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cHaPter 1

Introduction

1.1 Objectives and Background of the Study

1.1.1 History and Developments of Islamic Finance

Islamic finance as it is practiced today is actually as old as the religion itself. Islamic finance refers to the means by which financial institutions and corporations conduct financial transactions in accordance with the principles of Shari’ah, or Islamic law.1 From a historical point of view, the Islamic financial services industry started to grow rapidly during the second-half of the 20th century. In 1956, the Malaysian government start-ed with pioneering experiments by establishing the tabung Haji, or the Pilgrims’ Management and Fund Board, in Kuala Lumpur for providing Muslims a saving service scheme free from interest.2 In short, tabung Haji was devised in order to collect and manage the funds of depositors for hajj, the pilgrimage to Mecca, and invests the funds in such a way that it complied with Shari’ah principles.3 By 1960s, the high demand for Shari’ah-compliant financing methods resulted in the establishment of egypt’s Mit Ghamr Savings Bank (1963), which earned its income from trade and through profit-sharing investments.4 Since the mid-1970s, the Middle east witnessed a rise in the price of oil, resulting in an abundance of oil revenues and financial assets in oil-producing countries.5 as a result,

1 el tiby, a.M. (2011), Islamic Banking: How to Manage Risk and Improve Profitability, John Wiley & Sons, Hoboken, new Jersey, p. xiii.

2 Omar, M.a., abduh, M., and Sukmana, r. (2013), Fundamentals of Islamic Money and Capital Markets, John Wiley & Sons, Singapore, pp. 24-25; Hassan, K., and Mahlknecht, M. (2011), Islamic Capital Markets: Products and Strategies, John Wiley & Sons, chichester, West Sussex, p. 222.

3 See also: Islamic Development Bank (1995), Tabung Haji as an Islamic Financial Institution: The Mobilization of Investment Resources in an Islamic way and the Man-agement of Hajj, Islamic research and training Institute, Jeddah, pp. 9-12.

4 Hassan, K., and Mahlknecht, M. (2011), Islamic Capital Markets: Products and Strategies, John Wiley & Sons, chichester, West Sussex, p. 313; el tiby, a.M. (2011), Islamic Banking: How to Manage Risk and Improve Profitability, John Wiley & Sons, Hoboken, new Jersey, pp. 9-10.

5 askari, H., Iqbal, Z., and Mirakhor, a. (2009), New Issues in Islamic Finance and

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these developments offered strong incentives for creating Shari’ah-com-pliant investments for Muslims wanting to comply with Shari’ah.

By 1974, the first Islamic bank was established in the United arab emir-ates, the Dubai Islamic Bank, followed by the establishment of the Islamic Development Bank (1975). Since the 1980s, Islamic finance emerged as a rapidly growing industry, even though it was a small share of the global financial market. In the sake of the rapid growth, conventional banks started offering Shari’ah-compliant financial products through ‘Islamic windows’ in an attempt to attract clients directly without having an Islamic bank as intermediary.6 today, Islamic financial services are offered by fully-fledged Islamic banks, which offer a full range of banking services, including retail, commercial, and investment banking services.7 Similarly, conventional banks offer both Islamic and conventional financial services through bank branches, but assure clients a complete segregation of con-ventional banking funds and Islamic banking funds. In fact, this requires that conventional banks establish a separate entity with different capital funds, accounts, and reporting systems.8

today, Islamic finance has established itself as a rapidly growing indus-try with an increasingly global presence, resulting in an average growth by 15 to 20 percent annually.9 although the Islamic finance industry represents less than 2 per cent of banking assets worldwide, it currently accounts $1.66 trillion to $2.1 trillion controlled by more or less 300 Islamic financial institutions in more than 75 countries.10 By being one of the fastest growing segments in the global financial industry, it is no surprise that parallel to the growth the demand for Shari’ah-compliant risk mitigation arrangements is growing accordingly. as the Islamic finance industry grows, the financial institutions and corporations oper-ating on Shari’ah principles can no longer afford to leave their positions unhedged.11

Economics: Progress and Challenges, John Wiley & Sons, Singapore, p. 2.6 askari, H., Iqbal, Z., and Mirakhor, a. (2009), New Issues in Islamic Finance and

Economics: Progress and Challenges, John Wiley & Sons, Singapore, p. 3.7 Jackson-Moore, e. (2009), International Handbook of Islamic Banking and Finance,

Global Professional Publishing, cranbrook, p. 10.8 Solé, J. (2007), ‘Introducing Islamic Banks into Conventional Banking Systems’, Inter-

national Monetary Fund, IMF Working Paper 2007/175, p. 5.9 Hussain, M., Shahmoradi, a., and turk, r. (2015), ‘An Overview of Islamic Finance’,

International Monetary Fund, IMF Working Paper 2015/120, p. 29; See also Lukonga, I. (2015), ‘Islamic Finance, Consumer Protection, and Financial Stability’, International Monetary Fund, IMF Working Paper 2015/107, p. 8.

10 Čihák, M., and Hesse, H. (2008), ‘Islamic Banks and Financial Stability: An Empirical Analysis’, International Monetary Fund, IMF Working Paper 2008/16, p. 3.

11 cfr. tabash, M.I., and Dhankar, r.S. (2014), ‘The Impact of Global Financial Crisis on

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1.1.2 Risk Management, Derivatives, and Hedging Practices in Islamic Finance

Over the past centuries, derivatives have become a commonplace oc-currence, primarily to protect, minimize or neutralize any exposure to risks. as we know, in today’s volatile financial markets, financial institutions and corporations are subject to a wide range of risks in the course of their operations.12 although derivatives have been in existence for centuries and have a widespread use, derivatives as such are few and far in Islamic countries and have no precedents under Shari’ah.13 From a Shari’ah perspective, Shari’ah scholars have come out very strongly in objecting the use of derivatives.14 Shari’ah scholars commonly argue that derivatives fall into the category of gambling and speculation (maysir and qimar) and uncertainty (gharar), which are prohibited from a Shari’ah viewpoint.15 Shari’ah recognizes a range of contracts with derivative-like features that might be used and that can serve as partial proxies for some derivatives.16 In addition, Shari’ah recognizes the concept of hedging of risks, which must be seen in the light of wealth protection, justice, and fairness for parties. From a Shari’ah viewpoint, making a profit is only allowed if it is made on real economic activities, which involves taking

the Stability of Islamic Banks: An Empirical Evidence’, Journal of Islamic Banking and Finance 2014/2, p. 368; See also ISDa news release, March 2010, IIFM and ISDA Launch Tahawwut (Hedging) Master Agreement.

12 See also el tiby, a.M. (2011), Islamic Banking: How to Manage Risk and Improve Profitability, John Wiley & Sons, Hoboken, new Jersey, pp. 27-45.

13 askari, H., Iqbal, Z., Krichene, n., and Mirakhor, a. (2010), The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future, John Wiley & Sons, Singapore, p. 157-159; See also Jobst, a.a., and Solé, J. (2012), ‘Operative Principles of Islamic Derivatives: Towards a Coherent Theory’, International Monetary Fund, IMF Working Paper 2012/63, p. 3; Jobst, a.a. (2007), ‘Derivatives in Islamic Finance’, Journal of Islamic Economic Studies, 15/1, p. 2.

14 cfr. Kunhibava, S., and Shanmugam B. (2010), ‘Shari’ah and Conventional Law Ob-jections to Derivatives: A Comparison’, Arab Law Quarterly 24, 4, pp. 319-360; cfr. Kunhibava, S. (2010), Derivatives in Islamic Finance, International Shari’ah research academy for Islamic Finance (ISra), ISra research Paper 7/2010, pp. 8-32.

15 askari, H., Iqbal, Z., Krichene, n., and Mirakhor, a. (2010), The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future, John Wiley & Sons, Singapore, p. 157-159.

16 Malwaki, B.H. (2014), ‘Financial Derivatives between Western legal tradition and Islamic finance: A Comparative approach’, Journal of Banking Regulation,15/1, p. 47; Kunhibava, S. (2010), Derivatives in Islamic Finance, International Shari’ah research academy for Islamic Finance (ISra), ISra research Paper 7/2010, pp. 34-46; Kun-hibava, S. (2009), Overcoming Shari’ah Objections to Derivatives in Islamic Finance through Comparative Analysis, Doctoral Dissertation, School of Business and eco-nomics, Department of accounting and Finance, Monash University, pp. 242-243.

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essential risks and liabilities.17 also, Shari’ah recognizes that taking risks is inherent to economic activity, but contracting parties should always take steps of precaution in order to minimize loss due to certain risks.18 In other words, parties should adopt hedging to ensure risk reduction to a minimum while maintaining good possibilities for generating a return on investments.19

ISDA/IIFM Tahawwut (hedging) Master AgreementOn 1 March 2010, the International Swaps and Derivatives association (ISDa) in cooperation with the Bahrain-based International Islamic Fi-nancial Market (IIFM), published the ISDa/IIFM Tahawwut (hedging) Master agreement.20 Like the 2002 ISDa Master agreement, the ISDa/IIFM Tahawwut (hedging) Master agreement is a multi-product master or standard framework. The launch of the ISDa/IIFM Tahawwut (hedg-ing) Master agreement is a significant milestone for the industry, and marks the introduction of the first globally standardized bilateral master documentation for documenting privately negotiated Shari’ah-compli-ant over-the-counter (Otc) derivatives. It is an important step forward towards the standardization of the derivatives market, which on the long term should pave the way for bringing more liquidity, efficiency, and certainty to the market. In particular, it facilitates a benchmark for market participants to keep their eyes peeled on key commercial terms of individual transactions. at the same time, the launch of a standard legal framework shows a substantial fall of costs, reduced closing times for execution of transactions, and a decline in the price divergence between Shari’ah-compliant derivatives and their conventional counterparts. On the other side, the ISDa/IIFM Tahawwut (hedging) Master agreement provides only a structure for documenting murabaha and musawama transactions for effecting profit rate swaps and currency swaps. It is, therefore, important to develop in the near future specific standardized template product documentation for other Shari’ah-compliant hedging transactions in order to provide market participants a wide range of hedging products.

17 agha, S.e.U, and Sabirzyanov, r. (2015), ‘Risk Management in Islamic Finance: An Analysis from Objectives of Shari’ah Perspective’, International Journal of Business, Economics and Law, 7/3, p. 46.

18 razif, F.M., and Mohamad, S., and rahman, n.n.a. (2012), ‘Permissibility of Hedging in Islamic Finance’, Middle-East Journal of Scientific Research, 12/2, p. 156.

19 Ibid., p. 156.20 ISDa news release, March 2010, IIFM and ISDA Launch Tahawwut (Hedging) Master

Agreement.

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1.1.3 Scope, Methodology, and Limitations of the Study

In responding to the research question outlined in the following para-graph, the first part of this research focuses on a review of the existing literature and the theory in the field of Islamic finance. Before dwelling into different kinds of exotic derivatives, the scope of this research is only concerned with discussing the basic types of derivatives from a risk management perspective. In particular, this research examines over-the-counter (off-exchange) traded forwards, futures, swaps, and options. In addition, in terms of its limited content, this research explores just a few Shari’ah-compliant contracts, which can serve some of the risk-mitigat-ing characteristics of the aforementioned over-the-counter derivatives.

1.2 Research Questions

The aim of this research is to explore and analyze the objections from a Shari’ah perspective towards the use of derivatives. In this regard, this research outlines how the ISDa/IIFM Tahawwut (hedging) Master agreement has been adapted to take the concerns with respect to these derivatives away, while providing a standardized master framework that strictly complies with the Shari’ah principles and concepts. In addition, this research discusses the salient differences and parallels between the ISDa/IIFM Tahawwut (hedging) Master agreement and the 2002 ISDa Master agreement on which it was based. In doing so, this research maps out the following research question:

What are the objections from a Shari’ah perspective towards the use of derivatives in their conventional forms, and how has the ISDA/IIFM Tahawwut (hedging) Master Agreement been adapted to take the concerns with respect to these derivatives away, while providing a standardized master framework that strictly complies with the Shari’ah principles and concepts?

In answering the identified research question, the following specific questions were developed in order to answer the research question:1. What are the origins, objectives, and underlying principles and

concepts of the Islamic financial services industry?2. What is the nature of a derivative, its origin, and rationale for using

it?3. What are the objections from a Shari’ah perspective towards the use

of derivatives that challenge the permissibility of derivatives?4. Which Shari’ah-compliant contracts with derivative-like features

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exist which may mirror some of the risk-mitigating characteristics of derivatives in order to replicate the effects of derivatives?

5. Which key deviations have been made from the 2002 ISDa Master agreement in order to arrive at the ISDa/IIFM Tahawwut (hedging) Master agreement and why?

6. Which types of Shari’ah-compliant transactions are contemplated by the ISDa/IIFM Tahawwut (hedging) Master agreement and how do they work?

7. How has the ISDa/IIFM Tahawwut (hedging) Master agreement been adapted to take the concerns from a Shari’ah perspective towards derivatives away?

1.3 Outline of the Chapters

as we are going to see, chapter 2 sets the scene for the following chapters by addressing the basic features and principles of Islamic finance. In doing so, it also outlines the principle-based canonical legal system on which Islamic finance is based. Islamic finance is founded on a some-what different paradigm than conventional finance, and therefore, it may appear controversial to those accustomed to conventional finance. to that end, chapter two charts the parallels and differences between Islamic finance and conventional finance. The chapter then moves on by touching the Shari’ah principles for commercial contracts and their day-to-day workings.

Chapter 3 begins by examining the key characteristics of derivatives, including the nature of derivatives, their origins, and the rationale for using them. The chapter then continues in further detail by discussing the objectives and origins of hedging instruments, derivatives, and risk management from a Shari’ah perspective. also, this chapter highlights the Shari’ah objections that challenge the permissibility of derivatives. In addition, it explores a range of Shari’ah-compliant contracts that exist which may mirror some of the risk-mitigating characteristics of deriva-tives contracts in order to replicate the effects of derivatives.

Chapter 4 answers the research question. But, before doing that, it unveils different cornerstones of the ISDa/IIFM Tahawwut (hedging) Master agreement.

Chapter 5 will conclude the whole research.

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