The Islamic finance sector is growing at a rapid rate throughout the world. Having begun with basic trade-related products, it is now expanding into almost all areas of banking and finance. Over the years, the sector has continued to attract a growing number of service-providers, whether offering a comprehensive range of Shariah-compliant (Islamic law) products or focused on specialist areas such as private equity, real estate, sukuks (Islamic bonds) or structured finance.
The sector is now going through a transition phase in which service providers are moving into a more advanced stage of product development. In the early days, these were structured to meet basic requirements. Now, there is a move towards more sophisticated products to cater to investment and capital-raising requirements, including project finance, hedging products and investment funds covering diverse asset classes, from the likes of equities to shipping and aviation funds.
Islamic retail-banking products have been particularly successful in the Middle East, South Asia and Southeast Asia, allowing customers to participate in the sector in line with Shariah principles. The introduction of Islamic products has created an additional customer base attracting individuals who had previously stayed away from the banking sector or were participating at a very basic level for needs such as accounts and services.
The entry of international banks into the Islamic-banking sector has been positive – and will continue to be so – by helping to establish standards, as well as providing access to significant resources and infrastructure. The size of international banks means products and services can be offered in ways that better meet the demands of customers. This development is helping to convince more customers, both retail and wholesale, to choose Islamic banking products.
There have been a number of significant transactions in wholesale Islamic banking, in terms of their ability to match conventional products at competitive prices, as well as attract Islamic liquidity and invest in long-term projects and transactions. However, this has meant that Islamic institutions have had to assume risks for which financial solutions are required to ensure that the investment decisions are sound.
One such risk relates to hedging. Islamic institutions and customers – both corporate and retail – are exposed to risks for which there are tried and tested solutions in the conventional banking sector. By contrast, the Islamic sector is still in its infancy in terms of hedging solutions. It needs to move quickly towards viable alternatives if it is to sustain the growth that it has enjoyed until now.
The Case for Hedging Solutions
The retail products offered by most Islamic financial institutions are fixed rate and structured according to murabaha principles (sale contract with an agreed profit). Corporate customers are offered facilities based on floating benchmarks. Both institutions and customers are exposed to risks such as currency fluctuations, which may have serious consequences unless adequately addressed.
Long-term exposure may be a problem when the underlying transaction has been structured in a Shariah-compliant manner, whereas the hedging has been effected with a conventional instrument. It is far preferable for the entire transaction to be compliant, as well as competitive.
As the likes of mortgages and auto finance become more popular, the demand for competitive, fixed-price retail products is increasing. This also applies to corporate customers, who want fully compliant facilities for capital investment and overall hedging solutions to convert their entire financial needs in an acceptable manner. Once such publicly listed corporate customers are able to become fully Shariah-compliant, they will be able to attract capital from Islamic investors and equity-fund managers.
The most compelling need for Islamic hedging solutions is that of financial institutions to help them manage their risks and become truly competitive.
The availability of even basic hedging instruments will open new avenues for investors and customers in areas such as debt-capital markets, structured trade and project finance and overall balance-sheet management for Islamic financial institutions, including banks and takaful (cooperative) companies.
Need for Common Platforms
Being relatively young, the Islamic finance sector is in a unique situation, whereby the lack of common regulatory bodies and uniform rules – a common platform – is both a problem and an opportunity. On one hand, this can result in uncertainty and differences in practices. However, it also means that leading groups and institutions can be involved in devising rules to ensure the establishment of a workable system based on conventional banking experience.
In recent years, a number of Islamic groups have begun trying to establish uniform practices to address gaps and threats in the sector at regulatory and institution level. A brief description of some of these follows.
Accounting and Auditing Organisation for Islamic Financial Institutions
Established in 1991 to develop accounting and auditing standards for Islamic institutions, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has made commendable effort to formulate relevant standards of practice. Another key contribution is its compilation of Shariah standards for institutional governance and related contract standards.
Islamic Financial Services Board
On the regulatory front, the Islamic Financial Services Board (IFSB) has been addressing issues relating to prudential governance and the financial stability of Islamic institutions. It continues to try to establish a workable risk-management framework for these institutions, with the help of regulators from participating countries.
International Swaps and Derivatives Association
Within the area of Islamic hedging, the International Swaps and Derivatives Association (ISDA) is likely to play a major role in standardising hedging structures and related contracts. It has the advantage of having access to the expertise of established conventional practitioners. The ISDA may prove to be crucial in helping lift the Islamic sector to a point at which basic- to medium-level hedging instruments can be introduced.
Central banks
Islamic central banks, regulatory authorities and sector groups will play a crucial role in helping and ensuring the success of the efforts by bodies such as the AAOIFI, IFSB and ISDA.
Islamic Development Bank
The Islamic Development Bank (IDB) is also closely involved in developing the Islamic financial sector and a wide range of acceptable products, including hedging solutions.
Shariah scholars
Over the years, Shariah scholars have made significant contributions by ensuring an appropriate balance between advances within the sector and Shariah standards. Forums such as the Fiqh Academy, established by the 57-member Organisation of the Islamic Conference, have helped promote the sector, and scholars have ensured that common standards are adopted. Minor differences of opinion about interpretation have proved to be healthy for the sector.
Available Structures
There is consensus among those involved in the sector and regulators about the need to manage risks relating to currency and yield-curve movements. But they also agree that hedging solutions are not easy to structure within the framework of Shariah. Resolving this issue is now a major focus for Islamic financial institutions, with the guidance of Shariah scholars, along with the support of regulators and the groups mentioned above.
Foreign Exchange Hedging
The general view of scholars is that conventional foreign exchange (FX) forward contracts are not permissible. However, a number of scholars have permitted alternative solutions, three of the most common of which are outlined below.
Back-to-back loans
One acceptable and quite common mechanism is the execution of back-to-back, interest-free loans of different currencies. The loans do not carry any interest or any other benefit. The agreements are separate and neither one cross references to the other.
Murabaha-based contracts
A second common mechanism is based on the commodity murabaha mechanism (see Figure 1 below), by which the customer and the bank enter into two separate murabaha transactions to facilitate the FX forward contract. In such a transaction, the customer will buy a commodity for spot value and sell it to the bank for purchase price plus agreed profit (the basis point in a conventional FX forward deal), payable on a deferred basis. To address the other side of the FX forward deal, the bank will buy another commodity and sell it to the customer, again for purchase price plus agreed profit, on a deferred basis. Both the customer and the bank typically will sell the commodity back into the market to recover their initial investment.
Source: Standard Chartered Bank
Waad-based contracts
A third common mechanism is based on the concept of waad (meaning promise). Typically, Party A, who is looking for a hedge, will provide an undertaking to buy a currency from Party B in the future. The essential elements of the promise include the purchase price of the currency and the delivery date. The promise must not be conditional on any event. Party A is normally bound to fulfill its promise to Party B. However, Party B is not under any obligation to act on the transaction when an offer to purchase is submitted.
Profit-rate Swaps (Substituting for Interest-rate Swaps)
This article has argued that there is need for Islamic financial institutions and customers to manage market volatility risks relating to both foreign-exchange and rates. A number of institutions have tried to devise acceptable solutions, mostly based on the commodity murabaha model. Such products typically work in a similar manner to that described above for commodity-based FX hedging.
For FX and profit-rate swaps, this normally is not efficient from a capital-allocation perspective. In the case of FX, there may be daily valuation requirements for the different currencies (which will not be the case for profit-rate swaps). There are complications in profit-rate swaps on the mark-to-market valuation if the transactions for the swap are not conducted. This would not attract any penalty in the form of mark-to-market recovery because it would be against Shariah principles. The only amount that could be recovered would be actual losses (if any) suffered by the affected party as a result of the deal not going ahead.
Options
Options are another area in which a number of institutions have tried to devise alternative structures. One, commonly known as arbun, entails the provision of a deposit against a right to purchase something in the future. Although it looks like a conventional option with a premium, in arbun the party receiving the deposit must have the asset and must hold it for the life of the option.
Other structures employ aspects of both waad and commodity murabaha. All of these involve constraints that put them at a disadvantage, however slight, when compared with their conventional counterparts. However, given the importance of such services and the overall benefit, a small disadvantage is not significant.
Conclusion
The Islamic financial sector is evolving, and its development and future will depend on its ability to integrate into the global economy. Although it must distinguish itself from conventional, interest-based activities, it must be able to provide viable, alternative solutions. These must meet the demands of Islamic customers, but also be acceptable to conventional institutions and regulators because they will play an important role in the growth of the sector.
It is imperative for Islamic companies and institutions to have access to at least basic hedging products so they can compete with their conventional counterparts. An Islamic mortgage company, for example, wanting to provide fixed-rate finance can do so only if it is able to address the associated market risks. Otherwise it will be at a significant disadvantage to conventional mortgage lenders with access to a broad range of hedging products.
The success of Islamic hedging products will depend on the Shariah scholars. Although the concept may not be straightforward, the scholars will need to provide guidance on the best way to meet both the Shariah and business requirements. If the Islamic finance sector is to seriously challenge the conventional sector and prove itself as a viable alternative, it must lift itself to the next level.