Progress slow on standards for Islamic derivatives, AAOIFI chief warns

Concerns over the nature and use of derivatives are hindering the development of a standardised agreement for sharia-compliant contracts, said Mohamad Nedal Alchaar, secretary-general of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

Based in Bahrain, the AAOIFI is a non-profit body that prepares accounting, auditing and governance standards for the international Islamic finance industry. To date, it has issued up to 80 sharia standards, but no standard has been agreed upon for derivatives. A standard will only be implemented "once the structures of derivatives are considered to be acceptable from a sharia standpoint", Alchaar explained in an exclusive interview with Risk.

But this might not happen any time soon. "In developing sharia-compliant structures, the industry must first identify the specific economic outcomes of these transactions and then structure them accordingly to achieve this," he noted. "It is challenging to ensure both the outcomes and the underlying transactions adhere to sharia principles, especially those concerning the sharing of risks and rewards, and the prohibition of speculation."

A standardised agreement for Islamic derivatives has become increasingly important in recent years. A combination of cash-rich buyers in the region looking for new ways to boost returns, and a large number of local and international banks lining up to help them, resulted in a proliferation of instruments marketed as sharia-compliant, including derivatives. However, while some sharia scholars acknowledged the usefulness of derivatives in hedging risk, others criticised the products for being against the fundamental principles of sharia law, which prohibits speculation and uncertainty, and the concept of interest.

The lack of uniformity in the Islamic derivatives market produced a phenomenon known as 'scholar shopping', with dealers selling derivatives and complex structured products exploiting differing interpretations of sharia law. Standardisation of the Islamic derivatives market, it is hoped, will go a long way to eliminating this practice.

AAOIFI is not the only institution working on a framework for derivatives, however. A working group was established in 2003 by the International Swaps and Derivatives Association to create a master agreement for sharia-compliant over-the-counter derivatives. Isda subsequently joined forces in 2006 with the International Islamic Financial Market (IIFM) - a collective of central banks and regulators from Bahrain, Brunei, Indonesia, Malaysia, Sudan and the Saudi Arabia-based Islamic Development Bank.

While progress on the initiative has been painfully slow, Isda said in its 2009 yearbook, published in April, that the final draft of the agreement had been passed to the IIFM board of sharia scholars for approval. It expected to publish the document in the middle of 2009. But even when the Islamic master agreement is eventually published, further work will be needed on individual confirmation forms for specific products. In addition, clarification is required in some jurisdictions in relation to close-out netting, which has been a particular source of contention from the draft stages.

Through "application or incorporation of our standards into the relevant documentation", AAOIFI will support Isda's initiative, Alchaar said. However, he adds, the absence of a highly developed Islamic derivatives market has not entirely been a bad thing, given the events of the past two years.

"Although Islamic finance has not been affected in terms of direct exposure to some of the derivatives and financial instruments underlying the global financial turmoil, it is affected by the current difficult economic environment. However, the crisis has highlighted the point that Islamic finance values - especially prohibition of speculation and excessive leverage, as well as strict requirements for asset-backed transactions - can potentially benefit the entire financial system," he concluded.

See also: The future of sharia
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