The Demand For Islamic Derivatives Contracts

Via Reuters: “The launch of the first template for an over-the-counter Islamic derivative contract is "imminent" and will encourage more companies to hedge their risks, an executive at a bank involved in its creation said on Tuesday.” [Note: this same prediction appears to have been reported over a year ago, yet Reuters makes no mention of what the hold up has been.  -- KDK]

Credit Agricole CIB and the IIFM, an industry body backed by the central banks of several Muslim countries, have reportedly been working with the International Swaps and Derivatives Association (ISDA) on the contract -- to be known as Ta'Hawwut or hedging.  The goal is to create a standard legal framework for OTC derivatives in the Islamic market.  Currently contracts are governed by national banking regulations, the Islamic finance industry’s own standard-setting bodies, and scholars interpreting Islamic laws.  As a result, Reuters reports, contract design is currently very complicated, and can take as long as six to nine months. 

According to the article, Islamic institutions currently have limited access to derivative products, because “Islamic law requires the underlying assets in any transaction to be tangible, virtually excluding most of the mainstream derivatives instruments.”  But it is hoped that the new standard agreement will assuage the doubts associated with derivatives, allowing users to hedge more easily.

FT Alphaville described the problem in a post last year as follows:

There are two major schools of thought on derivatives in the world of Islamic finance. One view is that derivatives are necessarily speculative, and so would contravene the prohibition on gambling. Scholars who take this approach also tend to argue that since it is not always clear what the underlying assets referenced by a derivative are, use of the product violates the prescription that only tangible assets can be bought or sold.

The second, less conservative view is that derivatives are permitted as long as they are used solely to hedge existing positions.

Reuters reports that “Islamic scholars are split on the legitimacy of derivatives; some see them as permissible instruments to hedge risks but others as speculative transactions, which Islam forbids.” Nonetheless, according to Munir Khan, head of Islamic finance department at law firm Simmons and Simmons in Dubai, there is growing demand for hedging and Sharia-compliant derivatives products. 

For more see Derivatives in Islamic Finance, by Andreas A Jobst, International Monetary Fund (May 2008):

Based on the current use of accepted risk transfer mechanisms in Islamic finance, this article explores the validity of derivatives in accordance with fundamental legal principles of the Shariah and summarises the key objections of Shariah scholars that challenge the permissibility of derivatives under Islamic law. In conclusion, the article delivers suggestions for Shariah compliance of derivatives

This Allen & Overy memo is also quite helpful.  It examines key principles of Sharia and how the use of conventional derivatives products could be seen to run contrary to such principles.  It then uses the example of a Sharia-compliant profit rate swap (equivalent to a standard interest-rate swap) to explore how derivatives transactions can be structured to meet the demand for risk management products that abide by the tenets of Sharia.  From what I gather, metals, such as copper, aluminum and platinum, are used to underpin the deals, and ensure that investments abide by a central tenet of Islamic finance: that returns must be derived from a genuine business activity, such as trading goods. An example of the Profit Rate Swap is shown in Diagrams 2 and 3 above, achieving Sharia-compliance by using reciprocal murabaha transactions: a sale arrangement whereby a financier purchases goods from a supplier (at the cost price) and then on-sells them to a counterparty at a deferred price that is marked-up to include the financier's profit margin.  This profit margin is deemed justified since the financier takes title to the goods, albeit possibly only briefly, and hence accepts the commercial risk of their ownership.

As described here:

For example, a trade in copper can be structured to give a return equal to that of bank interest, which is banned by sharia.

Instead of, say, paying $10,000 (5,000 pounds) interest on a term deposit, the bank sells an investor some copper for $10,000 below the market rate. The investor quickly sells the metal for a $10,000 gain. Under sharia law, this is a trading profit, not interest.

"It's not something new. It's been used quite widely in the (Middle East) Gulf," Iqbal said.

"We would go for copper, platinum and crude oil and now we are looking at palm oil," he added, listing the kind of commodities Kuwait Finance House employed in Islamic finance.

I’ve been considering some readings on Sharia constraints on business and financial transactions for my Taboo Trades course (little did I know that it could double as an assignment for my Financial Derivatives course).  If anyone has suggested readings on Sharia constraints on business and finance, please send them my way.

(HT: Tyler Cowen)

Comments

[Patrick S. O'Donnell]

I sent some things, no doubt more general than you're looking for, but perhaps they'll be of some use. I'm noting this here because I used a non-academic e-mail address that doesn't always get through some spam filters at universities.

[Kim Krawiec]

I got them Patrick, and they'll be extremely helpful. Thanks so much! I should have known that you'd have a good bibliography on this. Best, Kim