The effects of the global financial turmoil have reverberated worldwide, even touching the once-thought-immune Islamic financial sector. Growth in global Islamic banking assets, for example, is set to slow this year to around 10-15% from about 20-30% in 2008, says a November report by Moody's Investors Service, Gulf Islamic Banks Resilient Amid Global Credit Woes.
The lack of a developed Islamic interbank market and the absence of risk-mitigation techniques for Islamic banks will hinder growth, says the rating agency. But that situation is changing, as the use of hedging tools such as futures and swaps, along with short-selling techniques in the Islamic context, become far more prolific.
Indeed, growth rates of 10-15% are viewed as robust, compared with the contraction seen in many other areas of finance, such as retail structured products. This growth, coupled with government support, should push assets under management in the Islamic finance market through the $1 trillion mark within the next year. This, in turn, should open up the prospects for hedging instruments.
Some governments have sought to boost the Islamic finance markets in their jurisdictions. In mid-January, the Singapore government completed its inaugural sovereign-rated sukuk issuance facility, through which banks that issue sukuk in Singapore would be able to give their securities equivalent credit standing to Singapore government securities. And Hong Kong intends shortly to issue sovereign or sovereign-rating-linked sukuk to kick-start its Islamic finance market, while Indonesia plans to offer its first US dollar sukuk.
But major obstacles remain. The most obvious is the lack of consensus among the various Islamic jurisdictions over the role and extent that hedging can be practised in the Islamic world. That's because interpretation of sharia compliance varies among Islamic scholars and from country to country.
Still, several developments are taking place that may help overcome this hurdle. One is an effort to create a derivatives master agreement for commodity murabaha (cost-plus-profit financing) profit rate swaps, which is likely to be the first global standard contract for Islamic over-the-counter derivatives transactions. This effort is being driven by the New York-based International Swaps and Derivatives Association (Isda) in collaboration with the International Islamic Financial Market (IIFM) - a Bahrain-based body set up by the central banks and monetary agencies of Bahrain, Brunei, Indonesia, Malaysia and Sudan and Saudi Arabia's Islamic Development Bank.
The creation of such an agreement has been made possible by the increasing acceptability of Islamic risk management tools, such as commodity-based murabaha. Wa'ad (unilateral undertaking promise) structures are also becoming acceptable in more jurisdictions. Some parties prefer wa'ad, because the promise gets around the need for support by a commodity structure, which can make the hedge more efficient due to the less complex underlying structure.
"Five years ago, the most common hedging instruments were largely commodity-based murabaha solutions mimicking a conventional rate hedging trade," says Sulaiman Moolla, an Islamic treasury salesman at HSBC Amanah in Dubai. "Today more promise-based, wa'ad structures are being done. Both murabaha and wa'ad give you the economic effect of a hedge, whether the client wants to hedge the underlying FX, commodity or rates exposure." Through murabaha, one enters into commodity trades and through wa'ad, one promises to enter into a transaction to buy that asset outright.
Islamic finance practitioners and scholars are also making an important distinction between what is acceptable as hedging for risk mitigation and the use of derivatives for speculation.
K Salman Younis, managing director of Kuwait Finance House's Malaysian branch in Kuala Lumpur, says hedging used to have a preconception in the Islamic world as being synonymous with short-selling, which had given rise to the assumption that hedging was out of sync with sharia principles. "Speculation must be viewed with caution," he says. "Given the similarities between it and gambling, many scholars at first view this activity as haram (unlawful or forbidden), as it equates to gambling." If a decision is to be more exposed to risk to gain a profit, it is seen as gambling in the eyes of some scholars, adds Younis.
"But with more information on the issue, and the steps taken by investors, speculation is now viewed as taking calculated and informed steps in the markets to selecting stocks in price movements," he says. Logically, then, it is not the nature of an instrument or activity that makes it haram, says Younis, but rather how the instrument works. For example, he says, if hedging involves the use of leverage, it has to be regulated and monitored, because leverage may create excessive debt flow and instability in the overall market.
Islamic law clearly prohibits the giving and receiving of riba, or interest. Meanwhile, gharar - excessive uncertainty - is also prohibited, as is gambling, or maysir. Bai'ma'dum, the sale of goods one does not already own, covers short-selling, a practice rejected outright by some scholars.
But some parties say there are ways around restrictions on short selling. Yusuf Talal DeLorenzo, chief sharia officer at Connecticut-based Islamic finance investment company Shariah Capital, says the use of arboon (earnest money sale) is permitted by the US's Securities and Exchange Commission (SEC) as a sharia-compliant means of short-selling. Another approach, called salam (advance purchase), is also viewed as sharia-compliant by some parties, but is not endorsed by the SEC. Both approaches are commonly used alternative routes to achieve the economic results of a conventional short-sale without selling something a party does not own.
Arboon allows the seller to take an urbun (earnest money, or deposit) from the buyer, with the understanding that the deposit will be credited toward the price if the sale is concluded, but not refundable the deal falls through. Salam was designed to provide farmers with seeds and at the same time offer merchants protection from price fluctuations on crops they had effectively financed by providing the seeds.
DeLorenzo says in sharia-compliant arboon, stocks are bought using an arboon contract, so that the investor actually takes ownership of the stocks. It is a technique used by several banks, such as Deutsche Bank. Using arboon, the prime broker, for example, agrees to sell stock to the investment manager at the quoted - and therefore agreed - market price, says DeLorenzo. The investment manager, meanwhile, makes an arboon down-payment and assumes ownership of the stocks. If the investment manager decides not to complete the sale, he returns the shares and forfeits the arboon earnest money.
In Malaysia, meanwhile, the Securities Commission's (SC) Shariah Advisory Council allows regulated short-selling under sharia, if the short-sales are covered by an arrangement that meets the principles of bai' (a purchase of security), and wa'd (a promise to sell back the security), says Goh Ching Yin, an executive director for strategy development at the SC in Kuala Lumpur. Under the qabd (effective and intended ownership interest) principle, the short-seller can proceed with the sale of the stock pending its delivery, as long as the sharia-compliant replicated stock borrowing and lending has been conducted thoroughly, he says. This is based on the fuqaha (Islamic law jurists') view, under which a party may sell an item, other than food, that is pending delivery.
It is such acceptance of sharia-compliant replicated stock borrowing and lending by regulators such as the SC and the SEC that has enabled the establishment of sharia-compliant hedge funds, which are considered unlawful by many Islamic finance practitioners and scholars. Barclays Capital, for example, has partnered with Shariah Capital in launching its Al Safi Trust, an Islamic hedge fund platform for which Shariah Capital serves as the sharia adviser and the UK bank as the prime broker and structured product distributor.
Meanwhile, some banks have pushed money-market products. For example, in November, CIMB Islamic launched a commodity murabaha deposit through its Hong Kong branch in partnership with Hong Leong Bank. This was the city's first sharia-compliant interbank money-market product.
Many Malaysian banks have already been offering commodity murabaha deposit products in the country's Islamic interbank money-market as a way to mobilise funds. They have also introduced the product as a liquidity-management tool where corporates can park their short-term surplus funds - in foreign currencies as well - so the corporate can earn a pre-agreed margin on a deferred day.
An interbank cash deposit product would involve two banks entering into a commodity murabaha deposit transaction, through which one of them would sell crude palm oil contracts as the underlying asset and place the proceeds with its counterparty bank. The counterparty would agree to pay the selling bank at a marked-up price on a deferred day. Since the proceeds from the sale of the crude palm oil contract are placed with the counterparty bank by the bank that sold the commodity, such placement is seen as a cash deposit product in the interbank market.
In terms of structure, sharia-compliant derivatives are different from their conventional counterparts, chiefly in terms of underlying structures such as cashflow mechanisms, tests, legal documentation and so on, says Geert Bossuyt, head of structuring for the Middle East and north Africa at Deutsche Bank in Dubai.
The need to use underlying assets to generate cashflows - a fundamental sharia requirement that is usually linked to commodity trades - also brings about regulatory, tax and credit risk issues that can often be complex, Bossuyt adds.
"Yet ultimately Islamic derivatives function in just the same way as their conventional counterparts and the economics are identical," he says. "Indeed, as innovation and growth in the Islamic financial markets persist, almost all transactions that can be done conventionally can now be structured in Islamic format." That means Deutsche Bank is offering a full range of Islamic hedging solutions, from widely used profit rate swaps to less common Islamic repos, foreign exchange options and total-return swaps.
Banks market their Islamic solutions as being approved by their own sharia boards, but institutional investors also have their own sharia advisory panels that select assets based on their own compliance criteria, says Goh Wee Peng, head of fixed income in the fund management unit of AM Investment Bank in Kuala Lumpur. For example, for Middle Eastern clients, institutions would submit the product structure to their panel, which will strip down the entire concept and structure to check it is compliant, says Goh. This can mean a long education process before a product can roll out, he adds.
Meanwhile, any capital-market product sold in Malaysia as sharia-compliant must confirm with the regulations and guidelines of the SC and be approved by the SC's Shariah Advisory Council.
But a gradual trend towards convergence appears to be taking place. That's because, from a risk management perspective, the most pressing requirements centre on three areas, says IIFM's Dubai-based chief executive, Ijlal Ahmed Alvi: profit margin risk management, currency risk management and commodity risk management.
The Isda/IIFM working group now involves 70 institutions active in Islamic finance both in Asia and the Middle East. The aim is to finalise a draft of a Ta'Hawwut hedging master agreement in the first half of 2009, and subsequent versions will be developed to include additional Islamic products. The first effort will over murabaha-based Islamic profit rate swap transactions, since the bulk of Islamic deals today are done under such cost-plus financing principles.
But Shahriman Shariff, regional head of Islamic structuring at Citi in Kuala Lumpur, believes there are many issues that Isda and Islamic standard-setting bodies must resolve for a master agreement to cover more Islamic derivatives. The biggest issue centres on the different approaches banks use when trading Islamic swaps, he says. For example, some banks prefer to do bilateral deals, while others conduct tripartite trades.
The way each commodity trade is executed in a commodity murabaha also varies from bank to bank, adds Shariff. For example, some banks may designate the commodity trade to just one commodity broker, while others may prefer using two brokers for the initial purchase of the commodity and its subsequent sale.
Isda says a second meeting by IIFM's board of Sharia experts is slated to take place in January to further discuss the Ta'Hawwut hedging master agreement.
But Shariff believes the main barrier to the development of longer-term Islamic hedging solutions is the lack of a counterparty risk mitigation mechanism. "We're working on a counterparty-risk-mitigation mechanism, a credit enhancement that is very important in this market environment," he says. "This is already available in the conventional space and is something we need to replicate for Islamic (finance), as we are looking at similar process to reduce counterparty risks." Without such a mechanism, it is difficult for banks to offer hedges of more than five-year tenor.
ASIAN REGULATORS ON ISLAMIC FINANCE
Goh Ching Yin, executive director, strategy and development at the Securities Commission (SC), Malaysia:
- What are the guiding principles that the regulator uses to distinguish between hedging for the purpose of risk management and so-called 'hedging' used for speculative gain?
While the SC does not issue any principles related to hedging, in the case of Islamic instruments its Shariah Advisory Council examines in detail the overall structure of proposed capital market-related hedging instruments for compliance with sharia principles.
In general, sharia allows for two broad approaches to hedging. One concerns protection against volatility of asset prices or yields and is based on the concept of tawarruq or a tripartite reverse-commodity murabaha (cost plus sale). This concept is also used for structured products or for managing short-term financing needs.
A second approach to hedging relates to contractual risk, and is based on principles such as the reverse urbun. This involves earnest money - a deposit - constituting part-payment for goods or services, which would be forfeited if the transaction were cancelled; the forfeited money is considered as hibah, or a gift.
- There are already quite a number of sharia-compliant hedging solutions available in the market. Do these products need any sign-off from the commission? What are the most common enquiries the SC has received from the sharia advisors within financial institutions?
All Islamic capital market products need to have their structures approved by the SC's Shariah Advisory Council. This includes sukuk, equities and exchange-traded instruments. Derivatives contracts that have been approved by the council as sharia-compliant include futures on crude palm oil and palm-oil kernel, as well as single-stock futures - provided the underlying stock is sharia-compliant.
The SC typically receives enquiries from banks on structures that relate to capital market-related products. Those related to banking transactions are approved by the central bank of Malaysia.
Tai Boon Leong, executive director at the Monetary Authority of Singapore:
- How does the Monetary Authority of Singapore see the development of hedging tools applied in Islamic finance? Which potential hedging instruments would be most in demand in Asia?
Many of the risks inherent in Islamic finance are similar to those of conventional finance. Islamic banks face comparatively greater liquidity risks than their conventional counterparts, given the more limited and less developed range of sharia-compliant liquidity and hedging instruments.
The inadequacies thrown up by the risk management problems encountered by international financial institutions should spur the Islamic banks to devote greater resources to develop a wider range of sharia-compliant hedging tools.
Given the greater connectivity of Asian markets and the growth of trade and investment flows between the Middle East and Asia, cross-currency instruments as well as commodity-related contracts will be in demand.
- How is the development of a sharia-compliant interbank market in Singapore coming along?
Tai: Islamic financial institutions in Singapore can transact in sharia-compliant deposits and loans in both the interbank and retail markets. The value of these activities has grown and is expected to expand with the 5% concessionary tax rate introduced in 2008 for sharia-compliant lending, a clearer regulatory framework to allow more Islamic banking products and the issuance of a MAS sukuk (Singapore set up a sukuk issuance facility in mid-January), which will provide Islamic banks with liquid risk-free assets to support their market needs.
- What potential do you see for sharia-compliant project finance, given that MAS officials have publicly stated Singapore's potential of being a hub for infrastructure financing?
Asia's project financing demands are numerous and cover many areas - physical infrastructure, education and healthcare, just to name a few. With the current financial crisis, the need for such financing has become more pressing.
Islamic finance is an avenue through which such needs can be met and also helps to diversify the funding sources for project financing in Asia. With its deep and liquid markets, Singapore is well positioned to play this role, as can be seen from the doubling of non-Singapore-dollar project financing by banks in Singapore, from S$47 billion ($31 billlion) in 2004 to S$94 billion in 2007.
As an international financial centre and the gateway to Asia, Singapore will have a central role in mediating capital flows. We have already seen many Asian companies secure sharia-compliant financing for developmental projects in the Middle East and Asia. One example is Capitaland, which raised Islamic funding to build the multi-billion dollar Raffles City Bahrain.
Edmond Lau, executive director in the monetary management department of the Hong Kong Monetary Authority (HKMA)
- Can you outline the regulatory groundwork being laid for the issuance of sukuk by local issuers?
The HKMA had looked into ways to maximise the readiness of the financial infrastructure to process Islamic finance-related transactions. In this regard, it implemented several initiatives in the payment and settlement systems in Hong Kong in 2008, including the activation of a new payment code specifically for Islamic-related payments; the provision of additional settlement accounts in US dollar and euro real-time gross settlement systems for segregation of Islamic-related funds from other funds; and enhancements to the Central Moneymarkets Unit to cater for custodian, clearing and settlement services for Islamic bonds in Hong Kong.
- What do you feel about the prospects for a sharia-compliant interbank market in Hong Kong?
We possess one of the world's biggest and most influential clusters of international and regional banks, which possess vast experience in serving Islamic finance businesses around the world either as windows or subsidiaries. Some of them have started operating Islamic banking windows in Hong Kong. They have brought sharia-compatible interbank money-market tools, such as commodity murabaha deposits, which would give the banks in Hong Kong an excellent foundation. We have also had the first Islamic syndicated loan facility arranged for a corporate by a local bank in Hong Kong in December based on commodity murabaha contracts.