Shariah-compliant FX hedging takes centre stage

By:
Paul Golden
Published on:

Growing use of Islamic finance places greater importance on the ability of corporates to access hedging solutions that are complaint with Shariah principles.

According to the World Bank, the Islamic finance industry has expanded rapidly over the past decade, growing at 10% to 12% annually. It estimates that Shariah-compliant financial assets worldwide are worth around $2 trillion, despite various limitations.

For example, a forward or future sale is not permitted from a Shariah perspective, so a conventional forward where both parties enter into an agreement to sell/purchase the respective currencies in future at an agreed rate is not acceptable.

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  It is vital that counterparties have access to such products, in order for Islamic finance to continue to grow

Laurent Marliere,
ISFIN

A number of mechanisms have been developed to enable companies to execute Shariah compliant hedges. The most straightforward approach is through back-to-back loans – agreed separately – of different currencies, which do not carry any interest or any other benefit.

However, Kazi Hussain, head of Islamic finance, and Fahad Mehboob, associate director of Islamic Finance, at Europe Arab Bank, describe this as a simplistic hedge that does not take into account forward FX rates and therefore tends to be used in day-to-day dealings between local traders and in small amounts.

Another option is based on commodity murabaha, defined in Islamic finance as a tri-lateral sale arrangement whereby a financier or intermediary purchases goods from a supplier and sells them to an end-user at a deferred price that is marked-up to include the intermediary’s profit margin.

In this scenario, the customer and the bank enter into separate murabaha transactions to facilitate the FX forward contract. The customer will buy a commodity for spot value and sell it to the bank for the purchase price plus agreed profit, the basis point in a conventional FX forward deal, payable on a deferred basis.

To address the other side of the FX forward deal, the bank will buy another commodity and sell it to the customer, again for the purchase price plus agreed profit, on a deferred basis. Both the customer and the bank typically will sell the commodity back into the market to recover their initial investment.

However, the cost associated with incorporating a commodity in the transaction has given the impetus for Islamic institutions to seek alternative methods of hedging their FX exposures.

As a result, Islamic FX transactions are increasingly structured as a unilateral wa’ad, or promise, from one party to another to purchase the relevant currency at the agreed rate. A unilateral and binding promise is provided by one party to another on the trade date and a spot FX transaction takes place on the settlement date for the exchange of currencies.

The promise cannot be conditional on any event and will have details of the amount of the currency to be purchased along with the future date of purchase.

Industry participants acknowledge that Shariah-compliant FX transactions represent a tiny fraction of global foreign-exchange volumes.

We expect demand to increase further on the back of the overall growth of the Islamic banking industry
Ahsan Ali, Standard Chartered Saadiq

However, they expect volumes to grow, particularly since emerging market (EM) currency volatility generally weighs more heavily on corporates whose financial transactions are conducted in accordance with Islamic finance principles – eight of the top 10 Islamic finance markets are classified as EMs.

In 2008, Standard Chartered announced it was the first bank to launch online services in Islamic FX utilizing the wa’ad structure.

Demand for this product is growing as Islamic banks are expanding their product offering for their corporate client base to include treasury and FX hedging and investment products, says Ahsan Ali, global head of Islamic origination at Standard Chartered Saadiq.

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"In addition, Islamic corporates are increasingly using currency hedging instruments to hedge FX exposures resulting from cross-border trading and investment activities. We expect demand to increase further on the back of the overall growth of the Islamic banking industry and the increasing sophistication of product offerings."

Laurent Marliere, CEO of Islamic market advisory firm ISFIN, says there is substantial demand for Islamic treasury products since corporates, banks or other institutions wishing to conduct business in a Shariah-compliant manner face the same risks as their conventional counterparts.

As the Islamic market develops, basic hedging and risk-management tools need to evolve within the boundaries of Shariah so as to not only maintain compliance credibility but also to expand trade between banks, intermediaries and corporates, he adds.

"It is vital that counterparties have access to such products, in order for Islamic finance to continue to grow and an increased level of financial intermediation to occur as a result," Marliere concludes.

Expansion of Sharia-compliant forward FX transactions remains constrained by
a lack of standardization, adds Aadil Nastar, head of treasury at QInvest.

"This has led to a proliferation of bespoke documentation," he says. "Given the existence of a unified standard for cross-currency basis swaps – the tahawwut or hedging master agreement introduced by the International Islamic Financial Market and the International Swaps and Derivatives Association in 2010 – it is surprising that we don't have a standardized approach."

However, the capacity for growth remains, particularly as corporates in the Gulf Cooperation Council become more comfortable with the use of vanilla derivatives to hedge relevant exposures more appropriately, Nastar concludes.