By Arno Maierbrugger/Gulf Times correspondent/Bangkok
The disruption of financial markets caused by the coronavirus crisis in recent months and the subsequent volatility in the industry has revived the long discussion about the need for Shariah-compliant hedging tools, namely derivatives, in the Islamic finance sector. The up and down of oil prices and volatilities in profit rates, exchange rates and commodity prices in general has exacerbated the situation, so that many players have resumed to look for adequate risk management techniques for their Shariah-compliant banking and finance portfolios.
Basically, hedging tools in finance are technologies and methods to minimise the impact of fluctuations in financial markets. They can be used in a number of sectors, for example for hedging of volatilities in stock prices, commodities and agricultural products, energy and fuel prices, consumer prices, precious metals, exchange rates and for other forms of more sophisticated financial risk management techniques. Basically, they can be engineered from a wide range of financial instruments, including forward contracts, swaps, options, futures contracts and other form of derivative products, as well as insurance contracts and obligations, among others. They are widely used in conventional finance and reach from asset-based financial contracts to highly complex synthetic financial products. Particularly the latter include high-risk technologies such as mortgage-backed securities and collateralised debt obligations which played a sad role in the 2007-08 financial crisis.
In Islamic finance, however, the requirement of Shariah-compliance of derivatives is a major limitation for their development. Many conventional financial risk management technologies are not Shariah-compliant due to their imminent characteristics of being speculative and incompatible to the risk-sharing prerequisite in Islamic finance. This leaves the halal financial industry with far fewer hedging instruments compared with their conventional peers.
What comes closest to Islamic finance requirements are such derivatives that derive their value from the performance of an underlying entity which itself has intrinsic value. Such Islamic derivaties are called tahawwut, describing a hedging process that is used or offered by Islamic banks and financial institutions to help mitigate risks, or khatar (market or price uncertainty). However, Islamic scholars and Islamic financial practitioners are far from being in agreement over how to define halal hedging tools that bear a similar functionality by replicating conventional derivative structures in a Shariah-compatible way.
Essential processes so far developed include Islamic contracts such as salam, which resembles a conventional forward contract, ijarah, an adjusted futures contracts, as well as back-to-back loans as a replacement for swaps. Other concepts there are arbun and khiyar (used to replicate option-type structures) and wa’ad (used for obligations).
That said, Islamic banks and financial institutions remain constraint to this small number of hedging options not only due to the relatively small number of Shariah-compliant technologies, but also due to the lack of standardisation and harmonisation of available hedging instruments across jurisdictions.
“All this is constraining the expansion of the Islamic derivatives market at a time when there is an increased need for the usage of derivatives for risk-management purposes for Islamic financial institutions, as well as sukuk issuers and investors and Shariah-compliant non-financial corporates,” said Bashar al-Natoor, global head of Islamic finance at Fitch Ratings, who urged Islamic finance jurisdictions to develop the market by establishing more over-the counter markets for Islamic derivatives, adopt legislation to improve the development and enforceability of Islamic derivative contracts and generally impose clear guidelines and standards for Islamic derivatives.
“Derivatives play a vital role in hedging and mitigating risks that come from volatilities in profit rates, exchange rates and commodity prices,” al-Natoor said, adding that they are not only essential for banks in limiting their risk exposure and increasing their earnings generation capabilities by creating and offering derivative products to clients, but also could have a positive effect on liquidity and solvency on banks, financial institution and takaful companies and as such in the Islamic finance market as a whole.
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