Some Examples of Derivatives that can be used by Islamic Banking institutions to mitigate financial risks

Muhammad Arif
Muhammad Arif: Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan.

With growth by only about 5% on average in 2019-20, owing to tepid economic conditions in certain core markets, the combined total worth of the three broad sectors of the IFSI (banking, capital markets and insurance) was estimated at USD 2.9 trillion at the end of 2019 compared to USD 2.05 trillion recorded at the end of 2017.

 However, Islamic finance (IF) generates distinct operations, with risk profiles and balance sheet structures that differ significantly from those of conventional banks, which will have implications for IF stability. Some of the unique risks faced by Islamic financial institutions (IFIs) include displaced commercial risk, equity investment risk, rate-of-return (ROR) risk, and Sharī`ah non-compliance risk. In addition, some of the traditional risks, such as credit, concentration and liquidity risks, can be amplified, as transactions in financial derivatives to hedge risks and the availability of Sharī`ah-compliant liquidity instruments are limited.

Due to the evolving nature of the financial market and its operation, risk management has become a dominant factor in the global financial markets. To avoid unpredictable losses and to be competitive in the modern business environment, almost every firm pays considerable attention to hedging as part of its risk strategy. With the distinct nature of Islamic finance instruments, the use of hedging instruments in the IFSI is found to be rather limited due to incompatibility of risk management tools under the purview of Sharī`ah.

Hedging instruments, tools and strategies not only align with the operationalization of a number of Islamic contracts for the purpose of minimizing risks, but also are in sync with one of the essentials of the Sharī`ah, which is to protect wealth. As such, Islamic hedging instruments are being used in various forms in several jurisdictions, essentially as a Sharī`ah-compliant alternative to conventional derivative instruments. These instruments include alternatives to profit rate swaps, foreign currency swaps, foreign currency forwards, options, etc.

 A fundamental difference between conventional derivatives and their Islamic alternatives is that the latter cannot be used, without a genuine underlying real transaction, for the sole aim of generating profits. In this regard, market volatility is minimized and systemic stability is ensured. Furthermore, most such Sharī`ah-compliant hedging transactions are organized over the-counter (OTC), rather than through an organized exchange, which results in the opaqueness of the market and the unavailability of data.

However, due to the very nature of these transactions, it is important for regulatory and supervisory authorities (RSAs) to fully know the nature and size of such transactions being used by institutions offering Islamic financial services (IIFS) in their market, as well as their counterparties and underlying contracts, in order to fully understand the potential risks such transactions pose to systemic stability. For these reasons, there exists the need for research on the development of innovative Sharī`ah-compliant hedging instruments. Viewed from a macro-finance perspective, the proposed research is envisaged to highlight pertinent regulatory and supervisory issues, as well as to offer policy recommendations relating to Sharī`ah-compliant hedging instruments.

The risk profile of IFIs is not much different from that of conventional banks and thus credit risk, liquidity risk and rate-of return risk were considered to be the main risks for Islamic institutions. But, surprisingly, in most instances, IFIs seem reluctant to use hedging instruments to manage their risk, which might be due to the standardization of Sharī`ah-compliant hedging instruments or the lack of regulation to manage hedging practices.

Most of the IFIs were using their country’s central bank directives specifically on Islamic hedging instruments, or sometimes applied regulations pertaining to Islamic finance activities. It was encouraging to see that a vast majority of the institutions agree that there should be standardized, globally accepted regulations issued by global standard setters such as the IFSB, IIFM or AAOIFI.

Some methodologies in use are as follows.

Murābaḥah, which is known as cost-plus financing, is a particular type of Sharī`ah compliant financing technique that forms the foundation of many Islamic derivative products. For example, under such a structure, typically there are four steps:  A bank purchases commodities from a third-party broker, Broker 1, at a particular price (X) [Step 1].  The bank sells these commodities to the counterparty (C) at a price that includes the bank’s cost price (X) and some profit/markup (Δ), which the bank discloses to C. Thus, C’s cost price is equal to X + Δ (Y) [Step 2].  Typically, Y is payable by C in installments, but it can also be paid as a onetime bullet payment on a specified date in the future (similar to the “sale and deferred payment” model in conventional financing) [Step 3].  Having purchased the commodities from Bank B, C sells these to another third-party broker, Broker 2, at a price equal to X [Step 4].

Wa’d In Islamic finance, refers to an obligation issued by one counterparty, such as a potential purchaser, to another, and whereby the promissor undertakes towards the promise to proceed with the contract. Since the wa’d is a unilateral promise, it does not have to satisfy the requirements of a bilateral contract (aqd) under Sharī`ah (i.e. knowledge of the price, and possession or ownership of the subject matter of the contract). This inherent flexibility of the wa’d renders it particularly helpful in developing several innovative Sharī`ah-compliant structures, such as a foreign exchange (FX) option or a total return swap.

Arbun, which literally translates into “earnest money contract”, is a conditional purchase contract that is permissible under Sharī`ah. Under an arbun contract, the buyer (B) concludes a purchase and makes an advance of some sum (X), which is less than the purchase price (Y), to the seller (S).  The contract stipulates that if B decides to proceed with the transaction, he will pay S the purchase price minus the initial deposit (Y minus X = Z).  If B decides not to proceed with the transaction, he forfeits the deposit in favor of S Arbun, which literally translates into “earnest money contract”, is a conditional purchase contract that is permissible under Sharī`ah. Under an arbun contract, the buyer (B) concludes a purchase and makes an advance of some sum (X), which is less than the purchase price (Y), to the seller (S).  The contract stipulates that if B decides to proceed with the transaction, he will pay S the purchase price minus the initial deposit (Y minus X = Z).  If B decides not to proceed with the transaction, he forfeits the deposit in favor of SA profit rate swap is best analogized to a conventional interest rate swap, under which the parties agree to exchange periodic fixed and floating payments by reference to a pre-agreed notional amount. An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another over a set period of time. An Islamic profit rate swap is an agreement to exchange profit rates between a fixed rate party and a floating-rate party, or vice versa, implemented through the execution of a series of underlying contracts to trade certain assets. Each party’s payment obligation is computed using a different pricing formula. In an Islamic profit rate swap, the notional principal is never exchanged as it is netted off.

 A term murābaḥah is used to generate fixed payments (comprising both a cost price and a fixed profit element), and a series of corresponding reverse murābaḥah contracts is used to generate the floating leg payments. (The cost price element under each of these reverse murābaḥah contracts is fixed, but the profit element is floating.) A basic commodity price swap entails two counterparties exchanging cash flows at various points in time, with specifics agreed in advance. In the standard case, the two counterparties agree to periodically exchange a given quantity of a commodity for a specified period of time. The Islamic commodity swap is becoming popular in recent times, and is being applied to crude palm oil contracts for hedging purposes (particularly in Malaysia). The Sharī`ah principles that can be applied in a crude palm oil swap contract are the principles of wa‘d and murābaḥah/musawamah. A wa‘d, or promise, is given at the beginning, whereas the murābaḥah/musawamah is implemented on the transaction day. If murābaḥah is applied, the cost and profit margin is already known to the investor and thus the price can be fixed at the start. However, if musawamah is used, the investor does not know with certainty the cost involved from the beginning.

A conventional cross-currency swap usually consists of three stages: (a) a spot exchange of principal at the outset (Initial Exchange); (b) a continuing exchange of interest payments during the swap’s life (essentially, a series of FX forward trades) (Interim Amounts); and (c) a re-exchange of principal at the maturity of the contract (normally at the same spot rates as those used at the start) (Final Amount). Clearly, the prohibitions on riba, maysir and gharar would render such a structure untenable under Sharī`ah. Short-Selling Using Arbun Structure and Cash Flows In this structure, a hedge fund (HF) advises the prime broker (PB) to sell an option to purchase shares (S) in a particular entity at a specified price (USD 100), with delivery to take place on a specified date in the future (Day 10) [Step 1].  PB then sells this option to the buyer and receives an initial payment of USD 70 from the buyer [Steps 2 and 3]. – In the present example, (a) the buyer takes a “long” position on S – i.e. the buyer expects the market value of S on Day 10 to be greater than USD 70; and (b) HF takes a “short” position on S – i.e. HF expects the market value of S on Day 10 to be less than USD 70.  Simultaneously with Steps 2 and 3, PB enters into an arbun contract with HF, whereby PB pays HF USD 68 (USD 70 minus PB’s spread of USD 2), with HF obliged to deliver S on Day 10 [Step 4].  On Day 10, if the buyer chooses to exercise the option to buy S and proceeds with the transaction, the buyer pays PB the remainder of the purchase price (USD 30) (remainder). The exercise of the option by the buyer triggers the legally binding obligations between the parties. Therefore, following payment of the remainder by the buyer, HF will be under an obligation to purchase the stocks and deliver them to PB, who will pass them on to the buyer. PB, therefore, pays HF USD 30 [Step 5], following which HF purchases S from the market on Day 10 [Steps 6 and 7] and delivers it to PB [Step 8]. PB then passes S on to the buyer.

Under this structure, a special purpose vehicle issuer issues certificates to investors in return for the issue price.  The issuer then uses the issue price to acquire a pool of Sharī`ah-compliant assets from the market [Steps 3 and 4]. – These Sharī`ah-compliant assets could, for example, be shares listed on the Dow Jones Islamic Market Indices. – The investors (holders of the certificates) gain exposure to an underlying index or assets (the underlying) based on two mutually exclusive wa’d between the issuer and the bank.  Under one wa’d (Wa’d 1), the Issuer promises to sell the Sharī`ah-compliant assets to the bank at a particular price (which is linked to the performance of the underlying) (Wa’d sale price) [Step 5]; while under the other wa’d (Wa’d 2), the bank promises to buy the Sharī`ah-compliant assets from the issuer at the wa’d sale price [Step 6]. – Out of these two wa’d, only one shall ever be enforced. (Numbers in figure 8 denote chronology of events. Either one of Steps 5 or 6 will occur, but never both.)

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