and discuss what is put in front of them. The bank has different Shari’ah boards in various countries, although it does not have a board for every state.
Growth set to resume
These products are traded on a substantial scale and investor interest is growing. The world financial crisis has inevitably given sceptics further ammunition to oppose derivatives because of the supposed part they played in destabilising the financial system, and their growth has been interrupted. But many market participants believe that it will pick up again when the economy improves.
“Most of what has been offered so far by Western banks is a replication of conventional products in a Shari’ah-compliant manner,” says Danny Goldblum, global head of FX and precious metals structuring at HSBC in London. “Demand is mainly driven by investors in the Middle East, or Middle Eastern investors based abroad, but market conditions have caused this to dip recently,” he says.
Ghazanfar Naqvi, head of Islamic products at Standard Chartered in Dubai, says that Islamic hedging instruments “have grown on a year-on-year basis and growth has been substantial. There’s a lot of space in this market,” he adds. “There are prospective users out there who are looking.”
Most Islamic derivatives are structured around the murabaha. This is a contract through which one party sells goods to another on a deferred basis, at cost plus an agreed profit. The technique is used in a wide variety of applications in Islamic finance, such as liquidity management.
“The murabaha is by far the biggest instrument being used,” says Raza, though he adds: “It’s a very small market. For a time it was very controversial.”
Standard Chartered has been offering Islamic hedging solutions since 2005 for currency and interest rate risk, which are comparable to conventional derivative solutions. It is also working on commodity and equity products.
The bank’s interest rate swaps are based on ‘commodity murabaha’ products, a kind of murabaha in which a customer buys a commodity from a financial institution for cost plus profit, with deferred payment terms, and then immediately sells the commodity to a third party for cost, giving it a positive balance in its accounts until the deal expires.
For the interest rate swap, both parties enter into a commodity murabaha, one with a fixed rate and the other with a floating rate.
In a three year deal, for example, they might swap cash flows for every six months. Over the life of the deal, each party would have entered into six commodity murabuha contracts.
The Islamic products offered by HSBC include forwards, vanilla options and over-the-counter swaps.
“We have approval to use a wide range of FX products within a structured deposit wrapper,” says Goldblum. “It is even possible to do an interest rate swap referencing standard Libors using murabaha or wa’ad structures.”
The secondary market for Islamic hedging instruments is much more complex. If a party wants to get out of a contract, the new entity stepping into its shoes has to execute a fresh trade directly with the original counterparty.
“You can build in provisions that enable you to assign the contract to someone else,” says Naqvi, “but it requires an extra bit of effort than with conventional contracts.”
Hard work on standardisation
One of the constraints on growth is the lack of standardisation. Every product requires a large amount of documentation, which makes trading time-consuming and expensive.
The International Swaps and Derivatives Association (Isda) and the International Islamic Financial Market (IIFM) are working on a master document designed to help reduce the amount of paperwork, and hence the time, required for each transaction. It will be the Islamic equivalent to the Isda Master Agreements used widely in the OTC derivative markets.
“At the moment, every transaction you complete needs to be approved by a Shari’ah board,” says Peter Werner, director of policy for Europe at Isda. “There is no blanket agreement available.” He expects volume to grow after the agreement is finalised.
The agreement is intended to be contract-neutral. “To be more product-specific would be a second step,” says Werner.
The Isda-IIFM document, in other words, would provide a bedrock of standard documentation which users could amend as required.
Some are sceptical of the prospects for success. “The uniformity of Islamic documents is difficult to achieve,” says Mufti at Lovells. “[The Isda master document] is probably a good idea but is probably going to be difficult to achieve.”
Ghazanfar Naqvi at Standard Chartered describes the Isda-IIFM Ta’Hawwut agreement as “an important step in bringing consistency and transparency to the market” but stresses that there is a degree of standardisation in the market already.
“A murabaha is a murabaha,” he says, adding that even conventional non-Islamic derivatives are not always standardised. “The Islamic finance industry is growing and will keep on expanding geographically and in its product offering. Standardisation will come along. I see quite a bright future for Islamic hedging instruments,” he says.
Exchanges take first steps
If the OTC Islamic derivatives market is beginning to blossom, the exchange-traded side has barely germinated. But there does seem to be potential for growth, and exchanges have explored a variety of ways to structure derivative-style contracts.
“Given their bespoke nature, exchange-traded Shari’ah derivatives are not something we are considering in the short run,” says Goldblum at HSBC.
Several exchanges have been looking for ways to appeal to Islamic investors. The Turkish derivatives exchange Turkdex, for example, will soon introduce two foreign exchange contracts that will be Shari’ah-compliant.
The contracts, which will be launched in July or August this year, will be physically deliverable. Turkdex is hoping to attract industrial importers and exporters with an Islamic background and expects some of the transactions that are now done by banks OTC to move on to the exchange.
Turkdex also wants to launch Shari’ah-compliant cotton futures and is looking at establishing a licensed warehouse to facilitate delivery.
At the beginning of March, Nasdaq Dubai listed a Shari’ah-compliant product that offers exposure to gold in the form of securities similar to shares, known as Dubai Gold Securities (DGS).
In this exchange-traded commodity structure, physical gold is kept by HSBC in London and each security matches a certain quantity of it. Investors do not pay interest and can require redemption of their securities. The assets are segregated and held off HSBC’s balance sheet, which is intended to keep them safe from credit risk.
Sameer Meralli, managing director of Dubai Commodity Asset Management, which markets DGS, says the product is attracting interest from retail investors and wealthy individuals, as well as from Islamic financial institutions and the Islamic “windows” of conventional banks.
Peter Fitzgerald, chief operating officer of Nasdaq Dubai, says: “The gold ETC is growing but it hasn’t yet got the volume that we want to see.”
Asked whether the exchange is considering other similar products, Fitzgerald says: “We will look into Islamic derivatives as the market develops more.” Jeff Singer, the exchange’s chief executive, says he is “bullish on Shari’ah”.
Another way investors can trade derivative-style products is to buy and sell London Metal Exchange warrants in the OTC market. Each warrant conveys the ownership of a specified 25 tonnes of metal or plastic stored in an LME warehouse.
“LME warrants can be purchased at a cost-plus-profit price,” says Mufti. “Banks buy purposefully for the borrower on a cost-plus-profit basis. They are sold on a deferred payment basis.”
Waiting for the tipping point
At the moment Dow Jones Indexes has no Islamic derivatives indices, but it does have several Islamic indices, most of which are equity-based. “We are ready to go when we find a successful derivative product has been launched,” says Sumeet Nihalani, senior director of sales for Asia Pacific and the Middle East at Dow Jones Indexes in Singapore. “I think the Islamic derivatives market will take shape more in the next few years.”
Eurex has looked into Islamic derivatives, but has so far not found enough demand to create a contract.
“There are a number of Islamic-compliant equity indexes out there and the assets under management in related ETFs are growing slowly, but it’s a critical mass issue,” says Brendan Bradley, global head of product strategy at Eurex in Frankfurt. “We do not see the demand to list something in the near future. It’s a developing marketplace and there are more bond issues (eg sukuk) and structured products being issued. We’ll keep it on the radar,” he says.
The market is tentatively establishing itself, but critical mass will take a while to build up, especially now that market participants are being so cautious.
“Before the credit crunch there was a real momentum for trying to come up with Shari’ah-compliant repos and CDOs. There’s been a lot of wind taken out of the sails,” says Mufti.
“If the financial crisis settles down, the Islamic market will be moving towards Islamic derivatives,” says Raza. “It’s a very small market for the time being but I hope that in the next few years they will be looking at developing new contracts.”
“I believe the Islamic derivatives market is definitely going to grow over the next few years, but it’s not going to be as phenomenal as conventional derivatives.”