Derivative Instruments, Risk Management and Shariah Compliance

Think Piece By Prof. Dr. Obiyathulla Ismath Bacha

The acceptability of financial derivative instruments like forwards, futures, options and swaps for shariah-compliant businesses remains unresolved. As of now, there appears to be no consensus on whether Muslim businesses can use derivative instruments for their risk management needs. While the issue is still being debated and deliberated, risk management remains the soft underbelly of Islamic banking and finance. Still, there has been some progress. Shariah scholars have allowed the use of wa’ad (promise) based contracts in the case of managing exchange rate risk. Today, wa’ad based contracts that mimic currency forwards and currency options are available both in the Gulf and in Malaysia as shariah-compliant ways of hedging exchange risk. The allowance for such innovation came after years of debate and “pressure” on shariah scholars in view of the obvious need for such instruments. The approval for the use of these instruments came with the requirement that the Islamic bank entering into these bilateral arrangements must ensure that customer is using the derivative solely for hedging. The bank verifies this by requiring the customer who will become the counterparty, to show documentary evidence of its underlying currency exposure. Even if this puts the onus on banks to ensure the derivatives are not misused for speculation, it is indeed a workable solution and has been well accepted. It is hard to imagine prohibition on the use of currency derivatives in a world with such volatile exchange rates.

Much of the reluctance that shariah scholars have with derivatives arises from the fear that they can easily be used for speculation. While this fear is real and well placed, one needs to also consider the huge handicap placed on Muslim businesses from a blanket prohibition. Given the state of the world, businesses today face many complex risks. Often a risk is not visible until it hits. A classic case is that of contingent exposure, a common occurrence for companies involved in bidding for competitive international tenders. For example, when a company submits a bid to undertake a future foreign currency denominated transaction, and the outcome of the competitive bid will be known a month later, its foreign currency exposure is contingent upon its bid being selected. The bidding company does not know until a month later whether its bid has been accepted, yet, since the bid commits the firm to undertake a future transaction at a predetermined foreign currency amount, its currency exposure begins the very day its submits the bid. So, how does one hedge such exposure? The only way to hedge such contingent exposure is by way of currency options. In fact, derivatives evolved from forwards to futures and then to options precisely to enable the management of such complex risks.

Perhaps due to the continued suspicion surrounding derivatives, as of today, managers of Islamic Mutual Funds have little means to manage the equity risks they face other than through traditional methods of asset allocation. Since it is not possible to reverse allocations overnight or within short periods, asset allocation strategies enable managers to make a call on medium and long term market moves, not short term corrections. Whereas the conventional fund manager can ride out short term market turbulence and sharp drops by hedging with equity index options or index futures contracts, there is no such avenue for the shariah-compliant fund manager. These instruments can be executed very quickly and at much lower cost than asset allocation entails. There are two issues of note here. First, this inadequacy of Islamic mutual fund managers goes against the shariah requirement for the preservation of wealth. Second, there are larger implications for the competitiveness of Islamic Mutual funds and indeed its long term viability vis-à-vis conventional mutual funds. There is no reason why an accommodation cannot be made here as in the case of currency risk management. With strict requirements for their use only in cases of hedging.

Finally, the lack of a coordinated stand on the use of derivatives has resulted in the stunted growth of risk management within Islamic Finance. Despite the huge strides that Islamic banking and finance have made in the last decades, shariah-compliant risk management has not kept pace. Inadequate risk management capability will be a serious drag on Islamic banking and finance as it moves from infancy to growth. There is an obvious need for a well-considered and enlightened stand on the use of derivatives for hedging.

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