Islamic derivatives increasingly necessary: Fitch Ratings

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Observer Report

Karachi

The recent volatility in key Islamic finance markets caused by the Covid-19 pandemic, oil price fall and cuts in central banks repo rates highlights the need to use effective shariah-compliant derivatives as hedging tools.
However, derivatives markets remain underdeveloped in most countries where Islamic finance is prevalent, Fitch Ratings said in a statement today. Moreover, it said issues with the shariah 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,” it said. For example, the rating agency said many shariah governing bodies and scholars are of the view that conventional futures and forward contracts are not shariah-compliant, leaving the halal industry with far fewer hedging instruments compared with their conventional peers.
Furthermore, it said 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.
It said 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,” it added.
According to Fitch Rating, Islamic banks, similar to conventional banks, face credit risk, liquidity risk, profit-rate risk and currency risks, among others.
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 shariah-compliant hedging derivative products to their customers would also support Islamic banks’ earnings generation capabilities, it said.
“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,” it added.
Fitch Rating said 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, it said, 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.
“The future growth of derivatives in key Islamic finance markets will also depend on regulators and policymakers adopting legislation 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,” it said.
The rating agency said added that 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.
To address the issue of lack of standardisation and harmonisation across jurisdictions, it said various regulatory, as well as sharia standard-setting bodies, have issued a number of guidelines and standards related to derivatives. “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,” it said.—Bernama