Derivatives dispute divides Islamic finance market

By Liau Y-Sing

KUALA LUMPUR (Reuters) - Islamic banks are struggling to develop hedging tools as religious differences cast doubt on the use of derivatives, exposing the industry to risks of increased volatility as markets deteriorate.

Strict rules on transparency and simpler deal structures saved sharia lenders from the worst of the current credit crisis, but their ability to survive future shocks is in question because they have few instruments to guard against wild swings in currency and interest rate movements.

"To the extent there are not enough sharia-compliant liquidity and risk management products, then clearly Islamic finance would be disadvantaged compared to conventional banks and would be less able to manage their liquidity risks," said Hussein Hassan, head of Islamic structuring at Deutsche Bank (DBKGn.DE).

The $1 trillion (694 billion pounds) industry bans banking structures that are vague or ambiguous to avoid exploitation -- a rule which some argue shuts out the use of common hedging instruments such as currency and interest rate swaps and futures contracts.

But as more markets embrace Islamic finance, and the need for risk protection increases, there are growing attempts to find sharia hedging tools.

More complex derivatives have come under widespread scrutiny by regulators and governments in the West for their role in the credit crisis. Some products have been blamed for spreading risks of bad assets rather than containing them, and amplifying the impact of losses in the financial slump.

Derivatives were a prickly issue in Islam even before the U.S. subprime mortgage market collapsed. Reflective of the diverse interpretations of Islamic law, the industry is divided over the use of derivatives -- and for different reasons.

This has left Islamic institutions with far fewer hedging devices than their conventional peers.

Conservative religious scholars reject derivatives because hedging practices are deemed speculative bets on currency and stock movements which violate the sharia ban on gambling.

These suspicions have deepened with derivatives having evolved from relatively simple contracts such as foreign-exchange forwards to complex tools like credit default swaps, over-the counter-contracts between two parties that bet on whether a company will default on its bonds within a certain time.

The conventional credit derivatives market alone was estimated to be worth some $55 trillion by last October.

With derivatives seen as a key trigger for the financial crisis and ensuring global economic downturn, opinion in Islamic finance may have now swung in favour of the conservative view.

"Just as there are fewer takers for conventional derivatives, fewer Islamic investors are biting at Islamic derivatives," said Hooman Sabeti, an Islamic finance lawyer with Allen & Overy.

"Similarly, new participants in Islamic derivatives with the fortitude to proceed are steering away from more controversial structures and embracing more conservative ones."

Some sharia advisers, however, permit derivatives as long as they are used to hedge risks on existing investments and not for speculation.

The difficulties with this argument are clear.

"Islam encourages you to manage your risk," said Agil Natt, chief executive of INCEIF, an Islamic university based in Kuala Lumpur. "But when does risk management end and gambling begin?"

Derivatives are also avoided as their underlying assets can be uncertain, as many loss-laden Western banks and investors have discovered.

"In Islamic law, there must be something tangible that you are selling," said Mohammad Akram Laldin, a sharia scholar who sits on various sharia advisory boards including HSBC Amanah.

"You cannot be selling something in which you do not know the status of the subject matter."

Last year, CIMB Islamic, the world's top arranger of Islamic debt, launched a forex hedging tool where investors enter into an Islamic transaction with the bank.

The net proceeds -- which are similar to the premium paid for conventional options -- gives investors the right to exercise the option at the agreed rate on the maturity date.

But some bankers say the industry is struggling to find enough Islamic contracts that can be used to create derivatives.

"Most of the contracts that we have today aren't entirely and immediately transferrable towards structuring derivatives products," said Deutsche's Hussein.

"Apart from 'arbun', which is the contract that is used mostly to do options, it's not immediately clear that we've got enough other contracts that can be used to do other things."

Under an arbun contract, a purchaser makes a deposit (which forms part of the purchase price) to buy particular assets at a later date. Should the sale not proceed, the seller keeps the deposit.

Another difficulty is that Islamic finance contracts are subject to varying interpretations due to different readings of the sharia.

The International Swaps and Derivatives Association is working on a template to standardise the main terms for over-the-counter sharia derivative contracts.

"In the Islamic market acceptance has to come from a wide range of independent sharia boards, which might be challenging," said Mahmoud Abushamma, HSBC's (HSBA.L) head of sharia division in Jakarta.
(To read more stories about the growing debate over how to manage derivatives in the West, click on)

(Additional reporting by Harry Suhartono in Jakarta)