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ISDA Writes Global Standards for Islamic Derivatives

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Oct. 27 (Bloomberg) — Global standards for Islamic derivatives contracts may be published as soon as December, helping companies and investors manage risk more effectively, according to the International Swaps and Derivatives Association. “This is a real innovation in what could potentially be a huge growth area,” ISDA Chairman Eraj Shirvani said in an interview in Singapore yesterday. “Establishing market standards with the input of the scholars’ opinions, combined with the expertise and benefits of the ISDA framework, potentially opens up a significant array of new hedging possibilities for issuers and investors.”

The New York-based ISDA, which represents more than 830 organizations active in the $592 trillion derivatives market, started working on its Shariah-compliant master agreement with the Bahrain-based International Islamic Financial Market in 2006. The first version of their framework will focus on swaps for profit-rate and currency transactions, Shirvani said. Islamic finance is the fastest-growing segment of the global financial system with $919 billion of assets under management, including $114 billion of Shariah-compliant bonds, known as sukuk, Prudential Financial Inc. said on Oct. 7. Assets will grow to as much as $1.1 trillion this year, Kuwait Finance House KSC forecast in July, as the world emerges from recession and a recovery in oil prices boosts Arab wealth. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Bond Trading

“Investors will have the ability to trade in sukuk they perhaps wouldn’t have been able to before without a hedging tool available to them,” Angus Amran, treasury and capital markets head for Cagamas Bhd., Malaysia’s biggest buyer of home loans, said in a phone interview from Kuala Lumpur. The standards will “promote homogeneity and acceptance of Islamic financial products,” he said. Because Muslim Shariah law prohibits payment or receipt of interest, speculation and uncertainty, many Islamic investors avoid derivatives. To ensure compliance with Shariah, new Islamic financial products must be vetted and approved by recognized scholars who are versed in its principles.

Standardized terms in derivatives agreements may help market participants focus on “developing a more innovative and diverse range of Shariah-compliant derivative tools and products instead of channeling resources to reduce documentation risks,” said Mark Toh, who helps manage about $525 million in Islamic funds at Prudential Corp. Asia in Kuala Lumpur.

Oil Prices

Created in the 1970s after an almost 20-fold jump in oil prices over 10 years, the Shariah finance industry caters to the world’s 1.57 billion Muslims. From being almost non-existent a decade ago, the Islamic bond market has grown to $130 billion, according to Moody’s Investors Service. Sukuk have returned 27 percent this year, an HSBC Holdings Plc index shows, after the market fell four times as much as conventional investment-grade corporate debt last year. The Dubai government set up a $2.5 billion Islamic bond program on Oct. 25 as the emirate seeks to sell international bonds for the first time in more than a year.

Malaysia, which has 14 Islamic banks and the biggest sukuk market, said in July that it would introduce a trading platform to make it easier for companies to buy and sell commodities like palm oil and rice that are used to back Islamic securities. Sukuk are asset-based bonds that pay a profit rate to investors to avoid interest.

Government Efforts

South Korea said on Aug. 26 that it plans to exempt sukuk from tax on distributions, joining countries including Singapore, Hong Kong, the U.K. and France that are modifying regulations to help attract Islamic investments.

Islamic financial institutions have been more resilient to the global financial crisis than their conventional counterparts because direct investment in subprime assets and derivatives is prohibited to them, Moody’s said in February. “We have had many enquiries regarding derivatives and some people say this is important for the industry and some people have done without them,” Mohamad Alchaar, secretary-general of the Accounting & Auditing Organization for Islamic Financial Institutions, said in a phone interview today. The Bahrain-based AAOIFI, which promotes industry standards, is not part of the ISDA’s project with the IIFM, Alchaar said.

Market Contagion

U.S. and European regulators have called for the adoption of central clearinghouses to reduce risk in derivatives after President Barack Obama’s administration described the contracts as a “major source of contagion” in the credit crunch. The derivatives market relies on counterparties negotiating their own buy and sell orders, with no guarantees either will complete the trade.

“In Islamic finance gambling is prohibited, but running a big un-hedged open position is gambling in my way of thinking, so I’m pleased to hear there will now be more alternatives available for reducing risk,” Deborah Schuler, Moody’s group credit officer for Asia, the Middle East and Africa, said in a phone interview from Singapore.

Best Regards

  • With branch manager and credit officer of Bank Muamalat Malaysia Berhad, Miri, Sarawak.

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