Islamic Finance

Fitch: Islamic derivatives increasingly necessary, but constraints remain

Fitch Ratings-Dubai/London-17 June 2020: Fitch Ratings says that the recent volatility in key Islamic finance markets caused by the coronavirus pandemic, oil price fall and cuts in central banks repo rates highlights the need to use effective sharia-compliant derivatives as hedging tools (tahawwut). However, derivatives markets remain underdeveloped in most countries where Islamic finance is prevalent. Moreover, issues with the sharia compliance of derivatives and the lack of standardisation and harmonisation across jurisdictions of available hedging instruments are constraining the expansion of Islamic derivatives market.

We consider an increased usage of derivatives for risk-management purposes as positive for Islamic financial institutions, sukuk investors, issuers and sharia-compliant non-financial corporates. Derivatives play a vital role in hedging and mitigating risks that come from volatilities in profit rates, exchange rates and commodity prices. However, the sharia compliance of derivatives is a major limitation. For example, many sharia governing bodies and scholars are of the view that conventional futures and forward contracts are not sharia-compliant. This leaves the halal industry with far fewer hedging instruments compared with their conventional peers.

Furthermore, general guidelines pertaining to Islamic hedging stipulate that transactions should be entered into only for the purpose of hedging actual risks of the relevant party and that transactions should not be entered into for speculative purposes, which means that actual settlement of assets and payments must take place, and that cash settlements cannot take place without finalising the transaction. This prevents Islamic banks from engaging in speculative activities, but it also prevents Islamic financial institutions from trading derivatives in the same way as conventional banks do.

Islamic banks, similar to conventional banks, face credit risk, liquidity risk, profit-rate risk and currency risks, among others. Conventional banks use derivatives to hedge their exposures against interest-rate risk and currency risk, in addition to offering their customers derivative products. However, more than 30% of Fitch-rated Islamic banks do not use derivatives, and most of the remaining 70% use it in a limited capacity, constraining it to instruments like profit-rate swaps and Islamic-currency forward contracts.

As part of its assessment of Viability Ratings, Fitch analyses an Islamic bank's exposure to profit-rate risk alongside mitigants employed to neutralise/hedge and manage those risks through, for example, the use of derivatives. Offering sharia-compliant hedging derivative products to their customers would also support Islamic banks' earnings generation capabilities. Hedging is also important for takaful companies as we assess, among other areas, their hedging activities through the lens of risk management and primarily focus on how these institutions reduce their exposures to market risks. We also assess the effects of hedging on insurers' liquidity and solvency. Hedging is also important for sharia-compliant non-financial corporates as we assess their risk management practises.

Another key challenge in analysing Islamic derivatives is that public disclosures in financial statements are in general limited and do not typically provide detailed information on their intended purpose and their effectiveness. This impedes analysis of the appropriateness and effectiveness of an Islamic bank's hedging programmes, as well as their impact on the financial results on a case-by-case basis.

In countries where Islamic finance has a key presence, the derivatives market in general remains underdeveloped. In April 2019, the over-the-counter (OTC) interest-rate derivatives turnover (daily average) in the UAE, Malaysia, Saudi Arabia, Indonesia, Turkey and Bahrain, combined, was only USD3 billion and geographically stood at less than 1% of global OTC interest-rate derivatives turnover, based on BIS data. Furthermore, with the exception of the UAE, no other Gulf Cooperation Council (GCC) country has an exchange-traded derivatives market, although Saudi Arabia had announced its plan to launch one in 2020.

The future growth of derivatives in key Islamic finance markets will also depend on regulators and policy makers adopting legislations that permit the enforceability of close-out netting provisions and collateral arrangement provisions in derivatives contracts. The enforceability of close-out netting provisions is important as it enables firms to mitigate credit risks by terminating outstanding transactions with a counterparty following an event of default and calculating the net amount due to one party by the other. Collateral arrangement provisions also help to mitigate credit risk by enabling trading parties to pledge variable levels of collateral in support of their trading positions on an ongoing basis.

Close-out netting legislation has not been adopted in key Islamic finance jurisdictions like Saudi Arabia, Kuwait, Oman and Pakistan. However, it has been adopted in other key Islamic finance jurisdictions like Malaysia, the UAE (at the federal level and the free zones of Dubai International Financial Centre & Abu Dhabi Global Market (ADGM)), Qatar (Qatar Financial Centre), Bahrain, Turkey and Indonesia. This is a positive credit development, but we will be monitoring how this legislation is enforced in practice for Islamic banks. Legislation pertaining to collateral arrangement provisions has been adopted by Malaysia, Indonesia and Turkey. However, none of the GCC countries adopted this in their legislation, with the exception of ADGM in the UAE.

To address the issue of lack of standardisation and harmonisation across jurisdictions, various regulatory as well as sharia standard-setting bodies have issued a number of guidelines and standards related to derivatives. One of the regulators active in this segment is Malaysia's Central Bank, Bank Negara Malaysia, which in 2007 issued the Islamic Derivative Master Agreement.

Another initiative was led by the Bahrain-based International Islamic Financial Market (IIFM), which had partnered with the International Swaps and Derivatives Association (ISDA) to publish the ISDA/IIFM Tahawwut Master Agreement. While the uptake of the IIFM's standards is increasing, particularly in Saudi Arabia and the UAE, the market's approach to documentation still remains fragmented and a number of institutions continue to use bespoke documentation, which results in increased negotiations and longer lead time for execution.

Derivatives usage by small-to-medium sized Islamic banks tend to be limited as they would need to have in place sophisticated risk-management systems and controls due to the increased exposure to counterparty, operational, market, credit and liquidity risks caused by entering into derivatives contracts. Without adequate systems and proper management oversight, the use of derivatives could result in significant financial losses. As Islamic banks evolve their risk-management practises, the effectiveness of their derivatives portfolio needs to be regularly estimated, including its impact on their banks' capital/solvency positions and future profits.

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