Standardizing Derivatives for Islam
Uniform platforms should boost growth in market segment
By Karen Lane
The Wall Street Journal Asia, 16^th November 2006

Standardized Shariah-compliant derivatives are set to overtake a collection of tailor-made Islamic hedging tools pieced together by investment banks in a move that should boost growth in Islamic financing.

The New York-based International Swaps and Derivatives Association and Bahrain's International Islamic Financial Market yesterday held the second in a series of meetings aiming to unveil an agreement next year on standards compliant with Shariah, or Islamic law.

Islamic banking, fast-growing among the world's Muslim population of around 1.4 billion, condemns interest payments as usury and bans speculative activities deemed similar to gambling. So Islamic investors can't use conventional hedging tools -- interest-rate swaps, forwards or options -- to offset fluctuations in interest rates and currencies. The few tailor-made hedging tools now in use have concentrated such risk into the hands of a small number of investors. Global standards would help spread it more evenly, bankers say.

Muslims aren't the only ones interested. Ijlal Alvi, chairman of the International Islamic Financial Market, says that many of those involved in discussions on a global standard for Islamic derivatives are conventional market participants looking to increase their presence in Islamic financing.

"For the Islamic market to exist in the proper manner, it must have all the relevant products that befit the financial market," says Badlisyah Abdul Ghani, head of the Islamic division of Malaysian bank CIMB Bhd. "For every single conventional product, you want to have the equivalent Islamic product."

Islamic derivatives won't soon compare to the huge conventional market that, according to the Bank for International Settlements, had a notional US$285 trillion in over-the-counter derivatives outstanding at the end of last year, but standardization would bring in a wider range of participants.

There is around $750 billion lodged in Islamic mutual funds, Islamic banks and the Islamic arms of conventional banks, with the industry growing at 10% to 15% a year, according to a conservative estimate by Moody's Investors Service earlier this year.

"In the past, Islamic derivatives haven't been approved by scholars, in part because they were deemed speculative," says Kuldeep Singh, head of Risk Treasury with Citigroup Inc. in Kuala Lumpur. "That penalized those who wanted to hedge to manage their investments better."

Many scholars are coming around to the idea that Shariah-compliant hedging instruments are not only acceptable but necessary. "There are Malaysian corporates who want to tap the funds in the Middle East and . . . there are Middle Eastern investors who want to invest here [in Malaysia] but don't want local currency risk," says Mohamed Iqbal, head of Treasury at Kuwait Finance House in Kuala Lumpur.

Currently, most Shariah-compliant derivatives are based around the Islamic principle of murabahah, where two parties agree to the sale of goods at a price that includes a profit margin.

For example: To hedge currency risk in the conventional market, a party might enter a forward contract that locks in the price at which it can buy or sell a currency on a future date. For Islamic investors to execute a currency forward trade, the parties would instead agree to sell assets -- usually commodities -- to each other for deferred payment in different currencies.

Citigroup recently built on this model to help Dubai Investment Group offset the currency and interest-rate risks arising from its October purchase of a 40% stake in Bank Islam, Malaysia's oldest Shariah-compliant bank.

Under that five-year, US$230 million currency profit-rate swap, the two sides exchange periodic floating-rate U.S.-dollar payments on murabahah metal contracts for floating-rate ringgit payments.

Islamic Capital &
Money Market
Unification
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